International_Economics_Tenth_Edition (1)

10.1 The Bureau of Economic Analysis compiles information on the u.s. balance of payments, u.S. exports and imports, and the international investment position of the United States. Set your browser to this URL:

http://www.bea.doc.gov

You can go directly to the Survey of Current Business and other BEApublications pages by setting your browser to this URL:

http://www.bea.doc.gov/bea/pubs.htm

10.2 Summary statistics on international aspects of the economy can be found at the White House Briefing Room. Set your browser to this URL:

http://www.whitehouse.gov/news/fsbr.

html

To go directly to the Council of Economic Advisers Publications page that includes the Economic Report of the President, log onto this URL:

http://www.whitehouse.gov/cea/pubs.htm I

Quoted pnces change as often as 20 times a minute. It has been estimated that the world's most active exchange rates can change up to 18,000 times during a single day.

Not all currencies are traded on foreignexchange markets. Currencies that are not traded are avoided for reasons ranging from political instability to economic uncertainty. Sometimes a country's currency is not exchanged for the simple reason that the country produces very few products of interest to other countries.

Unlike stock or commodity exchanges, the foreign-exchange market is not an organized structure. It has no centralized meeting place and no formal requirements for participation. Nor is the foreign-exchange market limited to anyone country. For any currency, such as the U.S. dollar, the foreign-exchange market consists of all locations where dollars are exchanged for other national currencies. Three of the largest foreign-exchange markets in the world are located in London, New York, and Tokyo. A dozen or so other market centers also exist around the world, such as Paris and Zurich. Because foreign-exchange dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently than if it were a centralized market.

The foreign-exchange market opens on Monday morning in Hong Kong, which is still Sunday evening in New York. As the day progresses, markets open in Tokyo, Frankfurt, London, New York, Chicago, San Francisco, and elsewhere. As the West Coast markets of the United States close, Hong Kong is only one hour away from opening for Tuesday business. Indeed, the foreignexchange market is a round-the-clock operation.

A typical foreign-exchange market functions at three levels: (1) in transactions between commercial banks and their commercial customers, who are the ultimate demanders and suppliers of foreign exchange; (2) in the domestic interbank market conducted through brokers; and (3) in active trading in foreign exchange with banks overseas.

Exporters, importers, investors, and tourists buy and sell foreign exchange from and to commercial banks rather than each other. As an example, consider the import of German autos by a

U.S. dealer. The dealer is billed for each car it imports at the rate of 50,000 euros per car. The U.S. dealer cannot write a check for

this amount because it does not have a checking account denominated in euros. Instead, the dealer

goes to the foreign-exchange department of, say, Chase Manhattan Bank to arrange payment. If the exchange rate is 1.1 euros = $1, the auto dealer writes a check to Chase Manhattan Bank for $45,454.55 (50,000/1.1 = 45,454.55) per car. Chase Manhattan will then pay the German manufacturer 50,000 euros per car in Germany. Chase Manhattan is able to do this because it has a checking deposit in euros at its branch in Bonn.

The major banks who trade foreign exchange generally do not deal directly with one another but instead use the services of foreign-exchange brokers. The purpose of a broker is to permit the trading banks to maintain desired foreign-exchange balances. If at a particular moment a bank does not have the proper foreign-exchange balances, it can turn to a broker to buy additional foreign currency or sell the surplus. Brokers thus provide a wholesale, interbank market in which trading banks can buy and sell foreign exchange. Brokers are paid a commission for their services by the selling bank.

The third tier of the foreign-exchange market consists of the transactions between the trading banks and their overseas branches or foreign correspondents. Although several dozen u.s. banks trade in foreign exchange, it is the major New York banks that usually carry out transactions with foreign banks. The other, inland trading banks meet their foreign-exchange needs by maintaining correspondent relationships with the New York banks. Trading with foreign banks permits the matching of supply and demand of foreign exchange in the New York market. These international transactions are carried out primarily by telephone and computers.

Prior to 2000, companies that needed hard currency on a daily basis to meet foreign payrolls or to convert sales in foreign currencies into U.S. dollars traditionally dealt with traders at major banks such as Citicorp, JP Morgan, and Chase Manhattan. This required corporate customers to work the phones, talking to traders at several banks at once

342 Foreign Exchange

to get the right quotation. However, there was little head-to-head competition among the banks, and corporate clients were looking for alternatives. All of this changed when start-up Currenex, Inc., built an online marketplace where banks could compete to offer foreign-currency exchange service to companies. The concept was embraced by major banks as well as corporate clients such as Home Depot. Being online makes the currency trading process more transparent. Corporate clients can see multiple quotes instantly and shop for the best deal.

