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All things are obedient to money. of entering into a forward exchange contract is that JAL knows
INTERNATIONAL BUSINESS MANAGEMENT
-English Proverb now what it will have to pay for the 747 in five years. For
example, if the value of the yen is expected to increase against
Objectives: the dollar, foreign exchange traders might offer a forward
• To learn the fundamentals of foreign exchange exchange contract that allows JAL to purchase dollars at a rate
• To identify the major characteristics of the foreign-exchange of $1 =¥185 in five years, instead of the $1 =¥240 rate that
market and how governments Control the flow of currencies prevailed at the time of ordering. At this forward exchange rate,
across national borders the 747 would only cost ¥1.85 billion, a 23 percent saving over
• To understand why companies deal in foreign exchange
the yen price implied at time of ordering.
when they must pay a foreign company for its products or from all of its food and drink activities during 1991!
services in its country’s currency. For example, our friend Michael
George Soros-The Man Who Moved Currency
runs a company called NST, a large British travel service for
Markets
school groups. Each year Michael’s company arranges vacations
George Soros, a Hungarian-born financier, is the principal
for thousands of British schoolchildren and their teachers in
partner of the Quantum Group, which controls a series of
France. French hotel proprietors demand payment in euros, so
hedge funds with assets of about $15 billion. A hedge fund is
MiChael must convert large sums of money from pounds into
an investment fund that not only buys financial assets (such as
euros to pay them.
stocks, bonds, and currencies) but also sells them short. Snort
Third, international businesses use foreign exchange markets selling occurs when an investor places a speculative bet that the
when they have spare cash that they wish to invest for short value of a financial asset will decline and then profits from that
terms in money market. For example, consider a U.S. company decline. A common variant at short selling occurs when an
that has $10 million it wants to invest for three months. The investor borrows stock from his broker and sells that stock. The
best interest rate it can earn on these funds in the United States short seller has to ultimately pay back that stock to his broker.
may be 8 percent. Investment in a South Korean: money However, he hopes that in the intervening period the value of
market account, however, may earn 12 percent. Thus, the the, stock will decline so that the cost of repurchasing the stock
company may change its $10 million into Korean won and to pay back the broker is significantly less than the income he
invest it in South Korea. Note, however, that the rate of return received from the initial sale of the stock. For example, imagine
it earns on this investment depends not only on the Korean that a short seller borrows 100 units of IBM stock and sells it in
interest rate, but also on the changes in the value of the Korean the market at $150 per share, yielding a total income of $15,000.
won against the dollar in the intervening period. In one year, the short seller has to give the 100 units of IBM
Finally, currency speculation is another use of foreign exchange, stock back to his broker. In the intervening period, the value of
markets. Currency speculation typically involves the short-term the IBM stock falls to $50. Consequently, it now costs the
movement of funds from one currency to another in the hopes shortselleronly $5,000 to repurchase the 100 units of IBM stock
of profiting from shift in exchange rates. Consider again the for his broker. The difference between the initial sales price
U.S. Company with $10 million to invest for three months. ($150) and the repurchase price’ ($50) represents the short
Suppose the company suspects that the U.S. dollar is overval- seller’s profit, which in the case is $100 per unit of stock for a
ued against the Japanese yen. That is, the company expects the total profit of $ 10,000.Short selling was originally developed as
value of the dollar to depreciate against that of the yen. Imagine a mean of reducing risk (of hedging), but it, is often used for
the current dollar/yen exchange rate is $1 == ¥120. The speculation.
company exchanges its $10 million into yen, receiving ¥1.2 Along with other hedge funds, Soros’s Quantum Fund often
billion. Over the next three months, the value of the dollar takes a short position in currencies that he expects to decline in
depreciates until $1 = ¥100. Now the company exchanges its value. Fort example, if ,Soros expects the British pound to
¥1.2 billion back into dollars and finds that it has $12 million. decline against the U.S. dollar, he may borrow 1 billion pounds
The company has made a $2 million profit on currency specula- from a currency trader and immediately sell those for U.S.
