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Assignment Topic: Exchange Risk
Review the opening case on Walmart in International business: Opportunities and challenges in a flattening world: Chapter 7. Why does Walmart need to be concerned about exchange rates? How can the company use the tools described in Chapter 7 to manage its exposure to currency risk?
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Your paper should be a minimum of one double-spaced page in length and comply with APA formatting guidelines. Make sure you include at least 2 valid references. Make sure to include proper reference page (APA style). Review the Weekly Written Assignment rubric for full grading criteria. Upload your paper as an MS Word compatible file to this assignment link no later than 11:59 p.m.
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This is “Foreign Exchange and the Global Capital Markets”, chapter 7 from the book Challenges and Opportunities
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i
Chapter 7
Foreign Exchange and the Global Capital Markets
© 2003–2011, Atma Global Inc. Reprinted with permission.
WHAT’S IN IT FOR ME?
1.
2.
3.
4.
What do we mean by currency and foreign exchange?
How do you determine exchange rates?
What are the global capital markets?
What is the impact of the global capital markets (particularly the
venture capital and global capital markets) on international business?
This chapter explores currencies, foreign exchange rates, and how they are
determined. It also discusses the global capital markets—the key components and
how they impact global business. Foreign exchange is one aspect of the global
capital markets. Companies access the global capital markets to utilize both the
debt and equity markets; these are important for growth. Being able to access
transparent and efficient capital markets around the world is another important
component in the flattening world for global firms. Finally, this chapter discusses
how the expansion of the global capital markets has benefited entrepreneurship
and venture capitalists.
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Chapter 7 Foreign Exchange and the Global Capital Markets
Opening Case: Why a Main Street Firm, Walmart, Is
Impacted by Foreign Exchange Fluctuations
Most people in North America are familiar with the name Walmart. It conjures
up an image of a gigantic, box-like store filled with a wide range of essential
and nonessential products. What’s less known is that Walmart is the world’s
largest company, in terms of revenues, as ranked by the Fortune 500 in 2010.
With $408 billion in sales, it operates in fifteen global markets and has 4,343
stores outside of the United States, which amounts to about 50 percent of its
total stores. More than 700,000 people work for Walmart internationally. With
numbers like this, it’s easy to see how important the global markets have
become for this company.“Walmart Stores Inc. Data Sheet—Worldwide Unit
Details November 2010,” Walmart Corporation, accessed May 25, 2011,
http://walmartstores.com/pressroom/news/10497.aspx.
Walmart’s strength comes from the upper hand it has in its negotiations with
suppliers around the world. Suppliers are motivated to negotiate with Walmart
because of the huge sales volume the stores offer manufacturers. The business
rationale for many suppliers is that while they may lose a certain percentage of
profitability per product, the overall sales volume of an order from Walmart
can make them far more money overall than orders from most other stores.
Walmart’s purchasing professionals are known for being aggressive negotiators
on purchases and for extracting the best terms for the company.
In order to buy goods from around the world, Walmart has to deal extensively
in different currencies. Small changes in the daily foreign currency market can
significantly impact the costs for Walmart and in turn both its profitability and
that of its global suppliers.
A company like Walmart needs foreign exchange and capital for different
reasons, including the following common operational uses:
1. To build new stores, expand stores, or refurbish stores in a specific
country
2. To purchase products locally by paying in local currencies or the
US dollar, whichever is cheaper and works to Walmart’s advantage
3. To pay salaries and benefits for its local employees in each country
as well as its expatriate and global workforce
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Chapter 7 Foreign Exchange and the Global Capital Markets
4. To take profits out of a country and either reinvest the money in
another country or market or save it and make profits from
returns on investment
To illustrate this impact of foreign currency, let’s look at the currency of China,
the renminbi (RMB), and its impact on a global business like Walmart. Many
global analysts argue that the Chinese government tries to keep the value of its
currency low or cheap to help promote exports. When the local RMB is valued
cheaply or low, Chinese importers that buy foreign goods find that the prices
are more expensive and higher.