Types of Foreign-Exchange

Transactions

When conducting purchases and sales of foreign currencies, banks promise to pay a stipulated amount of currency to another bank or customer on an agreed-upon date. Banks typically engage in three types of foreign-exchange transactions: spot, forward, and swap.

A spot transaction is an outright purchase and sale of foreign currency for cash settlement not more than two business days after the date the transaction is recorded as a spot deal. The 2-day period is known as immediate delivery. By convention, the settlement date is the second business day after the date on which the transaction is agreed to by the two traders. The 2-day period provides ample time for the two parties to confirm the agreement and arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.

In many cases, a business or financial institution knows it will be receiving or paying an amount of foreign currency on a specific date in the future. For example, in August a U.S. importer may arrange for a special Christmas-season shipment of Japanese radios to arrive in October. The agreement with the Japanese manufacturer may call for payment in yen on October 20. To guard against the possibility of the yen's becoming more expensive in terms of the dollar, the importer might contract with a bank to buy yen at a stipulated price, but not actually receive them until October 20 when they are needed. When the contract matures, the U.S. importer pays for the yen

with a known amount of dollars. This is known as a forward transaction.

Forward transactions differ from spot transactions in that their maturity date is more than two business days in the future. A forward-exchange contract's maturity date can be a few months or even years in the future. The exchange rate is fixed when the contract is initially made. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance.

Trading foreign currencies among banks also involves swap transactions. A currency swap is the conversion of one currency to another currency at one point in time, with an agreement to reconvert it back to the original currency at a specified time in the future. The rates of both exchanges are agreed to in advance. Swaps provide an efficient mechanism through which banks can meet their foreignexchange needs over a period of time. Banks are able to use a currency for a period in exchange for another currency that is not needed during that time.

For example, Chase Manhattan Bank may have excess balances of dollars but needs pounds to meet the requirements of its corporate clients. At the same time, Royal Bank of Scotland may have excess balances of pounds and insufficient amounts of dollars. The banks could negotiate a swap agreement in which Chase Manhattan Bank agrees to exchange dollars for pounds today and pounds for dollars in the future. The key aspect is that the two banks arrange the swap as a single transaction in which they agree to pay and receive stipulated amounts of currencies at specified rates.

Figure 11.1 illustrates the distribution of foreignexchange transactions by u.s. banking institutions, by transaction type. As of 2001, currency swaps accounted for the largest share of foreignexchange transactions. Also, the average daily amount of foreign-exchange transactions was $254 billion in 2001. The U.S. dollar was by far the most important currency traded in foreignexchange markets, being involved in more than 90 percent of all transactions. The euro was the second most actively traded currency and was one of the currencies in 39 percent of all trades. Other leading currencies were the Japanese yen, Canadian dollar, and Swiss franc.

I Interbank Trading

In the foreign-exchange market, currencies are actively traded around the clock and throughout the world. Banks are linked by telecommunications equipment that permits instantaneous communication. A relatively small number of money center banks carry out most of the foreign-exchange transactions in the United States. Virtually all the big New York banks have active currency-trading operations, as do their counterparts in London, Tokyo, Hong Kong, Frankfurt, and other financial centers. Large banks in cities such as Los Angeles, Chicago, San Francisco, and Detroit also have active currency-trading operations. For most U.S. banks, currency transactions are not a large part of their business; these banks have ties to correspondent banks in New York and elsewhere to conduct currency transactions.

All these banks are prepared to purchase or sell foreign currencies for their customers. Bank purchases from and sales to consumers are classified as retail transactions when the amount involved is less than 1 million currency units. Wholesale transactions, involving more than 1 million currency units, generally occur between banks or with large corporate customers. Bank transactions with each other constitute the interbank market. It is in this market that most foreign-exchange trading occurs.

Foreign-exchange departments of major commercial banks typically serve as profit centers. A bank's foreign-exchange dealers are in constant contact with other dealers to buy and sell currencies. In most large banks, dealers specialize in one or more foreign currencies. The chief dealer establishes the overall trading policy and direction of trading, trying to service the foreign-exchange needs of the bank's customers and make a profit for the bank.

344 Foreign Exchange

Currency trading is conducted on a 24-hour basis, and exchange rates may fluctuate at any moment. Bank dealers must be light sleepers, ready to react to a nighttime phone call that indicates exchange rates are moving sharply in foreign markets. Banks often allow senior dealers to conduct exchange trading at home in response to such developments.

