This document provides an overview of the global foreign exchange and capital markets. It discusses the major characteristics of the foreign exchange market, including the different players, instruments, and locations. It describes how commercial banks and other financial institutions facilitate foreign exchange trading in both over-the-counter and exchange-traded markets. It also examines global capital markets, including sources of debt financing like Eurocurrencies, international bonds, and equity securities.

1. 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 foreign-exchange
instruments for business, speculative, or personal purposes. Primarily, foreign
exchange is used to settle international trade, licensing, and investment transactions.
Chapter 9 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 Eurocurrencies, international bonds, and
equity markets.
CHAPTER OUTLINE
OPENING CASE: Western Union
This case describes Western Union’s international money transfer services and the
increasing competition the company is facing from banks. Western Union has been
particularly successful in attracting business from Mexican emigrants in the United States
who send part of their paycheck home to support their families. Western Union charges
relatively high fees and uses its own exchange rates that are usually significantly lower
than the market rate. Banks have been introducing their own money transfer services,
many with lower fees and better exchange rates than Western Union. Due to many
Mexicans’ distrust of banks, however, Western Union continues to enjoy large profit
margins and a large market share in the money transfer business.
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2. TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Nine and select
those you find most useful for enhancing your lecture and class discussion. For
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.
An 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 institutions—this is where most foreign-exchange
activity occurs. The exchange-traded market includes certain securities
exchanges (e.g., the Chicago Mercantile Exchange and the Philadelphia Stock
Exchange) where particular types of foreign-exchange instruments (such as futures
and options) are traded.
A. A Brief Description of Foreign-Exchange Instruments
Several types of foreign exchange instruments are available for trading. In
addition, several types of transactions may occur. Spot transactions involve the
exchange of currency “on the spot,” or technically, transactions that are settled
within two business days after the date of agreement to trade. The spot rate is
the exchange rate quoted for transactions that require 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. In 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. In fact, the same currency is
bought and sold simultaneously, but delivery occurs at two different times. FX
swaps account for nearly 45 percent of all foreign-exchange transactions. In
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. 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
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3. 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. The Size, Composition and Location of the Foreign-Exchange
Market
The Bank for International Settlements (BIS) estimated in 2004 that $1.9 trillion
in foreign exchange was traded each day. This increase more than reversed the
decline seen from 1998 to 2001. 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
U.S. dollar remains the most important currency in the foreign-exchange market,
comprising one side (buy or sell) of 89 percent of all foreign currency
transactions worldwide in 2004. 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.
Nonetheless, the largest foreign exchange market is in the United Kingdom,
which is strategically situated between Asia and the Americas, followed by the
United States, Japan and Singapore.
DOES GEOGRAPHY MATTER?
Foreign-Exchange Trades
Even though the U.S. dollar is the most widely traded currency in the world, some trading
centers outside the U.S. are very important in the global currency trade. London, for
example, is a major trading center because it is close to the major capital markets in
Europe and is in a time zone that straddles the other major markets in Asia and the U.S.
Despite the fact that the currency market is a 24 hour market, the heaviest volumes of
trade are concentrated in the hours when Asia and Europe are open or when Europe and
the U.S. are open (see Figure 9.3). Also, prices tend to be better when markets are active
and liquid.
III. MAJOR FOREIGN-EXCHANGE INSTRUMENTS
A. The Spot Market
The spot market consists of players who conduct those foreign-exchange
transactions that occur “on the spot,” or technically, within two business days
following the date of agreement to trade. Foreign-exchange traders always quote
a bid (buy) and offer (sell) rate. The bid is the rate at which traders buy foreign
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4. exchange; 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. Exchanges can be quoted in American terms, i.e., a dollar-direct quote
that gives the value in dollars of a unit of foreign currency, or European terms,
i.e., an indirect quote that gives the value in foreign currency of one U.S. dollar.
The base currency, or the denominator, is the quoted, underlying, or fixed
currency; the terms currency is the numerator. Most large newspapers quote
exchange rates daily, listing both spot and forward rates. The spot rates listed
are usually the selling rates for interbank transactions (transactions between
banks) of $1 million or more.
B. The Forward Market
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 quoted today for the future
delivery of a foreign currency. A 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. Options
An 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).
Options 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. An option is more flexible, but also more expensive, than a forward
contract.
D. Futures
A foreign currency future resembles a forward contract because it specifies an
exchange rate sometime in advance of the actual exchange of the currency.
