Chapter 9. GLOBAL FOREIGN EXCHANGE MARKETS
Multinational enterprises (MNEs) do business in more than one country. Because countries
have different currencies (e.g. US dollar, Japanese Yen), MNEs will conduct transactions in
several currencies. This chapter (and the next chapter) will look at how companies handle the
complexities of dealing with multiple currencies.
II. KEY CONCEPTS
– A currency is an instrument of payment in a country (e.g. US dollar) or grouping of countries
(e.g. Euro in most European Union countries).
– Foreign exchange is money denominated in the currency of another country (e.g. China has
more than US$2 trillion in reserve).
– Foreign exchange market is the place where currencies are traded. The foreign exchange
market is comprised of two segments:
+ The over-the-counter market (OTC) includes commercial banks, investment banks, and other financial institutions. The OTC is where most foreign exchange activity occurs
+ The exchange-traded market includes certain securities exchanges (e.g., the Chicago Mercantile Exchange and NASDAQ OMX) where particular types of foreign-exchange instruments (such as futures and options) are traded.
– Players on the foreign exchange market are institutions that take part in foreign exchange
transactions. There are three major players on the foreign exchange market:
+ Reporting dealers (or money centers) are large banks (e.g. Deutsche Bank, HSBC)
+ Other financial institutions such as local and regional commercial banks, hedge funds, pension funds, mutual funds, etc.
+ Non-financial institutions such as governments and companies
– Exchange rate is the number of units of one currency needed to buy a unit of another currency.
A direct quote is an exchange rate that gives the value in dollars of a unit of foreign currency (it
is also referred to as an exchange rate quoted in American terms). An example of a direct quote
is US$1.2 = Euro 1. An indirect quote is an exchange rate that gives the value in foreign
currency of one US dollar (it is also referred to as an exchange rate quoted in European terms).
An example of an indirect quote is US$1= Euro 0.94
– Spot transactions represent the exchange of currencies settled within two business days after
the date of agreement. The spot rate is the exchange rate quoted for spot transactions
– Forward transactions represent the exchange of currencies beyond two business days. The
forward rate is the exchange rate used for forward transactions
– 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.
III. CHARACTERISTICS OF THE FOREIGN EXCHANGE MARKET
1. Size of foreign exchange market: It is estimated in 2007 that $4 trillion in foreign exchange
was traded each day. One reason for such a trading activity is the growing importance of foreign
exchange as an alternative asset and the larger emphasis on hedge funds (a fund, usually used by
wealthy individuals and institutions, which is allowed to use aggressive trading strategies
unavailable to mutual funds).
2. Importance of the US dollar: The U.S. dollar remains the most important currency in the foreign-exchange market, and represented of 84.9 percent of all foreign currency transactions worldwide in 2010. This is because the dollar is:
+ An investment currency in many capital markets
+ Held as a reserve currency by many central banks
+ The currency for many international transactions
+ The invoice currency in many contracts
+ Often used as an intervention currency when foreign monetary authorities wish to influence their own exchange rates.
Dollarization: It is the use of the US dollar in some nations in addition to their domestic
currencies. For example, in Congo several stores and other merchants accept the US$ alongside
the Congolese Frank. Nations whose economies are dollarized tend to have unstable currencies.
3. Locations of foreign exchange market: The largest foreign exchange market is in the United
Kingdom (London), which is strategically situated between Asia and the Americas, followed by
the United States, Japan, and Singapore. Four of the most commonly traded currency pairs
involve the U.S. dollar, with the top two pairs being euro/dollar (EUR/USD) and the dollar/yen
IV. HOW COMPANIES USE FOREIGN EXCHANGE
Companies enter the foreign-exchange market to facilitate their regular business transactions, and/or to speculate:
1. Imports and exports: When a company must pay for purchases (imports) or receive payment for sales (exports), it has an option on the documents to use, including a draft and a letter of credit:
– Draft: A draft (or commercial bill of exchange) is an instrument in which one party directs another to make a payment. If the exporter demands payment to be made immediately, the draft is called a sight draft. If the payment is to be made later, it is called a time draft. With a draft however, it is always possible the importer will not be able to make the payment to the exporter. The letter of credit minimizes this possibility
– Letter of credit: A letter of credit (L/C) is an instrument of payment that obligates the buyer’s bank to honor the draft. There are still risks with an L/C. It must adhere to all the conditions in the document to be valid. A letter of credit may also be confirmed by another bank and is called a confirmed letter of credit.
2. Other financial flows: MNEs also deal in foreign exchange for other transactions, such as the receipt or payment of dividends or the receipt or payment of loans and interests.
3. Speculation: Sometimes companies deal in foreign exchange for profit (i.e. for speculation). Speculation involves buying (or selling) a currency based on the expectation it will gain (or lose) value against other currencies. Although speculation offers the chance to profit, it also contains an element of risk. 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.