However, Chinese exporters, those businesses that sell goods and services to
foreign buyers, find that sales increase because their prices are cheaper or
lower for the foreign buyers. Economists say that the Chinese government has
intervened to keep the renminbi cheap in order to keep Chinese exports cheap;
this has led to a huge trade surplus with the United States and most of the
world. Each country tries to promote its exports to generate a trade advantage
or surplus in its favor. When China has a trade surplus, it means the other
country or countries are running trade deficits, which has “become an irritant
to a lot of China’s trading partners and those who are competing with China to
sell goods around the world.”David Barboza, “Currency Fight with China
Divides U.S. Business,” New York Times, November 16, 2010, accessed May 25,
2011, http://www.nytimes.com/2010/11/17/business/global/
17yuan.html?_r=1&pagewanted=2.
For Walmart, an American company, a cheap renminbi means that it takes
fewer US dollars to buy Chinese products. Walmart can then buy cheap Chinese
products, add a small profit margin, and then sell the goods in the United States
at a price lower than what its competitors can offer. If the Chinese RMB
increased in value, then Walmart would have to spend more US dollars to buy
the same products, whether the products are clothing, electronics, or furniture.
Any increase in cost for Walmart will mean an increase in cost for their
customers in the United States, which could lead to a decrease in sales. So we
can see why Walmart would be opposed to an increase in the value of the RMB.
To manage this currency concern, Walmart often requires that the currency
exchange rate be fixed in its purchasing contracts with Chinese suppliers. By
fixing the currency exchange rate, Walmart locks in its product costs and
therefore its profitability. Fixing the exchange rate means setting the price that
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Chapter 7 Foreign Exchange and the Global Capital Markets
one currency will convert into another. This is how a company like Walmart
can avoid unexpected drops or increases in the value of the RMB and the US
dollar.
While global companies have to buy and sell in different currencies around the
world, their primary goal is to avoid losses and to fix the price of the currency
exchange so that they can manage their profitability with surety. This chapter
takes a look at some of the currency tools that companies use to manage this
risk.
Global firms like Walmart often set up local operations that help them balance
or manage their risk by doing business in local currencies. Walmart now has
304 stores in China. Each store generates sales in renminbi, earning the
company local currency that it can use to manage its local operations and to
purchase local goods for sale in its other global markets.David Barboza,
“Currency Fight with China Divides U.S. Business,” New York Times, November
16, 2010, accessed May 25, 2011, http://www.nytimes.com/2010/11/17/
business/global/17yuan.html?_r=1&pagewanted=2.
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Chapter 7 Foreign Exchange and the Global Capital Markets
© 2011, Walmart International
Opening Case Exercises
(AACSB: Ethical Reasoning, Multiculturalism, Reflective Thinking, Analytical
Skills)
1. List two reasons a global company needs foreign exchange.
2. Why is Walmart concerned about foreign exchange rates?
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Chapter 7 Foreign Exchange and the Global Capital Markets
7.1 What Do We Mean by Currency and Foreign Exchange?
LEARNING OBJECTIVES
1. Understand what is meant by currency and foreign exchange.
2. Explore the purpose of the foreign exchange market.
3. Understand how to determine exchange rates.
What Are Currency and Foreign Exchange?
In order to understand the global financial environment, how capital markets work,
and their impact on global business, we need to first understand how currencies
and foreign exchange rates work.
Briefly, currency1 is any form of money in general circulation in a country. What
exactly is a foreign exchange? In essence, foreign exchange2 is money
denominated in the currency of another country or—now with the euro—a group of
countries. Simply put, an exchange rate3 is defined as the rate at which the market
converts one currency into another.
1. Any form of money in general
circulation in a country.
2. Money denominated in the
currency of another country.
Money can also be
denominated in the currency
of a group of countries, such as
the euro.
