PART FOUR WORLD FINANCIAL ENVIRONMENT International ...

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PART FOUR

WORLD FINANCIAL ENVIRONMENT


International Business

Chapter Nine

Global Foreign Exchange and
Capital Markets

9
-
2

Chapter 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


To show how companies make payment for international
transactions

9
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3

Foreign Exchange: Basic Concepts

Foreign exchange (Fx):

money denominated in the
currency of another nation or group of nations

[a financial instrument issued by a foreign country]

Exchange rate:

the price of one currency
expressed in terms another currency

[the number of units of a given currency needed to buy
one unit of another currency]

Foreign exchange market:

banks and currency
exchanges that buy and sell foreign currencies
and other exchange instruments

[a market for converting the currency of

one country into that of another country]

9
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4

The Foreign Exchange Market:
Major Segments



Over
-
the
-
counter (OTC) market:

commercial and investment banks

[most foreign exchange activity occurs here]



Exchange
-
traded market:

specialized
securities exchanges where particular
types of foreign
-
exchange instruments
are traded



[instruments such as futures and




options are exchange
-
traded]

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5

Fig. 9.1: Average Daily Volume in
World Foreign Exchange Markets,
1989
-
2004

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6

Currency Distribution of Global
Foreign Exchange Market Activity





April

April

April

April

April

April

CURRENCY


1989

1992

1995

1998

2001

2004

U.S. Dollar



90


82


83


87


90


89

Euro
















38


37

Japanese Yen


27


23


24


21


23


20

Pound Sterling


15


14


10


11


13


17

Swiss Franc


10


9


7


7


6


6

All others



31


32


39


44


30


31



Source:

Bank for International Settlements,
Central BankSurvey of Foreign Exchange and Derivatives Market Activity,
2004.

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7

The U.S. dollar is the most widely traded
currency in the world because it serves as:


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 their
own exchange rates






The most frequently traded currency pairs are:




-

the U.S. dollar/euro [28%]




-

the U.S. dollar/yen [17%]

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8

Fig. 9.2: Geographical Distribution
of Global Foreign Exchange Market
Activity, April 2004

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9

Location of the Foreign Exchange
Market


London is the largest foreign exchange market
(followed by New York, Tokyo, and Singapore)
because of its strategic location between Asia
and the Americas.


Market activity first heightens when Europe and
Asia are open and again when Europe and the
United States are open.


Cross
-
trading:

using the U.S. dollar as a vehicle
currency for trades between two other currencies


Cross rate:
the exchange rate between two non
-
U.S.
dollar currencies that is computed from the exchange
rate of each currency in relation to the U.S. dollar



[Use currency A to buy currency C (US $1),
and then use currency C to buy currency B.]

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10

Fig. 9.3: The Circadian Rhythms of
the Foreign Exchange Market

9
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11

Map 9.1: International Time Zones
and the Single World Market

9
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12

Foreign Exchange Terms and
Conventions


Bid:

the price at which a trader is willing to buy a
foreign currency


Offer:

the price at which a trader is willing to sell
a foreign currency


Spread:

the difference between the bid and the
offer rates, i.e., the trader’s profit


American terms:

the U.S. point of view, i.e., the
number of U.S. dollars per unit of foreign currency


European terms (indirect quote):

the number of
units of foreign currency per U.S. dollar

[continued]

9
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13



A quote in
American terms

(US$/Fx) is always the
reciprocal of a quote in
European terms

(Fx/US$).



$1.00/
¥.009430


¥
106.04/$1.00





Base currency:
the quoted, underlying, or fixed
currency




Traders always quote the
base currency

(the denominator) first, followed by the
terms currency

(the numerator).




An example:


Dollar
-
yen quote: dollar = base, yen = terms




Oct. 10, 2004


April 28, 2005




¥
110.96/$1.00


¥
106.04/$1.00


T
he dollar (base)
weakened;

the yen (terms)
strengthened.

9
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14

Types of Foreign Exchange Markets


Spot market:

the market in which foreign exchange
transactions occur “on the spot,” i.e., for delivery
within two business days following the date of
agreement to trade


Spot rate:

the rate quoted for transactions that require
immediate delivery, i.e. within two days


Forward market:

the market in which foreign
exchange transactions occur at a set rate for
delivery beyond two business days following the
date of agreement to trade


Forward rate:

a contractually established exchange rate
between a foreign exchange trader and the trader’s client
for delivery of foreign currency on a specified date




forward discount:
the forward rate is less than the spot rate


forward premium:
the forward rate is higher than the spot rate

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Forward/Future Instruments


Forward contract:

a contract between a firm or
individual and a bank to deliver foreign currency
at a specific exchange rate on a future date


Outright forward:

a forward contract that is not
connected to a spot transaction, i.e., a contact to
deliver foreign currency beyond two days following
the date of agreement at the forward rate


