PART FOUR WORLD FINANCIAL ENVIRONMENT CHAPTER NINE GLOBAL FOREIGN EXCHANGE AND CAPITAL MARKETS

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

CHAPTER OVERVIEW
The foreign-exchange market consists of all those players who buy and sell foreignexchange instruments for business, speculative, or personal purposes. Primarily, foreign exchange is used to settle international trade, licensing, and investment transactions. hapter ! explains in detail basic concepts "such as rates, instruments, and convertibility# and explores the major characteristics of the foreign-exchange markets. The chapter includes a discussion of the foreign-exchange trading process that focuses on both the over-the-counter and the exchange-traded markets, i.e., banks, securities exchanges, electronic brokerages, and the respective roles they play. The chapter concludes with a discussion of global capital markets, including $urocurrencies, international bonds, and e%uity markets.

CHAPTER OUTLINE
OPENING CASE: Western Uni n This case describes &estern 'nion(s international money transfer services and the increasing competition the company is facing from banks. &estern 'nion has been particularly successful in attracting business from )exican emigrants in the 'nited *tates who send part of their paycheck home to support their families. &estern 'nion charges relatively high fees and uses its own exchange rates that are usually significantly lower than the market rate. +anks have been introducing their own money transfer services, many with lower fees and better exchange rates than &estern 'nion. ,ue to many )exicans( distrust of banks, however, &estern 'nion continues to enjoy large profit margins and a large market share in the money transfer business.

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T EACHING T IPS: arefully review the PowerPoint slides for hapter -ine and select those you find most useful for enhancing your lecture and class discussion. .or 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. /n 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 commercial banks, investment banks, and other financial institutions0this is where most foreignexchange activity occurs. The exchange-traded market includes certain securities exchanges "e.g., the hicago )ercantile $xchange and the Philadelphia *tock $xchange# where particular types of foreign-exchange instruments "such as futures and options# are traded. A! A Brie# Des$ri%ti n # F rei&n"E'$()n&e Instr*+ents *everal types of foreign exchange instruments are available for trading. 1n addition, several types of transactions may occur. Spot transactions involve the exchange of currency 2on the spot,3 or technically, transactions that are settled within two business days after the date of agreement to trade. The spot rate is the exchange rate %uoted for transactions that re%uire 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. 1n 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. 1n fact, the same currency is bought and sold simultaneously, but delivery occurs at two different times. .4 swaps account for nearly 56 percent of all foreign-exchange transactions. 1n 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. /n 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. / futures contract is a foreign-exchange instrument that specifies an exchange rate, an amount, and a maturity date in advance of the

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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! T(e Si,e- C +% siti n )n. L $)ti n # t(e F rei&n"E'$()n&e M)r/et The +ank for 1nternational *ettlements "+1*# estimated in 9885 that :7.! trillion in foreign exchange was traded each day. This increase more than reversed the decline seen from 7!!; to 9887. This reversal is likely due to the growing importance of foreign exchange as an alternative asset and the larger emphasis on hedge fund "a fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive trading strategies unavailable to mutual funds#. The '.*. dollar remains the most important currency in the foreign-exchange market, comprising one side "buy or sell# of ;! percent of all foreign currency transactions worldwide in 9885. 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. -onetheless, the largest foreign exchange market is in the 'nited =ingdom, which is strategically situated between /sia and the /mericas, followed by the 'nited *tates, >apan and *ingapore. DOES GEOGRAPH0 MATTER1 F rei&n"E'$()n&e Tr).es $ven though the '.*. dollar is the most widely traded currency in the world, some trading centers outside the '.*. are very important in the global currency trade. ?ondon, for example, is a major trading center because it is close to the major capital markets in $urope and is in a time @one that straddles the other major markets in /sia and the '.*. ,espite the fact that the currency market is a 95 hour market, the heaviest volumes of trade are concentrated in the hours when /sia and $urope are open or when $urope and the '.*. are open "see .igure !.A#. /lso, prices tend to be better when markets are active and li%uid.

