Foreign Exchange and the Global Capital Markets

What Do We Mean by Currency and Foreign

Exchange?
LEARNING OBJECTIVES

1. Understand what is meant by currency and foreign exchange.

2. Explore the purpose of the foreign exchange market.

What Are Currency and Foreign Exchange?

In order to understand the global financial environment, how capital

markets work, and their impact on global business, we need to first
understand how currencies and foreign exchange rates work.

Briefly, currency is any form of money in general circulation in a country.

What exactly is a foreign exchange? In essence, foreign exchange is money
denominated in the currency of another country or—now with the euro—a
group of countries. Simply put, an exchange rate is defined as the rate at
which the market converts one currency into another.

Any company operating globally must deal in foreign currencies. It has to

pay suppliers in other countries with a currency different from its home
country’s currency. The home country is where a company is
headquartered. The firm is likely to be paid or have profits in a different
currency and will want to exchange it for its home currency. Even if a
company expects to be paid in its own currency, it must assess the risk that
the buyer may not be able to pay the full amount due to currency
fluctuations.
If you have traveled outside of your home country, you may have
experienced the currency market—for example, when you tried to
determine your hotel bill or tried to determine if an item was cheaper in one
country versus another. In fact, when you land at an airport in another
country, you’re likely to see boards indicating the foreign exchange rates
for major currencies. These rates include two numbers: the bid and the
offer. The bid (or buy) is the price at which a bank or financial services firm
is willing to buy a specific currency. The ask (or the offer or sell), refers to
the price at which a bank or financial services firm is willing to sell that
currency. Typically, the bid or the buy is always cheaper than the sell;
banks make a profit on the transaction from that difference.

What Is the Purpose of the Foreign Exchange Market?

The foreign exchange market (or FX market) is the mechanism in which

currencies can be bought and sold. A key component of this mechanism is
pricing or, more specifically, the rate at which a currency is bought or sold.
We’ll cover the determination of exchange rates more closely in this section,
but first let’s understand the purpose of the FX market. International
businesses have four main uses of the foreign exchange markets.

Currency Conversion

Companies, investors, and governments want to be able to convert one

currency into another. A company’s primary purposes for wanting or
needing to convert currencies is to pay or receive money for goods or
services. Imagine you have a business in the United States that imports
wines from around the world. You’ll need to pay the French winemakers in
euros, your Australian wine suppliers in Australian dollars, and your Chilean
vineyards in pesos. Obviously, you are not going to access these currencies
physically. Rather, you’ll instruct your bank to pay each of these suppliers
in their local currencies. Your bank will convert the currencies for you and
debit your account for the US dollar equivalent based on the exact
exchange rate at the time of the exchange.

Currency Hedging

One of the biggest challenges in foreign exchange is the risk of rates

increasing or decreasing in greater amounts or directions than
anticipated. Currency hedging refers to the technique of protecting against
the potential losses that result from adverse changes in exchange rates.
Companies use hedging as a way to protect themselves if there is a time lag
between when they bill and receive payment from a customer. Conversely, a
company may owe payment to an overseas vendor and want to protect
against changes in the exchange rate that would increase the amount of the
payment. For example, a retail store in Japan imports or buys shoes from
Italy. The Japanese firm has ninety days to pay the Italian firm. To protect
itself, the Japanese firm enters into a contract with its bank to exchange the
payment in ninety days at the agreed-on exchange rate. This way, the
Japanese firm is clear about the amount to pay and protects itself from a
sudden depreciation of the yen. If the yen depreciates, more yen will be
required to purchase the same euros, making the deal more expensive. By
hedging, the company locks in the rate.

Currency Arbitrage

Arbitrage is the simultaneous and instantaneous purchase and sale of a

currency for a profit. Advances in technology have enabled trading systems
to capture slight differences in price and execute a transaction, all within
seconds. Previously, arbitrage was conducted by a trader sitting in one city,
such as New York, monitoring currency prices on the Bloomberg terminal.
Noticing that the value of a euro is cheaper in Hong Kong than in New York,
the trader could then buy euros in Hong Kong and sell them in New York for
a profit. Today, such transactions are almost all handled by sophisticated
computer programs. The programs constantly search different exchanges,
identify potential differences, and execute transactions, all within seconds.

Currency Speculation

Speculation refers to the practice of buying and selling a currency with the
expectation that the value will change and result in a profit. Such changes
could happen instantly or over a period of time.

