What australian company is the largest surfwear manufacturer

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After you have read this chapter you should be able to:

1 Describe the functions of the foreign exchange market.

2 Understand what is meant by spot exchange rates.

3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk. 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits. 5 Identify the merits of different approaches toward exchange rate forecasting.

6 Compare and contrast the differences between translation, transaction, and economic exposure, and explain what managers can do to manage each type of exposure.

part 4 Global Money System

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opening case

B illabong is a quintessential Australian company. The maker of “surf wear” from wet suits and board shorts to T-shirts and watches has a powerful brand name that is recognized by surfing enthusiasts around the globe. The company is a major exporter. Some 80 percent of its sales are generated outside of Australia through a network of 10,0000 outlets in more than 100 countries. Not surprisingly given the history of surfing, the largest foreign market for Billabong is the United States, which accounts for about 50 percent of the company’s $800 million in annual sales. As a result, Billabong’s fortunes are closely linked to the value of the Australian dollar against the U.S. dollar. When the Australian dollar falls against the U.S. dollar, Billabong’s products become less expensive in U.S. dollars, and this can drive sales forward. Conversely, if the Australian dollar rises in value, this can raise the price of Billabong’s products in terms of U.S. dollars, which impacts sales negatively. Billabong’s CEO has stated that every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. During the second half of 2008 it looked as if things were going Billabong’s way. The Australian dollar fell rapidly in value against the U.S. dollar. In June 2008 one Australian dollar was worth $0.97. By October 2008 it was worth only $0.60. The fall in the value of the Australian dollar was in part due to a fear among currency traders that as the world slipped into a recession, global demand for many of the raw materials pro- duced in Australia would decline, exports would slump, and Australia’s trade bal- ance would deteriorate. In anticipation of this, institutions sold Australian dollars, driving down its value on foreign exchange markets. For Billabong, however, this was something of a blessing. The cheaper Australian dollar would give it a pricing advantage and help to promote sales in the United States and elsewhere. When sales in U.S. dollars were translated back

Billabong

The Foreign Exchange Market

9 c h a p t e r

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into Australian dollars, their value increased as the Australian dollar fell. An- ticipating this, in February 2009 Billabong’s CEO affirmed that he expected the company to increase its profits by as much as 10 percent in 2009, despite the weak global retail environment. Currency markets, however, can be difficult to predict, and sharp reversals do occur. Between March and November 2009 the Australian dollar surged in value, rising all the way back to $0.94. The cause was twofold. First, there was a global sell-off of the American dollar as the full impact of the global financial crisis became apparent, and as the scale of debt in the United States became clearer. Second, despite a recession in the United States and Europe, the emerging economies of China and India continued to grow, and this helped to support demand for many of the basic commodities that Australia exports, which led to a strengthening of the Australian dollar. For Billabong, the sharp reversal was an embarrassment. The strong Australian dollar eradicated any pricing advantage Billabong might have enjoyed. Also, now the amount of Australian dollars that the company received for every sale made in U.S. dol- lars was declining. In February 2009 every $1 earned in U.S. currency could be exchanged for 1.66 Australian dollars. By October 2009 every $1 earned in U.S. currency could only be exchanged for 1.06 Australian dollars. In May 2009, with the Australian dollar rising rapidly, the CEO was forced to revise his previ- ously bullish forecast for sales and earnings. Now he said, a combination of weaker than expected demand in the United States plus a strengthening Australian dollar would lead to a 10 percent decline in profits for 2009. • Sources: C. Marriott, “Caught in the Impact Zone,” Australian FX , January 2010, pp. 11–12; R. Donkin, “Billabong Seeks $290 Million, Slashes Forecast, Stores,” The Western Australian , May 19, 2009; and “Billabong Ready to Ride the Currency Wave,” The Australian , October 29, 2008, p. 40.

Introduction Like many enterprises in the global economy, Billabong is impacted by changes in the value of currencies on the foreign exchange market. As detailed in the opening case, during late 2008 and early 2009 it looked as if the weak Australian dollar would help to boost Billabong’s exports of surf wear to markets like the United States, and it is- sued bullish profit forecasts. By May 2009, an unanticipated rise in the value of the Australian dollar forced the company to revise its earnings forecasts for 2009 down- ward. As stated in the case, every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. When the Australian dollar appreciates again the U.S. dollar, Billabong’s products became more expensive in U.S. dollar terms, effectively putting the company at a price disadvantage in the United States, its major foreign market. As at Billabong, what happens in the foreign exchange market can have a funda- mental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the working of the foreign exchange market,