3. The rate at which the market
converts one currency into
another.
4. The price at which a bank or
financial service firm is willing
to buy a specific currency.
5. Quote that refers to the price
at which a bank or financial
services firm is willing to sell
that currency.
Any company operating globally must deal in foreign currencies. It has to pay
suppliers in other countries with a currency different from its home country’s
currency. The home country is where a company is headquartered. The firm is
likely to be paid or have profits in a different currency and will want to exchange it
for its home currency. Even if a company expects to be paid in its own currency, it
must assess the risk that the buyer may not be able to pay the full amount due to
currency fluctuations.
If you have traveled outside of your home country, you may have experienced the
currency market—for example, when you tried to determine your hotel bill or tried
to determine if an item was cheaper in one country versus another. In fact, when
you land at an airport in another country, you’re likely to see boards indicating the
foreign exchange rates for major currencies. These rates include two numbers: the
bid and the offer. The bid (or buy)4 is the price at which a bank or financial services
firm is willing to buy a specific currency. The ask (or the offer or sell)5, refers to
the price at which a bank or financial services firm is willing to sell that currency.
Typically, the bid or the buy is always cheaper than the sell; banks make a profit on
the transaction from that difference. For example, imagine you’re on vacation in
Thailand and the exchange rate board indicates that the Bangkok Bank is willing to
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Chapter 7 Foreign Exchange and the Global Capital Markets
exchange currencies at the following rates (see the following figure). GBP refers to
the British pound; JPY refers to the Japanese yen; and HKD refers to the Hong Kong
dollar, as shown in the following figure. Because there are several countries that
use the dollar as part or whole of their name, this chapter clearly states “US dollar”
or uses US$ or USD when referring to American currency.
This chart tells us that when you land in Thailand, you can use 1 US dollar to buy
31.67 Thai baht. However, when you leave Thailand and decide that you do not need
to take all your baht back to the United States, you then convert baht back to US
dollars. We then have to use more baht—32.32 according to the preceding figure—to
buy 1 US dollar. The spread6 between these numbers, 0.65 baht, is the profit that
the bank makes for each US dollar bought and sold. The bank charges a fee because
it performed a service—facilitating the currency exchange. When you walk through
the airport, you’ll see more boards for different banks with different buy and sell
rates. While the difference may be very small, around 0.1 baht, these numbers add
up if you are a global company engaged in large foreign exchange transactions.
Accordingly, global firms are likely to shop around for the best rates before they
exchange any currencies.
What Is the Purpose of the Foreign Exchange Market?
6. The difference between the bid
and the ask. This is the profit
made for each unit of currency
bought and sold.
The foreign exchange market (or FX market) is the mechanism in which currencies
can be bought and sold. A key component of this mechanism is pricing or, more
specifically, the rate at which a currency is bought or sold. We’ll cover the
determination of exchange rates more closely in this section, but first let’s
understand the purpose of the FX market. International businesses have four main
uses of the foreign exchange markets.
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
Currency Conversion
Companies, investors, and governments want to be able to convert one currency
into another. A company’s primary purposes for wanting or needing to convert
currencies is to pay or receive money for goods or services. Imagine you have a
business in the United States that imports wines from around the world. You’ll need
to pay the French winemakers in euros, your Australian wine suppliers in
Australian dollars, and your Chilean vineyards in pesos. Obviously, you are not
going to access these currencies physically. Rather, you’ll instruct your bank to pay
each of these suppliers in their local currencies. Your bank will convert the
currencies for you and debit your account for the US dollar equivalent based on the
exact exchange rate at the time of the exchange.
