Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-1 Part Four World Financial Environment Chapter Nine Global Foreign Exchange And Capital Markets

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-2 Chapter’s 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 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

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-3 Foreign Exchange Foreign exchange is money denominated in the currency of another nation or group of nations The market in which these transactions take place is the foreign-exchange market. The exchange rate is the price of a currency

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-4 The Foreign Exchange 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 nonfinancial institutions. Dealers can trade currency by telephone or electronically, especially through Reuters, EBS, or Bloomberg The foreign exchange market is divided into the over-the-counter market (OTC) and the exchange-traded market

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-5 Some Traditional Foreign Exchange Instruments Spot transactions involve the exchange of currency on the second day after the date on which the two dealers agree to the transaction Outright forward transactions involve the exchange of currency three or more days after the date on which the dealers agree to the transaction An FX swap is a simultaneous spot and forward transaction

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-6 Foreign Exchange Derivatives Currency swaps deal more with interest-bearing financial instruments (such as a bond), and they involve the exchange of principal and interest payments. Options are the right but not the obligation to trade foreign currency in the future. 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.

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-7 Some Aspects Of The Foreign Exchange Market Approximately $3.2 trillion in foreign exchange is traded every day. The US dollar is the most widely traded currency in the world (on one side of 86% of all transactions) London is the main foreign exchange market in the world

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-8 Why the US dollar is the most widely traded currency 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 in market operations to influence their own exchange rates.

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-9 The Spot Market Foreign exchange dealers quote bid (buy) and offer (sell) rates on foreign exchange If the quote is in American terms, the dealer quotes the foreign currency as the number of dollars and cents per unit of the foreign currency If the quote is in European terms, the dealer quotes the number of units of the foreign currency per dollar The numerator is called the “terms currency” and the denominator the “base currency.”

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-10 The Forward Market If the foreign currency in a forward contract is expected to strengthen in the future (the dollar equivalent of the foreign currency is higher in the forward market than in the spot market), the currency is selling at a premium. If the opposite is true, it is selling at a discount An option is the right, but not the obligation, to trade foreign currency in the future Options can be traded OTC or on an exchange

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-11 Futures A foreign currency future is an exchange- traded instrument that guarantees a future price for the trading of foreign exchange, but the contracts are for a specific amount and specific maturity date

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-12 Foreign-Exchange Markets: Exchange-Based and OTC Options

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-13 The Foreign-Exchange Trading Process

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-14 The Foreign Exchange Trading Process Companies work with foreign exchange dealers to trade currency Dealers also work with each other and can trade currency through:  voice brokers  electronic brokerage services  directly with other bank dealers Internet trades of foreign exchange are becoming more significant

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-15 How Companies Use Foreign Exchange The major institutions that trade foreign exchange are the large commercial and investment banks and securities exchanges Commercial and investment banks deal in a variety of different currencies all over the world The CME Group and the Philadelphia Stock Exchange trade currency futures and options

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-16 Letter-of-Credit Relationships

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-17 How Companies Use Foreign Exchange Companies use foreign exchange to settle transactions involving the imports and exports of goods and services, for foreign investments, and to earn money through arbitrage or speculation