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and what the impact of changes in currency exchange rates might be for their enter- prise. With this in mind, the current chapter has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates, and to discuss the degree to which it is possible to pre- dict future exchange rate movements. The third objective is to map the implications for international business of exchange rate movements. This chapter is the first of two that deal with the international monetary system and its relationship to international business. In the next chapter, we will explore the institutional structure of the interna- tional monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional struc- ture of the international monetary system can exert a profound influence on the devel- opment of foreign exchange markets. The foreign exchange market is a market for converting the currency of one coun- try into that of another country. An exchange rate is simply the rate at which one cur- rency is converted into another. For example, Billabong uses the foreign exchange market to convert the dollars it earns from selling surf wear in the United States into Australian dollars. Without the foreign exchange market, international trade and inter- national investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other. We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly pre- dicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001 one U.S. dollar bought 1.065 euros, but by the start of 2010, one U.S. dollar bought only 0.74 euro. The dollar had fallen sharply in value against the euro. This made American goods cheaper in Europe, boosting export sales. At the same time, it made European goods more expensive in the United States, which hurt the sales and profits of European companies that sold goods and services to the United States. One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for international businesses to suffer losses because of unpredicted changes in ex- change rates. Currency fluctuations can make seemingly profitable trade and invest- ment deals unprofitable, and vice versa. We begin this chapter by looking at the functions and the form of the foreign ex- change market. This includes distinguishing among spot exchanges, forward ex- changes, and currency swaps. Then we will consider the factors that determine exchange rates. We will also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies; that is, when its currency is not convertible. The chapter closes with a discussion of these things in terms of their im- plications for business.

The Functions of the Foreign Exchange Market The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, by which we mean the adverse consequences of unpredictable changes in exchange rates. 1

Foreign Exchange Market A market for converting the currency of one country into that of another country.

Exchange Rate The rate at which one currency is converted into another.

LEARNING OBJECTIVE 1 Describe the functions of

the foreign exchange market.

Foreign Exchange Risk The risk that changes in exchange rates will hurt the profitability of a business deal.

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CURRENCY CONVERSION Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and other members of the euro zone it is the euro (€); in Japan, the yen (¥ ); and so on. In general, within the borders of a par- ticular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky. When a tourist changes one currency into another, she is participating in the for- eign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 5 $1.30 specifies that one euro buys $1.30 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imag- ine the current pound/dollar exchange rate is £1.00 5 $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 3 2). She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain). Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it re- ceives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but since those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Billabong sells its surfing products in the United States for dollars; it must convert the U.S. dollars it receives into Australian dollars to use them in Australia. Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money mar- kets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 4 percent. Investing in a South Korean money market account, however, may earn 12 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate, but also on the changes in the value of the Korean won against the dollar in the intervening period.

Another Per spect i ve

How Foreign Exchange Challenges Business Travel Ethics In preparation for a trip to Japan, you exchange U.S. dol- lars for yen in late May, just before you leave. For $1,000, your bank gives you ¥104,000. During your time in Osaka, the dollar weakens against the yen, to ¥99.5 to the dollar. Meanwhile, you enjoyed Japanese hospitality and spent only ¥10,000. Back home, you take your remaining ¥94,000 to the bank to convert back to dollars. How much have you spent on your trip?

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Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one cur- rency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 5 ¥120. The company ex- changes its $10 million into yen, receiving ¥1.2 billion ($10 million 3 120 5 ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 5 ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on cur- rency speculation in three months on an initial investment of $10 million! In gen- eral, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong. A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to bor- row in Japanese yen, then convert the money into U.S. dollars and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the trans- action costs associated with changing one currency into another. The speculative ele- ment of this trade is that its success is based upon a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar-yen carry trade was actually very significant during the mid-2000s, peaking at over $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade. 2 This carry trade declined in importance during 2008–09 precisely because the Japanese yen was in- creasing in value against the dollar, making the trade riskier (in addition, interest rate differentials were falling as U.S. rates came down, making the trade less profitable even if exchange rates were stable).

INSURING AGAINST FOREIGN EXCHANGE RISK A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, we say that is it engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

LEARNING OBJECTIVE 2 Understand what is meant

by spot exchange rates.

Spot Exchange Rate The exchange rate at which a foreign exchange dealer will convert one currency into another currency on a particular day.

Currency Speculation Involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Carry Trade Involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high.

Hedging The process of insuring one’s business against foreign exchange risk by using forward exchanges or currency swaps.

