1. Part 4 World Financial Environment 9-1 Copyright © 2011 Pearson Education

2. 9-2 Chapter 9 Global Foreign Exchange Markets

3. 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 describe how the foreign-exchange market works To examine the different institutions that deal in foreign exchange To understand why companies deal in foreign exchange 9-3 Copyright © 2011 Pearson Education

4. Money denominated in the currency of another nation or group of nations Can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits, or other short-term claims An exchange rate is the price of a currency 9-4 Copyright © 2011 Pearson Education

5. The Bank for International Settlements divides the foreign-exchange market into reporting dealers (also known as dealer banks or money center banks), other financial institutions, and non-financial institutions. Reporting dealers, also known as money center banks, are widely assumed to include the 10 largest banks in terms of overall market share in foreign exchange trading: Deutsche Bank, UBS, Barclays Capital, RBS, Citi, JP Morgan, HSBC, Goldman Sachs, Credit Suisse, and Bank of America. Because of the volume of transactions that the money center banks engage in, they are influential in setting prices and are the market makers. 9-5 Copyright © 2011 Pearson Education

6. Over-the-counter (OTC) commercial and investment banks. Securities exchanges CME, NASDAQ OMX, NYSE Life 9-6 Copyright © 2011 Pearson Education

7. Spot Transactions: The spot rate is the exchange rate quoted for transactions that require delivery within two days. Outright Forward Transactions: Outright forwards involve the exchange of currency beyond three days at a fixed exchange rate, known as the forward rate. FX Swap: In an FX swap, one currency is swapped for another on one date and then swapped back on a future date. Most often, the first leg of an FX swap is a spot transaction, with the second leg of the swap a forward transaction. 9-7 Copyright © 2011 Pearson Education

8. Currency Swaps: Currency swaps deal more with interest-bearing financial instruments (such as a bond), and they involve the exchange of principal and interest payments. Options: Options are the right, but not the obligation, to trade foreign currency in the future. Futures Contract: A futures contract is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date, as specified in a standardized contract to all participants in that currency futures exchange. 9-8 Copyright © 2011 Pearson Education

9. Size of the foreign-exchange market—$3.2 trillion daily The U.S. dollar is the most important currency on the foreign-exchange market Frequently Traded Currency Pairs Top two pairs include EUR/USD and USD/JPY 9-9 Copyright © 2011 Pearson Education

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11. Copyright © 2011 Pearson Education 9-11

12. Direct and Indirect Quotas Base and Term Currencies Inter-bank Transactions 9-12 Copyright © 2011 Pearson Education Key foreign-exchange terms: Bid — the rate at which traders buy foreign exchange Offer — the rate at which traders sell foreign exchange Spread — the difference between bid and offer rates American terms, or direct quote — the number of dollars per unit of foreign currency European terms, or indirect quote — the number of units of foreign currency per dollar

13. 9-13 Copyright © 2011 Pearson Education Base and Term Currencies: When dealers quote currencies to their customers, they always quote the base currency (the denominator) first, followed by the terms currency (the numerator). A quote for USD/JPY (also shown as USDJPY = X) means the dollar is the base currency and the yen is the terms currency. Inter-bank transactions Inter-bank transactions are transactions between banks. Retail transactions, those between banks and companies or individuals, provide fewer foreign currency units per dollar than inter-bank transactions.

14. Forward Discounts-exist when the forward rate is less than the spot rate. Forward Premiums-exist when the forward rate is greater than the spot rate. Option-the right, but not the obligation, to trade a foreign currency at a specific exchange rate. Futures-specifies an exchange rate in advance of the actual exchange of currency 9-14 Copyright © 2011 Pearson Education

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16. The top banks in the inter-bank market in foreign exchange are so ranked because of their ability to Trade in specific market locations. Engage in major currencies and cross-trades. Deal in specific currencies. Handle derivatives (forwards, options, futures, swaps). Conduct key market research. 9-16 Copyright © 2011 Pearson Education

17. Restrictions to the free flow of goods and services should diminish Technological developments cause foreign exchange trades to be executed more quickly and cheaply. Internet trade will increase currency price transparency and increase the ease of trading, thus allowing more investors into the market. 9-17 Copyright © 2011 Pearson Education

18. Cash Flow Aspects of Imports and Exports Commercial Bills of Exchange commercial bill sight draft time draft With a draft or commercial bill of exchange, one party directs another party to make payment. A sight draft requires payment to be made when it is presented. A time draft permits payment to be made after the date when it is presented. Letters of Credit A letter of credit obligates the buyer ’ s bank to honor a draft presented to it and assume payment; a credit relationship exists between the importer and the importer ’ s bank. Other Financial Flows Speculation Arbitrage 9-18 Copyright © 2011 Pearson Education

19. Other Financial Flows Speculation Speculation is the buying or selling of a commodity, in this case foreign currency, that has both an element of risk and the chance of great profit. For example, an investor could buy euros in anticipation that the euro will strengthen against other currencies. If it strengthens, the investor earns a profit; if it weakens, the investor incurs a loss. Speculators are important in the foreign-exchange market because they spot trends and try to take advantage of them. They can create demand for a currency by purchasing it in the market, or they can create a supply of the currency by selling it in the market. Arbitrage Arbitrage is the buying and selling of foreign currencies at a profit due to price discrepancies. Interest arbitrage involves investing in interest-bearing instruments in foreign exchange in an effort to earn a profit due to interest rate differentials. 9-19 Copyright © 2011 Pearson Education