Foreign Exchange Market:

Foreign Exchange (FX): Converting one currency to another, crucial for both personal and
business transactions.

 Key Point: Multinational enterprises (MNEs) and small import/export

companies must understand FX and exchange rates.
 Domestic vs. Foreign Transactions: Domestic transactions use one currency, while
foreign transactions involve multiple currencies.
 Foreign Exchange: Money in another country's currency. It can be in cash, credit/debit
cards, traveler’s checks, bank deposits, or other short-term claims.
 Exchange Rate: The price of one currency in terms of another. Changes daily; for
example, €1 = $1.3181 (or $1 = €0.7587).

Players in the Foreign-Exchange Market:

 Reporting Dealers: Large money center banks (e.g., Deutsche Bank, Barclays, JP
Morgan). They set prices and make markets.
 Other Financial Institutions: Smaller banks, hedge funds, mutual funds, and
companies like Western Union.
 Nonfinancial Institutions: Governments and corporations (MNEs, small-medium
firms).

Foreign Exchange Market Overview

 Foreign Exchange (FX): The process of converting one currency to another, essential
for both personal and business transactions.
 Exchange Rate: The price of one currency in terms of another. It fluctuates daily based
on market conditions.
 Market Participants:
o Reporting Dealers (Money Center Banks): Large financial institutions
like Deutsche Bank, Barclays, JP Morgan, etc., that influence pricing and trade
in the FX market.
o Other Financial Institutions: Smaller banks, hedge funds, mutual funds,
and Western Union (non-bank FX traders).
o Non-Financial Institutions: Governments and corporations (both large MNEs
and small firms) that use FX services for trade and investment.
 Types of FX Instruments:
o Spot: Currency exchange with delivery within two days.
o Outright Forward: Currency exchange at a fixed rate for future delivery.
o FX Swaps: Simultaneous spot and forward transactions.
o Currency Swaps & Options: Exchange of principal and interest in different
currencies and rights to exchange at future rates.
  Trading Methods:
o Electronic Systems: Systems like EBS, Thomson Reuters, and Bloomberg that
match trades and provide market data.
o Directly with Customers: Trades conducted between a dealer and a customer
without a third party.
o Interbank Transactions: Trades directly between dealer banks.
o Voice Brokers: Trades made through phone communication with brokers.
 Market Data Providers: Bloomberg and Reuters provide quotes, market data, and
statistics to ensure informed trading decisions.

Aspects of the Foreign-Exchange Market

 Market Segments:
o OTC Market: Composed of commercial banks, investment banks, and
other financial institutions.
o Exchange-Traded Market: Includes CME Group, NASDAQ OMX, and NYSE
Liffe, where futures and options are traded.
 Foreign Exchange Instruments:
o Spot Transactions: Currency exchange at current rate, settled within two
business days.
o Outright Forward Transactions: Currency exchange at a future date, settled at
a predetermined forward rate.
o FX Swaps: Combination of spot and forward transactions. Example: IBM
exchanges pounds for dollars, then swaps back in 30 days.
o Currency Swaps: Exchange of principal and interest payments, often related
to bonds.
o Options: Right (not obligation) to trade currency at a future rate.
o Futures Contracts: Agreement to trade currency at a specific price on a future
date.
 Market Dominance: Outright forwards and FX swaps are the most common
instruments in the OTC market, followed by spot transactions.

Foreign-Exchange Market: Size, Composition, and Growth

 2013 BIS Survey: Daily turnover in FX market was $5.3 trillion, a 32.5%
increase from 2010.
o Growth Drivers: Increase in spot market transactions and other financial
institutions trading more actively.
o Historical Context: Global economic crisis (2007-2010) slowed trading, but
recovery led to increased turnover.
 Market Composition by Instruments:
o Spot Transactions: 42% of turnover.
o Outright Forwards: 38% of turnover.
o FX Swaps: 13% of turnover.
o Currency Swaps: 6.3% of turnover.
o Options and Others: 1% of turnover.
  Growth of FX Trading:
o FX seen as an alternative asset.
o Hedge funds have increased activity due to aggressive strategies.

