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Part Four

World Financial Environment

Chapter Nine

Global Foreign-Exchange Markets

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Chapters Objectives

To learn the fundamentals of foreign exchange To identify the major characteristics of the

foreign exchange market and how governmentscontrol the flow of currencies across national

borders To describe how the foreign exchange market

works To examine the different institutions that deal in

foreign exchange To understand why companies deal in foreign

exchange

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Foreign Exchange

Foreign exchange is money denominatedin the currency of another nation or groupof nations

The market in which these transactionstake place is the foreign-exchange market.

The exchange rate is the price of acurrency

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The Foreign Exchange

The Bank for International Settlements dividesthe foreign exchange market into reportingdealers (also known as dealer banks or moneycenter banks), other financial institutions, andnonfinancial institutions.

Dealers can trade currency by telephone orelectronically, especially through Reuters, EBS,or Bloomberg

The foreign exchange market is divided into theover-the-counter market (OTC) and theexchange-traded market

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Some Traditional Foreign Exchange

Instruments

Spot transactions involve the exchange ofcurrency on the second day after the date onwhich the two dealers agree to the transaction

Outright forward transactions involve theexchange of currency three or more days afterthe date on which the dealers agree to thetransaction

An FX swap is a simultaneous spot and forwardtransaction

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Foreign Exchange Derivatives

Currency swaps deal more with interest-bearingfinancial instruments (such as a bond), and theyinvolve 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 twoparties to buy or sell a particular currency at aparticular price on a particular future date.

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Some Aspects

Of The Foreign Exchange Market

Approximately $3.2 trillion in foreignexchange is traded every day.

The US dollar is the most widely tradedcurrency in the world (on one side of 86%of all transactions)

London is the main foreign exchangemarket in the world

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Why the US dollar is the most widely

traded currency

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 in market operations to influence theirown exchange rates.

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The Spot Market

Foreign exchange dealers quote bid (buy) andoffer (sell) rates on foreign exchange

If the quote is in American terms, the dealer

quotes the foreign currency as the number ofdollars and cents per unit of the foreign currency

If the quote is in European terms, the dealerquotes the number of units of the foreign

currency per dollar The numerator is called the terms currency

and the denominator the base currency.

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The Forward Market

If the foreign currency in a forward contract isexpected to strengthen in the future (the dollarequivalent of the foreign currency is higher in the

forward market than in the spot market), thecurrency is selling at a premium. If the oppositeis true, it is selling at a discount

An option is the right, but not the obligation, to

trade foreign currency in the future

Options can be traded OTC or on an exchange

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Futures

A foreign currency future is an exchange-traded instrument that guarantees a futureprice for the trading of foreign exchange,

but the contracts are for a specific amountand specific maturity date

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The Foreign Exchange Trading

Process

Companies work with foreign exchangedealers to trade currency

Dealers also work with each other and can

trade currency through: voice brokers

electronic brokerage services

directly with other bank dealers Internet trades of foreign exchange are

becoming more significant

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How Companies Use Foreign

Exchange

The major institutions that trade foreignexchange are the large commercial andinvestment banks and securities exchanges

Commercial and investment banks deal in avariety of different currencies all over the world

The CME Group and the Philadelphia StockExchange trade currency futures and options

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How Companies Use Foreign

Exchange

Companies use foreign exchange to settletransactions involving the imports andexports of goods and services, for foreign

investments, and to earn money througharbitrageor speculation