tion in three months on an initial investment of $10 million. dollars. Soros will then hope that the value of the pound will
One of the most famous currency “speculators” is George decline against the dollar, so that when he has to repay the 1
Soros, whose Quantum Group of “hedge funds” controls billion pounds it will cost him considerably less (in U.S. dollars)
about $15 billion in assets. The activities of Soros, who has than he received from the initial sale.
been’ spectacularly successful, are profiled in the accompanying Since the 1970s,Soroshas consistently earned huge returns by
Management Focus. In general, however, companies should making such speculative bets. His most spectacular triumph
beware of speculation for it is a very risky business. The came in September 1992. He believed the British pound was
company cannot know for sure what will happen to exchange likely to decline in value against major currencies, particularly the
rates. While a speculator may profit handsomely if his specula- German deutsche mark. The prevailing exchange rate was £1
tion about future currency movements turns out to be correct, =Dm2.80. The British government was obliged by a European
he can also lose vast amounts of money if it turns out to be Union agreement on monetary policy to try to keep the pound
wrong. For example, in 1991, Clifford Hatch, the finance above DM2.77. Soros doubted that the British could do this,
director of the British food and drink company Allied-Lyons, so he shorted the pound, borrowing billions of pounds (using
bet large amounts of the company’s funds on the speculation the assets of the Quantum Fund as collateral) and immediately
that the British pound would rise in value against the U.S. began selling them for German deutsche marks. His simulta-
dollar. Over the previous three years, Hatch had made over $25 neous sale of pounds and purchase of marks were so large that
million for Allied-Lyons by placing similar currency bets. His it helped drive down the value of the pound against the mark.
1991 bet, however, went spectacularly wrong when the British Other currency traders, seeing Soros’s market moves and.
pound plummeted in value against the U.S. dollar. In February knowing his reputation for making successful currency bets,
1991, one pound bought $2; by April it bought less than $1.75. jumped on the bandwagon and started to sell pounds short
The total loss to Allied-Lyons from this speculation was a and buy deutsche marks. The resulting bandwagon effect put
enormous pressure on the pound. The British Central Bank, at
and FX swaps. In the OTC derivatives market, daily activity carry balances in many different currencies.
increased by 10 percent-to $1.4 trillion. This is also a significant Another way to consider foreign-currency trades is to look at the
slowdown in activity form the years between 1995 and 1998, most frequently traded currency pairs. Four of the top seven
when activity increased by 44 percent. In particular, spot currency pairs involve the U.S. dollar, with the top two pairs
transactions have decreased consistently since 1989. being the U.S. dollar and the euro (30 percent of total) and the
The U.S. dollar is the most important currency in the foreign- U.S. dollar and Japanese yen (20 percent). This reinforces the
exchange market; in 2001, it comprised one side (buy or sell) of idea that the dollar is a vehicle currency for trading between
90 percent of all foreign currency transactions worldwide, as other currencies, which is known as cross-trading.
table 6.1 illustrates. This means that almost every foreign- The euro is also in four of the top seven currency pairs.
exchange transaction Although the dollar is more popular in most emerging
markets, the euro is gaining ground, particularly in eastern
European countries like the Czech Republic and Hungary. The
Bank for International Settlements (BIS) believes the euro
resembles the German mark in the exchange market in four
ways: because of “its share in global foreign exchange trading,
the tightness of spreads,
Table 6.1
Currency Distribution Of Global Foreign Exchange Market
Activity
Percentage Of Daily Turnover
$1 million and more. Interbank transactions are transactions foreign currency is selling at a forward discount. If the forward
between banks. Retail transactions, those between banks and rate is greater than the spot rate, the foreign currency is selling at
companies or individuals, provide fewer foreign currency units a forward premium.
per dollar than interbank transactions. If I were going on a
International Time Zones and the Single World
business trip, I could check the Wall street journal to get an idea
Market
of the exchange rate in my destination country, just as I did in
The world’s communication networks are now so good that we
the opening case, but I would get fewer units of the foreign
can talk of a single world market. It starts in a small way in New
currency for my dollars than is quoted in the Journal. There are
Zealand around 9:00 A.M., just in time to catch the tail end of
also a number of good Internet sources for exchange-rate
the previous night’s New York market. Two or three hours
quotes, such as CNN (http://money.cnn.com/markets/
later, Tokyo opens, followed and hour later by Hong Kong and
currencies/).
