978-0134200057 Chapter 9 Lecture Notes

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PART FOUR

WORLD FINANCIAL ENVIRONMENT

CHAPTER NINE

GLOBAL FOREIGN-EXCHANGE MARKETS

OBJECTIVES

9-1 Define what foreign exchange is and who the major players are in the

foreign-exchange market

9-2 Summarize the major characteristics of the foreign-exchange market

9-3 Compare and contrast spot, forward, options, and futures markets

9-4 Explain some of the major aspects of the foreign-exchange markets

9-5 Show companies use foreign exchange to facilitate international trade

CHAPTER OVERVIEW

The foreign-exchange market consists of all those players who buy and sell

foreign-exchange instruments for business, speculative, or personal purposes. Primarily,

foreign exchange is used to settle international trade, licensing, and investment

transactions. Chapter Nine explains in detail basic concepts (such as rates, instruments,

and convertibility) and explores the major characteristics of the foreign-exchange

markets. The chapter includes a discussion of the foreign-exchange trading process that

focuses on both the over-the-counter and the exchange-traded markets, i.e., banks,

securities exchanges, electronic brokerages, and the respective roles they play.

CHAPTER OUTLINE

OPENING CASE: Going Down to the Wire in the Money-Transfer Market

This case describes Western Union’s international money transfer services and the

increasing competition the company is facing from a variety of sources. Western Union

has been particularly successful in attracting business from Mexican emigrants in the

United States who send part of their paycheck home to support their families. Financial

institutions such as banks have pressured Western Union to use better exchange rates.

This new onslaught of competition by banks has forced Western Union to cut its fees

and offer new services, including a home delivery service, where money is delivered

directly to the recipient’s door. Western Union is also moving into countries such as

China and India to boost its market share. The increased competition has driven down

remittance fees around the world. Western Union has also developed other delivery

mechanisms, including online and mobile delivery.

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I. WHAT IS FOREIGN EXCHANGE AND WHO ARE THE MAJOR PLAYERS

IN THE MARKET?

Foreign exchange is money denominated in the currency of another nation or group

of nations, i.e., it is a financial instrument issued by countries other than one’s own.

An exchange rate is the price of one currency expressed in terms of another, i.e., the

number of units of one currency needed to buy a unit of another.

The foreign-exchange market is made up of several players. The Bank of

International Settlements (BIS), a Swiss-based central banking institution, divides

the market into three major players: reporting dealers, other financial institutions,

and non-financial institutions. Reporting dealers are also known as money center

banks and include large banks such as Deutsche Bank and HSBC. Other financial

institutions include commercial banks other than money center banks (local and

regional banks), hedge funds, pension funds, money market funds, currency funds,

mutual funds, and specialized foreign-exchange trading companies. Non-financial

customers include governments and companies.

II. SOME ASPECTS OF THE FOREIGN-EXCHANGE MARKET

A. How to Trade Foreign Exchange

The foreign-exchange market is comprised of two major segments. The

over-the-counter market (OTC) includes commercial banks, investment banks, and

other financial institutions—this is where most foreign-exchange activity occurs.

The exchange-traded market includes certain securities exchanges (e.g., the Chicago

Mercantile Exchange and NASDAQ OMX) where particular types of

foreign-exchange instruments (such as futures and options) are traded.

B. Global OTC Foreign-Exchange Instruments

The phrase “global OTC foreign-exchange instruments” refers to spot transactions,

outright forwards, FX swaps, currency swaps, currency options, and other

foreign-exchange products. These instruments are all traded in the markets

mentioned above.

1. Spot transactions involve the exchange of currency “on the spot,” or

technically, transactions that are settled within two business days after the

date of agreement to trade. The spot rate is the exchange rate quoted for

transactions that require the immediate delivery of foreign currency, i.e.,

within two business days.

2. Outright forward transactions involve the exchange of currencies beyond

two days following the date of agreement at a set rate known as the

forward rate. In an FX swap (a simultaneous spot and forward transaction),

one currency is swapped for another on one date and then swapped back on

a future date. In fact, the same currency is bought and sold simultaneously,

but delivery occurs at two different times.

3. Currency swaps deal with interest-bearing financial instruments (such as

bonds) and involve the exchange of principal and interest payments.

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4. An option is a foreign-exchange instrument that guarantees the purchaser

the right (but does not impose an obligation) to buy or sell a certain amount

of foreign currency at a set exchange rate within a specified amount of

time.

5. A futures contract is a foreign-exchange instrument that specifies an

exchange rate, an amount, and a maturity date in advance of the exchange

of the currencies, i.e., it is an agreement to buy or sell a particular currency

at a particular price on a particular future date.

C. Size, Composition, and Location of the Foreign-Exchange Market.

The BIS estimated in its 2013 survey of global foreign-exchange activity that daily

foreign-exchange turnover was $5.3 trillion, an increase of 32.5 percent over the

2010 survey. However, the rise in activity was much smaller than the 71 percent

increase from 2004 to 2007 due to the global economic crisis that began in 2008.

