Unlike domestic transactions, international transactions involve the currencies of two or more nations. To exchange one currency for another in international transactions, companies rely on a mechanism called the foreign exchange market—a market in which currencies are bought and sold and their prices are determined. Financial institutions convert one currency into another at a specific exchange rate—the rate at which one currency is exchanged for another. Rates depend on the size of the transaction, the trader conducting it, general economic conditions, and sometimes government mandate.
foreign exchange market
Market in which currencies are bought and sold and their prices are determined.
Rate at which one currency is exchanged for another.
In many ways, the foreign exchange market is like the markets for commodities such as cotton, wheat, and copper. The forces of supply and demand determine currency prices, and transactions are conducted through a process of bid and ask quotes. If someone asks for the current exchange rate of a certain currency, the bank does not know whether it is dealing with a prospective buyer or seller. Thus it quotes two rates: The bid quote is the price at which it will buy, and the ask quote is the price at which it will sell. For example, say that the British pound is quoted in U.S. dollars at $1.9815. The bank may then bid $1.9813 to buy British pounds and offer to sell them at $1.9817. The difference between the two rates is the bid–ask spread. Naturally, banks will buy currencies at a lower price than they sell them and earn their profits from the bid–ask spread.
Functions of the Foreign Exchange Market
The foreign exchange market is not really a source of corporate finance. Rather, it facilitates corporate financial activities and international transactions. Investors use the foreign exchange market for four main reasons.
Companies use the foreign exchange market to convert one currency into another. Suppose a Malaysian company sells a large number of computers to a customer in France. The French customer wants to pay for the computers in euros, the European Union currency, whereas the Malaysian company wants to be paid in its own ringgit. How do the two parties resolve this dilemma? They turn to banks that will exchange the currencies for them.
Companies also must convert to local currencies when they undertake foreign direct investment. Later, when a firm’s international subsidiary earns a profit and the company wants to return some of it to the home country, it must convert the local money into the home currency.
The practice of insuring against potential losses that result from adverse changes in exchange rates is called currency hedging. International companies commonly use hedging for one of two purposes:
Practice of insuring against potential losses that result from adverse changes in exchange rates.
1. To lessen the risk associated with international transfers of funds
2. To protect themselves in credit transactions in which there is a time lag between billing and receipt of payment.
Suppose a South Korean carmaker has a subsidiary in Britain. The parent company in Korea knows that in 30 days—say, on February 1—its British subsidiary will be sending it a payment in British pounds. Because the parent company is concerned about the value of that payment in South Korean won a month in the future, it wants to insure against the possibility that the pound’s value will fall over that period—meaning, of course, that it will receive less money. Therefore, on January 2 the parent company contracts with a financial institution, such as a bank, to exchange the payment in one month at an agreed-upon exchange rate specified on January 2. In this way, as of January 2 the Korean company knows exactly how many won the payment will be worth on February 1.
Currency arbitrage is the instantaneous purchase and sale of a currency in different markets for profit. Suppose a currency trader in New York notices that the value of the European Union euro is lower in Tokyo than it is in New York. The trader can buy euros in Tokyo, sell them in New York, and earn a profit on the difference. Hightech communication and trading systems allow the entire transaction to occur within seconds. But note that if the difference between the value of the euro in Tokyo and the value of the euro in New York is not greater than the cost of conducting the transaction, the trade is not worth making.
Instantaneous purchase and sale of a currency in different markets for profit.
Currency arbitrage is a common activity among experienced traders of foreign exchange, very large investors, and companies in the arbitrage business. Firms whose profits are generated primarily by another economic activity, such as retailing or manufacturing, take part in currency arbitrage only if they have very large sums of cash on hand.
Interest arbitrage is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find better interest rates abroad than those that are available in their home countries. The securities involved in such transactions include government treasury bills, corporate and government bonds, and even bank deposits. Suppose a trader notices that the interest rates paid on bank deposits in Mexico are higher than those paid in Sydney, Australia (after adjusting for exchange rates). He can convert Australian dollars to Mexican pesos and deposit the money in a Mexican bank account for, say, one year. At the end of the year, he converts the pesos back into Australian dollars and earns more in interest than the same money would have earned had it remained on deposit in an Australian bank.
Profit-motivated purchase and sale of interest-paying securities denominated in different currencies.
Currency speculation is the purchase or sale of a currency with the expectation that its value will change and generate a profit. The shift in value might be expected to occur suddenly or over a longer period. The foreign exchange trader may bet that a currency’s price will go either up or down in the future. Suppose a trader in London believes that the value of the Japanese yen will increase over the next three months. She buys yen with pounds at today’s current price, intending to sell them in 90 days. If the price of yen rises in that time, she earns a profit; if it falls, she takes a loss. Speculation is much riskier than arbitrage because the value, or price, of currencies is quite volatile and is affected by many factors. Similar to arbitrage, currency speculation is commonly the realm of foreign exchange specialists rather than the managers of firms engaged in other endeavors.
Purchase or sale of a currency with the expectation that its value will change and generate a profit.
A classic example of currency speculation unfolded in Southeast Asia in 1997. After news emerged in May about Thailand’s slowing economy and political instability, currency traders sprang into action. They responded to poor economic growth prospects and an overvalued currency, the Thai baht, by dumping the baht on the foreign exchange market. When the supply glutted the market, the value of the baht plunged. Meanwhile, traders began speculating that other Asian economies were also vulnerable. From the time the crisis first hit until the end of 1997, the value of the Indonesian rupiah fell by 87 percent, the South Korean won by 85 percent, the Thai baht by 63 percent, the Philippine peso by 34 percent, and the Malaysian ringgit by 32 percent.4 Although many currency speculators made a great deal of money, the resulting hardship experienced by these nations’ citizens caused some to question the ethics of currency speculation on such a scale. (We cover the Asian crisis and currency speculation in detail in Chapter 10.)
Foreign exchange brokerage workers in Tokyo, Japan, dress in traditional Japanese kimonos for the first trading day of the year. Average daily turnover on Tokyo’s foreign exchange market is about $240 billion. Yet this is still significantly lower than trading volume in the U.K. market ($1.33 trillion) and the U.S. market ($618 billion). Around $3.2 trillion worth of currency is traded on global foreign exchange markets every day.