Exporting and Trading info

Case: The Mexican Peso On August 31,1976, the Mexican peso was cut loose from its exchange rate of 12.5 pesos to the dollar, which was established in 1955. From 1955 to 1976 the exchange rate had been maintained artificially through a variety of mechanisms. Import controls and market intervention were used extensively to allow the peso to appear stabler than it was, thereby frustrating firms operating in Mexico. Many companies established manufacturing operations in Mexico only to find that the government eventually would phase out their ability to import needed raw materials and components. During the 1970s pressure began to build for a change in the value of the currency. Tourism, a major source of foreign exchange, began to taper off because of rising prices resulting directly from general inflation in the economy. (See Map 7.2.) Mexico began importing more than it was exporting, which resulted in an outflow of pesos to buy the excess imports. Exporters to Mexico did not want t...

        A major distinction between domestic and international payments for goods and services is that more than one currency is used for international transactions. An exchange rate is the value of one currency in terms of another. A spot exchange rate is the rate quoted for current transactions, whereas the forward rate is a rate quoted by a foreign-exchange trader for a contract to receive or deliver foreign currency in the future. The difference between the spot and forward rates at the time of a contract is the forward spread. The foreign currency is selling at a discount if the spread is negative and at a premium if the spread is positive. Most foreign-exchange transactions take place through the traders of commercial banks, with the majority of the transactions occurring in the spot market rather than the forward market. Also, most of the foreign-exchange transactions are interbank transactions rather than between banks and non-banking institutions. ...

Arbitrage Arbitrage is the process of buying and selling foreign exchange at a profit due to price discrepancies between markets. For example, one could sell U.S. dollars for Swiss francs, Swiss francs for German marks, and German marks for U.S. dollars, the goal being to end up with more dollars at the end of the process. Assume that a trader converts $100 into SwF 150 (Swiss francs) when the exchange rate is SwF 1.5 = $1.00. The trader then converts the francs into DM 225 (German marks) at an exchange rate of DM 1.5 = SwF 1.00, and then finally converts the marks into $125 at an exchange rate of DM 1.8 = $1.00. Thus arbitrage yields $125 from the initial sale of $100. vi s Interest arbitrage involves investing in debt instruments in different countries. For example, a trader could take $1000 and invest it in the United ,s     States for 90 days, or take the $1000, convert it into British pounds, invest ic    the money in Great Britain for 90 days, and...

Making the Market "Making the market," another important use of foreign exchange, refers to transactions between brokers and traders at banks or directly between the traders at different banks. Normally these transactions are undertaken to provide sufficient foreign-exchange balances for the banks to conduct their normal commercial transactions as well as to balance their positions in foreign exchange so that they are not overbought or oversold in a currency. As mentioned earlier, 82 percent of the daily transactions in foreign exchange in the United States are between banks. These transactions obviously are part of making the market rather than commercial transactions.

Commercial Transactions The focus in this book is more on commercial transactions—that is, those transactions that involve the buying and selling of foreign exchange to facilitate the trade of goods and services—than it is on financial transactions. Thus GM of Canada may have to convert U.S. dollars into Canadian dollars when parts or components that it produces in Canada are shipped to the United States. A U.S. parent company might receive Canadian dollar dividends from its Canadian operations that it must convert into U.S. dollars. A Canadian company might borrow Swiss francs and convert them into Canadian dollars to use for expansion of operations in Canada. Some of these transactions are financial in nature, but they relate to the commercial side of the business.

THE USES OF THE FOREIGN-EXCHANGE MARKET  So far, we have defined the key terms and concepts involved in foreign exchange. Now we will discuss the four major uses of foreign exchange: commercial transactions: making the market, arbitrage, and risk bearing or riskreduction.12 The major facilitators of these transactions, as mentioned earlier in the volves the bank in serving as a vehicle for making payments between its own resident customers and foreign nationals. The purchase and sale of foreign exchange are undertaken by a commercial bank for many purposes. For instance, travelers going abroad or returning from a foreign country will want to purchase or sell foreign currency. Residents of one country wishing to invest abroad also would need to purchase foreign currency from a commercial bank. Suppose that a Canadian exporter is to receive payment from a U.S. importer in U.S. dollars, and the exporter wishes to use the funds to make payment for raw materials purchased in No...

