Introduction to Corporate Finance

PART 5: SPECIAL TOPICS

With this basic understanding of foreign exchange rates in place, let us now turn to some important

institutional features of the foreign exchange market.

17-1c THE FOREIGN EXCHANGE MARKET

The foreign exchange (or forex) ‘market’ is not actually a physical exchange, but a global telecommunications

market. In fact, it is the world’s largest financial market, with total volume of more than $4 trillion per day!

The forex market operates continuously during the business week, with trading beginning each calendar day

in New Zealand, closely followed by Australia. As the day evolves, trading moves westward as major dealing

centres in Tokyo, Singapore, Bahrain (Persian Gulf), continental Europe, London and, finally, North America

(particularly New York and Toronto) come online. Prices for all the floating currencies are set by global supply

and demand. Trading in fixed-rate currencies is more constrained and regulated, and frequently involves a

national government (or a state-owned bank) as the counterparty on one side of the trade.

The players in the forex market are numerous, as are their motivations for participating in the market.

We can break market participants into six distinct (but not mutually exclusive) groups: (1) exporters and

importers; (2) investors; (3) hedgers; (4) speculators; (5) dealers; and, at times, (6) governments.

Businesses that export goods to or import goods from a foreign country need to enter the foreign

exchange market to pay bills denominated in foreign currency, or to convert foreign currency revenues

back into their domestic currency. Along with all the other players in the market, exporters and importers

influence currency values. For instance, if Europeans develop a taste for Californian wines, then

European importers will exchange euros (or perhaps pounds, Swiss francs, etc.) for dollars to purchase

wine. Other factors held constant, these trades would tend to put upward pressure on the value of the

dollar and downward pressure on European currencies.

Investors also trade foreign currency when they seek to buy and sell financial assets in foreign

countries. For example, when foreign investors want to buy Australian shares or bonds, they must first

FIGURE 17.2B NO ARBITRAGE

The exchange rates in New York imply that one British pound should buy 1.89960 Canadian dollars. If a bank in London only offers to sell C$1.89960 for

one pound, then traders cannot make any profit by selling US dollars for pounds in New York, converting those to Canadian dollars in London, and then

selling the Canadian dollars for US dollars back in New York.

C$1.89960 = £1

US$1.5269

£0.8038 = C$1.89960/£

(US$1.5269 = £1)

(US$0.8038 = C$1)

Step 1:

sell US$1 000 000

for £654,922

Step 3:

sell C$1,244,090

for US$1,000,000

(i.e. US$0 arbitrage profit)

Step 2:

sell £654,922

for C$1,244,090

(C$1.89960 = £1)

US$1.5269 = £1

US$0.8038 = C$1