Voyevodins' Library _ "International Business: Competing in the Global Marketplace" / Charles W.L. Hill ... Chapter 9 ... factors of production, Financial Accounting Standards Board (FASB), financial structure, first-mover advantages, first-mover disadvantages, Fisher Effect, fixed exchange rates, fixed-rate bond, flexible machine cells, flexible manufacturing technologies, floating exchange rates, flow of foreign direct investment, folkways, foreign bonds, Foreign Corrupt Practices Act, foreign debt crisis, foreign direct investment (FDI), foreign exchange exposure, foreign exchange market, foreign exchange risk, foreign portfolio investment (FPI), forward exchange, forward exchange rate, franchising, free trade, free trade area, freely convertible currency, fronting loans, fundamental analysis, gains from trade, General Agreement on Tariffs and Trade (GATT), geocentric staffing, global learning, global matrix structure, global strategy, global web, globalization, globalization of markets, globalization of production, gold par value, gold standard Voevodin's Library: factors of production, Financial Accounting Standards Board (FASB), financial structure, first-mover advantages, first-mover disadvantages, Fisher Effect, fixed exchange rates, fixed-rate bond, flexible machine cells, flexible manufacturing technologies, floating exchange rates, flow of foreign direct investment, folkways, foreign bonds, Foreign Corrupt Practices Act, foreign debt crisis, foreign direct investment (FDI), foreign exchange exposure, foreign exchange market, foreign exchange risk, foreign portfolio investment (FPI), forward exchange, forward exchange rate, franchising, free trade, free trade area, freely convertible currency, fronting loans, fundamental analysis, gains from trade, General Agreement on Tariffs and Trade (GATT), geocentric staffing, global learning, global matrix structure, global strategy, global web, globalization, globalization of markets, globalization of production, gold par value, gold standard



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Chapter 9 Outline

The Nature of the Foreign Exchange Market

So far we have dealt with the foreign exchange market only as an abstract concept. It is now time to take a closer look at the nature of this market. The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment (see Chapter 1). In March 1986, for example, the average total value of global foreign exchange trading was about $200 billion per day. By April 1989, it had soared to over $650 billion per day, and by 1995 it was over $1,200 billion per day.3 The most important trading centers are London, New York, and Tokyo. In April 1995, over $450 billion was traded through London each day, $240 billion through New York, and $150 billion through Tokyo.4 Major secondary trading centers include Zurich, Frankfurt, Paris, Hong Kong, Singapore, San Francisco, and Sydney (see Figure 9.2).

London's dominance in the foreign exchange market is due to both history and geography. As the capital of the world's first major industrial trading nation, London had become the world's largest center for international banking by the end of the last

Figure 9.2

Reported Foreign Exchange Market Turnover in Major Centers in April 1989, April 1992, and April 1995

09.02

Source: Central Bank Survey of Foreign Exchange and Derivatives Market Activity (Basle, Switzerland: BIS, May 1996), Graph F-4.

century, a position it has retained. Today London's central position between Tokyo to the east and New York to the west has made it the critical link between the Tokyo and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York. However, some now argue that the failure of Britain to join the first round of European monetary union might lead to the demise of London as the center of global foreign exchange trading. This is particularly likely to occur if the euro emerges as a major currency unit after 2002, and if Britain stays out of the euro zone (see Chapter 8 for details of EMU).

Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. There are only 3 hours out of every 24 that Tokyo, London, and New York are all shut down. During these three hours, trading continues in a number of minor centers, particularly San Francisco and Sydney, Australia.

The second feature of the market is the extent of integration of the various trading centers. Direct telephone lines, fax, and computer linkages between trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers. For example, if the dollar/franc exchange rate quoted in London at 3 pm is $1 = FFr 5.0, the dollar/franc exchange rate quoted in New York at the same time (10 am New York time) will be identical. If the New York dollar/franc exchange rate were $1 = FFr 5.5, a dealer could make a profit through arbitrage, buying a currency low and selling it high. For example, if the prices differed in London and New York as given, a dealer could purchase FFr 550,000 for $100,000 in New York and immediately sell them in London for $110,000, making a quick profit of $10,000. If all dealers tried to cash in on the opportunity, however, the demand for francs in New York would result in an appreciation of the franc against the dollar, while the increase in the supply of francs in London would result in their depreciation there. The discrepancy in the New York and London exchange rates would disappear very quickly. Since foreign exchange dealers are continually watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes.

Another feature of the foreign exchange market is the important role played by the US dollar. Although a foreign exchange transaction can in theory involve any two currencies, most transactions involve dollars. This is true even when a dealer wants to sell one nondollar currency and buy another. A dealer wishing to sell Dutch guilders

Table 9.3

Use of Currencies on One Side of a Foreign Exchange Transaction as a Percentage of Global Gross Foreign Exchange Market Turnover
  (Percentage shares)
Currency April 1989 April 1992 April 1995
US dollar 90 82 83
Deutsche mark+ 27 40 37
Japanese yen 27 23 24
Pound sterling 15 14 10
French franc 2 4 8
Swiss franc 10 9 7
Canadian dollar 1 3 3
Australian dollar 2 2 3
ECU 1 3 2
Other EMS currencies 3 9 13
Currencies of other reporting countries 3 3 2
Other currencies 19 8 8
  All currencies 200 200 200

Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity (Basle, Switzerland: BIS, May 1996), Table F-3.

for Italian lira, for example, will usually sell the guilders for dollars and then use the dollars to buy lira. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of lira who wants to buy guilders. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for guilders or lira.

Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. Table 9.3 tells us that in April 1995, 83 percent of all foreign exchange transactions involved dollars. After the dollar, the most important vehicle currencies are the German mark, the Japanese yen, and the British pound in that order--reflecting the importance of these trading nations in the world economy (see Table 9.3). The British pound used to be second in importance to the dollar as a vehicle currency, but its importance has diminished in recent years. Despite this, London has retained its leading position in the global foreign exchange market, which suggests that the introduction of the euro might not have the negative impact suggested by critics of Britain's decision to stay out of EMU.

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Economic Theories of Exchange Rate Determination >>