With the latest electronic equipment, currency exchanges are negotiated on computer terminals; a push of a button confirms a trade. Dealers use electronic trading boards that permit them to instantly register transactions and verify their bank's positions. Besides trading currencies during daytime hours, major banks have established night-trading desks to capitalize on foreign-exchange fluctuations during the evening and to accommodate corporate requests for currency trades. In the interbank market, currencies are traded in amounts involving at least 1 million units of a specific foreign currency. Table 11.1 lists leading banks that trade in the foreign-exchange market.

How do banks such as Bank of America or Citibank earn profits in foreign-exchange transactions? Banks that regularly deal in the interbank market quote both a bid and an offer rate to other banks. The bid rate refers to the price that the bank

Top 10 Banks by Share of

Foreign-Exchange Marker

*Ranked by Euromoney survey of over 3,000 users of foreign exchange. This survey is updated annually.

Source: Euromoney. May 2003.

is willing to pay for a unit of foreign currency; the offer rate is the price at which the bank is willing to sell a unit of foreign currency. The difference berween the bid and the offer rate is the spread that varies by the size of the transaction and the liquidity of the currencies being traded. At any given time, a bank's bid quote for a foreign currency will be less than its offer quote. The spread is intended to cover the bank's costs of implementing the exchange of currencies. The large trading banks are prepared to "make a market" in a currency by providing bid and offer rates on request.

Foreign-exchange dealers who simultaneously purchase and sell foreign currency earn the spread as profit. For example, Citibank might quote bid and offer rates for the Swiss franc at $.5851/.5854. The bid rate is $.5851 per franc. At this price, Citibank would be prepared to buy 1 million francs for $585,100. The offer rate is $.5854 per franc. Citibank would be willing to sell 1 million francs for $585,400. If Citibank is able to simultaneously buy and sell 1 million francs, it will earn $300 on the transaction. This profit equals the spread ($.0003) multiplied by the amount of the transaction (1 million francs).

Besides earning profits from a currency's bid/offer spread, foreign-exchange dealers attempt to profit by anticipating correctly the future direction of currency movements. Suppose a Citibank dealer expects the Japanese yen to appreciate (strengthen) against the U.S. dollar. The dealer will likely raise both bid and offer rates, attempting to persuade other dealers to sell yen to Citibank and dissuade other dealers from purchasing yen from Citibank. The bank dealer thus purchases more yen than are sold. If the yen appreciates against the dollar as predicted, the Citibank dealer can sell the yen at a higher rate and earn a profit. Conversely, should the Citibank dealer anticipate that the yen is about to depreciate (weaken) against the dollar, the dealer will lower the bid and offer rates. Such action encourages sales and discourages purchases; the dealer thus sells more yen than are bought. If the yen depreciates as expected, the dealer can purchase yen back at a lower price to make a profit.

If exchange rates move in the desired direction, foreign-exchange traders earn profits. However, losses accrue if exchange rates move in the oppo-

site, unexpected direction. To limit possible losses on exchange-market transactions, banks impose financial restrictions on their dealers' trading volume. Dealers are subject to position limits that stipulate the amount of buying and selling that can be conducted in a given currency. Although banks maintain formal restrictions, they have sometimes absorbed substantial losses from unauthorized trading activity beyond position limits. Because foreign-exchange departments are considered by bank management to be profit centers, dealers feel pressure to generate an acceptable rate of return on the bank's funds invested in this operation.

Reading Foreign-Exchange

Quotations

Most daily newspapers publish foreign-exchange rates for major currencies. The exchange rate is the price of one currency in terms of another-for example, the number of dollars required to purchase 1 British pound (£). In shorthand notation, ER = $ 1£, where ER is the exchange rate. For example, if ER = 2, then purchasing £1 will require $2 (211 = 2). It is also possible to define the exchange rate as the number of units of foreign currency required to purchase 1 unit of domestic currency, or ER' =£/$. In our example, ER'

which implies that it requires £0.5 to buy $1. Of course, ER' is the reciprocal of ER (ER' = lIER).