Manila, and then half an hour later by Singapore. By now, with
A final definition that applies to the spot market is the cross the Far East market in full swing, the focus moves to the near
rate. This is the exchange rate between non-U.S. dollar curren- and middle East. Bombay opens two hours after Singapore,
cies. As an example, let’s use the quotes for the Swiss Franc and followed after an hour and a half by Abu Dhabi and Athens,
euro in European terms as given in Table 6.2 and figure the which Jidda and Beirut are an hour behind still. By this stage,
cross rate with the franc as the terms currency and the euro as trading in the Far and Middle East is usually thi8n as dealers
the base currency. In Table 6.2, the spot rates for these currencies wait to see how Europe will trade. Paris and Frankfurt open an
are 1.3990 francs per U.S. dollar and 0.9600 euro per U.S. dollar. hour ahead of London, and by this time Tokyo is starting to
The cross rate would be 1.3Q90/. 9600 or 1.4573 Swiss francs close down, so the European market can judge the Japanese
per euro. market. By lunchtime in London, New York is starting to open
The Wall Street Journal also publishes a cross-rate table along up, and as Europe closes down, positions can be passed
with the dollar-exchange rates. Table 6.3 identifies the cross rates westward. Midday in New York, trading tends to be quiet
for several key currencies. The rows are treated as the terms because there is nowhere to pass a position to. The San
currency and the columns as the base currency. For example, Francisco market three hours behind New York is effectively a
starting in the Switzerland row and going to the euro column, satellite of the New York market although very small positions
we find that the exchange rate is 1.4573 Swiss francs per euro. can be passed on to new Zealand banks. (Note that in the
The Swiss franc is the terms currency, and the euro is the base former Soviet Union standard tome zones are advanced an
currency. You can also find cross rates of key currencies on the hour. Also note that some countries and territories have
currency page of CNN online, and you can use the CNN adopted half-hour time zones.
currency converter to find out cross rates of more exotic Options
currencies. An option is the right but not the obligation to buy or sell a
The Forward Market foreign currency within a certain time period or on a specific date
As noted earlier, the spot market is for foreign-exchange at a specific exchange rate. An option can be purchased OTC
transactions that occur within two business days, but in some from a commercial or investment bank, or it can be purchased
transactions, a seller extends credit to the buyer for a period that on an exchange, such as the Philadelphia Stock Exchange. For
is longer than two days. For example, a Japanese exporter of example, assume a company purchases an OTC option to buy
consumer electronics might sell television sets to a U.S. importer Japanese yen at 120 yen per dollar (0.00833 dollars per yen). The
with immediate delivery but payment due in 30 days. The U.S. writer of the option, the commercial or investment bank in this
importer is obligated to pay in yen in 30 days and may enter case, will charge the company a fee
into a contract with a currency trader to deliver the yen at a Table 6.2 Foreign Exchange Rates, Friday, January 3, 2003
forward rate-the rate quoted today for future delivery. Because most currencies constantly fluctuate in value, many
In addition to the spot rates for each currency, Table 6.2 shows managers check values daily,
the forward rates for the British pound, Canadian dollar,
Japanese yen, and Swiss franc. These are the most widely traded
currencies in the forward market. Many currencies do not have a
forward market due to the small size and volume of transac-
tions in that currency.