High-risk, speculative investments by nonfinance companies are less

common these days than the current news would indicate. While companies
can engage in all four uses discussed in this section, many companies have
determined over the years that arbitrage and speculation are too risky and
not in alignment with their core strategies. In essence, these companies
have determined that a loss due to high-risk or speculative investments
would be embarrassing and inappropriate for their companies.

EXERCISES

What is currency and foreign exchange? Why are they so important to international
business?

Understanding International Capital Markets

LEARNING OBJECTIVES
 Understand the purpose of capital markets, domestic and international.

What Are International Capital Markets?

A capital market is basically a system in which people, companies, and

governments with an excess of funds transfer those funds to people,
companies, and governments that have a shortage of funds. This transfer
mechanism provides an efficient way for those who wish to borrow or invest
money to do so. For example, every time someone takes out a loan to buy a
car or a house, they are accessing the capital markets. Capital markets
carry out the desirable economic function of directing capital to productive
uses.

There are two main ways that someone accesses the capital markets—either
as debt or equity. While there are many forms of each, very simply, debt is
money that’s borrowed and must be repaid, and equity is money that is
invested in return for a percentage of ownership but is not guaranteed in
terms of repayment.

In essence, governments, businesses, and people that save some portion of

their income invest their money in capital markets such as stocks and
bonds. The borrowers (governments, businesses, and people who spend
more than their income) borrow the savers’ investments through the capital
markets. When savers make investments, they convert risk-free assets such
as cash or savings into risky assets with the hopes of receiving a future
benefit. Since all investments are risky, the only reason a saver would put
cash at risk is if returns on the investment are greater than returns on
holding risk-free assets. Basically, a higher rate of return means a higher
risk.
Capital markets promote economic efficiency. In the example, the beverage
company wants to invest its $100,000 productively. There might be a
number of firms around the world eager to borrow funds by issuing a debt
security or an equity security so that it can implement a great business
idea. Without issuing the security, the borrowing firm has no funds to
implement its plans. By shifting the funds from the beverage company to
other firms through the capital markets, the funds are employed to their
maximum extent. If there were no capital markets, the beverage company
might have kept its $100,000 in cash or in a low-yield savings account. The
other firms would also have had to put off or cancel their business plans.

International capital markets are the same mechanism but in the global
sphere, in which governments, companies, and people borrow and invest
across national boundaries. In addition to the benefits and purposes of a
domestic capital market, international capital markets provide the following
benefits:

1. Higher returns and cheaper borrowing costs. These allow

companies and governments to tap into foreign markets and access
new sources of funds. Many domestic markets are too small or too
costly for companies to borrow in. By using the international capital
markets, companies, governments, and even individuals can borrow
or invest in other countries for either higher rates of return or lower
borrowing costs.
2. Diversifying risk. The international capital markets allow
individuals, companies, and governments to access more
opportunities in different countries to borrow or invest, which in turn
reduces risk. The theory is that not all markets will experience
contractions at the same time.
The structure of the capital markets falls into two components—primary and
secondary. The primary market is where new securities (stocks and bonds
are the most common) are issued. If a corporation or government agency
needs funds, it issues (sells) securities to purchasers in the primary market.
Big investment banks assist in this issuing process as intermediaries. Since
the primary market is limited to issuing only new securities, it is valuable
but less important than the secondary market.

The vast majority of capital transactions take place in the secondary

market. The secondary market includes stock exchanges (the New York
Stock Exchange, the London Stock Exchange, and the Tokyo Nikkei), bond
markets, and futures and options markets, among others. All these
secondary markets deal in the trade of securities. The
term securities includes a wide range of financial instruments. You’re
probably most familiar with stocks and bonds. Investors have essentially
two broad categories of securities available to them: equity securities,
which represent ownership of a part of a company, and debt securities,
which represent a loan from the investor to a company or government
entity.

DID YOU KNOW??

Eurocurrency Markets

The Eurocurrency markets originated in the 1950s when communist

governments in Eastern Europe became concerned that any deposits of
their dollars in US banks might be confiscated or blocked for political
reasons by the US government. These communist governments addressed
their concerns by depositing their dollars into European banks, which were
willing to maintain dollar accounts for them. This created what is known as
the Eurodollar—US dollars deposited in European banks. Over the years,
banks in other countries, including Japan and Canada, also began to hold
US dollar deposits and now Eurodollars are any dollar deposits in a bank
outside the United States. (The prefix Euro- is now only a historical
reference to its early days.) An extension of the Eurodollar is
the Eurocurrency, which is a currency on deposit outside its country of
issue. While Eurocurrencies can be in any denominations, almost half of
world deposits are in the form of Eurodollars.