III! MAJOR FOREIGN"EXCHANGE INSTRUMENTS A! T(e S% t M)r/et The spot market consists of players who conduct those foreign-exchange transactions that occur 2on the spot,3 or technically, within two business days following the date of agreement to trade. .oreign-exchange traders always %uote a id "buy# and offer "sell# rate. The bid is the rate at which traders buy foreign 787

exchangeB 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. $xchanges can be %uoted in !merican terms, i.e., a dollar-direct "uote that gives the value in dollars of a unit of foreign currency, or #uropean terms$ i.e., an indirect "uote that gives the value in foreign currency of one '.*. dollar. The ase currency, or the denominator, is the %uoted, underlying, or fixed currencyB the terms currency is the numerator. )ost large newspapers %uote exchange rates daily, listing both spot and forward rates. The spot rates listed are usually the selling rates for inter ank transactions "transactions between banks# of :7 million or more. B! T(e F r2)r. M)r/et 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 %uoted today for the future delivery of a foreign currency. / 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! O%ti ns /n 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#. Cptions 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. /n option is more flexible, but also more expensive, than a forward contract. D! F*t*res / foreign currency future resembles a forward contract because it specifies an exchange rate sometime in advance of the actual exchange of the currency. Dowever, a future is traded on an exchange, not CT . &hile 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! F rei&n"E'$()n&e C n3erti4i5it6 %ard 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. Dard currencies are fully convertible, relatively stable and tend to be comparatively strong. Soft "weak# currencies are not fully convertible and tend to be the currencies of developing countries. To conserve scarce foreign exchange, governments may impose exchange restrictions on individuals andEor companies. 'nder a mu&tip&e exchange-rate system the government sets different rates for different types of transactions. 1f the government imposes an advance import deposit, importers will be re%uired to make a deposit with the central bank, often for as long as one year, to cover the full price of the products being sourced from abroad. &ith "uantity contro&s, 789

the government limits the amount of foreign currency that can be used for a given transaction. *uch 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 ar itrage, 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. 'nterest ar itrage involves investing in debt instruments "such as bonds# in different countries in order to maximi@e profits by capturing interest-rate and exchange-rate differentials. Specu&ation involves buying "or selling# a currency based on the expectation it will gain "or lose# in strength against other currencies. /lthough speculation offers the chance to profit, it also contains an element of risk. The Parker ,iscretionary .4 1ndex, which measures the performance of 7F currency managers worldwide, finished with a negative return in 98850the first negative return in 7! years. V! THE FOREIGN"EXCHANGE TRADING PROCESS &hen a firm needs foreign exchange, it typically goes to its commercial bank. 1f the bank is large enough, it may have its own foreign-exchange traders. / 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 %uotes of interbank traders. The +ank for 1nternational *ettlements "+1*# based in +asel, *wit@erland "effectively the central banks( central bank#, estimates there are about 7,988 dealer institutions worldwide that comprise the foreignexchange market. Cf these, approximately 788 to 988 are market markers and, of this group, only a select few are major players. A! C ++er$i)5 )n. In3est+ent B)n/s /t one time, only big money center banks could deal in foreign exchange. -ow, with the advent of electronic trading, smaller regional banks can hook up to Geuters and +loomberg and deal directly in the interbank market. 1n spite of these developments, the greatest volume of foreign-exchange activity still takes place with the big banks. ommercial banks and other financial institutions comprise the over-the-counter market (OTC). This is where most foreignexchange 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. Cther factors often mentioned are market share by si@e and region, advisory services, price, %uote speed, credit rating, li%uidity, back officeEsettlement, strategic advice, trade recommendations, out-of-hours serviceEnight desk, systems technology, innovation, risk appraisal, and e-commerce capabilities. / large firm may use more than one bank to conduct its foreign-exchange dealings, 78A