However, a future is traded on an exchange, not OTC. While 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. Foreign-Exchange Convertibility
Hard 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. Hard 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 and/or companies. Under a multiple exchange-rate system the
government sets different rates for different types of transactions. If the
government imposes an advance import deposit, importers will be required 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. With quantity controls,
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5. the government limits the amount of foreign currency that can be used for a given
transaction. Such 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 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. Speculation involves buying (or selling) a currency
based on the expectation it will gain (or lose) in strength against other currencies.
Although speculation offers the chance to profit, it also contains an element of risk.
The Parker Discretionary FX Index, which measures the performance of 17 currency
managers worldwide, finished with a negative return in 2004—the first negative
return in 19 years.
V. THE FOREIGN-EXCHANGE TRADING PROCESS
When a firm needs foreign exchange, it typically goes to its commercial bank. If the
bank is large enough, it may have its own foreign-exchange traders. A 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 quotes of interbank traders. The Bank for International Settlements (BIS)
based in Basel, Switzerland (effectively the central banks’ central bank), estimates
there are about 1,200 dealer institutions worldwide that comprise the foreign-exchange
market. Of these, approximately 100 to 200 are market markers and, of this
group, only a select few are major players.
A. Commercial and Investment Banks
At one time, only big money center banks could deal in foreign exchange. Now,
with the advent of electronic trading, smaller regional banks can hook up to
Reuters and Bloomberg and deal directly in the interbank market. In spite of
these developments, the greatest volume of foreign-exchange activity still takes
place with the big banks. Commercial banks and other financial institutions
comprise the over-the-counter market (OTC). This is where most foreign-exchange
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.
Other factors often mentioned are market share by size and region, advisory
services, price, quote speed, credit rating, liquidity, back office/settlement,
strategic advice, trade recommendations, out-of-hours service/night desk,
systems technology, innovation, risk appraisal, and e-commerce capabilities. A
large firm may use more than one bank to conduct its foreign-exchange dealings,
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6. given their particular strategic capabilities. In addition to the OTC market, there
are a number of exchanges where particular types of foreign-exchange
instruments (such as futures and options) are traded. The Chicago Mercantile
Exchange (CME) 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 dozen foreign currencies. The Philadelphia Stock Exchange
(PHLX) is the only exchange in the United States that trades foreign-currency
options. It 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.
VI. GLOBAL CAPITAL MARKETS
This section looks at the role of foreign debt and equity markets in moving currency
from one country to another.
A. Eurocurrencies
The Eurocurrency market is an important source of debt financing form MNEs.
A Eurocurrency is any currency that is banked outside its country of origin. A
Eurodollar, then, is a certificate of deposit in dollars in a bank outside of the
United States. Most Eurodollar CDs are held in London, but they could be held
in any bank outside the United States. A major advantage of the Eurodollar
market is that, since it is an offshore market, it is not regulated by the Federal
Reserve Board. Other Eurocurrencies are likewise not regulated by the major
regulatory bodies in their respective home countries. The major sources of
Eurocurrencies are:
• Foreign governments or individuals who want to hold dollars outside of
the United States
• Multinational enterprises 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
The Eurocurrency 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 Eurocurrency market is a wholesale market where major
players such as governments, central banks, and public sector corporations make
large transactions. The Eurocurrency market consists of short-term borrowing
(maturities less than one year) and medium-term borrowing. A Eurocredit is
any loan, line of credit, or other instrument with a one to five year maturity.
Syndications, also a form of Eurocredit, are situations in which several banks
pool resources to extend credit to a borrower and spread the risk. Loans are
traditionally made at a certain percentage above the London Inter-Bank
Offered Rate (LIBOR), which is the deposit rate that applies to interbank loans
within London. The amount of the interest rate above LIBOR 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 Eurocurrency market is completely
unregulated.
B. International Bonds: Foreign, Euro, and Global
The international bond market can be divided into foreign bonds, Eurobonds,
and global bonds. Foreign bonds are sold outside of the borrower’s country but
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7. are denominated in the currency of the country of issue. A Eurobond 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 World Bank in 1989, is a combination
of a domestic bond and a Eurobond—that is, it must be registered in each
national market according to that market’s registration requirements. It is also
issued simultaneously in several markets, usually those in Asia, Europe, and
North America.
C. Equity Securities and the Euroequity Market
Another source of financing is equity securities, where an investor takes an
ownership position in return for shares of stock in the company and the potential
for capital gains and/or dividends. Firms can gain access to capital through
private placements with wealthy individuals or venture capitalists. Another
source of demand for private placements is the corporate restructuring market in
Europe. Companies can also access the equity-capital market by listing their
shares publicly on a stock exchange, either in their home country or in another
country. The size of stock markets can be compared on the basis of market
capitalization (the total number of shares of stock listed times the market price
per share). The five biggest stock exchanges in the world are the New York
Stock Exchange, NASDAQ, Tokyo Stock Exchange, London Stock Exchange,
and Euronext. The growth of emerging stock markets was quite erratic in the
1990s. In recent years, however, emerging markets have grown more rapidly.
