giáo trình International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2 International business environments and operations 15th global edition bydaniels 2
www.downloadslide.net 350 PART The Global Monetary Environment Map 8.1 International Trade Zones and The Single World Market The world’s communication networks are now so good that we can talk of a single world market It starts in a small way in New Zealand at around 9:00 a.m (local time), just in time to catch the tail end of the previous night’s market in New York (where it’s about 4:00 p.m local time) Two or three hours later, Tokyo opens, followed an hour later by Hong Kong and Manila, then half an hour later by Singapore By now, with the Far East market in full swing, the focus moves to the Near and Middle East Mumbai (formerly Bombay) opens two hours after Singapore, followed after an hour and a half by Abu Dhabi and Athens At this stage, trading in the Far and Middle East is usually thin as dealers wait to see how Europe will trade Paris and Frankfurt open an hour ahead of London, and by this time Tokyo is starting to close down, so the European market can judge the Japanese market By lunchtime in London, New York is starting to open up, and as Europe closes down, positions can be passed westward Midday in New York, trading tends to be quiet because there is nowhere to pass a position to The San Francisco market, three hours behind New York, is effectively a satellite of the New York market, although very small positions can be passed on to New Zealand banks (Note that in the former Soviet Union, standard time zones are advanced an hour Also note that some countries and territories have adopted half-hour time zones, as shown by hatched lines.) Source: Based on Julian Walmsley, The Foreign Exchange Handbook (New York: John Wiley, 1983): 7–8 Reprinted by permission of John Wiley & Sons, Inc Some information taken from The Cambridge Factfinders, 3rd ed., David Crystal (ed.) (New York: Cambridge University Press, 1998): 440 London New York Tokyo Tokyo San Francisco Hong Kong Singapore Sydney Figure 8.5 Overlapping Time Zones and Foreign Exchange Trades Although foreign exchange is traded 24 hours a day, most of the trading activity occurs when the major foreign exchange markets, especially London and New York, are open Frankfurt London New York Wellington, NZ Sydney Tokyo Singapore Time in New York, EST M08_DANI6795_15_GE_C08.indd 350 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 01/04/14 3:06 PM www.downloadslide.net Chapter Markets for Foreign Exchange 351 Major Foreign-Exchange Markets The Spot Market Foreign-exchange dealers are the ones who quote the rates The bid (buy) rate is the price at which the dealer is willing to buy foreign currency; the offer (sell) is the price at which the dealer is willing to sell foreign currency In the spot market, the spread is the difference between the bid and offer rates, as well as the dealer’s profit margin In our opening case, we explain how Western Union quotes exchange rates for the purpose of trading dollars for pesos Its rates are often different from those quoted by commercial banks, but some people prefer to use Western Union, pay higher fees, and get lower exchange rates Why? In part, because of a lack of trust in the banking system. 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 bid and offer rates • American terms, or direct quote—the number of dollars per unit of foreign currency • European terms, or indirect quote—the number of units of foreign currency per dollar Direct and Indirect Quotes Let’s look at an example of how a bid and offer might work Assume that the rate a U.S.-based dealer quotes for the British pound is $1.5556/58 This means the dealer is willing to buy pounds at $1.5556 each and sell them for $1.5558 each—i.e., buying low and selling high In this example, the dealer quotes the foreign currency as the number of U.S dollars for one unit of that currency This method of quoting exchange rates is called the direct quote, which is the number of units of the domestic currency (the U.S dollar in this case) for one unit of the foreign currency It is also known as American terms The other convention for quoting foreign exchange is known as the indirect quote, or European terms It is the number of units of the foreign currency for one unit of the domestic currency On May 1, 3013, the direct quote for the U.K pound was $1.5556, and the indirect quote was £0.6429.11 Base and Term Currencies When dealers quote currencies to their customers, they always quote the base currency (the denominator) first, followed by the terms currency (the numerator) A quote for USD/JPY (also shown as USDJPY = X) means the dollar is the base currency and the yen is the terms currency (the number of Japanese yen for one U.S dollar) If you know the dollar/yen quote, you can divide that rate into to get the yen/dollar quote In other words, the exchange rate in American terms (the direct quote) is the reciprocal or inverse