Currency Hedging
One of the biggest challenges in foreign exchange is the risk of rates increasing or
decreasing in greater amounts or directions than anticipated. Currency hedging7
refers to the technique of protecting against the potential losses that result from
adverse changes in exchange rates. Companies use hedging as a way to protect
themselves if there is a time lag between when they bill and receive payment from a
customer. Conversely, a company may owe payment to an overseas vendor and
want to protect against changes in the exchange rate that would increase the
amount of the payment. For example, a retail store in Japan imports or buys shoes
from Italy. The Japanese firm has ninety days to pay the Italian firm. To protect
itself, the Japanese firm enters into a contract with its bank to exchange the
payment in ninety days at the agreed-on exchange rate. This way, the Japanese firm
is clear about the amount to pay and protects itself from a sudden depreciation of
the yen. If the yen depreciates, more yen will be required to purchase the same
euros, making the deal more expensive. By hedging, the company locks in the rate.
Currency Arbitrage
7. Refers to the technique of
protecting against the
potential losses that result
from adverse changes in
exchange rates.
Arbitrage is the simultaneous and instantaneous purchase and sale of a currency for
a profit. Advances in technology have enabled trading systems to capture slight
differences in price and execute a transaction, all within seconds. Previously,
arbitrage was conducted by a trader sitting in one city, such as New York,
monitoring currency prices on the Bloomberg terminal. Noticing that the value of a
euro is cheaper in Hong Kong than in New York, the trader could then buy euros in
Hong Kong and sell them in New York for a profit. Today, such transactions are
almost all handled by sophisticated computer programs. The programs constantly
search different exchanges, identify potential differences, and execute transactions,
all within seconds.
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
Currency Speculation
Speculation refers to the practice of buying and selling a currency with the
expectation that the value will change and result in a profit. Such changes could
happen instantly or over a period of time.
High-risk, speculative investments by nonfinance companies are less common these
days than the current news would indicate. While companies can engage in all four
uses discussed in this section, many companies have determined over the years that
arbitrage and speculation are too risky and not in alignment with their core
strategies. In essence, these companies have determined that a loss due to high-risk
or speculative investments would be embarrassing and inappropriate for their
companies.
Understand How to Determine Exchange Rates
How to Quote a Currency
8. The currency that is to be
purchased with another
currency and is noted in the
denominator.
9. The currency with which
another currency is to be
purchased.
10. Also known as US terms,
American terms are from the
point of view of someone in the
United States. In this approach,
foreign exchange rates are
expressed in terms of how
many US dollars can be
exchanged for one unit of
another currency (the non-US
currency is the base currency).
11. Foreign exchange rates are
expressed in terms of how
many currency units can be
exchanged for one US dollar
(the US dollar is the base
currency). For example, the
pound-dollar quote in
European terms is £0.64/US$1
(£/US$1).
There are several ways to quote currency, but let’s keep it simple. In general, when
we quote currencies, we are indicating how much of one currency it takes to buy
another currency. This quote requires two components: the base currency8 and the
quoted currency9. The quoted currency is the currency with which another
currency is to be purchased. In an exchange rate quote, the quoted currency is
typically the numerator. The base currency is the currency that is to be purchased
with another currency, and it is noted in the denominator. For example, if we are
quoting the number of Hong Kong dollars required to purchase 1 US dollar, then we
note HKD 8 / USD 1. (Note that 8 reflects the general exchange rate average in this
example.) In this case, the Hong Kong dollar is the quoted currency and is noted in
the numerator. The US dollar is the base currency and is noted in the denominator.
We read this quote as “8 Hong Kong dollars are required to purchase 1 US dollar.” If
you get confused while reviewing exchanging rates, remember the currency that
you want to buy or sell. If you want to sell 1 US dollar, you can buy 8 Hong Kong
dollars, using the example in this paragraph.
Direct Currency Quote and Indirect Currency Quote
Additionally, there are two methods—the American terms10 and the European
terms11—for noting the base and quoted currency. These two methods, which are
also known as direct and indirect quotes, are opposite based on each reference
point. Let’s understand what this means exactly.