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Spot exchange rates are reported on a real-time basis on many financial Web sites. Table 9.1 shows the exchange rates for a selection of currencies traded in the New York foreign exchange market as of 1:11 p.m. February 18, 2009. An exchange rate can be quoted in two ways: as the amount of foreign cur- rency one U.S. dollar will buy, or as the value of a dollar for one unit of foreign currency. Thus, one U.S. dollar bought €0.7954 on February 18, 2009, and one euro bought $1.2572 U.S. dollars.

Spot rates change continually, often on a minute- by-minute basis (although the magnitude of changes over such short periods is usually small). The value of a currency is determined by the interaction be- tween the demand and supply of that currency rela- tive to the demand and supply of other currencies.

For example, if lots of people want U.S. dollars and dollars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 5 $2.00 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 5 $1.98. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For example, a U.S. company that imports laptop com- puters from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each laptop computer, and the current dollar/yen spot exchange rate is $1 5 ¥120. At this rate, each computer costs the importer $1,667 (i.e., 1,667 5 200,000y120). The importer

Currency U.S. $ ¥en Euro Can $ U.K. £ AU $ Swiss Franc Last Trade N/A 1:22pm ET 1:22pm ET 1:22pm ET 1:22pm ET 1:20pm ET 1:22pm ET

1 U.S. $ 5 1 92.3550 0.7954 1.2641 0.7034 1.5736 1.1736

1 ¥en 5 0.0108 1 0.0086 0.0137 0.0076 0.0170 0.0127

1 Euro 5 1.2572 116.114 1 1.5893 0.8843 1.9784 1.4755

1 Can $ 5 0.7911 73.0599 0.6292 1 0.5564 1.2448 0.9284

1 U.K. £ 5 1.4217 131.290 1.1308 1.7971 1 2.2371 1.6685

1 AU $ 5 0.6355 58.6903 0.5055 0.8033 0.4470 1 0.7458

1 Swiss Franc 5 0.8521 78.6938 0.6777 1.0771 0.5994 1.3408 1

Major Currency Cross Rates

table 9.1

Value of the U.S. Dollar against other Currencies, February 18, 2009

Source: Yahoo! Finance.

Using insurance to protect against forward exchange rates helps companies hedge against financial risk.

LEARNING OBJECTIVE 3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

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knows she can sell the computers the day they arrive for $2,000 each, which yields a gross profit of $333 on each computer ($2,000 2 $1,667). However, the importer will not have the funds to pay the Japanese supplier until the computers have been sold. If over the next 30 days the dollar unexpectedly depreciates against the yen, say, to $1 5 ¥95, the importer will still have to pay the Japanese company ¥200,000 per computer, but in dollar terms that would be equivalent to $2,105 per computer, which is more than she can sell the computers for. A depreciation in the value of the dollar against the yen from $1 5 ¥120 to $1 5 ¥95 would transform a profitable deal into an unprofitable one. To insure or hedge against this risk, the U.S. importer might want to engage in a forward exchange. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates gov- erning such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our computer importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 5 ¥110. The im- porter enters into a 30-day forward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each computer (1,818 5 200,000y110). This guarantees her a profit of $182 per com- puter ($2,000 2 $1,818). She also insures herself against the possibility that an unan- ticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one. In this example, the spot exchange rate ($1 5 ¥120) and the 30-day forward rate ($1 5 ¥110) differ. Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 5 ¥130, for ex- ample, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days. In sum, when a firm enters into a forward exchange contract, it is taking out insur- ance against the possibility that future exchange rate movements will make a transac- tion unprofitable by the time that transaction has been executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign ex- change risk, there are some spectacular examples of what happens when firms don’t take out this insurance. An example is given in the accompanying Management Focus, which explains how a failure to fully insure against foreign exchange risk cost Volkswagen dearly.

Currency Swaps The discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies en- gaged in international trade—and you would be right. By April 2007, the latest date for which information is available, forward instruments accounted for some 69 percent of all foreign exchange transactions, while spot exchanges accounted for 31 percent. 3 However, the vast majority of these forward exchanges were not forward exchanges of the type we have been discussing, but rather a more sophisticated instrument known as currency swaps.

Forward Exchange When two parties agree to exchange currency and execute the deal at some specific date in the future.

Forward Exchange Rate The exchange rate governing forward exchange transactions.