Evidence Account Transaction Figure 7.6 shows how a complex transaction such as the F-18A sale to Canada might be structured. This type of transaction is sometimes known as an evidence account transaction because it requires adherence to certain contractual obligations. As noted, it involves the primary exporter, the importing government, and other secondary exporters and importers. Whether firms become involved in the complexities of offset trade depends mainly on the strength of demand for their products, alternative sources of supply, and foreign exchange problems in the buying country. However, offset trade results primarily from foreign exchange shortage and is a good example of how firms and governments can compensate for the shortage through creative business transactions.

Countertrade      Another type of compensatory trade, called offset trade or countertrade,  are js becoming increasingly important. Countertrade exists "when reciprocal and contingent exchanges of goods and services are specified by contract and each flow of deliveries is valued and settled in monetary units.'"1 A good  example of how a firm might have to deal with offset involves McDonnell Douglas and the sale of F-18A fighter aircraft to the government of Canada. The sale of aircraft to Canada in 1980 was to net McDonnell Douglas nearly $3 billion, a significant amount of money for one sale. Over the eight-year period involved in the delivery dates, this would result in average imports for Canada of several hundred million dollars per year. Given the weakness of the Canadian dollar in relation to the U.S. dollar at the time of the sale, this was bound to concern the Canadian government. As a result, the negotiations for the sale of the aircraft involved no...

COMPENSATORY TRADE Sometimes countries have so much difficulty generating enough foreign exchange to pay for imports that even licensing doesn't work; they need to come up with creative ways to get the products they want. Although this shortage of foreign exchange is associated primarily with the historically planned economies and developing countries, it can also impact industrial countries. Canada and Australia, for example, found that they had to enter into special agreements with McDonnell-Douglas to pay for the military aircraft that it wanted to purchase. As a result, firms and governments are often forced to resort to creative ways of settling payment, many of which involve  trading goods for goods as part of the transaction. The term compensatory trade refers to any one of a number of different arrangements in which goods and services are traded for each other, either on a bilateral or multilateral  basis. More specifically, it is defined as "any contractual commi...

EXCHANGE RESTRICTIONS Some governments impose various exchange restrictions to control access to foreign exchange. Some of the devices they use are import licensing, multiple exchange rates, import deposit requirements, and quantity controls. Licensing Governmental licenses fix the exchange rate by requiring all recipients, exporters, and others who receive foreign exchange to sell it to the central bank at tne official buying rate. The central bank of a country, which is the institution usually empowered to establish monetary policy, or some other government agency rations the currency it acquires by selling it at fixed rates to those needing to make payment abroad for goods considered essential. The test of essentiality is made by the government or some agency acting for the government, such as the central bank. An importer may purchase foreign exchange only if that importer has obtained a license for the importation of the goods in question. For example, purchases of raw ...

CONVERTIBILITY  The difficulty involved in exchanging one currency for others is a measure of       jts convertibility. For example, although it is easy to convert U.S. dollars  into Russian rubles, it is virtually impossible to convert rubles into dollars.  Therefore, the U.S. dollar is considered freely convertible, but the Russian ruble is considered inconvertible. Convertibility has essentially two parts. Most countries today have nonresident, or external, convertibility. For example, all nonresidents with deposits in French banks may at any time exchange all of their franc deposits for the currency of any other country. In other words, a U.S. exporter to France can be paid in francs and be assured that those francs can be converted to dollars or some other currency. However, not all countries permit nonresident convertibility. In the case of the Soviet Union, a foreign firm like Pizza Hut may generate significant ruble profits in the Soviet Union...

Specialized Markets Certain specialized institutions and markets deal in futures and options and offer some variety from the banking sector: the International Monetary Market (IMM) in Chicago, the London International Financial Futures Exchange (LIFFE), and the Philadelphia Stock Exchange (PSE). As noted in Fig. 7.4, a customer operates in these three markets through a broker. The International Monetary Market The International Monetary Market (IMM) was opened in 1972 by the Chicago Mercantile Exchange to deal primarily in futures contracts for the British pound, the Canadian dollar, the West German mark, the Swiss franc, the Japanese yen, and the Australian dollar. These contracts are for specific amounts and have a specific maturity date. For example, a futures contract in Japanese yen is set by the IMM at 12.5 million yen. If you wanted to buy futures for 100 million yen, you would have to buy eight yen contracts from a broker. The contract sizes for the other currencies are ...