The American terms, also known as US terms, are from the point of view of
someone in the United States. In this approach, foreign exchange rates are
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
expressed in terms of how many US dollars can be exchanged for one unit of
another currency (the non-US currency is the base currency). For example, a dollarpound quote in American terms is USD/GP (US$/£) equals 1.56. This is read as “1.56
US dollars are required to buy 1 pound sterling.” This is also called a direct quote12,
which states the domestic currency price of one unit of foreign currency. If you
think about this logically, a business that needs to buy a foreign currency needs to
know how many US dollars must be sold in order to buy one unit of the foreign
currency. In a direct quote, the domestic currency is a variable amount and the
foreign currency is fixed at one unit.
Conversely, the European terms are the other approach for quoting rates. In this
approach, foreign exchange rates are expressed in terms of how many currency
units can be exchanged for a US dollar (the US dollar is the base currency). For
example, the pound-dollar quote in European terms is £0.64/US$1 (£/US$1). While
this is a direct quote for someone in Europe, it is an indirect quote13 in the United
States. An indirect quote states the price of the domestic currency in foreign
currency terms. In an indirect quote, the foreign currency is a variable amount and
the domestic currency is fixed at one unit.
A direct and an indirect quote are simply reverse quotes of each other. If you have
either one, you can easily calculate the other using this simple formula:
direct quote = 1 / indirect quote.
To illustrate, let’s use our dollar-pound example. The direct quote is US$1.56 =
1/£0.64 (the indirect quote). This can be read as
1 divided by 0.64 equals 1.56.
12. States the domestic currency
price of one unit of foreign
currency. For example, €0.78/
US$1. We read this as “it takes
0.78 of a euro to buy 1 US
dollar.” In a direct quote, the
domestic currency is a variable
amount and the foreign
currency is fixed at one unit.
13. States the price of the domestic
currency in foreign currency
terms. For example,
US$1.28/€1. We read this as “it
takes 1.28 US dollars to buy 1
euro.” In an indirect quote, the
foreign currency is a variable
amount and the domestic
currency is fixed at one unit.
In this example, the direct currency quote is written as US$/£ = 1.56.
While you are performing the calculations, it is important to keep track of which
currency is in the numerator and which is in the denominator, or you might end up
stating the quote backward. The direct quote is the rate at which you buy a
currency. In this example, you need US$1.56 to buy a British pound.
Tip: Many international business professionals become experienced over their
careers and are able to correct themselves in the event of a mix-up between
currencies. To illustrate using the example mentioned previously, the seasoned
global professional knows that the British pound is historically higher in value than
the US dollar. This means that it takes more US dollars to buy a pound than the
other way around. When we say “higher in value,” we mean that the value of the
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
British pound buys you more US dollars. Using this logic, we can then deduce that
1.56 US dollars are required to buy 1 British pound. As an international
businessperson, we would know instinctively that it cannot be less—that is, only
0.64 US dollars to buy a British pound. This would imply that the dollar value was
higher in value. While major currencies have changed significantly in value vis-àvis each other, it tends to happen over long periods of time. As a result, this self-test
is a good way to use logic to keep track of tricky exchange rates. It works best with
major currencies that do not fluctuate greatly vis-à-vis others.
A useful side note: traders always list the base currency as the first currency in a
currency pair. Let’s assume, for example, that it takes 85 Japanese yen to purchase 1
US dollar. A currency trader would note this as follows: USD 1 / JPY 85. This quote
indicates that the base currency is the US dollar and 85 yen are required to
purchase a dollar. This is also called a direct quote, although FX traders are more
likely to call it an American rate rather than a direct rate. It can be confusing, but
try to keep the logic of which currency you are selling and which you are buying
clearly in your mind, and say the quote as full sentences in order to keep track of
the currencies.
These days, you can easily use the Internet to access up-to-date quotes on all
currencies, although the most reliable sites remain the Wall Street Journal, the
Financial Times, or any website of a trustworthy financial institution.