U.S. Dollar in the Foreign-Exchange Market

 U.S. Dollar: In 2013, it was involved in 87% of global FX transactions.

 Reasons for Dominance:
1. Investment currency in global capital markets.
2. Reserve currency held by central banks.
3. Transaction currency in international commodity markets.
4. Invoice currency in global contracts.
5. Intervention currency used by governments in market operations.
 Currency Conversion Example: Mexican company uses U.S. dollars to pay a Japanese
exporter (for currency exchange simplification).
 Most Traded Currency Pairs:
o EUR/USD (Euro/US Dollar): 24.1% of FX market.
o USD/JPY (Dollar/Yen): Second most traded pair.
 Cross Rates: Currency exchange between two currencies excluding the U.S.
dollar (e.g., Swiss franc/Brazilian real).
 FX Market Sensitivity: USD/JPY rate is influenced by U.S.-Japan trade
relations and carry trades (investing in higher-yielding assets like Brazil, borrowing
in yen).

Geography and Trading Centers in Foreign Exchange

 Top FX Markets:
o London: Dominates with 40.9% of global foreign exchange turnover.
o New York: 18.9% of turnover.
o Tokyo and Singapore: Other major centers, with all four markets (U.K., U.S.,
Japan, Singapore) accounting for 71.1% of global turnover.
 Role of the Euro:
o Euro is part of four of the top ten currency pairs.
o It is gaining importance, especially in Eastern Europe and other regions outside
Europe.
 London's Importance:
o Geographical Location: Close to European capital markets and positioned
between U.S. and Asian markets.
o Time Zone Advantage: London’s time zone overlaps with both Asian and U.S.
markets, allowing for key trading periods.
 Peak Trading Times:
o Tokyo and London overlap for 2 hours, generating the highest trading activity.
o London and New York overlap from 8:00 a.m. to noon New York time,
creating the second-highest activity.
 Global FX Market Timing:
 o The FX market operates globally across multiple time zones from New
Zealand to San Francisco, with continuous trading throughout the day.

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 the bid and offer rates, representing the dealer's profit
margin.
 American Terms (Direct Quote): The number of dollars per unit of foreign currency.
 European Terms (Indirect Quote): The number of units of foreign currency per
dollar.

Foreign-Exchange Markets: Spot Market

 Spot Market: Deals with immediate foreign exchange transactions.

o Bid/Offer Rates: Dealers quote a buy rate (bid) and a sell rate (offer).
o Spread: Difference between bid and offer rates, covering the dealer's profit
margin.
o Example: A dealer quoting $1.5556/58 for British pounds, meaning the dealer
buys at $1.5556 and sells at $1.5558.

Direct and Indirect Quotes

 Direct Quote (American Terms): The number of U.S. dollars per unit of foreign
currency.
o Example: $1.5556 for the U.K. pound.
 Indirect Quote (European Terms): The number of foreign currency units per dollar.
o Example: £0.6429 for the U.K. pound.

Base and Terms Currencies

 Base Currency: The first currency in a quote (denominator), e.g., USD in USD/JPY.
 Terms Currency: The second currency in a quote (numerator), e.g., JPY in USD/JPY.
 Reciprocal Quotes: The inverse of direct and indirect quotes.
o Example: If the direct quote is $1 = ¥97.39, the reciprocal would be ¥1 =
$0.010268.

Spot Rate and Interbank Transactions

 Spot Rates: Quoted rates for large interbank transactions (usually $1 million or more).
 Retail Transactions: Smaller transactions have a higher cost per dollar, meaning fewer
foreign currency units per dollar compared to interbank rates.

Forward Market and Key Concepts

  Forward Rate: The rate for currency transactions beyond two business days.
o Forward Discount: When the forward rate is less than the spot rate.
o Forward Premium: When the forward rate is greater than the spot rate.
 Forward Contracts:
o Used when a seller extends credit for longer periods.
o Example: A U.S. importer may enter into a contract with a dealer to buy yen at
a forward rate for future delivery.
 Forward Market Rates: Available for major currencies like USD, JPY, GBP,
and CHF through platforms like Bloomberg.
o For exotic currencies, forward rates are harder to find and may have greater
differences from the spot rate.
 Forward Premium/Discount Calculation:
o Premium: When forward rate > spot rate.
o Discount: When forward rate < spot rate.
o Formula: Forward Rate−Spot RateSpot Rate×12Months Forward×100Spot RateF
orward Rate−Spot Rate×Months Forward12×100
 Interest Rates: Affects the premium/discount; lower interest rates lead to smaller
premiums.
 Other FX Terms:
o Option: The right (not obligation) to trade currency at a set rate.
o Futures Contract: A less flexible contract that specifies the exchange rate in
advance.
o Settlement: Large MNEs use money center banks, smaller firms use local
banks.

