4. World Financial Environ

8/8/2019 4. World Financial Environ

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WORLD FINANCIALWORLD FINANCIAL

ENVIRONMENTENVIRONMENT

Global ForeignGlobal Foreign

ExchangeExchange&&



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ObjectivesObjectives

• Understand fundamentals of foreign exchange

• Identify major characteristics of FOREXmarket and Govt. Control of currencies flowsacross national borders

• Understand why companies deal in FOREX

• Understand how the foreign exchange marketworks

• Examine the different institutions that deal inFOREX

• Understand how companies make payment forinternational transactions



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CurrencCurrenc

y ?y ?

Money in any form when in actual use as a medium of exchange, circulation, prevalence (general acceptance oruse) and is up-to-dateness (state of being current)

A currency is a unit of exchange, facilitating the transfer of goods/services, e.g., coins & paper bills as money.

It is one form of money where anything that serves as a

medium of exchange, a store of value, and a standard of value.

Currencies are the dominant medium of exchange.

http://upload.wikimedia.org/wikipedia/en/b/b6/WorldCurrency.JPG



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Exchange:Exchange:

BasicBasic

ConceptsConcepts

Foreign exchange : money denominated in thecurrency of another nation or group of nations.Cash, funds available on credit & debit cards,traveler’s cheques, bank deposits etc.[a financial instrument issued by a foreign country]

Exchange rate: the price of one currencyexpressed in terms of another currency.

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

www.xe.com

Foreign exchange market: banks & currencyexchanges that buy & sell foreign currencies andother exchange instruments

[a market for converting the currency of one country into that of another country]

S 1

44.33

http://www.xe.com/

http://www.xe.com/



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Market: MajorMarket: Major

SegmentsSegments

• Over-the-counter (OTC) market: commercial and investment

banks [most foreign exchange activity occurs here]

• Exchange-traded market: specialized securities exchanges of

particular types of foreign-exchange instruments are traded[instruments such as futures & options are exchange-traded]

FOREX marketFOREX market biggest in the world ($4 trillion a day)

10 largest banks in the world trade over 70 % of total volume.

US dollar , the most important currency

USD/EUR & JPY/USD two top frequently traded currency

i ib i f



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Currency Distribution of Currency Distribution of

Global Foreign Exchange MarketGlobal Foreign Exchange Market

ActivityActivity

April April April April April April April

CURRENCY 199219951998200120042007 2010

U.S. Dollar 82 83 87 90 88 86 85

Euro — — — 38 37 37 39

Japanese Yen 23 24 22 24 21 17 19Pound Sterling 14 10 11 13 17 15 13

Swiss Franc 9 7 7 6 6 7 6

Australian dollar — — 3 4 6 7 8

Indian Rupee — — 0.1 0.2 0.3 0.7 0.9Source: Bank for International Settlements, Central BankSurvey of Foreign Exchange and Derivatives Market Activity, 2010.



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Geographical Distribution of FOREXGeographical Distribution of FOREX

MktsMkts



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Location of the Foreign ExchangeLocation of the Foreign Exchange

MarketMarket• London is the largest foreign exchange market

(followed by New York, Tokyo, and Singapore)because of its strategic location between Asia &the Americas.

• Market activity first heightens when Europe & Asiaare open and again when Europe and the UnitedStates are open.

• Cross-trading: using the U.S. dollar as a vehiclecurrency for trades between two other currencies– Cross rate: the exchange rate between two non-U.S.

dollar currencies that is computed from the exchange rateof each currency in relation to the U.S. dollar

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



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The Circadian Rhythms of theForeign Exchange Market

t t



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nternat ona me onesand the Single World

Market



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Foreign Exchange Terms &Conventions

• Bid: the price at which a trader is willing to buya foreign currency

• Offer/Ask: the price at which a trader is willingto sell a foreign currency

• Spread: the difference between the bid and theoffer rates, i.e., the trader’s profit

• American terms: the U.S. point of view, i.e., thenumber of U.S. dollars per unit of foreigncurrency

• European terms (indirect quote): the numberof units of foreign currency per U.S. dollar

[continued]



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• A quote in American terms (US$/Rs.) isalways the reciprocal of a quote in Europeanterms (Rs/US$).

$1.00/Rs. 0.02257 Rs.44.31/$1.00

• Base currency: the quoted, underlying, orfixed currency

• Traders always quote the base currency (the denominator) first, followed by theterms currency (the numerator).

• An example:

Dollar-yen quote: dollar = base, yen = terms Oct. 10, 2009 April 28, 2010 ¥110.96/$1.00 ¥106.04/$1.00

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

T f F i E hT f F i E h



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Types of Foreign ExchangeTypes of Foreign Exchange

MarketsMarkets• Spot market Spot market: (around 37% of FOREX Mkt. -

$1.5tr.) the market in which foreign exchangetransactions occur “on the spot,” i.e.,– Direct & Indirect quotes Base & term Currencies

– Inter-bank Transactions

– Spot rateSpot rate: the rate quoted for transactions that requireimmediate delivery, i.e. within two days

• Forward market Forward market: the market in which foreignexchange transactions occur at a set rate fordelivery beyond two business days following thedate of agreement to trade– Forward rateForward rate:: a contractually established exchange

rate between a foreign exchange trader and the trader’sclient for delivery of foreign currency on a specifieddate

forward discount forward discount: Forward rate < Spot rate

forward premiumforward premium: Forward rate > Spot rate

F d/F tF /F t



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Forward/FutureForwar /FutureInstrumentsInstruments

• Forward contract:Forward contract: a contract between a firm or

individual and a bank to deliver foreign currency at aspecific exchange rate on a future date

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

• Currency swap:Currency swap: the exchange of principal & interest payments via interest-bearing OTC financialinstruments (e.g., bonds)

• Futures contract:Futures contract: an agreement between two parties tobuy or sell a given currency at a given (negotiated)price on a particular future date, as specified in astandardized contract to all participants in thatcurrency futures exchange [not as flexible as aforward contract]

•



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• Option:Option: an instrument traded both OTC &

on exchanges that gives the purchaser theright (but not the obligation) to buy or sell acertain amount of foreign currency at aspecified exchange rate within a specifiedamount of time [more expensive but also more

flexible than a forward contract]

– Strike price: the exchange rate specified in theoption, i.e., the exercise price

– Premium: the fee paid to the writer of the option



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Exchange-based vs. Over-the-CounterExchange-based vs. Over-the-Counter

Forex InstrumentsForex InstrumentsEXCHANGE-BASEDEXCHANGE-BASED OTCOTC

(OPTIONS & FUTURES) (FORWARD CONTRACTS)

Contract Specs.Standard + Custom Custom

Regulation SEC Self

Type of market Open outcry, auction Dealer

Transparency Yes NoShort 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. usersSource: The Philadelphia Stock Exchange.



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Foreign ExchangeForeign Exchange

ConvertibilityConvertibility

Convertibility:Convertibility: the ability of residents andnonresidents to purchase foreign currency witha given (domestic) currency withoutgovernment restrictions

External convertibility:External convertibility: the ability of non-residents to purchase foreign currency with agiven currency without government limitations

Nonconvertibility:Nonconvertibility: the inability of residents andnonresidents to convert a given currency intoforeign currency because of government

limitations [continued]



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Fully convertible currenciesFully convertible currencies are those thatgovernments allow both residents andnonresidents to purchase in unlimited amounts,i.e., they are freely traded and accepted by thecentral banks (RBI).

Hard currenciesHard currencies are fully convertible, relativelystable, and tend to be comparatively strong.

Soft (weak) currencies are not fully convertible.

