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1. Multinational Business Finance Fifteenth Edition, Global Edition Chapter 5 The Foreign Exchange Market Copyright © 2021 Pearson Education Ltd. All Rights Reserved Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7

2. Learning Objectives 5.1 Explore the multitude of functions of the foreign exchange market 5.2 Detail how the structure of the global foreign exchange market has evolved 5.3 Describe the financial and operational transactions conducted in the foreign exchange market 5.4 Examine the forms of currency quotations used by currency dealers, financial institutions, and agents of all kinds when conducting foreign exchange transactions

3. Functions of the Foreign Exchange Market The foreign exchange market is the mechanism by which participants: transfer purchasing power between countries; obtain or provide credit for international trade transactions; and minimize exposure to the risks of exchange rate changes.

4. Structure of the Foreign Exchange Market The foreign exchange market today has evolved dramatically over time. The market is based on: supply and demand; market information and expectations; and negotiating strength. Global trading is a 24-hour-a-day process as shown in Exhibit 5.1. When the Asian-based trading centers overlap, the global currency markets exhibit the greatest depth and liquidity.

5. Exhibit 5.1 Global Currency Trading: The Trading Day For long description, see

6. Appendix 1 The currency trading day literally extends 24 hours per day. The busiest time of the day, which historically was the London and New York overlap, has now started shifting farther East to Asia.

7. Market Participants—The Players Participants in the foreign exchange market include liquidity seekers and profit seekers . Five broad categories of institutional participants operate in the market: Bank and nonbank foreign exchange dealers Private individuals and firms conducting commercial or investment transactions Speculators and arbitragers Central banks and treasuries Foreign exchange brokers

8. Market Participants: Bank and Nonbank Dealers Banks and nonbank traders profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask or offer price. Dealers in the foreign exchange department of large international banks often function as “market makers.” These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

9. Market Participants: Commercial and Investment Transactors Importers and exporters, international portfolio investors, multinational corporations, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Their use of the foreign exchange market is necessary, but incidental, to their underlying commercial or investment purpose.

10. Market Participants: Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

11. Market Participants: Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded, a practice known as foreign exchange intervention . They may act to support the value of their own currency because of policies adopted at the national level or because of commitments to other countries under exchange rate currency agreements. The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens. As willing loss takers, central banks and treasuries differ in motive from all other market participants.

12. Market Participants: Foreign Exchange Brokers Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction.

13. Evolution of the Market With the collapse of Bretton Woods and the flotation of currencies, profit seekers entered the market in volume. The evolution of foreign exchange trading institutions is described in Exhibit 5.2. The foreign exchange market is the world’s largest financial market.

14. Exhibit 5.2 Evolution of the Modern Currency Trading Marketplace For long description, see

15. Appendix 2

16. The Evolution of F X Trading: 1980s Foreign exchange dealers knew who they were talking to on the phone and trades were paper-based. Traders did not know: Recent trade rates at other banks Quotes from other dealers Trades were subject to recording errors.

17. The Evolution of F X Trading: 1990s Traders are conversing using computers and the Internet, but they still know the bank and trader on the other end of the link. The computer-based process is more efficient from a variety of operational perspectives, and more importantly, it is conducted in a market where individual agents have instantaneous access to much more relevant market data. But there are still constraints and limitations.

18. Exhibit 5.3 Foreign Exchange Trading in the 1980s and 1990s For long description, see

19. Appendix 3 Source: Constructed by authors based on “Foreign Exchange Market Structure, Players and Evolution,” Michael R. King, Carol Osler and Dagfinn Rime, Norges Bank, Working Paper,Research Department, 2011, 10, p. 21, and “The anatomy of the global F X market through the lens of the 2013 Triennial Survey,” by Dagfinn Rime and Andreas Schrimpf, B I SQuarterly Review , December 2013.

20. The Evolution of F X Trading: 2010 The separation of the interdealer and customer markets has effectively broken down (Exhibit 5.4) with the introduction of: multibank trading systems (M B T) single-bank trading systems (S M T) prime brokerage (P B) Small customers gain access to the global currency market through a variety of structures, including retail aggregators.