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Management FOCUS

Volkswagen’s Hedging Strategy

In January 2004, Volkswagen, Europe’s largest car maker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen’s operating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention—the sharp rise in the value of the euro against the dollar during 2003, and Volkswagen’s decision to only hedge 30 percent of its foreign currency exposure, as opposed to the 70 percent it had traditionally hedged. In total, currency losses due to the dollar’s rise are estimated to have reduced Volkswagen’s operating profits by some €1.2 billion ($1.5 billion). The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had recorded a volatile trading history against the U.S. dollar. In early 1999 the exchange rate stood at €1 5 $1.17, but by October 2000 it had slumped to €1 5 $0.83. Although it recovered, reach- ing parity of €1 5 $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar dur- ing 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003 the ex- change rate stood at €1 5 $1.25. For Volkswagen, which made cars in Germany and ex- ported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To un- derstand what happened, consider a Volkswagen Jetta built in Germany for export to the United States. The Jetta costs €14,000 to make in Germany and ship to a dealer in the United States, where it sells for $15,000. With the exchange rate standing at around €1 5 $1, the $15,000 earned from the sale of a Jetta in the United States could be converted into €15,000, giving Volkswagen a profit of €1,000 on every Jetta sold. But if the exchange rate changes during the

year, ending up at €1 5 $1.25 as it did during 2003, each dollar of revenue will now buy only €0.80 (€1y$1.25 5 €0.80), and Volkswagen is squeezed. At an exchange rate of €15$1.25, the $15,000 Volkswagen gets for the Jetta is now worth only €12,000 when converted back into euros, mean- ing the company will lose €2,000 on every Jetta sold (when the exchange rate is €1 5 $1.25, $15,000y1.25 5 €12,000). Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign ex- change market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 5 €1 (a forward contract gives the holder the right to exchange one cur- rency for another at some point in the future at a predeter- mined exchange rate). Called hedging , the financial strategy of buying forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to ex- change the dollars it got from selling Jettas in the United States into euros at $1 5 €1, irrespective of what the actual exchange rate was at that time . In 2003 such a strategy would have been good for Volkswagen. However, hedging is not without its costs. For one thing, if the euro had de- clined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive since foreign exchange dealers will charge a high commission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 though for- ward contracts, rather than the 70 percent it had historically hedged. The decision cost the company over a €1 billion. For 2004, the company announced that it would revert back to hedging 70 percent of its foreign currency exposure.

Sources: Mark Landler, “As Exchange Rates Wwing, Car Makers Try to Duck,” The New York Times , January 17, 2004, pp. B1, B4; N. Boudette, “Volkswagen Posts 95% Drop in Net,” The Wall Street Journal, February 19, 2004, p. A3; and “Volkswagen’s Financial Mechanic,” Corporate Finance , June 2003, p. 1.

A currency swap is the simultaneous purchase and sale of a given amount of for- eign exchange for two different value dates. Swaps are transacted between interna- tional businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incur- ring foreign exchange risk. A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that

Currency Swap Simultaneous purchase

and sale of a given amount of foreign exchange for two

different value dates.

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Chapter Nine The Foreign Exchange Market 319

buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 5 ¥120 and the 90-day forward exchange rate is $1 5 ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day for- ward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 milliony110 5 $1.09 million). Since the yen is trading at a pre- mium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against for- eign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

The Nature of the Foreign Exchange 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 communica- tions systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange mar- ket 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, the average total value of global foreign exchange trading was about $200 billion per day. According to the tri-annual survey by the Bank of International Settlements, by April 1995, it was more than $1,200 billion per day, by April 2004 it reached $1.8 trillion per day, and by April 2007 it had surged to $3.21 trillion per day. 4 The most important trading centers are London (34 percent of activity), New York (16 percent of activity), and Zurich, Tokyo, and Singapore (all with around 6 percent of activity). 5 Major second- ary trading centers include Frankfurt, Paris, Hong Kong, and Sydney. London’s dominance in the foreign exchange mar- ket is due to both history and geography. As the capi- tal 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 nineteenth century, a position it has retained. Today London’s central position between Tokyo and Singapore to the east and New York to the west has made it the criti- cal link between the East Asian and New York mar- kets. 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. 6 Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these three

Another Per spect i ve

Key into Exchange Rate Language The language used to describe exchange rates can be confusing, even though the ideas themselves are simple. Here’s why: Any given observation describes a changing relationship (the movement in the currencies) that itself describes two relationships (the exchange rates for both currencies). The important thing to remember is that an exchange rate is described in terms of other exchange rates. The language we use to describe these moving phenom- ena works in a similar, dual way: The euro gains against the dollar, so the euro is strengthening, or becoming dearer, from a dollar perspective. Meanwhile, the same observation indi- cates its mirror image, that the dollar is weakening, becom- ing cheaper against the euro, from a euro perspective

Even though the British pound has declined in its importance as a vehicle currency, London remains the key location for global foreign exchange.

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320 Part Four Global Money System