Foreign Exchange Options and Futures

 Options:
o Right, but not the obligation, to buy or sell foreign currency at a
specific exchange rate within a set time period.
o Example: A U.S. company buys an OTC option for 1,000,000 yen at ¥85 per
USD ($0.011765 per yen).
o Strike Price: The agreed exchange rate for the option.
o Premium: The cost of the option, higher if it benefits the buyer.
o Flexibility: The option can be ignored if the spot rate is better than the strike
price.
o Forward Contracts: Cheaper than options, but less flexible as they cannot be
canceled.
 Exotic/Structured Options:
o Used by companies to hedge risk while minimizing the premium. Tailored to a
company's risk profile.
 Futures Contracts:
o Similar to forward contracts in specifying a future exchange rate.
o Traded on exchanges (e.g., CME Group), unlike OTC forward contracts.
o Less flexible than forward contracts, useful for speculators or small companies.
Foreign Exchange Trading Process

 Selling Foreign Currency:

o Example: U.S. Company A receives euros and converts them to dollars via a
bank.
 Buying Foreign Currency:
o Example: U.S. Company B buys euros to pay a German
supplier using forward, swap, option, or futures contracts for hedging.
 Bank Relationships:
o MNEs deal directly with money center banks for foreign exchange services.
o Smaller companies use regional banks or financial institutions
with correspondent relationships with money center banks.

Banks and Foreign Exchange Markets

 Money Center Banks: These banks dominate the foreign exchange market and set global
prices.
o Examples: Deutsche Bank, Citi, Barclays, UBS, HSBC.
o Criteria for Ranking: Transaction volume, currency handling, cross-trades,
and derivatives (forwards, options, futures).
 Consolidation: Fewer banks handle the majority of global FX activity.
o From 177 banks in 1998 to 93 in 2010.
 Top Foreign-Exchange Dealers:
o Deutsche Bank: 14.57% market share.
o Citi: 12.26% market share.
o Barclays: 10.95% market share.
o Regional Share: Varies by Western Europe, North America, and Asia.
 Foreign Exchange Exchanges:
o CME Group: Trades 60 futures and 31 options contracts, including G10 and
emerging currencies.
o NASDAQ OMX: Offers currency options and futures, with a focus on U.S.
dollar-related pairs.
o NYSE Liffe: Europe’s largest derivatives exchange, handling Euro/USD futures
and options.
 Exchange Role: Major exchanges facilitate derivatives trading, providing a platform
for global currency trading.

How Companies Use Foreign Exchange

 Purpose of FX: Companies use foreign exchange to manage cash

flow for exports and imports, and to handle currency trading policies through their
treasury departments.
 Export/Import Payments:
o Boeing selling Dreamliners to LAN (South America) as an example of dealing
with foreign exchange.
o LAN needs dollars to pay, creating a foreign-exchange requirement.
Methods of Payment

 Commercial Bills of Exchange:

o A draft directs one party (the drawee) to make payment.
o Sight Draft: Requires immediate payment.
o Time Draft: Payment made later (e.g., 30 days after delivery).
 Letters of Credit (L/C):
o L/C: Guarantees bank payment when the proper documents are presented,
ensuring security for both buyer and seller.
o Counterparty Risk: Includes risks of forgeries and reliance on bank credit.
o L/C Currency: Can be in importer’s or exporter’s currency,
requiring currency conversion.

Risks with Letters of Credit

 Conditions for Validity: L/C is only valid if the conditions (e.g., number of packages)
are strictly followed.
 Impact of Global Financial Crisis: Increased counterparty risk and caution due to
bank instability.