International Financial Management

Whether you are a Dutch exporter selling Gouda cheese to a US supermarket for dollars, or a US mutual fund requiring pesos to invest in Mexican stocks on the Bolsa Mexicana de Valores, you will need to find a way to exchange foreign currency into your own currency and vice versa. These exchanges of monies occur in the foreign exchange market. Because different countries use different kinds of money, the globalization process of the past 35 years, described in Chapter 1, has led to spectacular growth in the volumes traded on this market.

This chapter introduces the institutional structure that allows corporations, banks, international investors, and tourists to convert one money into another money. We discuss the size of the foreign exchange market, where it is located, and who the important market participants are. We then examine in detail how prices are quoted in the foreign exchange market, and in doing so, we encounter the important concept of arbitrage. Arbitrage profits are earned when someone buys something at a low price and sells it for a higher price without bearing any risk.

At the core of the foreign exchange market are traders at large financial institutions. We study how these people trade with one another, and we consider the clearing mechanisms by which funds are transferred across countries and the risks these fund transfers entail. We also examine how foreign exchange traders try to profit by buying foreign money at a low price and selling it at a high price.

Finally, the chapter introduces the terms used to discuss movements in exchange rates. Developing the ability to use these terms correctly makes it easier to discuss the risks involved in doing business in an increasingly global marketplace.

The Organization of the Foreign Exchange Market

The foreign exchange (sometimes abbreviated “forex”) market typically conjures up images of a hectic trading room, full of computers and information networks, with traders talking excitedly on telephones. This image is a reality on the trading floors of the world's major banks and other financial institutions that make up the interbank market. It may help to think of the interbank market as the wholesale part of the forex market where banks manage inventories of currencies. Most transactions in the interbank market are large trades with values of $1 million or more.