of the exchange rate in European terms (the indirect quote) For example, on May 1, 2013, the indirect quote for Japanese yen (USD/JPY) was ¥97.39 for one dollar The reciprocal would be 1/¥97.39 = $0.010268.12 In a dollar/yen quote, the dollar is the denominator, the yen the numerator By tracking changes in the exchange rate, managers can determine whether the base currency is strengthening or weakening For example, on May 1, 2012, the dollar/yen rate was ¥80.08/$1.00; on May 1, 2013, it was ¥97.39/$1.00 As the numerator increases, the base currency (the dollar) is strengthening Conversely, the terms currency (the yen) is weakening There are many ways to get exchange rate quotes, including online and print media Because most currencies constantly fluctuate in value, many managers check the values daily For example, The Wall Street Journal provides spot rate quotes in American terms (US $ equivalent) and European terms (currency per US $) for several currencies In addition, if provides one-month, three-month, and six-month forward rates for a few currencies Interbank Transactions The spot rates provided by The Wall Street Journal are the selling rates for interbank transactions of $1 million and more Retail transactions—those between banks and companies or individuals—provide fewer foreign currency units per dollar than interbank transactions Similar quotes can be found in other business publications and online However, these are only approximations; exact quotes are available through the dealers M08_DANI6795_15_GE_C08.indd 351 01/04/14 3:06 PM www.downloadslide.net 352 PART The Global Monetary Environment Traders at GPS Capital Markets, a leading corporate foreign exchange brokerage firm, scan current exchange rate trends on the electronic services they subscribe to ▶ Source: GPS Capital Markets, Inc The Forward Market The forward rate is the rate quoted for transactions that call for delivery after two business days As noted earlier, the spot market is for foreign-exchange transactions that occur within two business days But in some transactions, a seller extends credit to the buyer for a period longer than that For example, a Japanese exporter of consumer electronics might sell television sets to a U.S importer with immediate delivery but payment due in 30 days The U.S importer is obligated to pay in yen in 30 days and may enter into a contract with a currency dealer to deliver the yen at a forward rate—the rate quoted today for future delivery In addition to the spot rates for each currency, The Wall Street Journal provides the forward rates for the Australian dollar, Japanese yen, Swiss franc, and British pound —the most widely traded currencies in the forward market However, forward contracts are available from dealers in many other currencies as well Electronic services such as Bloomberg provide forward rates for most currencies for different maturity dates in the future The more exotic the currency, the more difficult it is to get a forward quote out too far in the future, and the greater the difference is likely to be between the forward rate and the spot rate A forward discount exists when the forward rate is less than the spot rate Forward Discounts and Premiums Building on what we said earlier, we now can say that the difference between the spot and forward rates is either the forward discount or the forward premium In order to explain how to compute and interpret the premium or discount, let’s use the direct rate between the U.S dollar and the Swiss franc—in this case, the number of dollars per franc If the forward rate for the Swiss franc is greater than the spot rate, the franc would get more dollars in the future, so it would be trading at a premium If the forward rate is less than the spot rate, the franc would be selling at a discount since it would get you less dollars in the future Using the May 1, 2013 direct quote for the Swiss franc for a six-month forward contract13, the premium or discount would be computed as follows: $1.0808 − 1.0784 × 12 = 00445 × 100 or 0.45% 1.0784 A premium exists when the forward rate is greater than the spot rate M08_DANI6795_15_GE_C08.indd 352 The premium is annualized by multiplying the difference between the spot and forward rates by 12 months divided by the number of months forward—six months, in this example Then you multiply the results by 100 to put them in percentage terms Because the forward rate is 01/04/14 3:06 PM www.downloadslide.net Chapter Markets for Foreign Exchange 353 greater than the spot rate, the Swiss franc is selling at a premium in the forward market by 0.45 percent above the spot rate During this particular period of time, interest rates in the major economies were quite low because of the global economic slowdown and the desire to keep interest rates low in order to speed up economic growth Thus the premium is also quite low During periods of greater divergence in interest rates, the premium or discount could be much larger In 2007, for example, the franc was selling at a 2.5 percent premium in the sixmonth forward market Options An option is the right, but not the obligation, to trade a foreign currency at a specific exchange rate An option is the right, but not the obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate It can be purchased OTC from a commercial or investment bank or on an exchange For example, a U.S company purchases an OTC option from a commercial or investment bank to buy 1,000,000 Japanese yen at ¥85 per US $ ($0.011765 per yen)—or $11,765 The writer of the option will charge the company a fee for writing it The more likely the option is to benefit the company, the higher the fee The rate of ¥85 is called the strike price for the option; the fee or cost is called the premium On the date when the option is set to expire, the company can look at the spot rate and compare it with the strike price to see what the better exchange rate is If the spot rate were ¥90 per US $ ($0.01111 per yen)—or $11,000—it would not exercise the option because buying yen at the spot rate would cost less than buying them at the option rate However, if the spot rate at that time were ¥80 per US $ ($0.0125 per yen)—or $12,500—the company would exercise the option because buying at the option rate would cost less than at the spot rate The option gives the company flexibility because it can walk away from the option if the strike price is not a good price In the case of a forward contract, the cost is usually cheaper than the cost for an option, but the company cannot walk away from the contract So a forward contract is cheaper but less flexible The above example is for a simple, or vanilla, option However, exotic or structured options are used more widely to hedge exposure, especially by European companies The idea behind them is to provide an option product that meets a company’s risk profile and tolerance and results in a premium that is as close to zero as possible The writer of the option can still make money on the structured option, but if the option is set up effectively, the company buying it won’t have to write out a big check for the premium Futures A futures contract specifies an exchange rate in advance of the actual exchange of currency, but it is not as flexible as a forward contract A foreign currency futures contract resembles a forward contract insofar as it specifies an exchange rate some time in advance of the actual exchange of currency However, a future is traded on an exchange, not OTC Instead of working with a bank or other financial institution, companies work with exchange brokers when purchasing futures contracts A forward contract is tailored to the amount and time frame the company needs, whereas a futures contract is for a specific amount and maturity date It is less valuable to a company than a forward contract However, it may be useful to speculators and small companies that cannot enter into the latter The Foreign-Exchange Trading Process Large MNEs go through their money center banks to settle foreign-exchange balances, but smaller firms use local banks or other financial institutions M08_DANI6795_15_GE_C08.indd 353 When a company sells goods or services to a foreign customer and receives foreign currency, it needs to convert it into the domestic currency When importing, the company needs to convert domestic to foreign currency to pay the foreign supplier This conversion usually takes place between the company and its bank Originally, the commercial banks provided foreign-exchange services for their c ustomers Eventually, some in New York and other U.S money centers, such as Chicago and San 01/04/14 3:06 PM www.downloadslide.net 354 PART The Global Monetary Environment Figure 8.6 The Foreign-Exchange Trading Process Let’s say that you’re U.S Company A, that you’ve received euros in payment for goods, and that you want to sell your euros in return for dollars To make the exchange, you may contact your local bank or go directly to a money center bank On the other hand, perhaps you’re U.S Company B and you expect to receive euros as a future payment To protect yourself against fluctuations in the exchange rate, you want to buy euros that you can subsequently trade back for dollars You could choose, say, a forward or a swap, and your path would be essentially a mirror image of Company A’s Finally, either Company A or Company B could choose to convert by such means as an option or a futures contract—in which case the trade could be made by an options and/or futures exchange, either directly or through a broker U.S Company A Financial Institution A Euros In explaining “The Forces Driving Globalization” in Chapter 1, we observe that although many barriers to the cross-border movement of commercial resources— including capital—are being removed, they have by no means completely disappeared One reason for maintaining cordial relations with one’s banker is the fact that these barriers make conducting international business more expensive than conducting domestic business As we also explain in Chapter 5, conducting international business, especially on a large scale, requires high levels of capital mobility M08_DANI6795_15_GE_C08.indd 354 Financial Institution B Options/ Futures Exchange Broker Concept Check Money Center Bank U.S Company B Broker Dollars Francisco, began to look at foreign-exchange trading as a major business activity instead of just a service They became intermediaries for smaller banks by establishing correspondent relationships with them They also became major dealers in foreign exchange The left side of Figure 8.6 shows what happens when U.S Company A needs to sell euros for dollars This situation could arise when A receives payment in euros from a German importer The right side of the figure shows what happens when B needs to buy euros with dollars, which could happen when a company has to pay euros to a German supplier In either case, the U.S company would contact its bank for help in converting the currency If it is a large MNE, such as a Fortune 500 firm in the United States or a Global Fortune 500 company, it will probably deal directly with a money center bank (as shown on the top arrow in Figure 8.6) and not worry about another financial institution Generally, because the MNE already has a strong banking relationship with its money center bank (or several different money center banks), the bank trades foreign exchange for the client as one of the services it offers Companies below the Fortune 500 level operate through other financial institutions, such as local or regional banks or other banking institutions that can facilitate foreign-exchange trades In that case, Financial Institution A and Financial Institution B still operate through a money center bank to make the trade because they may be too small to trade on their own They typically have correspondent relationships with money center banks to allow them to make the trades Assume that U.S Company B is going to receive euros in the future Because it cannot convert in the spot market until it receives the euros, it can consider a forward, swap, options, or futures contract to protect itself until the currency is finally delivered Financial Institution B can a forward, swap, or options contract for Company B However, Company B can also consider an options or futures contract on one of the exchanges, such as the CME Group The same is true for Company A, which will need euros in the future Banks and Exchanges At one time, only the big money center banks could deal directly in foreign exchange Regional banks had to rely on them to execute trades on behalf of their clients The emergence of 01/04/14 3:06 PM www.downloadslide.net Chapter Markets for Foreign Exchange 355 electronic trading has changed that Now even the regional banks can hook up to Bloomberg, Thomson Reuters, or EBS and deal directly in the interbank market or through brokers Despite this, the greatest volume of foreign-exchange activity takes place with the big money center banks Because of their reach and volume, they are the ones that set the prices in global trading of foreign exchange The top banks in the interbank market in foreign exchange are so ranked because of their ability to • Trade in specific market locations, • Engage in major currencies and cross-trades, • Deal in specific currencies, • Handle derivatives (forwards, options, futures, swaps), • Conduct key market research Top Foreign-Exchange Dealers There is more to servicing customers in the foreignexchange market than size alone Each year, Euromoney magazine surveys treasurers, t raders, and investors worldwide to identify their favorite banks and the leading dealers in the interbank market In addition to examining transaction volumes and quality of services, the criteria for selecting the top foreign-exchange dealers include: • Ranking of banks by corporations and other banks in specific locations, such as London, Singapore, and New York • Capability of handling major currencies, such as the U.S dollar and the euro • Capability of handling major cross-trades, such as those between the euro and pound or the euro and yen • Capability of handling specific currencies • Capability of handling derivatives (forwards, swaps, futures, and options) • Capability of engaging in research and analytics.14 Given the differing capabilities, large companies may use several banks to deal in foreign exchange, selecting those that specialize in specific geographic areas, instruments, or currencies In the past, for example, AT&T used Citibank for its broad geographic spread and wide coverage of different currencies, but it also used Deutsche Bank for euros, Swiss Bank Corporation for Swiss francs, NatWest Bank for British pounds, and Goldman Sachs for derivatives Table 8.2 identifies the top banks in the world in terms of foreign-exchange trading They are the key players in the OTC market and include commercial banks (such as Deutsche Bank and Citi) as well as investment banks (such as UBS, the London-based investment banking division of Union Bank of Switzerland and Swiss Bank Corporation) Whether one is looking at overall market share of foreign-exchange trading or the best banks in the trading of specific currency pairs, these top 10 banks are usually at or near the top in every category It is also interesting to note that consolidation in the banking industry worldwide has resulted Table 8.2 Foreign-Exchange Trades: Top Commercial and Investment Banks, 2012 as Ranked by Overall Market Share Trading Bank Deutsche Bank Citi Barclays UBS HSBC JPMorgan RBS Credit Suisse Morgan Stanley 10 Goldman Sachs Estimated Market Share Market in Western Share% Europe 14.57% 12.26% 10.95% 10.48% 6.72% 6.60% 5.86% 4.68% 3.52% 3.12% 12.40% 11.03% 10.08% 13.21% 7.26% 5.53% 7.92% 5.67% 2.74% Market Share in North America 13.16% 12.31% 12.89% 9.39% 4.16% 9.21% 4.67% 4.18% 5.72% 4.94% Market Share in Asia Market Share in Australasia 20.66% 14.87% 11.26% 5.76% 9.69% 5.07% 4.12% 4.22% 20.83% 8.13% 7.76% 2.07% Source: Based on Estimated Market Share source: “FX Survey 2012: Overall results,” Euromoney (May 2012) - Estimated Market Share source; and Market Share by Region source: “FX Survey 2012: Market Share by Region,” Euromoney (May 2012) M08_DANI6795_15_GE_C08.indd 355 01/04/14 3:06 PM www.downloadslide.net 356 PART The Global Monetary Environment in a concentration of foreign exchange activity For example, in 1998, 177 banks were responsible for 75 percent of the foreign exchange turnover worldwide, whereas that number had dropped to only 93 banks in 2010 In the United States, that number had dropped from 20 to 7; in the United Kingdom, it went from 24 to 9.15 Top Exchanges for Trading Foreign Exchange Concept Check In Chapter 12, we explain why companies work so hard to establish and maintain effective value chains—frameworks for dividing value-creating activities into separate processes For one thing, a reliable value chain permits a firm to focus on its core competencies—the unique skills or knowledge that make it better at something than its competitors Because managing currencies and crosstrades is typically not among a firm’s core competencies, its bankers are key components of its value chain Major exchanges that deal in foreign currency derivatives are the CME Group, NASDAQ OMX, and NYSE Liffe Concept Check In Chapters 10 and 19, we discuss the functions of a company’s CFO, not only in managing its cash flows, but in managing its foreign-exchange exposure—the extent to which fluctuations in currencies can affect the costs of its international transactions M08_DANI6795_15_GE_C08.indd 356 In addition to the OTC market, foreign-exchange instruments, mostly options and futures, are traded on commodities exchanges Three of the best-known exchanges are the CME Group, NASDAQ OMX, and NYSE Liffe CME Group The CME Group was formed on July 9, 2007, as a merger between the Chicago Mercantile Exchange and the Chicago Board of Trade The CME operates according to so-called open outcry: Traders stand in a pit and call out prices and quantities The platform is also linked to an electronic trading platform, which is growing in popularity The CME Group trades many different commodities In terms of foreign exchange, it trades a suite of 60 futures and 31 options contracts, with a liquidity of over $105 billion daily16 Futures and options are traded in G10 and emerging market currencies Contracts are available for the dollar against a variety of currencies as well as cross-trades, such as the euro against the Australian dollar CME uses two electronic trading platforms to trade different commodities, including currencies: CME Globex and CME Clearport Technology is the key to opening access to trades and expanding their reach worldwide nasdaq omx Prior to 2008, the Philadelphia Stock Exchange was one of the pioneers in trading currency options In July 2008, PHLX merged with NASDAQ OMX and it now operates two U.S options markets—PHLX and the NASDAQ Options Market—that represent 20 percent of the total U.S equity options trading They also formed a new hybrid of trading, which involves both traditional floor and online trading Options were being offered by PHLX in the Australian dollar, the British pound, the Canadian dollar, the euro, the Japanese yen, and the Swiss franc Futures were offered in British pounds and the euro.17 These activities have now been absorbed by NASDAQ OMX NYSE Liffe NYSE Liffe Futures and Options is the global derivatives business of the NYSE Euronext Group It is Europe’s largest exchange by value of business traded and the second largest in the world The London International Financial Futures and Options Exchange (LIFFE) was founded in 1992 to trade a variety of futures contracts and options It was bought ten years later by Euronext, at the time a European stock exchange based in Paris but with subsidiaries in other European countries Beginning in 2003, the electronic platform where its derivatives products traded on member exchanges was known as LIFFE CONNECT In 2007, Euronext merged with the New York Stock Exchange to create NYSE Euronext The international derivatives business of NYSE Euronext is now handled by NYSE Liffe, using the LIFFE CONNECT platform developed before the merger between NYSE and Euronext Euro/Dollar futures and options are traded on LIFFE CONNECT When the purchase by ICE (InternationalExchange) of the NYSE Euronext is finally approved by regulators, the combined enterprise will have a significantly bigger footprint in many products, including derivatives like futures How Companies Use Foreign Exchange Companies enter the foreign-exchange market to facilitate their regular business transactions and/or to speculate Their treasury departments are responsible for establishing policies for trading currency and for managing banking relationships to make the trades From a business standpoint, a company, first of all, trades foreign exchange for exports/imports and the buying or selling of goods and services 01/04/14 3:06 PM www.downloadslide.net Chapter Markets for Foreign Exchange 357 When Boeing sells the new 787 Dreamliner commercial airplane to LAN, the largest airline in South America, it has to be concerned about the currency in which it will be paid and how it will receive payment In this case, the sale is probably denominated in dollars, so Boeing will not have to worry about the foreign-exchange market (nor, in theory, will its employees) However, LAN will have to worry about the market Where will it come up with the dollars, and how will it pay Boeing? Business Purposes (I): Cash Flow Aspects of Imports and Exports When a company must move money to pay for purchases, or receives money from sales, it has options as to the documents it can use, the currency of denomination, and the degree of protection it can ask for Obviously, if Boeing wanted the greatest security possible, it could ask LAN to pay for the Dreamliner before LAN takes title to the aircraft That is not very practical in this case, but sometimes it happens when the seller has all the control in the transaction More common is the use of commercial bills of exchange and letters of credit With a draft or commercial bill of exchange, one party directs another party to make payment A sight draft requires payment to be made when it is presented A time draft permits payment to be made after the date when it is presented A letter of credit obligates the buyer’s bank to honor a draft presented to it and assume payment; a credit relationship exists between the importer and the importer’s bank M08_DANI6795_15_GE_C08.indd 357 Commercial Bills of Exchange An individual or a company that pays a bill in a domestic setting can pay cash, but checks are typically used—often electronically transmitted The check is also known as a draft or a commercial bill of exchange A draft is an instrument in which one party (the drawer) directs another party (the drawee) to make a payment The drawee can be either a company, like the importer, or a bank In the latter case, the draft would be considered a bank draft Documentary drafts and documentary letters of credit are often used to protect both the buyer and the seller They require that payment be made based on the presentation of documents conveying the title, and they leave an audit trail identifying the parties to the transactions If the exporter requests payment to be made immediately, the draft is called a sight draft If the payment is to be made later—say, 30 days after delivery—the instrument is called a time draft Letters of Credit With a bill of exchange, it is always possible that the importer will not be able to make payment to the exporter at the agreed-upon time A letter of credit (L/C), however, obligates the buyer’s bank in the importing country to honor a draft presented to it, provided the draft is accompanied by the prescribed documents Of course, the exporter still needs to be sure the bank’s credit is valid as well, since the L/C could be a forgery issued by a nonexistent bank Even with the bank’s added security, the exporter still needs to rely on the importer’s credit because of possible discrepancies that could arise in the transaction The L/C could be denominated in the currency of either party If it is in the importer’s currency, the exporter will still have to convert the foreign exchange into its currency through its commercial bank Although a letter of credit is more secure than a documentary draft alone, there are still risks For the L/C to be valid, all of the conditions described in the documents must be adhered to For example, if the L/C states that the goods will be shipped in five packages, it will not be valid if they are shipped in four or six packages It is important to understand the conditions of the documents, as well as counterparty risk Although a forged L/C is an obvious danger, the global financial crisis has exposed counterparty risk when banks did not have sufficient capital to stand behind their L/Cs Prior to 2008, the risk was not so significant; afterward, businesses were hesitant to trust their banks because they might not be able to deliver on an L/C In addition, letters of credit are irrevocable, which means they cannot be canceled or changed in any way without the consent of all parties to the transaction 01/04/14 3:06 PM www.downloadslide.net 358 PART The Global Monetary Environment A key issue related to this chapter is that the L/C needs to specify the currency of the contract If the L/C is not in the exporter’s currency, the exporter will have to convert the foreign exchange into that currency as soon as it is received Confirmed Letter of Credit A letter of credit transaction may include a confirming bank in addition to the parties mentioned previously With a confirmed letter of credit, the exporter has the guarantee of an additional bank—sometimes in the exporter’s home country, sometimes in a third country It rarely happens that the exporter establishes the confirming relationship Usually, the opening bank seeks the confirmation of the L/C with a bank with which it already has a credit relationship For an irrevocable L/C, none of the conditions can be changed unless all four parties agree in advance.18 Companies also deal in foreign exchange for other transactions, such as the receipt or payment of dividends or the receipt or payment of loans and interest Speculators take positions in foreign-exchange markets and other capital markets to earn a profit Arbitrage is the buying and selling of foreign currencies at a profit due to price discrepancies Interest arbitrage involves investing in interest-bearing instruments in foreign exchange in an effort to earn a profit due to interest rate differentials M08_DANI6795_15_GE_C08.indd 358 Business Purposes (II): Other Financial Flows Companies may have to deal in foreign exchange for other reasons For example, if a U.S company has a subsidiary in the United Kingdom that sends a dividend to the parent company in British pounds, the parent company has to enter into the foreign-exchange market to convert pounds to dollars If it lends dollars to the British subsidiary, the subsidiary has to convert them into pounds When paying principal and interest back to the parent company, it has to convert pounds into dollars Speculation Companies sometimes deal in foreign exchange for profit This is especially true for some banks and all hedge funds But sometimes corporate treasury departments see their foreign-exchange operations as profit centers and also buy and sell foreign exchange with the objective of earning profits Investors can use foreign-exchange transactions to speculate for profit or to protect against risk Speculation is the buying or selling of a commodity—in this case, foreign currency— that has both an element of risk and a chance of great profit Assume that a hedge fund buys euros in anticipation that the euro will strengthen against other currencies If it does, the investor earns a profit; if it weakens, the investor incurs a loss Speculators are important in the foreign-exchange market because they spot trends and try to take advantage of them They can create demand for a currency by purchasing it in the market, or they can create a supply by selling However, speculation is also a very risky business In recent years, the advent of e-trading has attracted a lot of day traders in foreign exchange The problem is that day traders rarely make money speculating in exchange rates As we will show in Chapter 10, forecasting currency movements is indeed a risky business Arbitrage One type of profit-seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy For example, a dealer might sell U.S dollars for Swiss francs in the United States, then Swiss francs for British pounds in Switzerland, then the British pounds for U.S dollars back in the United States, with the goal of ending up with more dollars Here’s how the process might work: Assume the dealer converts 100 dollars into 150 Swiss francs when the exchange rate is 1.2 francs per dollar The dealer then converts the 150 francs into 70 British pounds at an exchange rate of 0.467 pounds per franc and finally converts the pounds into 125 dollars at an exchange rate of 0.56 pounds per dollar In this case, arbitrage yields $125 from the initial sale of $100 Given the transparency of exchange rate quotes globally, it is difficult to make a lot of money on arbitrage, but it is possible for an investor who has a lot of money and can move quickly Interest arbitrage is the investing in debt instruments, such as bonds, in different countries A dealer might invest $1,000 in the United States for 90 days, or convert $1,000 into British pounds, invest the money in the United Kingdom for 90 days, then convert the pounds back into dollars The investor would try to pick the alternative that would yield the highest return at the end of 90 days 01/04/14 3:06 PM www.downloadslide.net Chapter Point Point Yes People trade in foreign exchange for a number of