21. Exhibit 5.4 The Foreign Exchange Market Today For long description, see

22. Appendix 4 Source: Constructed by authors based on “Foreign Exchange Market Structure, Players and Evolution,” Michael R. King, Carol Osler and Dagfinn Rime, Norges Bank, Working Paper,Research Department, 2011, 10, p. 21, and “The anatomy of the global F X market through the lens of the 2013 Triennial Survey,” by Dagfinn Rime and Andreas Schrimpf, B I SQuarterly Review , December 2013.

23. The Three Components of F X Trades The exchange of a foreign exchange trade today actually involves three different components: The foreign exchange trade transaction agreement Electronic communication and notification for payment and settlement Final settlement of the currency trade

24. F X Market Manipulations: Fixing the Fix (1 of 2) Following the turmoil surrounding the setting of L I B O R rates in the interbank market during the 2007–2009 period, similar allegations arose over the possible manipulation of benchmarks in the foreign exchange markets in 2013 and 2014. Much of the focus was on the London fix, the 4 p.m. daily benchmark rate used by a multitude of institutions and indices for marking value. Traders were alleged to be exchanging emails, using social networking sites, and even phone calls, to collaborate on market movements and price quotes at key times.

25. F X Market Manipulations: Fixing the Fix (2 of 2) By 2014, nearly 75% of all currency trades were executed electronically. This growing dominance of electronic execution was thought to be something of a market fix for the 4 p.m. market spikes seen previously, thought to be caused by collusion among traders. Electronic trading might still facilitate market manipulation, just of a more sophisticated kind. It appears there will always be the human element in trading.

26. Transactions in the Foreign Exchange Market (1 of 3) A spot transaction is the purchase of foreign exchange with delivery and payment between banks taking place normally on the second following business day. Exhibit 5.5 provides a timetable of spot transactions, forward transactions, and swap transactions. The date of settlement is referred to as the value date.

27. Exhibit 5.5 Foreign Exchange Transactions and Settlement Foreign exchange operations are defined by the timing— the future date —set for delivery. There are in principle three major categories of over-the-counter transactions categorized by future delivery: spot (which may be overnight ), forward (including outright forward ), and swap transactions . For long description, see

28. Appendix 5

29. Transactions in the Foreign Exchange Market (2 of 3) An outright forward transaction (usually called just forward ) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six, and twelve months. Buying forward and selling forward describe the same transaction (the only difference is the order in which currencies are referenced).

30. Transactions in the Foreign Exchange Market (3 of 3) A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Both purchase and sale are conducted with the same counterparty. Some different types of swaps are: Spot against forward Forward-forward Nondeliverable forwards (N D F)

31. Size of the Foreign Exchange Market The Bank for International Settlements (B I S) estimated daily global net turnover in the foreign exchange market to be $5.1 trillion in April 2016, a 5% decline from its peak in 2013. Exhibit 5.6 shows data from 1989 to 2016.

32. Exhibit 5.6 Global Foreign Exchange Market Turnover, 1989-2016 For long description, see

33. Appendix 6 Source: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2016: Preliminary Results,” September 1, 2016, www.bis.org.

34. Geographical Distribution Exhibit 5.7 shows the proportionate share of foreign exchange trading for the most important national markets in the world between 1992 and 2016. The United Kingdom (London) continues to be the world’s major foreign exchange market in traditional foreign exchange market activity with 37% of the global market. Currency trading in Asia is growing at the fastest rate.

35. Exhibit 5.7 Top 6 Geographic Trading Centers in the F X Market For long description, see

36. Appendix 7 Source: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2016: Preliminary Results,” September 2016, www.bis.org . Japan’s market share fell 6% in 2016, while Switzerland’s fell to 2.4%.

37. Currency Composition Exhibit 5.8 shows global shifts in the currency composition of trading. The U.S. dollar increased its presence to 87.4% of global currency trades reversing a more than decade decline in market share. The Japanese yen and the European euro both showed declines in recent years in trade share, their roles as two of the world’s three most frequently traded currencies appearing to be under siege by the Chinese renminbi (3.8%, nearly doubling since 2013) and a number of other emerging market currencies.