The Euroloan market is also a growing part of the Eurocurrency market.

The Euroloan market is one of the least costly for large, creditworthy
borrowers, including governments and large global firms. Euroloans are
quoted on the basis of LIBOR, the London Interbank Offer Rate, which is the
interest rate at which banks in London charge each other for short-term
Eurocurrency loans.

The primary appeal of the Eurocurrency market is that there are no

regulations, which results in lower costs. The participants in the
Eurocurrency markets are very large global firms, banks, governments, and
extremely wealthy individuals. As a result, the transaction sizes tend to be
large, which provides an economy of scale and nets overall lower
transaction costs. The Eurocurrency markets are relatively cheap, short-
term financing options for Eurocurrency loans; they are also a short-term
investing option for entities with excess funds in the form of Eurocurrency
deposits.

Offshore Centers

The first tier of centers in the world are the world financial centers, which
are in essence central points for business and finance. They are usually
home to major corporations and banks or at least regional headquarters for
global firms. They all have at least one globally active stock exchange. While
their actual order of importance may differ both on the ranking format and
the year, the following cities rank as global financial centers: New York,
London, Tokyo, Hong Kong, Singapore, Chicago, Zurich, Geneva, and
Sydney.

1. What is a capital market? What is an international capital market?

2. What are the purposes of international capital market for international businesses?

INTERNATIONAL TRADE THEORIES

Absolute advantage versus Comparative advantage
Absolute and comparative advantage are two important concepts in international trade that
largely influence how and why nations devote limited resources to the production of
particular goods. Though the global economy is highly complex, the economics of food
production offer a straightforward illustration of both of these key concepts.

Though it is not economically feasible for a country to import all of the food needed to
sustain its population, the types of food a country produces can largely be affected by the
climate, topography, and politics of the region. Spain, for example, is better at producing fruit
than Iceland. The differentiation between the varying abilities of nations to produce goods
efficiently is the basis for the concept of absolute advantage.

Example One:

If Japan and the United States can both produce cars, but Japan can produce cars of a higher
quality at a faster rate, then it is said to have an absolute advantage in the auto industry. A
country's absolute advantage or disadvantage in a particular industry plays a crucial role in
the types of goods it chooses to produce. In this example, the U.S. may be better served to
devote resources and manpower to another industry in which it has the absolute advantage,
rather than trying to compete with the more efficient Japan.

The focus on the production of those goods for which a nation's resources are best suited is
called specialization. Given limited resources, a nation's choice to specialize in the
production of a particular good is also largely influenced by its comparative advantage.
Whereas absolute advantage refers to the superior production capabilities of one nation
versus another, comparative advantage is based on the concept of opportunity cost. The
opportunity cost of a given option is equal to the forfeited benefits that could have been
gained by choosing the alternative. If the opportunity cost of choosing to produce a particular
good is lower for one nation than for others, then that nation is said to have a comparative
advantage.

Assume that both France and Italy have enough resources to produce either wine or cheese,
but not both. France can produce 20 units of wine or 10 units of cheese. The opportunity cost
of each unit of wine, therefore, is 10 / 20, or 0.5 units of cheese. The opportunity cost of each
unit of cheese is 20 / 10, or 2 units of wine. Say Italy can produce 30 units of wine or 22 units of
cheese. Italy has an absolute advantage for the production of both wine and cheese, but its
opportunity cost for cheese is 30 / 22, or 1.36 units of wine, while the cost of wine is 22 / 30, or
0.73 units of cheese. Because France's opportunity cost for the production of wine is lower
than Italy's, it has the comparative advantage despite Italy being the more efficient producer.
Italy's opportunity cost for cheese is lower, giving it both an absolute and comparative
advantage.

Since neither nation can produce both items, the most efficient strategy is for France to
specialize in wine production because it has a comparative advantage and for Italy to
produce cheese. International trade can enable both nations to enjoy both products at
reasonable prices because each is specialized in the efficient production of one item.

Example Two:

The following table shows the amount of output Country A and Country B can produce in a
given period of time.

Output per Day of Work

Wine Cheese
Country A 6 3
Country B 1 2

Required:

Compute productivity of Country A and B basing on Absolute Advantage and Comparative

Advantage and give out your comments on how the two countries should specialize in
production of Wine and/or Cheese.