U.S. Banks and MNCs operate in a global economy, and need to buy, sell, and trade currencies.
Foreign trade, Exports + Imports = $3 trillion for U.S., most of it requiring the purchase or sale of FX.
Also, MNCs and FIs are exposed to FX risk. Exporters receiving FX in the future are worried about
foreign currencies depreciating, Importers paying FX in future are worried about $ depreciating, FX
Invoicing in FX exposes MNC to currency or FX risk, as CFs are converted into
or out of U.S. dollars.
International Investment also exposes investors to FX risk.
Investment in Japan, Mexico or
Europe for one year. If foreign currency depreciates (appreciates) over the next year, the dollar value
of the CFs received decreases (increases).
BACKGROUND of FX MARKETS
WWII to 1973 - Fixed exchange rates. Advantage?
Since 1973, Flexible/floating ex-rates. FX markets are OTC, mostly an inter-bank market, large banks
around the world trading FX on behalf of MNC clients. Chicago Mercantile Exchange (CME) trades
currency futures contracts, competing with banks offering currency forward contracts.
Futures vs. Forward markets for FX
: Currency futures contracts are standardized, in terms of
expiration dates (Mar, June, Sept and Dec) and contract size, exchange-traded, and are settled in cash
(99%). Currency forward contracts are more flexible, can be easily customized in terms of size and
maturity, OTC, are settled in currency (90%), usually in amounts of $1m and more.
$3T/day FX traded, London is largest, NYC, Tokyo. Trading is 24/7.
Recent FX development:
Introduction of Euro in 2002.
1) American, Direct, U.S. $ Equivalent, e.g., $1.9000/£; or 2) European, Indirect, Currency
Per USD, e.g., £0.5263/$. Currency trades are for $1m or more. Spot (cash) and Forward Markets for
FX are both important. If a currency is expected to appreciate (depreciate), it will sell at a forward
premium (discount). Spot is about 33% of FX market, and Forward contracts about 67%. Compared
to 1989, forward trading has increased from 46% to 67%, more hedging, see Table 8-2 on p. 226.
S = $1.90/£ to F = $1.9950/£, BP is expected to appreciate, and is selling at a 5% forward
premium. S = $1.90/£ to F = $1.8620/£, BP is expected to depreciate, and is selling at a 2% forward
FX is traded OTC, like corporate bonds and money market securities, using telecommunications and
computer networks. Electronic trading now dominates FX, about 85-95% compared to 20-30% in
1995. Reuters and EBS dominate the FX electronic trading equipment, but don't actually trade FX. FX
traders operate at large commercial banks (Citibank) and FIs, usually specializing in just a few
currencies. Smaller banks conduct FX trades through a line of credit at a larger bank.
BUS 468 / MGT 568: FINANCIAL MARKETS – CH 8