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International

Business
Lecture No,41
By
Dr.Shahzad Ansar

The Foreign Exchange


Market

Definitions
Foreign Exchange Market:
A market for converting the currency of
one country into the currency of another.
Exchange Rate:
The rate at which one currency is
converted into another.

The risk that arises from changes in


exchange rates.

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

Introduction
Fundamental difference between
payment transactions
Domestic transactionuse only
one currency
Foreign transactionuse two or
more currencies
Foreign exchange money
denominated in the currency of
another group of nations

Foreign-exchange marketmade up
of:
over-the-counter (OTC)
commercial and investment
banks
majority of foreign-exchange
activity
security exchanges
trade certain types of foreignexchange instruments

Exchange rateprice of
currency
Number of units of one
currency that buys one
unit of another
currency
Exchange rate can
change daily

Foreign-Exchange Instruments
Spot transactions exchange rate quoted
for transactions that require either immediate
delivery or delivery within two days

Spot rate settlement rate for the


transaction

Outright forwardexchange currency


beyond three days at a fixed exchange rate
Single purchase or sale of a currency for
future delivery

Forward ratesettlement rate for


transaction

Foreign-Exchange Instruments
FX swapa simultaneous spot and
forward transaction
Currency swapsinvolve interest-bearing
financial instruments
Exchange of principal and interest
payments
Optionsthe right but not the obligation
to trade foreign currency in the future
Futures contractagreement to buy or
sell a currency in the future at a
particular price

The Foreign-Exchange Market


Size of foreign-exchange market
$1.5 trillion daily in traditional
instruments
$110 billion daily in other OTC and
exchange-traded instruments
Spot transactions are only 40%t of total
transactions

The Foreign-Exchange Market


U.S. dollar is the most important currency because
it is:
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 to influence their exchange rates
Londonthe biggest market for foreign exchange

Average Daily Volume in World ForeignExchange


Markets, 19891998
U.S. dollars (billions)

1600

1,500

1400
1,190

1200
1000
820

800
600

590

400
200
0

1989

1992

1995

1998

Years
12

Average Daily Volume of Foreign-Exchange


Transactions

$350.90

$451.20

$78.60
$81.70

$139

$94.30
$148.60
$637.30

United States

Hong Kong

Switzerland

Germany

Japan

United Kingdom

Singapore

Others

13

Key Foreign-Exchange Terms


for the Spot Market
Bidprice at which traders are willing to
buy foreign currency
Offerprice at which traders are willing to
sell foreign currency
Spreaddifference between bid and offer
price
Profit margin for the trader
Direct quotethe number of U.S. dollars
per unit of foreign currency
American termsperspective of U.S.
trader

Key Foreign-Exchange Terms


for the Spot Market
Indirect quotethe number of units of
foreign currency per U.S. dollar
European termsperspective of
European trader
base currencyU.S. dollar
terms currencyother currency in
exchange
Cross rateexchange rate between non
U.S. dollar currencies

The Forward Market


Most widely traded currencies
British pound, Canadian dollar,
French franc, German mark,
Japanese yen, and U.S. dollar
Many currencies do not have a
forward market due to the small
size and volume of transactions

Forward ratethe rate quoted for transactions

after two days


Forward discountthe forward rate for foreign
currency is less than the spot rate
Forward premiumthe forward rate for foreign
currency is greater than the spot rate

Options
Optionthe right but not the obligation to trade a
foreign currency at a specific exchange rate
Can be purchased OTC or from an exchange
Forward contract is cheaper but less flexible
than an option

Futures
Futures contractspecifies in advance the
exchange rate to be used in exchanging
currency
Tailored to the amount and time frame
needed
Not as flexible as a forward contract
and, therefore, is less valuable

Foreign-Exchange Convertibility
Fully convertible currenciesgovernment
permits both residents and nonresidents
to purchase in unlimited amounts
Hard currencycurrencies that are fully
convertible
Relatively stable and strong
Soft currenciescurrencies that are not
fully convertible
Typically currencies of developing
countries
Nonresident convertibilityforeigners can

Governmental Restrictions on
Foreign-Exchange Convertibility
Restrictions used to conserve scarce foreign
exchange
Licensinggovernment regulates all
foreign-exchange transactions
those who receive foreign currency
required to sell it to its central bank at the
official buying rate
central bank rations foreign currency
Multiple exchange-rate systemdifferent
exchange rates set for different transactions

Governmental Restrictions on
Foreign-Exchange Convertibility
Advance import depositrequires importers
to make a deposit with central bank
covering price of goods they would
purchase from abroad
Quantity controlslimit the amount of
currency that resident can purchase for
foreign travel
Currency controls increase the cost of
international business and reduce overall
international trade

How Companies Use Foreign


Exchange
Most foreign-exchange transactions
involve international departments of
commercial banks
Banks buy and sell foreign currency;
banks collect and pay money in
transaction with foreign buyers and
sellers
Banks lend money in foreign currency

Companies use foreign-exchange market for:


Import and export transactions
Financial transactions such as FDI
Arbitragepurchase of foreign currency on
one market for immediate resale on another
market
Arbitragers hope to profit from price
discrepancy
Interest arbitrageinvesting in debt
instruments in different countries
Speculationbuying or selling foreign
currency has both risk and high profit
potential

Foreign-Exchange Trading Process


Companies work through their local banks to
settle foreign-exchange balances
Commercial banks in major money centers
became intermediaries for small banks
Most foreign-exchange activity takes place in
traditional instruments
Commercial and investment banks and
other financial institutions handle spot,
outright forward, and FX swaps
Foreign-exchange market made up of
about 2,000 dealer institutions worldwide

Most foreign-exchange takes place in


OTC market
Dealers can trade foreign exchange:
Directly with other dealers
Through voice brokers
Through electronic brokerage systems
Internet trades of currency are more
popular