38. Exhibit 5.8 Daily F X Trading by Currency Pair (percent of total) For long description, see

39. Appendix 8 Source: Constructed by authors based on data presented in Table 3, p. 11, of “Triennial Central Bank Survey, Foreign exchange turnonver in April 2016: preliminary global results,” Bank for International Settlements, Monetary and Economic Department, September 2016.

40. Foreign Exchange Rates and Quotations (1 of 7) A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote ) is a statement of willingness to buy or sell at an announced rate.

41. Foreign Exchange Rates and Quotations (2 of 7) Quotations may be designated by traditional currency symbols or by I S O codes. All electronic trading between institutions in the global marketplace uses the three-letter I S O codes. The paper currency of most countries continues to be represented using the country’s traditional currency symbol. Currency Traditional Symbol I S O 4217 Code U.S. dollar $ U S D European euro € E U R Great Britain pound £ G B P Japanese yen ¥ J P Y Mexican peso Ps M X N

42. Foreign Exchange Rates and Quotations (3 of 7) Every currency exchange involves two currencies: the base or unit currency (CUR1), and the price or quote currency ( CUR 2): CUR1 / CUR2 The quotation indicates the number of units of CUR2 required in exchange for receiving one unit of CUR1. For example, a quotation of EUR / U S D1.2174 designates the euro (EUR) as the base currency , the dollar (U S D) as the price currency . The exchange rate is U S D 1.2174 = EUR 1.00. Exhibit 5.9 provides an overview of the multitude of terms used to quote currencies.

43. Exhibit 5.9 Foreign Currency Quotations European terms Foreign currency price of one dollar (U S D) U S D/E U R 0.8214 or U S D 1.00 = E U R 0.8214 U S D is the base or unit currency E U R is the quote or price currency American terms U.S. dollar price of one euro (E U R) E U R/U S D 1.2174 or E U R 1.00 = U S D 1.2174 E U R is the base or unit currency U S D is the quote or price currency

44. Foreign Exchange Rates and Quotations (4 of 7) European terms, the quoting of the quantity of a specific currency per one U .S . dollar, is most common. There are two major exceptions: the euro and the U .K . pound sterling. Both are normally quoted in American terms —the U .S . dollar price of one euro and the U .S . dollar price of one pound sterling. American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with tourists.

45. Foreign Exchange Rates and Quotations (5 of 7) Foreign exchange quotes are at times described as either direct or indirect. In this pair of definitions, the home or base country of the currencies being discussed is critical. A direct quote is a home currency price of a unit of foreign currency. An indirect quote is a foreign currency price of a unit of home currency. The form of the quote depends on what the speaker regards as “home.”

46. Foreign Exchange Rates and Quotations (6 of 7) Interbank quotations are given as a bid and ask. Exhibit 5.10 shows how these quotations may be seen in the market. A bid is the price (i.e., exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices. A bid for one currency is also the offer for the opposite currency. See Exhibit 5.11 for closing rates for selected currencies (plus the S D R) as quoted by The Wall Street Journal .

47. Exhibit 5.10 Bid, Ask, and Mid-Point Quotation For long description, see

48. Appendix 9 In text documents of any kind, the exchange rate may be stated as mid-point quote , the average of bid and ask , of For example, The Wall Street Journal would quote the following currencies as follows: Blank Last Bid Blank Last Bid Euro (E U R/U S D) 1.2170 Brazilian Real (U S D/B R L) 1.6827 Japanese Yen (U S D/JPY) 83.16 Canadian Dollar (U S D/C A D) 0.9930 U.K. Pound (G B P/U S D) 1.5552 Mexican Peso (U S D/MXN) 12.2365

49. Exhibit 5.11 Exchange Rates: New York Closing Snapshot For long description, see

50. Appendix 10 Note: S D R from the International Monetary Fund; based on exchange rates for U.S., British and Japanese currencies. Quotes based on trading among banks of $1 million and more, as quoted at 4 p.m. E T by Reuters. Rates are drawn from the The Wall Street Journal online on January 2, 2018.

51. Foreign Exchange Rates and Quotations (7 of 7) Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate). Cross rates can be used to check on opportunities for intermarket arbitrage.