given their particular strategic capabilities. 1n addition to the CT market, there are a number of exchanges where particular types of foreign-exchange instruments "such as futures and options# are traded. The Chicago (ercanti&e #xchange (C(#) 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 do@en foreign currencies. The )hi&ade&phia Stock #xchange ()%*X) is the only exchange in the 'nited *tates that trades foreign-currency options. 1t lists six dollar-based standardi@ed currency options contracts. /lthough options cost more than futures, large firms prefer options because of their greater flexibility and convenience. VI! GLOBAL CAPITAL MARKETS This section looks at the role of foreign debt and e%uity markets in moving currency from one country to another. A! E*r $*rren$ies The #urocurrency market is an important source of debt financing form )-$s. / #urocurrency is any currency that is banked outside its country of origin. / #urodo&&ar, then, is a certificate of deposit in dollars in a bank outside of the 'nited *tates. )ost $urodollar ,s are held in ?ondon, but they could be held in any bank outside the 'nited *tates. / major advantage of the $urodollar market is that, since it is an offshore market, it is not regulated by the .ederal Geserve +oard. Cther $urocurrencies are likewise not regulated by the major regulatory bodies in their respective home countries. The major sources of $urocurrencies are< .oreign governments or individuals who want to hold dollars outside of the 'nited *tates )ultinational enterprises that have cash in excess of current needs $uropean banks with foreign currency in excess of current needs ountries such as Hermany, >apan, and Taiwan that have large balanceof-trade surpluses held as reserves The $urocurrency market exists partly for reasons of convenience and security and partly because of cheaper lending rates for the borrower and a better yield for the lender. The $urocurrency market is a wholesale market where major players such as governments, central banks, and public sector corporations make large transactions. The $urocurrency market consists of short-term borrowing "maturities less than one year# and medium-term borrowing. / #urocredit is any loan, line of credit, or other instrument with a one to five year maturity. Syndications, also a form of $urocredit, are situations in which several banks pool resources to extend credit to a borrower and spread the risk. ?oans are traditionally made at a certain percentage above the *ondon 'nter-+ank Offered ,ate (*'+O,)$ which is the deposit rate that applies to interbank loans within ?ondon. The amount of the interest rate above ?1+CG that a borrower is charged depends on the credit worthiness of the customer, but is usually less than it would be in the domestic market. The $urocurrency market is completely unregulated. B! Intern)ti n)5 B n.s: F rei&n- E*r - )n. G5 4)5 The international bond market can be divided into foreign onds, #uro onds, and g&o a& onds. .oreign bonds are sold outside of the borrower(s country but 785

are denominated in the currency of the country of issue. / $urobond is usually underwritten "placed in the market for the borrower# by a syndicate of banks from different countries and sold in a currency other than that of the country of issue. The global bond, introduced by the &orld +ank in 7!;!, is a combination of a domestic bond and a $urobond0that is, it must be registered in each national market according to that market(s registration re%uirements. 1t is also issued simultaneously in several markets, usually those in /sia, $urope, and -orth /merica. C! E7*it6 Se$*rities )n. t(e E*r e7*it6 M)r/et /nother source of financing is e%uity securities, where an investor takes an ownership position in return for shares of stock in the company and the potential for capital gains andEor dividends. .irms can gain access to capital through private placements with wealthy individuals or venture capitalists. /nother source of demand for private placements is the corporate restructuring market in $urope. ompanies can also access the e%uity-capital market by listing their shares publicly on a stock exchange, either in their home country or in another country. The si@e of stock markets can be compared on the basis of market capita&i-ation "the total number of shares of stock listed times the market price per share#. The five biggest stock exchanges in the world are the -ew Iork *tock $xchange, -/*,/J, Tokyo *tock $xchange, ?ondon *tock $xchange, and $uronext. The growth of emerging stock markets was %uite erratic in the 7!!8s. 1n recent years, however, emerging markets have grown more rapidly. /nother significant development in the past decade is the creation of the #uroe"uity market, the market for shares sold outside the boundaries of the issuing country(s home country. Dundreds of companies worldwide have issued stock simultaneously in two or more countries in order to attract more capital from a wider variety of shareholders. Gecently, however, several companies have reduced the number of exchanges on which their stocks are listed. 1nvestors are finding that the best price for their stocks is usually in their home market. ,espite these trends, there are still 5K8 foreign companies listed on the -ew Iork *tock $xchange, more than triple the number listed in 7!!A. The most popular way for a $uroe%uity to get a listing in the 'nited *tates is to issue an !merican .epositary ,eceipt (!.,)0a negotiable certificate issued by a '.*. bank in the 'nited *tates to represent the underlying shares of a foreign corporation(s stock held in trust at a custodian bank in the foreign country. *ome /,Gs will list for the same price in the home country and foreign country exchange, but some companies list for different prices in different countries. /nother major development in international e%uity markets is electronic trading. ompanies such as $LTrade and harles *chwab M ompany are now doing business in $urope and competing with local e-trade companies. POINT8COUNTERPOINT: S%e$*5)ti n in C)%it)5 M)r/ets POINT: urrency speculation is not illegal, nor is it necessarily bad. *peculators are merely trying to make a profit by trading based on market trends. urrency speculation allows investors to diversify their portfolios from traditional stocks and bonds, which are themselves forms of speculative investment. 786

COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign exchange or securities, to make money illegally or contrary to company policy. -icholas ?eeson, a 9;-year-old trader for +ritish bank +arings P? was chief trader for the bank in *ingapore. ?eeson had no checks and balances on his trading and made big bets on stock index futures assuming that the Tokyo stock market would rise. /fter the >anuary 7F, 7!!6 earth%uake in =obe, >apanese stocks plunged and ?eeson had to come up with cash to cover the margin call. &ith lax internal controls, ?eeson was able to make numerous %uestionable and illegal transactions to illicitly generate the cash needed to cover his positions. These actions resulted in huge losses in excess of :7 billion for +arings, putting the company into bankruptcy. *ince the collapse of +arings, measures have been put into place in banks to prohibit such conse%uences, yet the occurrence of and potential for negative outcomes from rogue trading continue to exist. LOOKING TO THE FUTURE: T(e F*t*re # F rei&n E'$()n&e )n. G5 4)5 C)%it)5 M)r/ets The speed at which transactions are processed and information is transmitted globally will continue to lead to greater efficiencies and more opportunities in foreign exchange markets. ompanies( costs of trading foreign exchange should come down and they should gain faster access to more currencies. Hovernment exchange restrictions should diminish as currency markets are liberali@ed. /s the euro continues to solidify its position in $urope, it will reduce exchange-rate volatility and should lead to the euro taking some of the pressure off the dollar so that it is no longer the only major vehicle currency in the world. The growth of 1nternet trades in currency will take away some of the market share of dealers and allow more entrants in the foreign0exchange market.

CLOSING CASE: HSBC )n. t(e Pes Crisis in Ar&entin) -one of the closing cases in the last version of the manual had any summary paragraph, so 1 did not provide them with the revision. D*+ Doldings plc is a ?ondon based global banking and insurance enterprise with over F,888 offices in ;7 countries. D*+ entered /rgentina in 7!!F through an ac%uisition. /fter a loss in 7!!;, the company earned a healthy profit in 7!!! and expected growth rates of 788N or more. 1n 9887, however, /rgentina experienced a tremendous financial that led to losses of :7.7 billion for D*+ . The country(s economy has recovered well since 9889, but D*+ has been reluctant to invest more in /rgentina. 1s now the time for increased investment, or should D*+ continue to be reserved in its operations in /rgentinaO

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9*esti ns 1. What are the major factors that caused the peso to fall in value against the dollar? What has the government done to reverse the recession? &hen the onvertibility ?aw pegged the /rgentine peso 7<7 with the '.*. dollar, the government(s ability to respond to external shocks was severely reduced. 1n effect, /rgentina(s exchange-rate and monetary policies were determined de facto by the 'nited *tates, and /rgentina(s interest rates were determined by the '.*. .ederal Geserve. &hen world commodity prices declined, the '.*. dollar, and hence the /rgentine peso, strengthened against other currencies. oncurrently, /rgentina(s main trading partner, +ra@il, devalued its currency. /s deflation set in, both the /rgentine government and many private companies found it difficult to pay their debts. Tax revenues fell, while public spending increased. 1nterest rates payments went primarily to overseas investors, thus further draining the economy. &hen /rgentine banks were pressured to buy government bonds, a bank run ensued. .ollowing the government(s default on its debt, the currency board was abandoned, and the peso was allowed to float against the dollar. 1n the latter half of 9889, the /rgentine peso was trading at about 9F cents to the dollar. What has been Argentinas experience ith the !"#? $as the !"# been helpful or not? /rgentina has had a somewhat tumultuous relationship with the 1).. 1nitially when the country sought help from the 1)., the 1). refused saying that /rgentina would have to restructure its banking system, fiscal policy, and exchange rate policy. $ventually the 1). did grant loans to /rgentina, but then was difficult to negotiate with when /rgentina had trouble repaying those loans. The 1). and /rgentina did finally agree to terms, however, and both are working to establish a long term relationship. $o has the fall in the value of the peso affected business opportunities for companies doing business in Argentina and in exporting and importing? The biggest effect of the fall in the value of the peso for companies doing business in /rgentina was hyperinflation. /lso, companies with dollar denominated debt were badly hurt as the cost to repay that debt escalated rapidly. The declining peso helped exporters to be more competitive but made the prices of imported goods increase faster than the prices of domestic goods. 'hould $'() invest more mone* in its operations in Argentina? What factors should the* monitor as the* make their decision? D*+ should continue to be cautious in its approach to increased investment in /rgentina. /lthough the situation appears to be stabili@ed, it is still potentially volatile. The company should monitor the government(s actions carefully, particularly its actions regarding the repayment of foreign debt. /lso, if the government re%uires that dollar denominated loans issued by D*+ and other banks in the past be allowed to be repaid in Pesos, D*+ should be very reluctant to issue any more dollar denominated loans.