Another significant development in the past decade is the creation of the
Euroequity market, the market for shares sold outside the boundaries of the
issuing country’s home country. Hundreds of companies worldwide have issued
stock simultaneously in two or more countries in order to attract more capital
from a wider variety of shareholders. Recently, however, several companies have
reduced the number of exchanges on which their stocks are listed. Investors are
finding that the best price for their stocks is usually in their home market.
Despite these trends, there are still 460 foreign companies listed on the New
York Stock Exchange, more than triple the number listed in 1993. The most
popular way for a Euroequity to get a listing in the United States is to issue an
American Depositary Receipt (ADR)—a negotiable certificate issued by a U.S.
bank in the United States to represent the underlying shares of a foreign
corporation’s stock held in trust at a custodian bank in the foreign country.
Some ADRs will list for the same price in the home country and foreign country
exchange, but some companies list for different prices in different countries.
Another major development in international equity markets is electronic trading.
Companies such as E*Trade and Charles Schwab & Company are now doing
business in Europe and competing with local e-trade companies.
POINT—COUNTERPOINT: Speculation in Capital Markets
POINT: Currency speculation is not illegal, nor is it necessarily bad. Speculators
are merely trying to make a profit by trading based on market trends. Currency
speculation allows investors to diversify their portfolios from traditional stocks and
bonds, which are themselves forms of speculative investment.
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8. COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign
exchange or securities, to make money illegally or contrary to company policy. Nicholas
Leeson, a 28-year-old trader for British bank Barings PLC was chief trader for the bank in
Singapore. Leeson had no checks and balances on his trading and made big bets on stock
index futures assuming that the Tokyo stock market would rise. After the January 17,
1995 earthquake in Kobe, Japanese stocks plunged and Leeson had to come up with cash
to cover the margin call. With lax internal controls, Leeson was able to make numerous
questionable and illegal transactions to illicitly generate the cash needed to cover his
positions. These actions resulted in huge losses in excess of $1 billion for Barings, putting
the company into bankruptcy. Since the collapse of Barings, measures have been put into
place in banks to prohibit such consequences, yet the occurrence of and potential for
negative outcomes from rogue trading continue to exist.
LOOKING TO THE FUTURE:
The Future of Foreign Exchange and Global Capital Markets
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. Companies’ costs of trading foreign exchange should come down and they
should gain faster access to more currencies. Government exchange restrictions should
diminish as currency markets are liberalized. As the euro continues to solidify its position
in Europe, 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 Internet trades in currency will take away some of the market share
of dealers and allow more entrants in the foreign—exchange market.
CLOSING CASE: HSBC and the Peso Crisis in Argentina
None of the closing cases in the last version of the manual had any summary paragraph, so
I did not provide them with the revision.
HSBC Holdings plc is a London based global banking and insurance enterprise with over
7,000 offices in 81 countries. HSBC entered Argentina in 1997 through an acquisition.
After a loss in 1998, the company earned a healthy profit in 1999 and expected growth
rates of 100% or more. In 2001, however, Argentina experienced a tremendous financial
that led to losses of $1.1 billion for HSBC. The country’s economy has recovered well
since 2002, but HSBC has been reluctant to invest more in Argentina. Is now the time for
increased investment, or should HSBC continue to be reserved in its operations in
Argentina?
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9. Questions
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?
When the Convertibility Law pegged the Argentine peso 1:1 with the U.S. dollar, the
government’s ability to respond to external shocks was severely reduced. In effect,
Argentina’s exchange-rate and monetary policies were determined de facto by the
United States, and Argentina’s interest rates were determined by the U.S. Federal
Reserve. When world commodity prices declined, the U.S. dollar, and hence the
Argentine peso, strengthened against other currencies. Concurrently, Argentina’s
main trading partner, Brazil, devalued its currency. As deflation set in, both the
Argentine government and many private companies found it difficult to pay their
debts. Tax revenues fell, while public spending increased. Interest rates payments
went primarily to overseas investors, thus further draining the economy. When
Argentine banks were pressured to buy government bonds, a bank run ensued.
Following the government’s default on its debt, the currency board was abandoned,
and the peso was allowed to float against the dollar. In the latter half of 2002, the
Argentine peso was trading at about 27 cents to the dollar.