52. Intermarket Arbitrage Quoted rates Citibank quotes U.S. dollars per euro U S D1.3297 = 1 EUR Barclays Bank quotes U.S. dollars per pound sterling U S D1.5585 = 1 G B P Dresdner Bank quotes euros per pound sterling EUR1.1722 = 1 G B P Cross rate calculation based on Citibank and Barclays Bank quotes For long description, see

53. Appendix 11 Which is .001 less than the Dressner Bank quote, which results in triangular arbitrage .

54. Exhibit 5.12 Triangular Arbitrage by a Market Trader For long description, see

55. Appendix 12

56. Forward Quotations Spot rates are typically quoted on an outright basis (meaning all digits expressed) whereas forward rates are typically quoted in points or pips (the last digits of a currency quotation). Forward rates of one year or less maturity are termed cash rates; for longer than one-year they are called swap rates . As shown in Exhibit 5.13, the bid and ask spot quotes are outright quotes, but the forwards are stated as points from the spot rate.

57. Exhibit 5.13 Spot and Forward Quotations for the Euro and Japanese Yen For long description, see

58. Appendix 13

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60. Appendix 1 Long Description for a diagram represents a trading day in global currency trading. A diagram represents a trading day in global currency trading. The diagram has a line at the bottom indicating the Greenwich Mean Time, G M T, from midnight up to 11.59 p m. The currency trading day literally extends 24 hours per day. The busiest time of the day, which historically was the London and New York overlap, has now started shifting farther East to Asia. Hong Kong stretches from 22 hundred the previous day to 0 800 on the day of trading. Tokyo and Sydney stretch from 0 100 to 0 800. Bahrain’s trading hours are from 0 400 to 10 hundred. Singapore has longer trading hours from 0 2 hundred to 11 30. The Hong Kong, Tokyo, Sydney, and Singapore markets overlap between the hours 0 100 to 08 30. Frankfurt’s currency trading begins from 07 30 and continues until 15 30. London’s trading hours are from 08 30 to 16 30. New York’s hours range from 13 hundred to 20 hundred. The London New York overlap is from 0 9 30 to 0 5 30. Chicago trades currencies between 14 hundred to 21 hundred. San Francisco stretches from 16 hundred to 23 hundred. Return to presentation

61. Appendix 2 Long Description for a timeline represents the evolution of the modern currency trading marketplace. The timeline illustrates the development of the modern currency trading marketplace from 1970 to 2016. The evolution of the marketplace can be divided into two major eras. the Telephone Era of Currency Trading from 1970 to 1987 and the Computer Era of Currency Trading from 1987 to the present. The following list provides the notable events during the Telephone Era by year. 1971. Bretton Woods begins to break down. 1973. SWIFT initiated. 1974. Bankhaus Herstatt Closure introduces settlement risk. 1987. Reuters launches system for bilateral trades between dealers and launches F X F X page. The following list provides the notable events during the Computer Era by year. 1990. E B S launches competitive product to Reuters. 1992. Reuters launches online limit order system. 1996. State Street launches retail aggregator F X Connect. 1999. Currenex multi bank trading system. 2002. Continuous Linked Settlement Bank, C L S, opens. 2005 to 2007. Interdealer and customer F X market tiering ends with introduction of multitude of electronic systems. 2016. Cyber attacks on central bank currency transaction messages in SWIFT. Return to presentation

62. Appendix 3 Long Description for a diagram compares foreign exchange trading in the nineteen eighties and nineteen nineties. The diagram compares how customers, brokers, and dealers interacted in the nineteen eighties versus how they interacted in the nineteen nineties. In the nineteen eighties, all trades were conducted by telephone between dealers and currency brokers. Retail customers were outsiders with limited access. In the nineteen nineties, electronic brokers began to conduct trades by voice and by electronic messaging with major dealers, but retail customers remained outsiders. Return to presentation

63. Appendix 4 Long Description for a diagram represents the structure of the present day foreign exchange market. The present day foreign exchange market is dominated by electronic trading, allowing customers all kinds of direct access to global trading. The two tier structure that separated the interdealer market and the customer market for so many years is effectively gone. Dealers now interact with electronic brokers, voice brokers, prime brokers, single bank trading systems, and multi bank training systems. Retail aggregators and single bank trading systems connect customers to dealers. Hedge fund customers interact with prime brokers and multi bank trading systems, and emergent market customers interact with voice brokers. Return to presentation