PART FOUR

WORLD FINANCIAL ENVIRONMENT

International Business

Chapter Nine
Global Foreign Exchange
and Capital Markets
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

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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]

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

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 Currency Distribution of Global
Foreign Exchange Market
Activity
April April April April April April
CURRENCY 198919921995199820012004
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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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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 Fig. 9.2: Geographical
Distribution of Global Foreign
Exchange Market Activity, April
2004

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

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Map 9.1: International Time
Zones and the Single World
Market

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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]

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• 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
The dollar (base) weakened; the yen (terms) strengthened.
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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]

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• 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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Foreign Exchange Markets:
Thursday, April 28, 2005
US$ EQUIVALENT CURRENCY PER US$
COUNTRY THUR WED THUR WED
Brazil (Real) .3917 .3972 2.55302.5176
Canada (Dollar) .7991 .8004 1.25141.2494
India (Rupee) .02291.0228843.64943.706
Japan (Yen) .009430 .009445 106.04105.88
Russia (Ruble).03597.0360727.80127.724
South Africa (Rand) .1630 .1646 6.13506.0753
Switzerland (Franc) .8383 .8390 1.19291.1919
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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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]

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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
Banks 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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Fig. 9.4: Structure of Foreign
Exchange Markets

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Fig. 9.5: Foreign Exchange
Transactions

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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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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.

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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.]

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

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Fig. 9.6: Growth of Emerging
Stock Markets

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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]

9-36
• 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]

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• 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.

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