Part Four

World Financial Environment

Chapter Nine
Global Foreign-Exchange Markets

9-1
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

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

9-3
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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
9-4
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
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

9-5
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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.

9-6
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

9-7
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
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.

9-8
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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.”

9-9
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

9-10
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

9-11
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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
9-12
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

9-13
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall
 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

9-14
Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall