PART FOUR: WORLD FINANCIAL ENVIRONMENT

Global Foreign Exchange and Capital Markets

Present By Group 4Janaka Heenkenda Pgia07-6944Vipula Jayakody Pgia07-6886Dilupi Lihinipita Pgia07-6937A. Krishnakumar Pgia07-6948

Learning 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 understand why companies deal in foreign exchange

To describe how the foreign exchange market works To examine the different institutions that deal in

foreign exchange To show how companies make payment for

international transactions

Foreign Exchange: Basic Concepts Foreign exchange (Fx): money denominated

in the currency of another nation or group of nationsA financial instrument issued by a foreign country

Exchange rate: the price of one currency expressed in terms another currencyThe number of units of a given currency needed to buy one unit of another currency

Foreign exchange market: banks and currency exchanges that buy and sell foreign currencies and other exchange instrumentsA market for converting the currency of one country into that of another country

The Foreign Exchange Market: Major Segments

Over-the-counter (OTC) market: commercial and investment banksMost foreign exchange activity occurs here

Exchange-traded market: specialized securities exchanges where particular types of foreign-exchange instruments are tradedInstruments such as futures and options are exchange-traded

Average Daily Volume in World Foreign Exchange Markets, 1989-2004

Currency Distribution of Global Foreign Exchange Market Activity

April April April April AprilApril

CURRENCY 1989 1992 1995 1998 20012004

U.S. Dollar 90 82 83 87 90 89Euro — — — — 38 37Japanese Yen 27 23 24 21 23 20Pound Sterling 15 14 10 11 13 17Swiss Franc 10 9 7 7 6 6All others 31 32 39 44 30 31

Source: Bank for International Settlements, Central BankSurvey of Foreign Exchange and Derivatives Market Activity, 2004.

The U.S. dollar is the most widely traded currency in the world because it serves as: 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

The most frequently traded currency pairs are:Number One: The U.S. dollar/euro - 28%Number Two : The U.S. dollar/yen -17%

Geographical Distribution of Global Foreign Exchange Market Activity, April 2004

Location of the Foreign Exchange Market London is the largest foreign exchange market

(followed by New York, Tokyo, and Singapore) because of its strategic location between Asia and the Americas.

Market activity first heightens when Europe and Asia are open and again when Europe and the United States are open.

Cross-trading: using the U.S. dollar as a vehicle currency for trades between two other currencies Cross rate: the exchange rate between two non-U.S.

dollar currencies that is computed from the exchange rate of each currency in relation to the U.S. dollar

Use currency A to buy currency C (US $1), and then use currency C to buy currency B.

The Circadian Rhythms of the Foreign Exchange Market

International Time Zones and the Single World Market

Foreign Exchange Terms and Conventions Bid: the price at which a trader is willing to

buy a foreign currency Offer: the price at which a trader is willing to

sell a foreign currency Spread: the difference between the bid and

the offer rates, i.e., the trader’s profit American terms: the U.S. point of view, i.e.,

the number of U.S. dollars per unit of foreign currency

European terms (indirect quote): the number of units of foreign currency per U.S. dollar

A quote in American terms (US$/Fx) is always the reciprocal of a quote in European terms (Fx/US$). $1.00/¥.009430 ¥106.04/$1.00

Base currency: the quoted, underlying, or fixed currency

Traders always quote the base currency (the denominator) first, followed by the terms currency (the numerator).

An example:

Dollar-yen quote: dollar = base, yen = terms

Oct. 10, 2004 April 28, 2005 ¥110.96/$1.00 ¥106.04/$1.00

The dollar (base) weakened; the yen (terms) strengthened.

Foreign Exchange Terms and Conventions

Types of Foreign Exchange Markets Spot market: the market in which foreign

exchange transactions occur “on the spot,” i.e., for delivery within two business days following the date of agreement to trade Spot rate: the rate quoted for transactions that require

immediate delivery, i.e. within two days

Forward market: the market in which foreign exchange transactions occur at a set rate for delivery beyond two business days following the date of agreement to trade Forward rate: a contractually established exchange rate

between a foreign exchange trader and the trader’s client for delivery of foreign currency on a specified date

forward discount: the forward rate is less than the spot rate forward premium: the forward rate is higher than the spot rate

Forward/Future Instruments Forward contract: a contract between a firm or individual and

a bank to deliver foreign currency at a specific exchange rate on a future date

Outright forward: a forward contract that is not connected to a spot transaction, i.e., a contact to deliver foreign currency beyond two days following the date of agreement at the forward rate

Fx swap: a simultaneous spot and forward trans-action, i.e., one currency is swapped for another on one date and then swapped back on a future date

Currency swap: the exchange of principal and interest payments via interest-bearing OTC financial instruments (e.g., bonds)

Futures contract: an agreement between two parties to buy or sell a given currency at a given (negotiated) price on a particular future date, as specified in a standardized contact to all participants in that currency futures exchange Not as flexible as a forward contract

Option: an instrument traded both OTC and on exchanges that gives the purchaser the right (but not the obligation) to buy or sell a certain amount of foreign currency at a specified exchange rate within a specified amount of time More expensive but also more flexible than a forward

contract Strike price: the exchange rate specified in the option, i.e.,

the exercise price Premium: the fee paid to the writer of the option

Forward/Future Instruments

Foreign Exchange Markets: Thursday, April 28, 2005

US$ EQUIVALENT CURRENCY PER US$

COUNTRY THUR WED THUR WEDBrazil (Real) .3917 .3972 2.5530 2.5176Canada (Dollar) .7991 .8004 1.2514 1.2494India (Rupee) .02291 .02288 43.649 43.706Japan (Yen) .009430 .009445 106.04 105.88Russia (Ruble) .03597 .03607 27.801 27.724South Africa (Rand) .1630 .1646 6.1350 6.0753Switzerland (Franc) .8383 .8390 1.1929 1.1919U.K. (Pound) 1.9068 1.9059 .5244 .5247Special Drawing Right 1.5135 1.5121 .6607 .6613Euro 1.2895 1.2933 .7755 .7732

Special Drawing Rights (SDRs) are based on exchange rates for the US dollar, the euro, the Japanese yen, and the British pound.Sources: International Monetary Fund; Wall Street Journal, 2005.

Exchange-based vs. Over-the-Counter Fx Instruments

EXCHANGE-BASED OTC(OPTIONS & FUTURES) (FORWARD CONTRACTS)

Contract Specs. Standard + Custom CustomRegulation SEC SelfType of market Open outcry, auction DealerTransparency Yes NoShort margin req. Yes NoAnonymous orders Yes NoMark positions daily Yes NoAudit trail Complete trail NoParticipants Public cust. + Corp. & inst. users

corp. & inst. usersSource: The Philadelphia Stock Exchange.

Foreign Exchange Convertibility Convertibility: The ability of residents and

nonresidents to purchase foreign currency with a given (domestic) currency without government restrictions

External convertibility : The ability of non- residents to purchase foreign currency with a given currency without government limitations

Nonconvertibility : The inability of residents and nonresidents to convert a given currency into foreign currency because of government limitations

Fully convertible currencies are those that governments allow both residents and nonresidents to purchase in unlimited amounts, i.e., they are freely traded and accepted by central banks.

Hard currencies are fully convertible, relatively stable, and tend to be comparatively strong. Soft (weak) currencies are not fully convertible.

A government may control the convertibility of its currency through: licensing a multiple exchange rate system advance import deposits quantity controls

Currency controls add to the cost of doing business and thus serve as serious impediments to trade and investment.

Foreign Exchange Convertibility

The Uses of Foreign Exchange The role of commercial banks:

buy and sell foreign exchange serve as vehicles for payments between

domestic and foreign customers lend money in foreign denominations

Business purposes: settlement of international business transactions Hedging (Risk reduction through loss protection) speculation (currency trading on expectations of future

prices) arbitrage (risk-free profit based on price differentials)

Interest arbitrage

The Fx Trading Process To settle foreign exchange balances, companies

may work through: local banks commercial and investment banks (OTC market) securities exchange brokers

Banks deal with each other in the interbank market, primarily through foreign-exchange brokers.

Brokers are specialist intermediaries who facilitate transactions in the interbank market by matching the best bid and offer quotes.

Banks’ fx dealers can trade foreign exchange: directly with other dealers through voice brokers through electronic brokerage systems

Structure of Foreign Exchange Markets

Foreign Exchange Transactions

The Over-the-Counter Market: Commercial and Investment Banks

Top banks in the interbank fx markets are so ranked because of their ability to: Trade in specific market locations Handle major currencies Handle major cross trades Deal in specific currencies Handle derivatives (forwards, options,

futures, swaps) Conduct key market research

Top OTC and Commercial and Investment Banks: Fx Trades

ESTIMATED BEST IN BEST IN BEST IN BEST INTRADING BANK MKT.SHARE LONDON NEW YORK EURO/US$ US$/YEN1. Deutsche Bank 19.75% 2 3 1 42. UBS Warburg 11.61% 5 4 4 33. Citigroup 7.33% 3 1 3 14. HSBC 6.64% 1 5 2 25. Barclays 6.41% 4 — 7 76. JP Morgan 5.38% 7 2 5 57. ABN Amro4.57% 9 7 6 68. Merrill Lynch 4.45% — — — —9. Goldman Sachs 4.38% 8 8 10 1010.Morgan Stanley 4.20% — 9 — —Source: “2005 Euromoney Foreign Exchange Poll,” Euromoney (May 2005).