International Transactions   The foreign-exchange market is based on the economic law of supply and demand. Sometimes governments intervene to control the flow of currency by having their central banks buy or sell currency in the open market. However, the central action in the foreign-exchange market revolves around the commercial banks in the major money centers of the world. In the 1989 New York Federal Reserve survey, it was determined that 82 percent of the foreign-exchange transactions were interbank; the remaining 18 percent were divided between the futures and options market, financial customers, and nonfinancial customers. The world's communication networks are now so good, and so many countries have fairly unrestricted markets that we can talk of a single world market. It starts in a small way in New Zealand around 9:00 A.M. New Zealand time, just in time to catch the tail end of the previous night's New York market. Two or three hours later, Tokyo opens, followed ...

HOW THE FOREIGN-EXCHANGE MARKET WORKS Basic Spot and Forward Markets With a basic understanding of exchange rate quotations, we can now exam- ine how foreign exchange is traded, The majority of foreign-exchange transactions are carried out by com- mercial banks, with the rest conducted by foreign-exchange brokers. Brokers are specialists who facilitate transactions between banks and replace direct contact between banks. 58 percent of all foreign-exchange trading in the United States is conducted in the spot market, primarily the interbank market.The next-largest category is the swap market. A swap is a simultaneous spot and forward transaction. For example, a U.S. firm might need British pounds for 30 days, so it enters into a spot transaction to exchange dollars for pounds and enters into a simultaneous forward transaction to exchange the pounds for dollars in 30 days when the need for British pounds is completed. The other major foreign-exchange transactions are outrigh...

The Forward Market As noted above, the spot market is for foreign exchange traded within two business days. However, some transactions may be entered into on one day but not completed until sometime in the future. For example, the French exporter of perfume might sell perfume to the U.S. importer with immediate delivery but not require payment for 30 days. The U.S. importer has an obligation to pay francs in 30 days, so he or she may enter into a contract with a trader to deliver dollars for francs in 30 days at a forward rate, the rate today for future delivery. Thus the forward rate is the rate quoted by foreign-exchange traders for the purchase or sale of foreign exchange in the future. As was noted in Table 7.1, there is a difference between the spot rate and the forward rate known as the spread in the forward market. In order to understand how spot and forward rates are determined, you should first know how to calculate the spread between the spot and forward rates. In the ex...

The Spot Market Since most foreign-currency transactions take place with foreign-exchange traders, the rates are quoted by the traders, who work for foreign exchange brokerage houses or commercial banks. That is one of the confusions identified in the opening case. The rates are quoted by the trader, not the buying or selling party. Whether the traders quote prices in the spot or the forward market, they always quote a bid (buy) and offer (sell) rate. The bid is what the trader is willing to buy foreign exchange for, and the offer is what the trader is willing to sell foreign exchange for. The spread in the spot market— the difference between the bid and offer rates—is the margin on which the trader earns a profit on overall transactions. Thus the rate quoted by a trader for the British pound might be $ 1.9420/10. This implies that the trader would be willing to buy pounds at $1.9410 and sell them for $1.9420. Obviously, the trader would want to buy low and sell high. As just note...

Introduction to Foreign rates There is a fundamental difference between making payment in the domestic market and making payment for goods, services, or securities purchased abroad. In a domestic transaction only one currency is used, whereas two or more currencies may be used in a foreign transaction. For example, a U.S. company that exports $100,000 worth of textile machinery to a Zurich textile producer will ask the Swiss buyer to remit payment in dollars unless the U.S. firm has some specific use for Swiss francs. (If the firm has a Swiss subsidiary, for instance, it may wish to make the funds acquired available to this subsidiary and would accept payment in Swiss francs.) Assume that the situation just described is not the case and that you are a U.S. importer who has agreed to purchase a certain quantity of French perfume and to pay the French exporter 20,000 francs for it. How would you go about paying? First, you would go to the international department of your local bank ...

Case: Foreign travels, Foreign-Exchange Travails I was traumatized by exchange rates long ago. It was in 1936, to be exact, when I had a course in international finance with the redoubtable Prof. Jacob Viner. I could never understand why the exchange rate on the British pound was $4.88, whereas the rate on the French franc was 20 to the dollar. If the pound was $4.88, why wasn't the franc $0.05? Or if the franc was 20 to the dollar, why wasn't the pound 0.205 to the dollar? I just didn't know which country was up. So I gave up thinking about the subject for a long, long time. When I can't avoid the subject it still baffles me. For example, I do some work on the Israeli economy. Now, when Americans say that the exchange rate went up they mean that the dollar rose relative to other currencies. But when the Israelis say that the exchange rate went up they mean that other currencies rose relative to the shekel. Baffling! Maybe it's because they read from right to le...