Global Foreign Exchange Markets

Global Foreign Exchange Markets

Chapter 9

Global Foreign Exchange Markets

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

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Learning Objectives (1 of 2)

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

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

Learning Objectives for the chapter.

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Learning Objectives (2 of 2)

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

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

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

Learning Objectives for the chapter.

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Foreign Exchange

Objective 9-1

What is foreign exchange?

Exchange rates

Bank for International Settlements (BIS)

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

Learning Objective 1: Define what foreign exchange is and who the major players are in the foreign-exchange market.

Foreign exchange is money denominated in the currency of another nation or group of nations. The market in which such transactions take place is the foreign-exchange market. Foreign exchange can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits, or other short-term claims.

An exchange rate is the price of a currency—specifically, the number of units of one currency that buy one unit of another currency. The number can change daily. The foreign-exchange market is made up of many different players.

The Bank for International Settlements (BIS), a financial organization centered in Basel, Switzerland, owned and controlled by 60 member central banks, divides the market into three major categories: reporting dealers, other financial institutions, and nonfinancial institutions.

Reporting dealers, also known as money center banks, are large financial institutions that actively participate in local and global foreign-exchange and derivative markets smaller local and regional commercial banks, investment banks and securities houses, hedge funds, pension funds, money market funds, currency funds, mutual funds, specialized foreign-exchange trading companies, and so forth.

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How Foreign Exchange is Traded

Objective 9-1

Ways of trading

Electronic means

Two major segments

Over the counter market

Exchange traded market

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Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

Dealers can trade foreign exchange

directly with customers,

through voice brokers,

through electronic,

brokerage systems, or

directly through interbanks.

Recently, more than 50 percent of foreign-exchange trading volume was being executed by electronic means.

.

The foreign-exchange market has two major segments: the over-the-counter market (OTC) and the exchange-traded market. The OTC market is composed of commercial banks as just described, investment banks, and other financial institutions. The exchange-traded market comprises securities exchanges, such as the CME Group, NASDAQ OMX, and Intercontinental Exchange (ICE), where certain types of foreign-exchange instruments, such as futures and options, are traded.

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Global OTC Foreign Exchange Instruments

Objective 9-2

Spot transactions

Outright forward transactions

FX Swap

Currency swap

Options

Futures

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Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

Spot transactions involve the exchange of currency for delivery in two business days the day the transaction was made. For example, a bank would quote an exchange rate for a transaction on Monday, but delivery would take place on Thursday. The rate at which the transaction is settled is the spot rate.

Outright forward transactions involve the exchange of currency on a future date beyond two business days. It is the single purchase or sale of a currency for future delivery. The rate at which the transaction is settled is the forward rate and is a contract rate between the two parties. The forward transaction will be settled at the forward rate no matter what the actual spot rate is at the time of settlement.

In an FX swap, one currency is traded for another on one date and then swapped back later. Most often, the first or short leg of an FX swap is a spot transaction and the second or long leg a forward transaction. Let’s say IBM receives a dividend in British pounds from its subsidiary in the United Kingdom but has no use for British pounds until it has to pay a UK supplier in 30 days. It would rather have dollars now than hold on to the pounds for a month. IBM could enter into an FX swap in which it sells the pounds for dollars to a dealer in the spot market at the spot rate and agrees to buy pounds for dollars from the dealer in 30 days at the forward rate.

Currency swaps deal more with interest-bearing financial instruments (such as a bond) and involve the exchange of principal and interest payments.

Options are the right, but not the obligation, to trade foreign currency in the future.

A futures contract is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date, as specified in a standardized contract to all participants in a currency futures exchange rather than in the over-the-counter market.

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The U.S. Dollar and Foreign Exchange Markets

Objective 9-2

U.S. Dollar as currency on the foreign exchange market

Insert table 9.1

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Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

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

Reasons for use of US Dollar:

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

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

It’s an invoice currency in many contracts.

It’s an intervention currency employed by monetary authorities in market operations to influence their own exchange rates.

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London as a Trading Center

Objective 9-2

London as an important Trading Center

Geographic Location

Time Zone

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Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

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.

Second, London is positioned in a unique way because of its time zone. As Map 9.1 shows, noon in London is 7:00 a.m. in New York and evening in Asia. The London market opens toward the end of the trading day in Asia and is going strong as the New York foreign-exchange market opens up. Thus, the city straddles both of the other major world markets.

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Geographical Distribution of Foreign Exchange Markets

Objective 9-2

Figure 9.1 Foreign-Exchange Markets: Geographical Distribution, September 2013

Source: Based on Bank for International Settlements, Central Bank Survey Report on Foreign Exchange Turnover in April 2013: Preliminary Global Results (Basel, Switzerland: BIS, September 2013: 14): 1.

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Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

This figure shows the Geographical distribution of foreign exchange markets.

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The Spot Market

Objective 9-3

Bid Rate

Direct and Indirect quotes

Base and term currencies

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Learning Objective 3: Compare and contrast spot, forward, options, and futures markets.

The spot market is for foreign-exchange transactions that occur within two business days.

Rates are quoted by foreign-exchange dealers. The bid (buy) rate is the price at which the dealer is willing to buy foreign currency; the offer (sell) is the price at which the dealer is willing to sell foreign currency. The difference between the bid and offer rates is the dealer’s profit margin.