Fx swap:

a simultaneous spot and forward trans
-
action, i.e., one currency is swapped for another on
one date and then swapped back on a future date


Currency swap:

the exchange of principal and
interest payments via interest
-
bearing OTC financial
instruments (e.g., bonds)


[continued]

9
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16


Futures contract:

an agreement between two parties
to buy or sell a given currency at a given
(negotiated) price on a particular future date, as
specified in a standardized contact to all participants
in that currency futures exchange [not as flexible as
a forward contract]


Option:

an instrument traded both OTC and on
exchanges that gives the purchaser the right (but
not the obligation) to buy or sell a certain amount of
foreign currency at a specified exchange rate within
a specified amount of time [more expensive but also
more flexible than a forward contract]


Strike price:

the exchange rate specified in the option, i.e.,
the exercise price


Premium:

the fee paid to the writer of the option

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17

Foreign Exchange Markets:
Thursday, April 28, 2005





US$ EQUIVALENT CURRENCY PER US$

COUNTRY


THUR

WED


THUR

WED

Brazil (Real)


.3917

.3972


2.5530

2.5176

Canada (Dollar)


.7991

.8004


1.2514

1.2494

India (Rupee)


.02291

.02288


43.649

43.706

Japan (Yen)


.009430

.009445


106.04

105.88

Russia (Ruble)


.03597

.03607


27.801

27.724

South Africa (Rand)

.1630

.1646


6.1350

6.0753

Switzerland (Franc)

.8383

.8390


1.1929

1.1919

U.K. (Pound)


1.9068

1.9059


.5244

.5247

Special Drawing Right 1.5135

1.5121


.6607

.6613

Euro



1.2895

1.2933


.7755

.7732



Special Drawing Rights (SDRs) are based on exchange rates for the US dollar, the euro, the Japanese yen,

and the British pound.

Sources:

International Monetary Fund;
Wall Street Journal,
2005.


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18

Exchange
-
based vs. Over
-
the
-
Counter Fx Instruments





EXCHANGE
-
BASED

OTC





(OPTIONS & FUTURES)

(FORWARD CONTRACTS)

Contract Specs.


Standard + Custom

Custom

Regulation


SEC



Self

Type of market


Open outcry, auction

Dealer

Transparency


Yes



No

Short margin req.

Yes



No

Anonymous orders

Yes



No

Mark positions daily

Yes



No

Audit trail


Complete trail


No

Participants


Public cust. +


Corp. & inst. users






corp. & inst. users

Source:

The Philadelphia Stock Exchange.


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Foreign Exchange Convertibility

Convertibility:

the ability of residents and
nonresidents to purchase foreign currency
with a given (domestic) currency without
government restrictions



External convertibility:

the ability of non
-

residents
to purchase foreign currency with a given
currency without government limitations



Nonconvertibility:

the inability of residents and
nonresidents to convert a given currency into
foreign currency because of government
limitations

[continued]

9
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20

Fully convertible currencies

are those that govern
-
ments allow both residents and nonresidents to
purchase in unlimited amounts, i.e., they are freely
traded and accepted by central banks.



Hard currencies

are fully convertible, relatively stable,
and tend to be comparatively strong.
Soft (weak)
currencies

are not fully convertible.



A government may control the convertibility of its
currency through:




licensing


a multiple exchange rate system


advance import deposits


quantity controls




Currency controls add to the cost of doing business
and thus serve as serious impediments to trade and investment.

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The Uses of Foreign Exchange


The role of commercial banks:


buy and sell foreign exchange


serve as vehicles for payments between domestic
and foreign customers


lend money in foreign denominations




Business purposes:


settlement of international business transactions


hedging
[risk reduction through loss protection]


speculation
[currency trading on expectations of future prices]


arbitrage
[risk
-
free profit based on price differentials]


interest arbitrage

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The Fx Trading Process


To settle foreign exchange balances, companies
may work through:


local banks


commercial and investment banks (OTC market)


securities exchange brokers


B
anks deal with each other in the interbank market,
primarily through foreign
-
exchange brokers.


Brokers are specialist intermediaries who facilitate transactions in the
interbank market by matching the best bid and offer quotes.





Banks’ fx dealers can trade foreign exchange:


directly with other dealers


through voice brokers


through electronic brokerage systems

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23

Fig. 9.4: Structure of Foreign
Exchange Markets

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24

Fig. 9.5: Foreign Exchange
Transactions

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25

The Over
-
the
-
Counter Market:
Commercial and Investment Banks

Top banks in the interbank fx markets are so
ranked because of their ability to:


trade in specific market locations



handle major currencies



handle major cross trades



deal in specific currencies



handle derivatives (forwards, options, futures,
swaps)



conduct key market research

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Top OTC and Commercial and
Investment Banks: Fx Trades





ESTIMATED BEST IN


BEST IN BEST IN BEST IN

TRADING BANK


MKT.SHARE LONDON NEW YORK EURO/US$ US$/YEN

1. Deutsche Bank 19.75%


2


3


1


4

2. UBS Warburg 11.61%


5


4


4


3

3. Citigroup


7.33%


3


1


3


1

4. HSBC


6.64%


1


5


2


2

5. Barclays


6.41%


4





7


7

6. JP Morgan 5.38%


7


2


5


5

7. ABN Amro


4.57%


9


7


6


6

8. Merrill Lynch


4.45%













9. Goldman Sachs 4.38%


8


8


10


10

10.Morgan Stanley 4.20%





9







Source:

“2005 Euromoney Foreign Exchange Poll,” Euromoney (May 2005).