Current daily turnover (mid-2016) is estimated to be closer to $7 trillion.

a. Using the U.S. Dollar on the Foreign-Exchange Market. The

The U.S. dollar is the most important currency on the foreign-exchange

market; in the latest BIS Survey, it was one side (buy or sell) of 87 percent of

all foreign currency transactions worldwide, as Table 9.1. Although the dollar,

euro, yen, and pound sterling are the most widely traded currencies, the

Chinese yuan is steadily growing in importance. There are five major reasons

why the dollar is so widely traded:

1. It’s an investment currency in many capital markets.

2. It’s a reserve currency held by many central banks.

3. It’s a transaction currency in many international commodity markets.

4. It’s an invoice currency in many contracts.

5. It’s an intervention currency employed by monetary authorities in

market operations to influence their own exchange rates.

b. Frequently Traded Currency Pairs. The dollar, the most traded

currency in the world, is part of four of the top seven currency pairs: the

dollar/euro and the dollar/yen are the top two. Because of the importance of the

U.S. dollar in foreign exchange trade, the exchange rate between two

currencies other than the dollar—for example, the exchange rate between the

euro and the Brazilian real—is known as a cross rate.

c. The Euro. The euro is also in four of the top ten currency pairs. The top

three currency pairs involving the euro are the dollar, the yen, and the British

pound. However, the euro is also important for other currencies in the EU that

are not part of the monetary union as well as non-EU countries in Europe, such

as Turkey.

D. Foreign-Exchange Trades and Time Zones.

If the U.S. dollar is the most widely traded currency in the world, why is London so

important as a trading center? There are two major reasons. First, London, which is

close to the major capital markets in Europe, is a strong international financial

center where many domestic and foreign financial institutions operate. Thus, its

geographic location relative to significant global economic activity is key [see

Figure 9.1]. Second, London is positioned in a unique way because of its time zone

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[see Map 9.1].

III. MAJOR FOREIGN-EXCHANGE MARKETS

A. The Spot Market

The spot market consists of players who conduct those foreign-exchange

transactions that occur “on the spot,” or technically, within two business days

following the date of agreement to trade. Foreign-exchange traders always quote a

bid (buy) and offer (sell) rate. The bid is the rate at which traders buy foreign

exchange; the offer is the rate at which traders sell foreign exchange. The spread is

the difference between the bid and offer rates, i.e., it is the profit margin of the

trade.

Exchanges can be quoted in American terms, i.e., a direct quote that gives the

value in dollars of a unit of foreign currency, or European terms, i.e., an indirect

quote that gives the value in foreign currency of one U.S. dollar. The base

currency, or the denominator, is the quoted, underlying, or fixed currency; the

terms currency is the numerator. Most large newspapers quote exchange rates

daily, listing both spot and forward rates. The spot rates listed are usually the

selling rates for interbank transactions (transactions between banks) of $1 million

or more.

B. The Forward Market

The forward market consists of those players who conduct foreign-exchange

transactions that occur at a set rate beyond two business days following the date of

agreement to trade. The forward rate is the rate quoted today for the future delivery

of a foreign currency. A forward contract is entered into whereby the customer

agrees to buy (or sell) over the counter a specified amount of a specific currency at

a specified price on a specific date in the future.

1. Forward Discounts and Premiums. The difference between the spot

and forward rates is either the forward discount (the forward rate, i.e., the

future delivery price, is lower than the spot rate) or the forward premium

(the forward rate is higher than the spot rate).

C. Options

An option is a foreign-exchange instrument that guarantees the right, but does not

impose an obligation, to buy or sell a foreign currency within a certain time period

or on a specific date at a specific exchange rate (called the strike price). Options

can be purchased over the counter from a commercial or investment bank or on an

exchange. The writer of the option will charge a fee, known as the premium. An

option is more flexible, but also more expensive, than a forward contract.

D. Futures

A foreign currency future resembles a forward contract because it specifies an

exchange rate sometime in advance of the actual exchange of the currency.

However, a future is traded on an exchange, not OTC. While a forward contract is

tailored to the amount and time frame the customer needs, futures contracts have

preset amounts and maturity dates. The futures contract is less valuable to a firm

than a forward contract, but it may be useful for small transactions or speculation.

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IV. THE FOREIGN-EXCHANGE TRADING PROCESS

When a firm needs foreign exchange, it typically goes to its commercial bank. If the

bank is large enough, it may have its own foreign-exchange traders. A smaller bank,

dealing either on its own account or for a client, can trade foreign exchange directly

with another bank or through a foreign exchange broker, who matches the best bid and

offer quotes of interbank traders. The foreign-exchange process can be seen in Figure

8.6.

A. Banks and Exchanges

At one time, only big money center banks could deal directly in foreign exchange.

Now, with the advent of electronic trading, smaller regional banks can hook up to

Reuters or Bloomberg and deal directly in the interbank market. In spite of these

developments, the greatest volume of foreign-exchange activity still takes place

with the big money center banks.

1. Top Foreign-Exchange Dealers. The top banks in the interbank market

are chosen because of their location, expertise in major and specific

currencies, and ability to deal in different financial instruments.