Spot Rates
The exchange rates discussed in this chapter are spot rates—exchange rates that
require immediate settlement with delivery of the traded currency. “Immediate”
usually means within two business days, but it implies an “on the spot” exchange of
the currencies, hence the term spot rate. The spot exchange rate14 is the exchange
rate transacted at a particular moment by the buyer and seller of a currency. When
we buy and sell our foreign currency at a bank or at American Express, it’s quoted
at the rate for the day. For currency traders though, the spot can change
throughout the trading day even by tiny fractions.
14. The exchange rate transacted
at a particular moment by a
buyer and seller of a currency.
When we buy and sell our
foreign currency at a bank or
at American Express, it’s
quoted as the rate for the day.
For currency traders, the spot
can change throughout the
trading day, even by tiny
fractions.
To illustrate, assume that you work for a clothing company in the United States and
you want to buy shirts from either Malaysia or Indonesia. The shirts are exactly the
same; only the price is different. (For now, ignore shipping and any taxes.) Assume
that you are using the spot rate and are making an immediate payment. There is no
risk of the currency increasing or decreasing in value. (We’ll cover forward rates in
the next section.)
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
The currency in Malaysia is the Malaysian ringgit, which is abbreviated MYR. The
supplier in Kuala Lumpur e-mails you the quote—you can buy each shirt for MYR
35. Let’s use a spot exchange rate of MYR 3.13 / USD 1.
The Indonesian currency is the rupiah, which is abbreviated as Rp. The supplier in
Jakarta e-mails you a quote indicating that you can buy each shirt for Rp 70,000. Use
a spot exchange rate of Rp 8,960 / USD 1.
It would be easy to instinctively assume that the Indonesian firm is more expensive,
but look more closely. You can calculate the price of one shirt into US dollars so
that a comparison can be made:
For Malaysia: MYR 35 / MYR 3.13 = USD 11.18
For Indonesia: Rp 70,000 / Rp 8,960 = USD 7.81
Indonesia is the cheaper supplier for our shirts on the basis of the spot exchange
rate.
Cross Rates
There’s one more term that applies to the spot market—the cross rate15. This is the
exchange rate between two currencies, neither of which is the official currency in
the country in which the quote is provided. For example, if an exchange rate
between the euro and the yen were quoted by an American bank on US soil, the rate
would be a cross rate.
15. The exchange rate between
two currencies, neither of
which is the official currency
in the country in which the
quote is provided
The most common cross-currency pairs are EUR/GBP, EUR/CHF, and EUR/JPY.
These currency pairs expand the trading possibilities in the foreign exchange
market but are less actively traded than pairs that include the US dollar, which are
called the “majors” because of their high degree of liquidity. The majors are EUR/
USD, GBP/ USD, USD/JPY, USD/CAD (Canadian dollar), USD/CHF (Swiss franc), and
USD/AUD (Australian dollar). Despite the changes in the international monetary
system and the expansion of the capital markets, the currency market is really a
market of dollars and nondollars. The dollar is still the reserve currency for the
world’s central banks. Table 7.1 “Currency Cross Rates” contains some currency
cross rates between the major currencies. We can see, for example, that the rate for
the cross-currency pair of EUR/GBP is 1.1956. This is read as “it takes 1.1956 euros
to buy one British pound.” Another example is the EUR/JPY rate, which is 0.00901.
However, a seasoned trader would not say that it takes 0.00901 euros to buy 1
Japanese yen. He or she would instinctively know to quote the currency pair as the
JPY/EUR rate or—more specifically—that it takes 111.088 yen to purchase 1 euro.