Table 11.2 on page 346 shows the exchange rates listed for March 9, 2004, in The Wall Street Journal. In columns 2 and 3 (U.S. dollar equivalent) of the upper portion of Table 11.2, the selling prices of foreign currencies are listed in dollars. The columns state how many dollars are required to purchase one unit of a given foreign currency. For example, the quote for the Argentinian peso for Tuesday was .3439. This means that $.3439 was required to purchase 1 peso. Columns 4 and 5 (Currency per U.S. dollar) show the foreign-exchange rates from the opposite perspective, telling how many units of a foreign currency are required to buy a u.s. dollar. Again referring to Tuesday, it would take 2.91 Argentinian pesos to purchase 1 U.S. dollar.

The term mid-range rate in the table's heading refersto the price at which a New York bank will sell

Most tables of exchange-rate quotations express currency values relative to the U.S. dollar; regardless of the country where the quote is provided. Yet there are many instancesin which the u.s. dollar is not part of a foreign-exchange transaction. In such cases, the people involved need to obtain an exchange quote

346

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between two nondollar currencies. As an example, if a British importer needs francs to purchase Swiss watches, the exchange rate of interest is the Swiss franc relative to the British pound. The exchange rate

between any two currencies (such as the franc and the pound) can be derived from the rates of these two currencies in terms of a third currency (the dollar). The resulting rate is called the cross exchange rate.

Referring to the New York foreign-exchange market quotations in the upper portion of Table 11.2, we see that, as of Tuesday, the dollar value of the U.K. pound is $1.8250 and the dollar value of the Swiss franc is $0.7797. We can then calculate the value of the U.K. pound relative to the Swiss franc as follows:

Thus, each U.K. pound buys about 2.34 Swiss francs; this is the cross exchange rate between the pound and the franc. In similar fashion, cross exchange rates can be calculated between any other two nondollar currencies in Table 11.2.

The lower portion of Table 11.2 gives the cross exchange rates for several leading currencies. Here, to find the value of the U.K. pound relative to the Swiss franc, we simply locate the intersection of the pound column and the Switzerland row. The cross rate is given as 2.3406. In like manner, the cross exchange rates of other key currencies can be read directly from the table.

Forward and Futures~'{;\'Q

Markets ~

Foreign exchange can be bought and sold for delivery immediately (the spot market) or for future delivery (the forward market). Forward contracts are normally made by those who will receive or make payment in foreign exchange in the weeks or months ahead. As seen in Table 11.2, the New York foreign-exchange market is a spot market for most currencies of the world. Regular forward markets, however, exist only for the more widely traded currencies. Exporters and importers, whose foreign-exchange receipts and payments are in the future, are the primary participants in the forward market. The forward quotations for currencies such as the British pound, Canadian dollar,Japanese yen, and Swissfranc are for delivery 1 month, 3 months, or 6 months from the date indicated in the table's caption (March 9, 2004).

Trading in foreign exchange can also be done in the futures market. In this market, contracting parties agree to future exchanges of currencies and set

applicable exchange rates in advance. The futures market is distinguished from the forward market in that only a limited number of leading currencies are traded; moreover, trading takes place in standardized contract amounts and in a specific geographic location. Table 11.3 on page 348 summarizes the major differences between the forward market and the futures market.

One such futures market is the International Monetary Market (IMM) of the Chicago Mercantile Exchange. Founded in 1972, the IMM is an extension of the commodity futures markets in which specific quantities of wheat, corn, and other commodities are bought and sold for future delivery at specific dates. The IMM provides trading facilities for the purchase and sale for future delivery of financial instruments (such as foreign currencies) and precious metals (such as gold). The IMM is especially popular with smaller banks and companies. Also, the IMM is one of the few places where individuals can speculate on changes in exchange rates.

Foreign-exchange trading on the IMM is limited to major currencies. Contracts are set for delivery on the third Wednesday of March, June, September, and December. Price quotations are in terms of U.S. dollars per unit of foreign currency, but futures contracts are for a fixed amount (for example, 62,500 British pounds).

Here is how to read the IMM's futures prices as listed in Table 11.4 on page 348. 3 The size of each contract is shown on the same line as the currency's name and country. For example, a contract for yen covers the right to purchase 12.5 million yen. Moving to the right of the size of the contract, we see the expression $ per yen (.00), which shows the number of cents required to purchase one yen. The first column of the table shows the maturity months of the contract; using March as an example, the remaining columns yield the following information:

Open refers to the price at which yen was first sold when the IMM opened on the morning of March 9, 2004. Depending on overnight events in the world, the opening price may not be identical

'This section is adapted from R. Wurman and others, The Wal! 51""!!

Journal: Guide to UnderstandingMoneyand Markets (New York: Simon and Schuster, Inc, 1990).