2. What has been Argentina’s experience with the IMF? Has the IMF been helpful or
not?
Argentina has had a somewhat tumultuous relationship with the IMF. Initially when
the country sought help from the IMF, the IMF refused saying that Argentina would
have to restructure its banking system, fiscal policy, and exchange rate policy.
Eventually the IMF did grant loans to Argentina, but then was difficult to negotiate
with when Argentina had trouble repaying those loans. The IMF and Argentina did
finally agree to terms, however, and both are working to establish a long term
relationship.
3. How 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
Argentina was hyperinflation. Also, 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.
4. Should HSBC invest more money in its operations in Argentina? What factors
should they monitor as they make their decision?
HSBC should continue to be cautious in its approach to increased investment in
Argentina. Although the situation appears to be stabilized, it is still potentially
volatile. The company should monitor the government’s actions carefully,
particularly its actions regarding the repayment of foreign debt. Also, if the
government requires that dollar denominated loans issued by HSBC and other banks
in the past be allowed to be repaid in Pesos, HSBC should be very reluctant to issue
any more dollar denominated loans.
WEB CONNECTION
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10. Teaching Tip: Visit www.prenhall.com/daniels for additional information and links
relating to the topics presented in Chapter Nine. Be sure to refer your students to the
online study guide, as well as the Internet exercises for Chapter Nine.
_________________________
CHAPTER TERMINOLOGY:
foreign exchange, p.307
exchange rate, p. 307
foreign exchange market, p. 307
spot transactions, p. 307
spot rate, p. 307
outright forward, p. 307
FX swap, p. 307
over-the-counter market, p.307
currency swaps, p. 308
options, p. 308
futures contract, p. 308
hedge funds, p. 308
bid, p. 311
offer, p. 311
spread, p. 311
direct quote, p. 311
American terms, p. 311
European terms, p. 311
indirect quote, p. 311
base currency, p. 311
terms currency, p. 311
interbank, p. 312
forward rate, p. 315
forward discount, p. 316
forward premium, p. 316
option, p. 316
hard currencies, p. 316
soft currencies, p. 316
weak currencies, p. 316
multiple exchange rate
system, p. 318
advance import deposit, p. 318
arbitrage, p. 318
quality controls, p. 318
interest arbitrage, p. 319
speculation, p. 319
Chicago Mercantile Exchange
(CME), p. 322
Philadelphia Stock Exchange, p.
322
Eurocurrency market, p. 323
Eurocurrency, p. 323
Eurodollar, p. 323
Eurocredit, p. 323
syndication, p. 323
London Inter-Bank Offered Rate
(LIBOR), p. 324
foreign bonds, p. 324
Eurobond, p. 325
global bond, p. 325
market capitalization, p. 326
Euroequity, p. 328
American Depositary Receipt
(ADR), p. 329
ADDITIONAL EXERCISES: The Foreign-Exchange Market
Exercise 9.1. Many students will have had experience with foreign currency
conversion. Ask them to describe the differences they have encountered in rates
quoted at the airport, in hotels and banks and on the street. Then ask students to
describe their experiences using credit cards and ATM cards in particular foreign
countries. How were the transactions reported on their statements? Were they
charged processing fees?
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11. Exercise 9.2. Take copies of the most recent editions of The Wall Street Journal
and the Financial Times to class. Explain to students where to find foreign exchange
rates, forward rates, cross rates, commodity prices, etc. Select the home countries of
various students in your class. Use the forward rates to engage the students in a
discussion as to which currencies appear to be stronger. Explore the possible
underlying reasons for a given currency’s strength or weakness.
Exercise 9.3. More than 150 currencies exist today. Some countries share a
common currency (e.g., those that participate in the EURO), while certain countries
peg their currencies to others (e.g., Chile’s currency is pegged to the U.S. dollar).
Many nations, however, maintain their own independent currencies. Ask students to
debate the potential for additional regional currencies such as the EURO. If they
support the concept, should those currencies necessarily be tied to regional economic
blocs?
Exercise 9.4. Have the students assume the role of CFO of a mid-sized U.S.
company that exports to Europe. The company has received a contract to supply
components to a European manufacturer with an agreed upon sales price of €4
million due in 90 days. Should the CFO do anything to hedge against possible
fluctuations in the dollar/euro exchange rate? If so, what? If not, why not?
Exercise 9.5. Go to a trading Web site like www.forex-markets.com or an
information site like finance.yahoo.com/currency and demonstrate the charting,
conversion calculators, and other research and information tools available for foreign
exchange.
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