7.1 What Do We Mean by Currency and Foreign Exchange?
359
Chapter 7 Foreign Exchange and the Global Capital Markets
Table 7.1 Currency Cross Rates
Currency United
Canadian
codes / Kingdom
Dollar
names
Pound
Euro
Hong
Kong
Dollar
GBP
1
0.6177
0.8374
0.08145 0.007544
0.6455 0.633
CAD
1.597
1
1.3358
0.1299
1.0296 1.0095 0.1517
EUR
1.1956
0.7499
1
0.09748 0.00901
HKD
12.2896
7.7092
10.2622 1
JPY
132.754
83.2905
111.088 10.8083 1
85.65
84.001 12.6213
CHF
1.5512
0.9732
1.2981
0.1263
0.011696
1
0.9815 0.1475
USD
1.5807
0.9915
1.3232
0.1287
0.011919
1.0199 1
CNY
10.5218
6.6002
8.8075
0.8565
0.07934
6.7887 6.6565 1
Japanese Swiss
US
Yen
Franc Dollar
0.012032
0.09267
0.771
Chinese
Yuan
Renminbi
0.09512
0.7563 0.1136
7.9294 7.7749 1.1682
0.1503
Note: The official name for the Chinese currency is renminbi and the main unit of the
currency is the yuan.
Source: “Currency Cross Rates: Results,” Oanda, accessed May 25, 2011,
http://www.oanda.com/currency/cross- rate/
result?quotes=GBP”es=CAD”es=EUR”es=HKD”es=JPY”es=
CHF”es=USD”es=CNY&go=Get+my+Table+++.
Forward Rates
16. The rate at which two parties
agree to exchange currency
and execute a deal at some
specific point in the future,
usually 30 days, 60 days, 90
days, or 180 days in the future.
17. The currency market for
transactions at forward rates.
18. A contract that requires the
exchange of an agreed-on
amount of a currency on an
agreed-on date and a specific
exchange rate.
The forward exchange rate16 is the exchange rate at which a buyer and a seller
agree to transact a currency at some date in the future. Forward rates are really a
reflection of the market’s expectation of the future spot rate for a currency. The
forward market17 is the currency market for transactions at forward rates. In the
forward markets, foreign exchange is always quoted against the US dollar. This
means that pricing is done in terms of how many US dollars are needed to buy one
unit of the other currency. Not all currencies are traded in the forward market, as it
depends on the demand in the international financial markets. The majors are
routinely traded in the forward market.
For example, if a US company opted to buy cell phones from China with payment
due in ninety days, it would be able to access the forward market to enter into a
forward contract to lock in a future price for its payment. This would enable the US
firm to protect itself against a depreciation of the US dollar, which would require
more dollars to buy one Chinese yuan. A forward contract18 is a contract that
requires the exchange of an agreed-on amount of a currency on an agreed-on date
and a specific exchange rate. Most forward contracts have fixed dates at 30, 90, or
7.1 What Do We Mean by Currency and Foreign Exchange?
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Chapter 7 Foreign Exchange and the Global Capital Markets
180 days. Custom forward contracts can be purchased from most financial firms.
Forward contracts, currency swaps, options, and futures all belong to a group of
financial instruments called derivatives. In the term’s broadest definition,
derivatives19 are financial instruments whose underlying value comes from
(derives from) other financial instruments or commodities—in this case, another
currency.
Swaps, Options, and Futures
Swaps, options, and futures are three additional currency instruments used in the
forward market.
A currency swap20 is a simultaneous buy and sell of a currency for two different
dates. For example, an American computer firm buys (imports) components from
China. The firm needs to pay its supplier in renminbi today. At the same time, the
American computer is expecting to receive RMB in ninety days for its netbooks sold
in China. The American firm enters into two transactions. First, it exchanges US
dollars and buys yuan renminbi today so that it can pay its supplier. Second, it
simultaneously enters into a forward contract to sell yuan and buy dollars at the
ninety-day forward rate. By entering into both transactions, the firm is able to
reduce its foreign exchange rate risk by locking into the price for both.
19. Financial instruments whose
underlying value comes from
(derives from) other financial
instruments or commodities.
20. A simultaneous buy and sell of
a currency for two differ