Direct and Indirect Quotes Let’s look at an example of how a bid and offer might work. For example, the rate a U.S.-based dealer quoted for the British pound on April 1, 2016, was $1.4228/30. This means the dealer is willing to buy pounds at $1.4228 each and sell them for $1.4230 each (i.e., buying low and selling high). In this example, the dealer quotes the foreign currency as the number of U.S. dollars for one unit of that currency. This method of quoting exchange rates is called the direct quote, which is the number of units of the domestic currency (the U.S. dollar in this case) for one unit of the foreign currency. It is also known as American terms.

The other convention for quoting foreign exchange is known as the indirect quote, or European terms. It is the number of units of the foreign currency for one unit of the domestic currency.

Base and Term Currencies: When dealers quote currencies to their customers, they always quote the base currency (the denominator) first, followed by the terms currency (the numerator).

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The Forward, Options, and Futures Markets

Objective 9-3

Forward Markets

Forward Discount

Forward Premium

Option

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Learning Objective 3: Compare and contrast spot, forward, options, and futures markets.

As noted earlier, the spot market is for foreign-exchange transactions that occur within two business days. But in some transactions, a seller extends credit to the buyer for a period longer than that. For example, a Japanese exporter of consumer electronics might sell television sets to a U.S. importer with immediate delivery but payment due in 30 days. The U.S. importer is obligated to pay in yen in 30 days and may enter into a contract with a currency dealer to deliver the yen at a forward rate—the rate quoted today for future delivery. This is a forward market.

Building on what we said earlier, we now can say that the difference between the spot and forward rates is either the forward discount or the forward premium.

An option is the right, but not the obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate.

A foreign currency futures contract resembles a forward contract insofar as it specifies an exchange rate some time in advance of the actual exchange of currency. However, a future is traded on an exchange, not OTC. Instead of working with a bank or other financial institution, companies work with exchange brokers when purchasing futures contracts.

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Foreign Exchange Markets

Objective 9-4

Largest Markets

CME Group

NASDAQ

NYSE: ICE

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Learning Objective 4: Explain some of the major aspects of the foreign-exchange markets.

When a company sells goods or services to a foreign customer and receives foreign currency, it needs to convert it into the domestic currency. When importing, the company needs to convert domestic to foreign currency to pay the foreign supplier. This conversion usually takes place between the company and its bank.

At one time, only the big money center banks could deal directly in foreign exchange. Regional banks had to rely on them to execute trades on behalf of their clients. The emergence of electronic trading has changed that.

Top exchanges for foreign transactions .

CME Group The CME Group was formed on July 9, 2007, as a merger between the Chicago Mercantile Exchange and the Chicago Board of Trade. The CME operates according to so-called open outcry: Traders stand in a pit and call out prices and quantities. The platform is also linked to an electronic trading platform, which is growing rapidly.

NASDAQ Prior to 2008, the Philadelphia Stock Exchange was one of the pioneers in trading currency options. In July 2008, PHLX merged with NASDAQ OMX, and in 2014, the name was changed to NASDAQ. 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.

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.

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The Foreign Exchange Trading Process: A Visual

Objective 9-4

Figure 9.3 The Foreign-Exchange Trading Process

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Learning Objective 4: Explain some of the major aspects of the foreign-exchange markets.

This figure visually shows the trading process for foreign exchange.

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How Companies Use Foreign Exchange

Objective 9-5

Draft or Commercial Bill of Exchange

Letter of Credit

Speculation

Arbitrage

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Learning Objective 5: Show how companies use foreign exchange to facilitate international trade.

Companies enter the foreign-exchange market to facilitate their regular business transactions and/or to speculate. Their treasury departments are responsible for establishing policies for trading currency and for managing banking relationships to make the trades. From a business standpoint, a company, first of all, trades foreign exchange for exports/imports and the buying or selling of goods and services.

When Boeing sells the new 787 Dreamliner commercial airplane to LAN, the largest airline in South America, it has to be concerned about the currency in which it will be paid and how it will receive payment. In this case, the sale is probably denominated in dollars, so Boeing will not have to worry about the foreign-exchange market (nor, in theory, will its employees). However, LAN will have to worry about the market. Where will it come up with the dollars, and how will it pay Boeing?

An individual or a company that pays a bill in a domestic setting can pay cash, but checks are typically used—often electronically transmitted. The check is also known as a draft or a commercial bill of exchange. A draft is an instrument in which one party (the drawer) directs another party (the drawee) to make a payment. The drawee can be either a company, like the importer, or a bank. In the latter case, the draft would be considered a bank draft.

With a bill of exchange, it is always possible that the importer will not be able to make payment to the exporter at the agreed-upon time. A letter of credit (L/C), however, obligates the buyer’s bank in the importing country to honor a draft presented to it, provided the draft is accompanied by the prescribed documents.

Speculation: Companies sometimes deal in foreign exchange for profit. This is especially true for some banks and all hedge funds. But sometimes corporate treasury departments see their foreign-exchange operations as profit centers and also buy and sell foreign exchange with the objective of earning profits.

One type of profit-seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy. For example, a dealer might sell U.S. dollars for Swiss francs in the United States, then Swiss francs for British pounds in Switzerland, then the British pounds for U.S. dollars back in the United States, with the goal of ending up with more dollars.

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Copyright

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved.


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