Chapter 15 • International aspects of business finance
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currency). The word ‘normally’ is used in the preceding sentences because, in particu-
lar circumstances, the conversion may not be necessary. For example, the foreign
customer may have the required amount of the seller’s home currency, perhaps from
a sale that it has made to a home country customer. Possibly the seller has a financial
obligation, unconnected with the present transaction, which will need to be met in the
foreign currency. However, generally, and in the long run, a sale to a foreign customer
will require that some foreign currency is ‘sold’ to ‘buy’ the required amount of the
home currency.What is the foreign exchange market?
The market in which one currency is converted into another is known as the foreign
exchange market. This market is operated by commercial banks, national central banks
(the Bank of England in the UK), brokers and others. The market does not have a par-
ticular location, but part of it exists anywhere that one currency is converted into
another. When we are preparing to travel overseas and arrange to take some of the
currency of the destination country with us, we might well do this through our nor-
mal bank. Here, we and the bank form part of the foreign exchange market. If you had
a few dollar bills left following a visit to the USA and exchanged these for sterling with
a friend who was shortly to go there, you and your friend would briefly form part of
the foreign exchange market.Dealing in foreign exchange
When dealing with foreign exchange professionals, it is normally possible to trade
on either of two bases. The currencies can be exchanged immediately, at today’s rate,
known as the spot rate. Alternatively, the contract can be to exchange the currencies
at some specified future date, at a rate determined today, known as the forward rate.
For reasons that will be discussed shortly, the spot and forward rates are frequently
different from one another.
When foreign exchange dealers are approached with a view to a spot foreign
exchange transaction, they will quote two rates at which they will deal: one at which
they will sell and one at which they are prepared to buy. For example, dealers may be
prepared to accept $1.96 in exchange for £1, but only be prepared to give you $1.95 in
exchange for £1. This is to say that they will sell you £1 for a price of $1.96, but will
pay only $1.95 to buy £1 from you. In reality, for most commercial transactions, the
difference between the two rates is usually rather closer than in this example. The
‘spread’ (difference between the two rates) represents the dealers’ profit. The existence
of this spread means that there is a cost involved in using the foreign exchange mar-
ket. The size of the spread tends to reflect the efficiency of the market, the volatility
of the exchange rate concerned, and the size of the transaction involved. Where the
market is efficient, the volatility of the exchange rate low and the transaction a large
one, the spread tends to be smallest.How are foreign exchange rates determined?
If we had looked at the financial pages of our newspaper in early 2008, we should have
seen that £1 sterling was worth about US$1.95. Why was that the rate at that time?
The answer is that the free market, that is, a market subject to the laws of supply and‘