International Business Lecture No 41 By Dr Shahzad

International Business Lecture No, 41 By Dr. Shahzad Ansar

• The Foreign Exchange Market

Definitions • Foreign Exchange Market: –A market for converting the currency of one country into the currency of another. • Exchange Rate: –The rate at which one currency is converted into another.

OBJECTIVES – To learn the fundamentals of foreign exchange – To identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders – To understand why companies deal in foreign exchange – To describe how the foreign-exchange market works – To examine the different institutions that deal in foreign exchange

Introduction – Fundamental difference between payment transactions • Domestic transaction—use only one currency • Foreign transaction—use two or more currencies – Foreign exchange— money denominated in the currency of another group of nations

• Foreign-exchange market—made up of: –over-the-counter (OTC) » commercial and investment banks » majority of foreign-exchange activity –security exchanges » trade certain types of foreignexchange instruments

Exchange rate—price of currency Number of units of one currency that buys one unit of another currency Exchange rate can change daily

Foreign-Exchange Instruments – Spot transactions —exchange rate quoted for transactions that require either immediate delivery or delivery within two days • Spot rate— settlement rate for the transaction – Outright forward—exchange currency beyond three days at a fixed exchange rate • Single purchase or sale of a currency for future delivery • Forward rate—settlement rate for transaction

Foreign-Exchange Instruments – FX swap—a simultaneous spot and forward transaction – Currency swaps—involve interest-bearing financial instruments • Exchange of principal and interest payments • Options—the right but not the obligation to trade foreign currency in the future • Futures contract—agreement to buy or sell a currency in the future at a particular price

The Foreign-Exchange Market – Size of foreign-exchange market • $1. 5 trillion daily in traditional instruments • $110 billion daily in other OTC and exchange-traded instruments • Spot transactions are only 40%t of total transactions

The Foreign-Exchange Market – U. S. dollar is the most important currency because it is: • An investment currency in many capital markets • A reserve currency held by many central banks • A transaction currency in many international commodity markets • An invoice currency in many contracts • An intervention currency employed by monetary authorities to influence their exchange rates – London—the biggest market foreign exchange

Average Daily Volume in World Foreign. Exchange Markets, 1989– 1998 U. S. dollars (billions) 1600 1, 500 1400 1, 190 1200 1000 820 800 600 590 400 200 0 1989 1992 1995 1998 Years 12

Average Daily Volume of Foreign-Exchange Transactions $350. 90 $451. 20 $78. 60 $81. 70 $139 $94. 30 $148. 60 $637. 30 United States Hong Kong Switzerland Germany Japan United Kingdom Singapore Others 13

Key Foreign-Exchange Terms for the Spot Market – Bid—price at which traders are willing to buy foreign currency – Offer—price at which traders are willing to sell foreign currency – Spread—difference between bid and offer price • Profit margin for the trader – Direct quote—the number of U. S. dollars per unit of foreign currency • American terms—perspective of U. S. trader

Key Foreign-Exchange Terms for the Spot Market – Indirect quote—the number of units of foreign currency per U. S. dollar • European terms—perspective of European trader – base currency—U. S. dollar – terms currency—other currency in exchange – Cross rate—exchange rate between non– U. S. dollar currencies

The Forward Market – Most widely traded currencies • British pound, Canadian dollar, French franc, German mark, Japanese yen, and U. S. dollar • Many currencies do not have a forward market due to the small size and volume of transactions

– Forward rate—the rate quoted for transactions after two days • Forward discount—the forward rate foreign currency is less than the spot rate • Forward premium—the forward rate foreign currency is greater than the spot rate • Options – Option—the right but not the obligation to trade a foreign currency at a specific exchange rate • Can be purchased OTC or from an exchange • Forward contract is cheaper but less flexible than an option

Futures – Futures contract—specifies in advance the exchange rate to be used in exchanging currency • Tailored to the amount and time frame needed • Not as flexible as a forward contract and, therefore, is less valuable

Foreign-Exchange Convertibility – Fully convertible currencies—government permits both residents and nonresidents to purchase in unlimited amounts – Hard currency—currencies that are fully convertible • Relatively stable and strong – Soft currencies—currencies that are not fully convertible • Typically currencies of developing countries – Nonresident convertibility—foreigners can

Governmental Restrictions on Foreign-Exchange Convertibility – Restrictions used to conserve scarce foreign exchange • Licensing—government regulates all foreign-exchange transactions – those who receive foreign currency required to sell it to its central bank at the official buying rate – central bank rations foreign currency • Multiple exchange-rate system— different exchange rates set for different transactions

Governmental Restrictions on Foreign-Exchange Convertibility • Advance import deposit—requires importers to make a deposit with central bank covering price of goods they would purchase from abroad • Quantity controls—limit the amount of currency that resident can purchase foreign travel – Currency controls increase the cost of international business and reduce overall international trade

How Companies Use Foreign Exchange – Most foreign-exchange transactions involve international departments of commercial banks • Banks buy and sell foreign currency; banks collect and pay money in transaction with foreign buyers and sellers • Banks lend money in foreign currency

– Companies use foreign-exchange market for: • Import and export transactions • Financial transactions such as FDI – Arbitrage—purchase of foreign currency on one market for immediate resale on another market • Arbitragers hope to profit from price discrepancy • Interest arbitrage—investing in debt instruments in different countries – Speculation—buying or selling foreign currency has both risk and high profit potential

Foreign-Exchange Trading Process – Companies work through their local banks to settle foreign-exchange balances • Commercial banks in major money centers became intermediaries for small banks – Most foreign-exchange activity takes place in traditional instruments • Commercial and investment banks and other financial institutions handle spot, outright forward, and FX swaps • Foreign-exchange market made up of about 2, 000 dealer institutions worldwide

• Most foreign-exchange takes place in OTC market – Dealers can trade foreign exchange: • Directly with other dealers • Through voice brokers • Through electronic brokerage systems – Internet trades of currency are more popular