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. An easy way to
understand the difference between the forward rate and the spot
rate is to use currency quotes in American terms. If the forward
Britain (Pound) 1.6094 1.5939 0.6213 0.6274 Canada 1.5647 1.6299 2.5182 1.1184 0.1506 0.0131 …
1 Month Forward 1.6058 1.5904 0.6227 0.6288 Japan 119.73 124.72 192.7 85.854 11.521 … 76.521
3 Months Forward 1.5993 1.5837 0.6253 0.6314 Mexico 10.393 10.826 16.726 7.4288 … 0.0868 6.6421
6 Months Forward 1.5895 1.5740 0.6291 0.6353 Switzerland 1.399 1.4573 2.2515 … 0.1346 0.0117 0.8941
Canada (Dollar) 0.6391 0.6381 1.5647 1.5672
U.K. 0.6213 0.6473 … 0.4441 0.0598 0.0052 0.3971
1 Month Forward 0.6383 0.6373 1.5667 1.5691
Euro 0.96 … 1.545 0.6862 0.0924 0.008 0.6135
3 Months Forward 0.6367 0.6358 1.5706 1.5728
U.S. … 1.0417 1.6094 0.7148 0.0962 0.0084 0.6391
6 Months Forward 0.6343 0.6334 1.5765 1.5788
Chile (Peso) 0.001401 0.001392 713.78 718.39 Source: Wall street Journal. Central edition [staff produced copy
China (Renminbi) 0.1208 0.1208 8.2781 8.2781 only by staff. Copyright 2003 by Dow Jones & Co., Inc.
Colombia (Peso) 0.0003508 0.0003524 2,850.6 2,837.7 Reproduced with permission of Dow Jones & Co., Inc. in the
Czech Republic format Textbook via Copyright Clearance Center.
(Koruna) For writing the option. The more likely the option is to benefit
Commercial Rate 0.03322 0.03309 30.102 30.221
the company, the higher the fee. The rate of 120 yen is called the
Denmark (Krone) 0.1403 0.1395 701276 7.1685 strike price for the option. The fee or cost of the option is called
Ecuador (US the premium. On the date when the option is set to expire, the
Dollar)-e 1.0000 1.0000 1.0000 1.0000 company can look at the spot rate and compare it with the strike
Hong Kong (Dollar) 0.1282 0.1282 7.8003 7.8003 price to see which is the better exchange rate. If the spot rate
Hungary (Forint) 0.004427 0.004390 225.89 227.79 were 130 yen per dollar (0.00769 dollars per yen), it would not
exercise the option because buying yen at the spot rate would
India(Rupee) 0.02084 0.02083 47.985 48.008
cost less than buying them at the option rate. However, if the
Indonesia (Rupiah) 0.0001120 0.0001121 8,928.60 8,920.6 spot rate at that time were 110 yen per dollar (0.00909 dollars
Israel (Shekel) 0.2087 0.209O 4.7916 4.7847 per yen), the company would exercise the option because buying
Japan (Yen) 0.008352 0.008331 119.73 120.03 at the option rate would cost less than buying at the spot rate.
The option provides the company flexibility, because it can walk
1 Month Forward 0.008362 0.008340 119.59 119.90 away from the option if the strike price is not a good price. In
3 Months Forward 0.008380 0.008359 119.33 119.63 the case of a forward contract, the cost is usually cheaper than
6 Months ForWard 0.008409 0.008388 118.92 119.22 the cost for an option, but the company cannot’ walk away
from the contract. So a forward contract is cheaper but less
Jordan (Dinar) 1.4092 1.4092 0.7096 0.7096
flexible than an option.
Kuwait (Dinar) 3.3354 3.3320 0.2998 0.3001
Futures
Lebanon (Pound) 0.0006634 0.0006634 1,507.40 1,507.4 A foreign currency future resembles a forward contract insofar as
Malaysia (Ririgiit)-b 0.2632 0.2632 3.7994 3.7994 it specifies an exchange rate sometime in advance of the actual
Malta (lira) 2.4947 2.4805 0.4008 0.4031 exchange of currency. However, a future is traded on an
exchange, not OTC. Instead of working with a banker,
Mexico (Peso) 0.09622 0.09637 10.393 10.377
New Zealand companies work with exchange brokers when purchasing
(DolIar) 0.5286 0.5224 1.8918 1.9142 futures contracts. A forward contract is tailored to the amount
and time frame that the company needs, whereas a futures
Norway (Krone) 0.1438 0.1427 6.9541 7.0077
contract is for a specific amount and specific maturity date. The
futures contract is less valuable to a company than a forward
contract. However, it may be useful to speculators and small
companies that do not have a good enough relationship with a
bank to enter into a forward contract or that need a contract for
an amount that is too small for the forward market. The
difference between the forward contract, which is traded OTC,
summarized in the Table 6.4 fixed rates to those needing to make payment abroad for
Foreign Exchange Convertibility Table 6.4 essential goods. An importer may purchase foreign exchange
only if that importer has obtained an import license for the
goods in question.