A government may control the convertibility of itscurrency through:

– licensing– a multiple exchange rate system– advance import deposits– quantity controls

Currency controls add to the cost of doing business & thus serve as seriousimpediments to trade & investment.



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The Uses of ForeignThe Uses of Foreign

ExchangeExchange• The role of commercial banks:– buy and sell foreign exchange

– serve as vehicles for payments between domesticand 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 futureprices]

– arbitrage [risk-free profit based on price differentials]

• interest arbitrage



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The Forex 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 inthe interbank market by matching the best bid & offer quotes.

• Banks’ fx dealers can trade foreign exchange:– directly with other dealers– through voice brokers– through electronic brokerage systems

St t f F i E h



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Structure of Foreign ExchangeMarkets



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Foreign Exchange Transactions

The Over the Counter Market:



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The Over-the-Counter Market:Commercial & Investment

Banks Top banks in the interbank fx marketsare so ranked because of their abilityto:

• 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

T OTC d C i l d



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Top OTC and Commercial andInvestment 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 42. UBS Warburg 11.61% 5 4 4 33. Citigroup 7.33% 3 1 3 14. HSBC 6.64% 1 5 2 25. Barclays 6.41% 4 — 7 76. JP Morgan 5.38% 7 2 5 57. ABN Amro 4.57% 9 7 6 68. 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 ExchangesU.S. exchanges where fx instruments (primarily

options and futures) are traded include:

• Chicago Mercantile Exchange (CME): offersfutures and futures options contracts in more

than a dozen foreign currencies

• Philadelphia Stock Exchange (PHLX): theonly U.S. exchange that trades foreign currency

options; lists six dollar-based standardizedcurrency options contracts

Although options cost more than futures, large firms prefer optionsbecause of their greater flexibility and convenience.

Gl b l C it l M k t



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Global Capital Markets:Eurocurrencies

• Eurocurrency: any currency banked outside itscountry of origin

• Eurocurrency market: an offshore, wholesalecurrency market [started with the deposit of U.S.dollars in London banks]

• Eurodollars: dollars banked outside of the UnitedStates, i.e., a certificate of deposit in dollars in abank located outside of the U.S.(constitute 65-80% of the Eurocurrency market)

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



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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 thatmatures in one to five years

•Syndication: the process of pooling the specificresources of several banks in order to spread the

risks associated with large loans

•London Inter-bank Offered Rate (LIBOR): reflectsthe interest rate London banks charge oneanother for short-term Eurocurrency loans

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

Gl b l C it l Mkt I t ti l



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Global Capital Mkts:InternationalBonds• 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; usuallyunderwritten by a syndicate of banks from differentcountries; typically sold over-the-counter

• Global bond: registered in different national markets

according to the registration requirements of eachmarket; traded simultaneously in numerous capitalmarkets

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

Global Capital Mkts:Equity



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Global Capital Mkts:EquitySecurities

•Private placement: an investment by aventure capitalist or other private party inexchange for stock

•Market capitalization: the total number of

shares listed times the market price pershare

• 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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,Bil.)

Gro th of Emerging Stock



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Growth of Emerging StockMarkets

Global Capital Mkts The Euroequity



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Global Capital Mkts:The EuroequityMkt

•Euroequity market: shares sold outside theboundaries of the issuing firm’s home country;issuing stock simultaneously in two or morecountries in order to attract capital from a

wider variety of shareholders

•Global share offering: the simultaneousoffering of actual shares on different stockexchanges

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

[continued]



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•American Depository Receipt (ADR): anego-tiable certificate issued by a U.S.

bank that represents underlying sharesof stock of a foreign corporation held intrust 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 foreignexchange is traded each day.

• The major institutions that trade foreignexchange are the large commercial andinvestment 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, butLondon represents the main foreignexchange market in the world.

•Some players buy and sell foreignexchange to settle trade transactions,some for purposes of foreign direct

investment, others for purposes of portfolio investment, and still othersfor arbitrage and speculation.



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