6. Foreign Exchange Market

Unlike domestic transactions, international transactions involve the currencies of two or more nations. To exchange one currency for another in international transactions, compaies rely on a mechanism called the foreign exchange market-a market in which currencies are bought and sold and their prices determined. Financial institutions convert one currency into another at a specific exchange rate-the rate at which one currency is exchanged for another. Rates depend on the size of the transaction, the trader conducting it, general economic conditions, and sometimes, government mandate.

foreign exchange market

Market in which currencies are bought and sold and their prices determined.

exchange rate

Rate at which one currency is exchanged for another

In many ways, the foreign exchange market is like the markets for commodities such as cotton, wheat, and copper. The forces of supply and demand determine currency prices, and transactions are conducted through a process of bid and ask quotes. If someone asks for the current exchange rate of a certain currency, the bank does not know whether it is dealing with a prospective buyer or seller. Thus, it quotes two rates: The bid quote is the price at which it will buy, the ask quote is the price that it will pay. For example, say that the British pound is quoted in U.S. dollars at $1.6296. The bank may then bid $1.6294 to buy British pounds and offer to sell them at $1.6298. The difference between the two rates is the bid-ask spread. Naturally, banks always buy low and sell high, earning their profits from the bid-ask spread.

Functions of the Foreign Exchange Market

The foreign exchange market is not really a source of corporate finance. Rather, it facilitates corporate financial activities and international transactions. Investors use the foreign exchange market for four main reasons.

Currency Convertansion Companies use the foreign exchange market to convert one currency into another. Suppose a Malaysian company sells a large number of computers to a customer in France. The French customer wishes to pay for the computers in euros, the European Union currency, whereas the Malaysian company wants to be paid in its own ringgit. How do the two parties resolve this dilemma? They turn to banks to exchange the currencies for them.

Companies also must convert to local currencies when they undertake foreign direct investment. Later, when a firm's international subsidiary earns a profit and the company wishes to return some of it to the home country, it must convert the local money into the home currency.

Currency Hedging The practice of insuring against potential losses that result from adverse changes in exchange rates is called currency hedging. International companies commonly use hedging for one of two purposes:

1) To lessen the risk associated with international transfers of funds

2) To protect themselves in credit transactions in which there is a time lag between billing and receipt of payment.

Suppose a South Korean caremaker has a subsidiary in Britain. The parent company in Korea knows that in 30 days-say, on February 1-its British subsidiary will be sending it a payment in British pounds. Because the parent company is concerned about the value of that payment in South Korean won 1 month in the future, it wants to insure against the possibility that the pound's value will fall over that period - meaning, of course, that it will receive less money. Therefore, on January 2 the parent company contracts with a financial institution, such as a bank, to exchange the payment in I month at an agreed-upon exchange rate specified on January 2. In this way, as of January 2 the Korean company knows exactly how many won the payment will be worth on February 1.

Currency Arbitrage Currency arbitrage is the instantaneous purchase and sale of currency in different markets for profit. For instance, assume that a currency trader in New York notices that the value of the European Union euro is lower in Tokyo than in New York. Therefore, the trader can buy euros in Tokyo, sell them in New York, and earn a profit on the difference. High-tech communication and trading systems allow the entire transaction to occur within seconds. However, if the difference between the value of the euro in Tokyo and the value of the euro in New York is not greater than the cost of conducting the transaction, it is not worth making.

Currency arbitrage is a common activity among experienced traders of foreign exchange, very large investors, and companies in the arbitrage business. Firms whose profits are generated primarily by another economic activity, such as retailing or manufacturing take part in currency arbitrage only if they have very large sums of cash on hand.

Interest Arbitrage Interest arbitrage is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find better interest rates abroad than those that are available in their home countries. The securities involved in such transactions include government treasury bills corporate and government bonds, and even bank deposits. Suppose a trader notices that the interest rates paid on bank deposits in Mexico are higher than those paid in Sydney Australia (after adjusting for exchange rates). He can convert Australian dollars to Mexican pesos and deposit the money in a Mexican bank account for, say, 1 year. At the end of the year, he converts the pesos back into Australian dollars and earns more in interest than the same money would have earned had it remained on deposit in an Australian bank.

Currency Speculation Currency speculation is the purchase or sale of a currency with the expectation that its value will change and generate a profit. The shift in value might be expected to occur suddenly or over a longer period. The foreign exchange trader may bet that a currency's price will go either up or down in the future. Suppose a trader in London believes that the value of the Japanese yen will increase over the next three months. Therefore, today she buys yen with pounds at the current price, intending to sell them in 90 days. If the price of yen rises in that time, she earns a profit; if it falls, she takes a loss. Speculation is much riskier than arbitrage because the value, or price, of currencies is quite volatile and is affected by many factors. Like arbitrage, currency speculation is commonly the realm of foreign exchange specialists rather than the managers of firms engaged in other endeavors.

A classic example of currency speculation unfolded in Southeast Asia in 1997. After news emerged in May about Thailand's slowing economy and political instability, currency traders sprang into action. They responded to poor economic growth prospects and an overvalued currency, the Thai baht, by dumping the baht on the foreign exchange market. When the supply glutted the market, the value of the baht plunged. Meanwhile, traders began speculating that other Asian economies were also vulnerable. From the time the crisis first hit until the end of 1997, the value of the Indonesian rupiah fell by 87 percent, the South Korean won by 85 percent, the Thai baht by 63 percent, the Philippine peso by 34 percent, and the Malaysian ringgit by 32 percents Although many currency speculators made a great deal of money, the resulting hardship experienced by these nations' citizens caused some to question the ethics of currency speculation on such a scale.

Foreign Exchange Market Today

The foreign exchange market is actually an electronic network that connects the world's major financial centers. In turn, each of these centers is a network of foreign exchange traders, currency trading banks, and investment firms. In a single day, the volume of trading on the foreign exchange market (comprising currency swaps and spot and forward contracts) totals more than $1.2 trillion-roughly the yearly gross domestic product of Italy. Several major trading centers and several currencies dominate the foreign exchange market.

Trading Centers

Most of the world's major cities participate in trading on the foreign exchange market. However, in recent years, just three countries have come to account for slightly more than half of all global currency trading: the United Kingdom, the United States, and Japan. Accordingly, most of this trading takes place in the financial capitals of London, New York, and Tokyo.

London dominates the foreign exchange market for historic and geographic reasons. The United Kingdom was once the world's largest trading nation. British merchants needed to exchange currencies of different nations, and London naturally assumed the role of financial trading center. London quickly came to dominate the market and still does so because of its location halfway between North America and Asia. A key factor is its time zone. Because of differences in time zones, London is opening for business as markets in Asia close trading for the day. When New York opens for trading in the morning, trading continues in London for several hours. Map 1 shows why it is possible to trade foreign exchange 24 hours a day (except weekends and major holidays). At least one of the three major centers (London, New York, and Tokyo) keeps the market open for 21 hours each day. Moreover, trading does not stop during the three hours they are closed because other trading centers (including San Francisco and Sydney, Australia) remain open. Also, most large banks that are active in for­eign exchange ensure continuous trading by employing overnight traders.