Part Four

The World Financial Environment

 

Chapter 9

The Foreign-Exchange Market

 

 

Objectives

 

!          Learn the fundamentals of foreign exchange.

!          Identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders.

!          Understand why companies deal in foreign exchange.

!          Describe how the foreign-exchange market works.

!          Examine the different institutions that deal in foreign exchange.

 

 

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 9 explains in detail basic concepts (such as rates, instruments and convertibility) and explores the major characteristics of the foreign-exchange markets. The chapter concludes with a discussion of the foreign exchange trading process that focuses upon both the over-the-counter and the exchange-traded markets, i.e., banks and securities exchanges, and the respective roles they play.

 

Chapter Outline

 

OPENING CASE: Foreign Travels, Foreign-Exchange Travails: Excerpts from the Travel Journal of Lee Radebaugh [See Map 9.1.]

This case describes Lee Radebaugh’s experiences during a trip to Chile, Argentina and Brazil. Brazil has changed the name of its currency seven times since 1967. Chile and Argentina both call their currencies the peso, although the respective value of each is vastly different. The case describes the challenges of converting one currency into another as well as Radebaugh’s attempts to use traveler’s checks along the way.

 

Teaching Tip: Carefully review the PowerPoint slides for Chapter 9 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures, tables and maps in the text.

I.                   INTRODUCTION


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.

 

II.        MAJOR CHARACTERISTICS OF THE FOREIGN-EXCHANGE MARKET

The foreign-exchange market consists of the different players who buy and sell foreign currencies and other exchange instruments. Their combined activities affect the supply of and demand for currencies. The market is comprised of two major segments. The over-the-counter market (OTC) includes banks (both commercial 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 the Philadelphia Stock Exchange) where particular types of foreign-exchange instruments (such as futures and options) are traded.

A.                A Brief Description of Foreign-Exchange Instruments

Several types of foreign exchange instruments are available for trading. In addition, several types of transactions may occur. Spot transactions involve the exchange of currency “on the spot,” or technically, transactions which 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. 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. FX swaps account for nearly 45 percent of all foreign-exchange transactions. In addition to the traditional instruments, several other ways now exist with which to participate in the foreign-exchange market. Currency swaps deal with interest-bearing financial instruments (such as bonds) and involve the exchange of principal and interest payments. 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. 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. 

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


The Bank for International Settlements (BIS) estimated in 2001 that $1.2 trillion in foreign exchange was traded each day. The substantial decline from earlier years is thought to be the result of the consolidation of the banking industry (fewer trading desks) and the introduction of the EURO. The U.S. dollar remains the most important currency in the foreign-exchange market, comprising one side (buy or sell) of 90 percent of all foreign currency transactions worldwide in 2001. This is because the dollar:

·         is an investment currency in many markets

·         is held as a reserve currency by many central banks

·         is a transaction currency in many international commodity markets

·         serves as an invoice currency in many contracts

·         is often used as an intervention currency when foreign monetary authorities wish to influence their own exchange rates.

Nonetheless, the largest foreign exchange market is in the United Kingdom, which is strategically situated between Asia and the Americas, followed by the United States, Japan and Singapore.

 

III.       MAJOR FOREIGN-EXCHANGE INSTRUMENTS

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 dollar-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. The cross rate represents the exchange rate between non-U.S. dollar currencies; it is derived by using currency A to buy currency C (US $1) and then using currency C to buy currency B.

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. 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 it is 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.

E.                 Foreign-Exchange Convertibility

Fully convertible currencies are those that governments allow both residents and nonresidents to purchase in unlimited amounts, i.e., currencies freely traded and accepted in international business. Hard currencies are fully convertible, relatively stable and tend to be comparatively strong. Soft (weak) currencies are not fully convertible. To conserve scarce foreign exchange, governments may impose exchange restrictions on individuals and/or companies. Under a multiple exchange rate system the government sets different rates for different types of transactions. If the government imposes an advance import deposit, importers will be required to make a deposit with the central bank, often for a long as one year, to cover the full price of the products being sourced from abroad. With quantity controls, the government limits the amount of foreign currency that can used for a given transaction. Such currency controls significantly add to the cost of doing business and can serve as serious impediments to trade.

 

IV.       HOW COMPANIES USE FOREIGN EXCHANGE


The most obvious use of foreign exchange is for the settlement of international business transactions, i.e., trade, licensing and investment activities. 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. Currency 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. Foreign exchange instruments such as outright forwards, FX swaps, options and futures can all be used to hedge (insure) against the risk associated with foreign-exchange transactions.

 

V.                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 Bank for International Settlements (BIS) based in Basel, Switzerland (effectively the central banks’ central bank), estimates there are about 2,000 dealer institutions worldwide that comprise the foreign-exchange market. Of these, approximately 100 to 200 are market markers and, of this group, only a select few are major players.

A.                Commercial and Investment Banks

Commercial banks and other financial institutions comprise the over-the-counter market (OTC). This is where most foreign-exchange activity occurs. Top banks in the interbank market are so ranked because of their abilities to:

·         trade in specific market locations

·         handle major currencies

·         engage in cross-trades

·         deal in specific currencies

·         handle derivatives (forwards, options, futures, and swaps)

·         conduct key market research.

Other factors often mentioned are price, quote speed, liquidity, back office/settlement, strategic advice, trade recommendations, out-of-hours service/night desk, systems technology, innovation, risk appraisal and e-commerce capabilities. A large firm may use more than one bank to conduct its foreign-exchange dealings, given their particular strategic capabilities. Exotic currencies, i.e., currencies from developing and transitional economies, allow certain banks to develop market niches because such currencies are difficult for businesses to work with.

B.                 Exchanges

The exchange-traded market is composed of certain securities exchanges (e.g., the Chicago Mercantile Exchange and the Philadelphia Stock Exchange) where particular types of foreign-exchange instruments (such as futures and options) are traded. The Chicago Mercantile Exchange (CME) offers futures and futures options contracts (contracts that are options on futures contracts, rather than options on foreign exchange per se) in more than a dozen foreign currencies. The Philadelphia Stock Exchange (PHLX) is the only exchange in the U.S. that trades foreign-currency options. It lists six dollar-based standardized currency options contracts. Although options cost more than futures, large firms prefer options because of their greater flexibility and convenience.

 


ETHICAL DILEMMA:

The Need for Checks and Balances

One of the most publicized events in the derivatives market in recent years involved Nicholas Leeson and the 233-year-old Barings PLC. A Barings trader, Leeson was sent to Singapore in the early 1990s. Within a year he was promoted to chief trader and began both trading securities and booking the settlements, which meant there were no checks and balances on Leeson’s trading actions. Soon he lost over $1 billion on Tokyo stock index futures; he assumed the market would rise, but instead it fell. Leeson was using Barings’ funds to cover positions he was taking for himself, not for clients, and he also forged documents to cover his transactions. He later fled the country, but was caught in Germany and returned to Singapore for trial. He was imprisoned until 1999, when he was released and returned to his native Britain. Although banks have since implemented measures to prohibit actions such as Leeson’s, rogue trading continues to happen. In 2002, Allied Irish Banks lost $750 million in foreign-exchange derivatives as a result of trades made by one of its employees at its U.S. subsidiary. The bank suspects he was involved with fictitious trades and collusion.

 

LOOKING TO THE FUTURE:

Exchange Markets in the New Millennium

The lessening of exchange restrictions and capital controls and continuing technological developments will all lead to greater efficiencies and opportunities for foreign-exchange trading. In addition, the introduction of the EURO will serve to reduce exchange-rate volatility and take pressure off the U.S. dollar. Furthermore, the increasing use of the Internet will allow more entrants to participate in the foreign exchange market and will also increase currency price transparency.