Another way governments control foreign-exchange convertibil-
ity is by establishing more than one exchange rate. This
restrictive measure is called a multiple exchange-rate system. The
government determines which kinds of transactions are to be
conducted at which exchange rates. Countries with multiple
exchange rates often have a very high exchange rate (i.e., it takes
more unit of the local currency to buy dollars) for luxury goods
and financial flows, such as dividends. Then they have a lower
exchange rate for other trade transactions, such as imports of
essential commodities and semi manufactured goods.
Another form of foreign-exchange convertibility control is the
advance import deposit. In this case, the government tightens
the issue of import licenses and requires importers to make a
deposit with the central bank, often for as long as one year and
A key aspect of exchanging one currency for another is its
interest-free, covering the full price of manufactured goods, they
convertibility. Fully convertible rate currencies are those that the
would purchase from abroad.
government allows both residents and nonresidents to
purchase in unlimited amounts. Hard currencies, such as the Governments also may limit the amount of exchange through
U.S. dollar and Japanese yen, are currencies that fully convertible. quantity controls, which often apply to tourism. A quantity
‘They also are relatively stable in value or tend to be strong in control limits the amount of currency that a local resident can
purchase from the bank for foreign travel. The government sets
Comparison with other currencies. In addition, they are
a policy on how much money a tourist is allowed to take
desirable assets. Currencies that are not fully convertible are
overseas, and the individual is allowed to convert only that
often called soft currencies, or weak currencies. They tend to be
amount of money.
the currencies of developing countries, also known as exotic
currencies. In the past, these currency controls have significantly added to
the cost of doing business internationa1ly, and they have
Most countries today have nonresident, or external, convertibil-
resulted in the overall reduction of trade. However, the
ity, meaning that foreigners can convert their currency into the
liberalization of trade in recent years has eliminated a lot of
local currency and can convert back into their currency as well.
these controls to the point that they are found to be a minor
For example, travelers to Zimbabwe can convert U.S. dollars
impediment to trade.
(USD) into Zimbabwe dollars (ZWD) and convert ZWD back
into USD when they leave. However, they have to show receipts How Companies Use Foreign Exchange
of all conversions into or from ZWD inside the country to Most foreign exchange transactions stem form the international
make sure that all transactions took place on the official market. departments of commercial banks, which perform three
Whatever the travelers converted in the official market was the essential financial function: (1) they buy and sell foreign
maximum they would have been allowed to convert back into exchange, (2) they collect and pay money in transactions with
USD when they left. In addition, they have to declare electronics foreign buyers and sellers, and (3) they lend money in foreign
products, such as cameras and stereos, upon entering the currency. In performing collections, the bank serves as a vehicle
country and then prove they had them upon leaving. The for payments between its domestic and foreign customers.
government was afraid visitors would sell the products in the Lending usually takes place in the currency of the bank’s
black market and then try to convert the proceeds into dollars headquarters, but the bank might be able to provide loans in a
and take them out of the country. Some countries limit foreign currency if it has a branch in that country.
nonresident convertibility. Commercial banks buy and sell foreign currency for many
To conserve scarce foreign exchange, some governments impose purposes. For one, travelers going abroad or returning from a
exchange restrictions on companies or individuals who want to foreign country will want to purchase or sell back its foreign
exchange money. The devices they use include import licensing currency. Also, residents of one country wanting to invest
multiple exchange rates, import deposit requirements, and abroad need to purchase foreign currency from a commercial
quantity controls. As you will read in the concluding case, bank. Further, suppose a Canadian exporter receives payment
Argentina’s government placed exchange restrictions on from a U.S. importer in U.S. dollars and wants to use the dollars
individuals and companies at the beginning of 2002. to buy raw materials in Norway. The bank in this case simulta-
Government licenses fix the exchange rate by requiring all neously serves as a collector and acts as a dealer in a
recipients, exporters, and others who receive foreign currency to foreign-exchange transaction.
sell it to its central bank at the official buying rate. Then the