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U.S. Securities Exchanges

U.S. exchanges where fx instruments (primarily
options and futures) are traded include:


Chicago Mercantile Exchange (CME):

offers
futures and futures options contracts in more
than a dozen foreign currencies


Philadelphia Stock Exchange (PHLX):

the only
U.S. exchange that trades foreign currency
options; 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.

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28

Global Capital Markets:
Eurocurrencies


Eurocurrency:

any currency banked outside its
country of origin


Eurocurrency market:

an offshore, wholesale
currency market [started with the deposit of
U.S. dollars in London banks]


Eurodollars:

dollars banked outside of the
United States, i.e., a certificate of deposit in
dollars in a bank located outside of the U.S.



(constitute 65
-
80% of the Eurocurrency market)





Eurocurrencies are also known as
offshore currencies
, while currencies
banked within their country of origin are known as
onshore currencies
.

9
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Major Sources of Eurocurrencies


Foreign governments or individuals who want to
hold dollars outside of the United States


MNEs that have cash in excess of current needs


European banks with foreign currency in excess
of current needs


Countries such as Germany, Japan, and Taiwan
that have large balance
-
of
-
trade surpluses held
as reserves

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Demand for Eurocurrencies


Demand for Eurocurrencies reflects:


greater convenience


increased security


lower rates and thus higher yields


Demand for Eurocurrencies comes from:


sovereign governments


supranational agencies (e.g., the World Bank)


firms and individuals

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Eurocurrency Borrowing


Eurocredit:

a type of loan or line of credit that
matures in one to five years


Syndication:

the process of pooling the specific
resources of several banks in order to spread
the risks associated with large loans


London Inter
-
bank Offered Rate (LIBOR):

reflects the interest rate London banks charge
one another for short
-
term Eurocurrency loans




[Traditional loans are made at a certain percentage
above the LIBOR.]

9
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32

Global Capital Markets:
International Bonds


Foreign bonds:

sold outside of the borrower’s
home country but denominated in the currency
of the country of issue


Eurobonds:

sold in countries other than the one in
whose currency the bond is denominated; usually
underwritten by a syndicate of banks from different
countries; typically sold over
-
the
-
counter


Global bond:

registered in different national markets
according to the registration requirements of each
market; traded simultaneously in numerous capital
markets





Eurobonds may have currency options which allow the creditor to demand
repayment in one of several currencies, thus reducing the exchange risk.

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Global Capital Markets:
Equity Securities


Private placement:

an investment by a venture
capitalist or other private party in exchange for
stock


Market capitalization:

the total number of
shares listed times the market price per share


The three largest markets in the world are
New York, Tokyo, and London.


The growth of emerging stock markets has been
very sensitive to global economic conditions and
events.

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34

Map 9.2: Market Capitalization,
2001 (US$ Bil.)

9
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35

Fig. 9.6: Growth of Emerging Stock
Markets

9
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36

Global Capital Markets:
The Euroequity Market


Euroequity market:

shares sold outside the
boundaries of the issuing firm’s home country;
issuing stock simultaneously in two or more
countries in order to attract capital from a wider
variety of shareholders



Global share offering:

the simultaneous offering
of actual shares on different stock exchanges


A major source of competition to the world’s traditional
stock exchanges is the electronic trading of stocks
through companies such as E*Trade.

[continued]

9
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37


American Depository Receipt (ADR): a nego
-
tiable certificate issued by a U.S. bank that
represents underlying shares of stock of a
foreign corporation held in trust at a custodial
bank in a foreign country


In addition to ADRs, there are:


global depository receipts


European depository receipts




Depository receipts are traded like stocks, with each
receipt representing some number of shares of an
underlying stock.

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Implications/Conclusions



Approximately U.S. $1.2 trillion in foreign
exchange is traded each day.


The major institutions that trade foreign
exchange are the large commercial and
investment banks (over
-
the
-
counter) and
securities exchanges.

[continued]

9
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39


The U.S. dollar is the most widely traded
currency in the world, but London represents
the main foreign exchange market in the
world.


Some players buy and sell foreign exchange
to settle trade transactions, some for
purposes of foreign direct investment, others
for purposes of portfolio investment, and still
others for arbitrage and speculation.