reasons, and one of them is speculation, which is not illegal or necessarily bad Just as stockbrokers invest people’s money to try to earn a return higher than the market average, foreign currency traders invest people’s money in foreign exchange to make a profit for the investors Or individuals can become day traders and try to make a profit trading online on their own Speculation is merely taking a position on a currency in order to profit from market trends Electronic trading has made it easier for a variety of investors to speculate in foreign exchange Hedge funds are an important source of this foreign-exchange speculation There is no one specific strategy that hedge fund managers follow However, the transparency in trading has driven the smaller players out of the market and allowed the large institutions and traders to earn profits on small margins that require large volumes of transactions Hedge funds generally deal in minimum investments that are quite large, so the hedge fund managers that trade in foreign exchange trade in very large volumes They might make long-term bets on a currency based on macroeconomic conditions, or they might try to balance off buy-and-sell strategies in currencies so that one side offers protection against the other In either case, the hedge fund manager is betting on the future position of a currency to earn money for the investors in the fund Speculation is not for the faint of heart Political and economic conditions outside the speculators’ control can quickly turn profits to losses—probably quicker than in the stock market Currencies are inherently unstable Consider the problems of the U.S dollar in 2007 and 2008, when it was quite weak against the euro and the yen What should hedge fund managers do? They might expect the dollar to continue to weaken But what if it strengthens? Or they might think the dollar has reached its floor and is ready for a rise, which would argue that the managers should buy dollars But when will it rise and by how much? By midMarch 2008, the dollar had declined by 15 percent in the prior 12 months; two months later, many experts felt it had M08_DANI6795_15_GE_C08.indd 359 Markets for Foreign Exchange 359 Is It OK to Speculate on Currency? reached a low point and expected it to rise This was based on the market expectations that interest cuts by the Fed were expected to stop and that the credit crisis was beginning to soften Now the speculators have to decide what to with those expectations Similar trends occurred in 2010-2011 when the dollar fell from a mid-2010 high of $1.2187 per euro to a low of $1.4546 by early May 2011 However, uncertainty over the Greek debt crisis pushed the euro down, leaving speculators wondering what would happen next Sometimes speculators can buy a currency on the basis of good economic fundamentals, or they can buy or sell currency because they feel that governments are following poor economic policies In late 2012, the Japanese economy was very weak, but the yen was strong As the new Japanese government announced that it was considering policies to weaken the yen, many hedge funds jumped into the market and sold yen, helping to push down the value At what point they feel that the yen has fallen enough and that it is in their best interests to be on a rise in the value of the yen? It is always tough to figure out the right timing of a movement and how far it will rise (or fall) As long as markets are free and information is available, traders ought to be able to make some money on their predictions of the future There is even a good argument that speculators help keep governments honest by betting in directions they feel reflect political and economic fundamentals Either governments must adjust to reality or suffer the consequences Of course, if governments close their markets to speculation, as is the case with China, it’s tough for the speculators to trade and make money The key is that currency speculation is a different way to invest money and allows investors to diversify their portfolios from traditional stocks and bonds Just as foreign exchange can be traded for speculative purposes, trading in shares is also speculation Even though we call such trades “investments,” they are just another form of speculation hoping to gain a return that is higher than the market average and certainly higher than what a CD can yield 01/04/14 3:06 PM ... Europe 14.57% 12. 26% 10.95% 10.48% 6. 72% 6.60% 5.86% 4.68% 3. 52% 3. 12% 12. 40% 11.03% 10.08% 13 .21 % 7 .26 % 5.53% 7. 92% 5.67% 2. 74% Market Share in North America 13.16% 12. 31% 12. 89% 9.39%... official in 20 00, inflation rose to 96.1 percent Then it dropped back to 29 .2 percent in 20 01, less than 20 percent in 20 02, under percent in 20 03, and to an estimated 3.4 percent in 20 06 However,... 1 43 22 .6 27 14 .2 Composite Other Monetary Policy Framework Monetary Inflationaggregate target targeting Other 5 1 13 6.8 4 .2 4 1 14 19 11 32 16.8 20 38 20 29 15.3 99.9 Source: Based on International