 

WEB CONNECTION

 

Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter 9. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 9.

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CLOSING CASE: HSBC and the Peso Crisis in Argentina

 

1.         What are the major factors that caused the peso to fall in value against the dollar?

When the Convertibility Law pegged the Argentine peso 1:1 with the U.S. dollar, the government’s ability to respond to external shocks was severely reduced. In effect, Argentina’s exchange-rate and monetary policies were determined de facto by the United States, and Argentina’s interest rates were determined by the U.S. Federal Reserve. When world commodity prices declined, the U.S. dollar, and hence the Argentine peso, strengthened against other currencies. Concurrently, Argentina’s main trading partner, Brazil, devalued its currency. As deflation set in, both the Argentine government and many private companies found it difficult to pay their debts. Tax revenues fell, while public spending increased. Interest rates payments went primarily to overseas investors, thus further draining the economy. When Argentine banks were pressured to buy government bonds, a bank run ensued. Following the government’s default on its debt, the currency board was abandoned, and the peso was allowed to float against the dollar. In the latter half of 2002, the Argentine peso was trading at about 27 cents to the dollar.

 

2.                  What should President Duhalde do to stabilize Argentina’s currency?

Both economic and political stability need to be restored if Argentina is to succeed in stabilizing and restoring confidence in the peso. One of the most important things that must be accomplished is to secure the aid of the International Monetary Fund. Admittedly, this will be difficult as it will require changes in Argentina’s exchange-rate policy, fiscal policy and banking system, and many of those measures are unpopular with provincial governors and the courts. Certain economists believe Argentina should proceed with the full dollarization of its currency at a rate that would be even more binding than its previous policy. Others argue for a system of “managed floating plus” in order to provide the government with the flexibility to adjust its monetary policy while maintaining certain targets and reducing its currency mismatching. To a certain extent, the IMF requirements will likely influence that decision.

 

3.                  What are HBSC’s options in Argentina, and what do you think they should do?

HBSC can choose to continue to fight losses in Argentina or cease its operations there. The pesification instituted by the Argentine government has resulted in deeply discounted loan repayments, which will result in further losses, so time is of the essence. Recently HBSC injected $211 million into its Argentine operations in order to keep them stable while the IMF stalls. Clearly, the firm is committed to remaining in Argentina if possible. Already two foreign banks have withdrawn from the country and others are threatening to do the same. The remaining banks, including HBSC, should in concert approach both the IMF and the Argentine government, explain their plight and offer to work together to find a solution. Meanwhile, HBSC may need to consolidate some of its Argentine operations so that it can minimize its costs (and losses) while a turnaround is effected. In addition, definite guidelines for exiting should be established in the event that the situation worsens and HBSC is forced to withdraw from Argentina.

 


Additional Exercises: The Foreign-Exchange Market

 

Exercise 9.1. Many students will have had experience with foreign currency conversion. Ask them to describe the differences they have encountered in rates quoted at the airport, in hotels and banks and on the street. Then ask students to describe their experiences using credit cards and ATM cards in particular foreign countries. How were the transactions reported on their statements? Were they charged processing fees?

 

Exercise 9.2. Take copies of the most recent editions of The Wall Street Journal and the Financial Times to class. Explain to students where to find foreign exchange rates, forward rates, cross rates, commodity prices, etc. Select the home countries of various students in your class. Using information in the papers, have the students calculate the cross rates for various currencies. Then use the forward rates to engage the students in a discussion as to which currencies appear to be stronger. Explore the possible underlying reasons for a given currency’s strength or weakness.

 

Exercise 9.3. More than 150 currencies exist today. Some countries share a common currency (e.g., those that participate in the EURO), while certain countries peg their currencies to others (e.g., Chile’s currency is pegged to the U.S. dollar). Many nations, however, maintain their own independent currencies. Ask students to debate the potential for additional regional currencies such as the EURO. If they support the concept, should those currencies necessarily be tied to regional economic blocs?