B. Top Exchanges for Trading Foreign Exchange

Major exchanges that deal in foreign currency derivatives are the CME Group,

NASDAQ, and NYSE:ICE.

1. CME Group. The Chicago Mercantile Exchange (CME) offers futures

and options contracts in numerous foreign currencies. CME uses three

electronic trading platforms to trade different commodities, including

currencies: CME Globex, DME Direct, and CME Clearport.

2. NASDAQ OMX. In 2008, The Philadelphia Stock Exchange merged with

NASDAQ OMX. NASDAQ trades options in seven currencies—the

Australian dollar, the British pound, the Canadian dollar, the euro, the

Swiss franc, the New Zealand dollar, and the Japanese yen.

3. NYSE:ICE. In 2013, Intercontinental Exchange (ICE) purchased

NYSE Euronext, forming NYSE:ICE. The combined company is a

giant in futures and options. ICE Futures US offers cross-trades in a

number of currencies through ICE’s futures contracts on key currency

pairs traded in the interbank market through an electronic trading

platform

IV. HOW COMPANIES USE FOREIGN EXCHANGE

Companies enter the foreign-exchange market to facilitate their regular business

transactions and/or to speculate.

A. Cash Flow Aspects of Imports and Exports

When a company must move money to pay for purchases or receives money for

sales, it has an option on the documents it can use, the currency of denomination,

and the degree of protection it can ask for.

1. Commercial Bills of Exchange. In order for these transactions to take

place, a number of documents are needed, including a draft and a letter of

credit. A draft or commercial bill of exchange is an instrument in which

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one party directs another to make a payment. If the exporter demands

payment to be made immediately, the draft is called a sight draft. If the

payment is to be made later, it is called a time draft.

2. Letters of Credit. With a bill of exchange, it is always possible the

importer will not be able to make the payment to the exporter. A letter of

credit (L/C) obligates the buyer’s bank to honor the draft. There are still

risks with an L/C. It must adhere to all the conditions in the document in

order to be valid. A letter of credit may also be confirmed by another bank

and is called a confirmed letter of credit.

B. Other Financial Flows

Companies also deal in foreign exchange for other transactions, such as the

receipt or payment of dividends or the receipt or payment of loans and interest.

1. Speculation. Sometimes companies deal in foreign exchange for profit.

Speculation involves buying (or selling) a currency based on the

expectation it will gain (or lose) in strength against other currencies.

Although speculation offers the chance to profit, it also contains an

element of risk.

2. Arbitrage. Profit-seekers may engage in arbitrage, i.e., they may purchase

foreign currency on one market for immediate resale on another market (in

a different country) in order to profit from a price discrepancy. Interest

arbitrage involves investing in debt instruments (such as bonds) in

different countries in order to maximize profits by capturing interest-rate

and exchange-rate differentials.

POINT—COUNTERPOINT: Is it OK to Speculate on Currency?

POINT: Currency speculation is not illegal, nor is it necessarily bad. Speculators are

merely trying to make a profit by trading based on market trends. Currency speculation

allows investors to diversify their portfolios from traditional stocks and bonds, which

are themselves, forms of speculative investment.

COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign

exchange or securities, to make money illegally or contrary to company policy.

Nicholas Leeson, a 28-year-old trader for British bank Barings PLC was chief dealer for

the bank in Singapore. Leeson had no checks and balances on his trading and made big

bets on stock index futures assuming that the Tokyo stock market would rise. After the

January 17, 1995, earthquake in Kobe, Japanese stocks plunged and Leeson had to come

up with cash to cover the margin call. With lax internal controls, Leeson was able to

make numerous questionable and illegal transactions to illicitly generate the cash needed

to cover his positions. These actions resulted in huge losses in excess of $1 billion for

Barings, putting the company into bankruptcy. Since the collapse of Barings, measures

have been put into place in banks to prohibit such consequences, yet the occurrence of

and potential for negative outcomes from rogue trading continue to exist. Another

recent example, Jerome Kerviel of the French bank Societe Generale shows the ongoing

risk for banks to lose significant amounts of money.

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LOOKING TO THE FUTURE:

Where Are Foreign-Exchange Markets Headed?

The speed at which transactions are processed and information is transmitted globally

will continue to lead to greater efficiencies and more opportunities in foreign-exchange

markets. Companies’ costs of trading foreign exchange should come down and they

should gain faster access to more currencies. Government exchange restrictions should

diminish as currency markets are liberalized. The big change in the future will be the

increasing usage of the yuan in global transactions, especially for countries that trade

with China. The yuan can only be successful as a major player in the global

foreign-exchange market as it becomes more accepted as a reserve currency that

countries have confidence in. As the yuan increases in importance, it will be interesting

to see how much Singapore and Hong Kong will increase in importance, and whether or

not Shanghai will increase in importance. In 2009, the Bitcoin was launched, ushering in

the world of cryptocurrencies, also known as virtual or digital currencies. Although

other virtual currencies, such as Ethereum, have been launched, Bitcoin is still the

number one virtual currency—but Ethereum is gaining ground.

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