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WEB CONNECTION 78F

Teaching Tip/ Pisit www0prenha&&0com1danie&s for additional information and links relating to the topics presented in hapter -ine. +e sure to refer your students to the online study guide, as well as the 1nternet exercises for hapter -ine. QQQQQQQQQQQQQQQQQQQQQQQQQ CHAPTER T ERMINOLOG0: foreign exchange, p.A8F exchange rate, p. A8F foreign exchange market, p. A8F spot transactions, p. A8F spot rate, p. A8F outright forward, p. A8F .4 swap, p. A8F over-the-counter market, p.A8F currency swaps, p. A8; options, p. A8; futures contract, p. A8; hedge funds, p. A8; bid, p. A77 offer, p. A77 spread, p. A77 direct %uote, p. A77 /merican terms, p. A77 $uropean terms, p. A77 indirect %uote, p. A77 base currency, p. A77 terms currency, p. A77 interbank, p. A79 forward rate, p. A76 forward discount, p. A7K forward premium, p. A7K option, p. A7K hard currencies, p. A7K soft currencies, p. A7K weak currencies, p. A7K multiple exchange rate system, p. A7; advance import deposit, p. A7; arbitrage, p. A7; %uality controls, p. A7; interest arbitrage, p. A7! speculation, p. A7! hicago )ercantile $xchange " )$#, p. A99 Philadelphia *tock $xchange, p. A99 $urocurrency market, p. A9A $urocurrency, p. A9A $urodollar, p. A9A $urocredit, p. A9A syndication, p. A9A ?ondon 1nter-+ank Cffered Gate "?1+CG#, p. A95 foreign bonds, p. A95 $urobond, p. A96 global bond, p. A96 market capitali@ation, p. A9K $uroe%uity, p. A9; /merican ,epositary Geceipt "/,G#, p. A9!

ADDITIONAL EXERCISES: T(e F rei&n"E'$()n&e M)r/et E'er$ise :!;! )any students will have had experience with foreign currency conversion. /sk them to describe the differences they have encountered in rates %uoted at the airport, in hotels and banks and on the street. Then ask students to describe their experiences using credit cards and /T) cards in particular foreign countries. Dow were the transactions reported on their statementsO &ere they charged processing feesO

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E'er$ise :!<! Take copies of the most recent editions of +he Wall 'treet ,ournal and the #inancial +imes to class. $xplain to students where to find foreign exchange rates, forward rates, cross rates, commodity prices, etc. *elect the home countries of various students in your class. 'se the for ard rates to engage the students in a discussion as to which currencies appear to be stronger. $xplore the possible underlying reasons for a given currency(s strength or weakness. E'er$ise :!=! )ore than 768 currencies exist today. *ome countries share a common currency "e.g., those that participate in the $'GC#, while certain countries peg their currencies to others "e.g., hile(s currency is pegged to the '.*. dollar#. )any nations, however, maintain their own independent currencies. /sk students to debate the potential for additional regional currencies such as the $'GC. 1f they support the concept, should those currencies necessarily be tied to regional economic blocsO E'er$ise :!>! Dave the students assume the role of .C of a mid-si@ed '.*. company that exports to $urope. The company has received a contract to supply components to a $uropean manufacturer with an agreed upon sales price of 5 million due in !8 days. *hould the .C do anything to hedge against possible fluctuations in the dollarEeuro exchange rateO 1f so, whatO 1f not, why notO E'er$ise :!?! Ho to a trading &eb site like www.forex-markets.com or an information site like finance.yahoo.comEcurrency and demonstrate the charting, conversion calculators, and other research and information tools available for foreign exchange.

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