U.S. Securities ExchangesU.S. exchanges where fx instruments (primarily

options and futures) are traded include:

Chicago Mercantile Exchange (CME): offers futures and futures options contracts in more than a dozen foreign currencies

Philadelphia Stock Exchange (PHLX): the only U.S. exchange that trades foreign currency options; lists six dollar-based standardized currency options contracts

Although options cost more than futures, large firms prefer options because of their greater flexibility and convenience.

Global Capital Markets: Eurocurrencies Eurocurrency: any currency banked outside its

country of origin Eurocurrency market: an offshore, wholesale

currency market Started with the deposit of U.S. dollars in London banks

Eurodollars: dollars banked outside of the United States, i.e., a certificate of deposit in dollars in a bank located outside of the U.S. Constitute 65-80% of the Eurocurrency market

Eurocurrencies are also known as offshore currencies, while currencies banked within their country of origin are known as onshore currencies.

Major Sources of Eurocurrencies Foreign governments or individuals who want to

hold dollars outside of the United States

MNEs that have cash in excess of current needs

European banks with foreign currency in excess of current needs

Countries such as Germany, Japan, and Taiwan that have large balance-of-trade surpluses held as reserves

Demand for Eurocurrencies Demand for Eurocurrencies reflects:

greater convenience increased security lower rates and thus higher yields

Demand for Eurocurrencies comes from: sovereign governments supranational agencies (e.g., the World Bank) firms and individuals

Eurocurrency Borrowing Eurocredit: a type of loan or line of credit that

matures in one to five years

Syndication: the process of pooling the specific resources of several banks in order to spread the risks associated with large loans

London Inter-bank Offered Rate (LIBOR): reflects the interest rate London banks charge one another for short-term Eurocurrency loansTraditional loans are made at a certain percentage above the LIBOR.

Global Capital Markets: International Bonds Foreign bonds: sold outside of the borrower’s

home country but denominated in the currency of the country of issue

Eurobonds: sold in countries other than the one in whose currency the bond is denominated; usually underwritten by a syndicate of banks from different countries; typically sold over-the-counter

Global bond: registered in different national markets according to the registration requirements of each market; traded simultaneously in numerous capital markets

Eurobonds may have currency options which allow the creditor to demand repayment in one of several currencies, thus reducing the exchange risk.

Global Capital Markets: Equity Securities Private placement: an investment by a

venture capitalist or other private party in exchange for stock

Market capitalization: the total number of shares listed times the market price per share

The three largest markets in the world areNew York, Tokyo, and London.

The growth of emerging stock markets has been very sensitive to global economic conditions and events.

Market Capitalization, 2001 (US$ Bil.)

Growth of Emerging Stock Markets

Global Capital Markets: The Euroequity Market Euroequity market: Shares sold outside the boundaries of the issuing

firm’s home country; issuing stock simultaneously in two or more countries in order to attract capital from a wider variety of shareholders

Global share offering: the simultaneous offering of actual shares on different stock exchangesA major source of competition to the world’s traditional stock exchanges is the electronic trading of stocks through companies such as E*Trade.

American Depository Receipt (ADR): A negotiable certificate issued by a U.S. bank that represents underlying shares of stock of a foreign corporation held in trust at a custodial bank in a foreign country

In addition to ADRs, there are: global depository receipts European depository receipts

Depository receipts are traded like stocks, with each receipt representing some number of shares of an underlying stock.

Summary Approximately U.S. $1.2 trillion in foreign exchange is traded

each day.

The major institutions that trade foreign exchange are the large commercial and investment banks (over-the-counter) and securities exchanges.

The U.S. dollar is the most widely traded currency in the world, but London represents the main foreign exchange market in the world.

Some players buy and sell foreign exchange to settle trade transactions, some for purposes of foreign direct investment, others for purposes of portfolio investment, and still others for arbitrage and speculation.

End of the Presentation Thank You !