OBJECTIVES CHAPTER OVERVIEW CHAPTER OUTLINE SEMINAR 28 NOV 2013

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1 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 describe how the foreign-exchange market works To examine the different institutions that deal in foreign exchange To understand why companies deal in foreign exchange CHAPTER OVERVIEW The foreign-exchange market consists of all those players who buy and sell foreignexchange instruments for business, speculative, or personal purposes. Primarily, foreign exchange is used to settle international trade, licensing, and investment transactions. Chapter 9 explains in detail basic concepts (such as rates, instruments, and convertibility) and explores the major characteristics of the foreign-exchange markets. The chapter includes a discussion of the foreign-exchange trading process that focuses on both the over-the-counter and the exchange-traded markets, i.e., banks, securities exchanges, electronic brokerages, and the respective roles they play. CHAPTER OUTLINE OPENING CASE: Going Down to the Wire in the Money-Transfer Market This case describes Western Union s international money transfer services and the increasing competition the company is facing from banks. Western Union has been particularly successful in attracting business from Mexican emigrants in the United States who send part of their paycheck home to support their families. Western Union charges relatively high fees and uses its own exchange rates that are usually significantly lower than the market rate. Banks have been introducing their own money transfer services, many with lower fees and better exchange rates than Western Union. Due to many Mexicans distrust of banks, however, Western Union continues to enjoy large profit margins and a large market share in the money transfer business. You can check currency prices by visiting the Web site

2 DOES GEOGRAPHY MATTER? Foreign-Exchange Trades Even though the U.S. dollar is the most widely traded currency in the world, some trading centers outside the U.S. are very important in the global currency trade. London, for example, is a major trading center because it is close to the major capital markets in Europe and is in a time zone that straddles the other major markets in Asia and the U.S. Despite the fact that the currency market is a 24-hour market, the heaviest volumes of trade are concentrated in the hours when Asia and Europe are open or when Europe and the U.S. are open. Also, prices tend to be better when markets are active and liquid. [See Map 9.1 and Fig 9.3] POINT COUNTERPOINT: Is it OK to Speculate on Currency? POINT: Currency speculation is not illegal, nor is it necessarily bad. Speculators are merely trying to make a profit by trading based on market trends. Currency speculation allows investors to diversify their portfolios from traditional stocks and bonds, which are themselves forms of speculative investment. COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign exchange or securities, to make money illegally or contrary to company policy. Nicholas Leeson, a 28-year-old trader for British bank Barings PLC was chief dealer for the bank in Singapore. Leeson had no checks and balances on his trading and made big bets on stock index futures assuming that the Tokyo stock market would rise. After the January 17, 1995 earthquake in Kobe, Japanese stocks plunged and Leeson had to come up with cash to cover the margin call. With lax internal controls, Leeson was able to make numerous questionable and illegal transactions to illicitly generate the cash needed to cover his positions. These actions resulted in huge losses in excess of $1 billion for Barings, putting the company into bankruptcy. Since the collapse of Barings, measures have been put into place in banks to prohibit such consequences, yet the occurrence of and potential for negative outcomes from rogue trading continue to exist. Another recent example, Jerome Kerviel of the French bank Societe Generale shows the ongoing risk for banks to lose significant amounts of money.

3 LOOKING TO THE FUTURE: Where Are Foreign-Exchange Headed? The speed at which transactions are processed and information is transmitted globally will continue to lead to greater efficiencies and more opportunities in foreign exchange markets. Companies costs of trading foreign exchange should come down and they should gain faster access to more currencies. Government exchange restrictions should diminish as currency markets are liberalized. As the euro continues to solidify its position in Europe, it will reduce exchange-rate volatility and should lead to the euro taking some of the pressure off the dollar so that it is no longer the only major vehicle currency in the world. The growth of Internet trades in currency will take away some of the market share of dealers and allow more entrants in the foreign-exchange market. Internet trade will also increase currency price transparency and increase the ease of trading. CLOSING CASE: Do Yuan to Buy Some Renminbi? The yuan is the official currency of China. It has been historically fixed and controlled by the Chinese government, but that may be changing. As China becomes a greater global exporter and economic powerhouse, critics are claiming that the currency is being undervalued and manipulated in an attempt to protect domestic markets. There are additional levels of complexity impacting China as the nation must deal not only with economic competition, but also internal political and social pressures. As China continues to loosen capital controls, there is great fear that the government may lose control of inflation and interest rates, thereby causing a great deal of labor and social unrest, while negatively impacting China s competitive advantages. There are currently platforms in place to increase the circulation of the yuan, but those platforms are currently limited and severely restricted. Questions 1. Why is it important for the yuan to become a major world currency? 2. What needs to take place for the yuan to be listed right along with the U.S. dollar and the euro as global currencies?

4 3. Why is the Chinese government so hesitant to open up the yuan to market forces to determine its value inside and outside of China? 4. What roles do foreign banks like HSBC and electronic platforms like Thomson Reuters and ICAP play in helping the yuan move closer to becoming a global currency? 3. If you were to predict what the foreign exchange trading world will look like in 2014 when the Bank for International Settlements issues its next triennial survey in foreign exchange, what would you predict? ADDITIONAL EXERCISES: The Foreign-Exchange Market Exercise 9.1. You may have had experience with foreign currency conversion. Describe the differences you have encountered in rates quoted at the airport, in hotels and banks, and on the street. Describe your experiences using credit cards and ATM cards in particular foreign countries. How were the transactions reported on your statements? Were you charged processing fees? (LO: 3, Learning Outcome: To describe how the foreign-exchange market works, AACSB: Reflective Thinking) Exercise 9.2. Take copies of the most recent editions of The Wall Street Journal and the Financial Times to class. Explain where to find foreign exchange rates, forward rates, cross rates, commodity prices, etc. Select the home countries of various peers in your class. Use the forward rates to engage the students in a discussion as to which currencies appear to be stronger. Explore the possible underlying reasons for a given currency s strength or weakness. (LO: 1, Learning Outcome: To learn the fundamentals of foreign exchange, AACSB: Analytical Skills) Exercise 9.3. More than 150 currencies exist today. Some countries share a common currency (e.g., those that participate in the euro), while certain countries peg their currencies to others (e.g., Chile s currency is pegged to the U.S. dollar). Many nations, however, maintain their own independent currencies. Debate the potential for additional regional currencies such as the euro. If you support the concept, should those currencies necessarily be tied to regional economic blocs? (LO: 2, Learning Outcome: To identify the major characteristics of the foreignexchange market and how governments control the flow of currencies across national borders, AACSB: Communication Abilities) Exercise 9.4. Assume the role of CFO of a mid-sized U.S. company that exports to Europe. The company has received a contract to supply components to a European manufacturer with an agreed upon sales price of 4 million due in 90 days. Should

5 the CFO do anything to hedge against possible fluctuations in the dollar/euro exchange rate? If so, what? If not, why not? (LO: 5, Learning Outcome: To understand why companies deal in foreign exchange, AACSB: Analytical Skills) Exercise 9.5. Go to a trading Web site like or an information site like finance.yahoo.com/currency and demonstrate the charting, conversion calculators, and other research and information tools available for foreign exchange. (LO: 1, Learning Outcome: To learn the fundamentals of foreign exchange, AACSB: Use of Information Technology)