The Hong Kong exporting company must pay the Hong Kong toy manufacturer in Hong Kong dollars. But he sells to the US importer in US dollars. Consequently the Hong Kong exporter must convert the US dollars received from the sale into Hong Kong dollars to pay the manufacturer.
Each company also wants the transaction to be done at the most advantageous price possible. Since the values of US and Hong Kong dollars are likely to fluctuate between the date when business is initiated and the actual payment is made, the importer may want to use the forward foreign exchange market to fix the exchange rate. Usually these exchange transactions are done through a commercial bank. The bank itself may then sell the US dollars to other banks in the foreign exchange market or perhaps to a central bank. So one commercial transaction can and frequently does involve many transactions in the foreign exchange market.
The trade transaction takes place between only two parties; the importer and the exporter of the toy. All other participants in the transaction, such as the bank which exchanges the money, are only intermediaries. Again, the need for foreign exchange arises from business transactions between corporations located in different countries. These international corporations are all over the world. Exports, a measure of their activity, is what is referred to as world trade.
Last year's world trade was measured in the trillions of dollars. This means international companies bought and sold goods and services worth trillions from companies located in other countries. How did companies pay for this?
Companies in the United States had to pay for this in yen, euros, pounds and other currencies. Companies in Japan had to pay in US dollars, euros, pounds and other currencies. Some of these companies were exchanging dollars for pesos, some were exchanging pesos for euros, while other weres exchanging euros for dollars. Therefore, all companies participating in the multi-trillion dollar world trade had to buy or sell other currencies.
To create some order in this business of buying and selling currencies, we have foreign exchange markets. Howecer, most corporations have neither the facilities nor the expertise required to manage foreign exchange operations. Furthermore, they are not prepared to risk maintaining an open foreign exchange position for an extended period of time. Instead they commonly use services provided by commercial banks.
Today international corporations transact business in over 100 countries and currencies. The volume of exchange business required is enormous. Every company must not only buy and sell currencies but must do it at the best possible price. The single commercial transaction of our toy importer probably created a chain reaction resulting in several foreign exchange transactions. First he had to sell US dollars to buy Hong Kong dollars from his commercial bank. In turn the bank may have sold US dollars to another bank in the foreign exchange market or even to a central bank. Additionally if our importer decided to lock into a fixed exchange rate, even more foreign exchange transactions would be required.
It may be helpful to define some terms commonly used in foreign exchange trading. Just as a yield curve for funds, the value of a currency is usually discussed in terms of its maturity - that is, sport and forward rates.
- Spot Rate: Price of currency for delivery in two business days
- Forward Rate: Price of currency for delivery more than two business days in future
- Open Position Long (short): Excess (shortfall) of assets and buy contracts over liabilities and sell contracts in a currency
- Hedge: Elimination of an open position
A spot rate is the price of a currency when payments are made or received in two business days. Likewise a forward rate is the price of currency for delivery more than two business days in the future.
Open foreign exchange positions exist when our assets and purchase contracts are not equal to liabilities and sale contracts in a given currency. All open positions are either short of long.
We are long in a currency when our assets and buy contracts exceed our liabilities and sale contracts, and are short when this situation is reversed. For example, the toy importer has US dollars in cash assets and Hong Kong dollars in accounts payable liability. He is long in US dollars and short in Hong Kong dollars. Therefore, he has foreign exchange exposure, or an open position.
As the value of the Hong Kong dollar fluctuates against the US dollar, the toy importer's liability also changes. This importer may want to protect himself by hedging against the rate fluctuation. Thus a hedge is nothing more than the elimination of an open position.
To illustrate how multiple foreign exchange transactions and positions are created by a single commercial deal, let us look at what happens when a Volkswagen is purchased in the United States.
Volkswagen USA receives US dollars which it must remit to the parent company for the car. Consequently, the company is now long in dollars and short in euros. Volkswagen USA has dollar assets but needs marks to pay the parent company in Germany. To complete the transaction, Volkswagen USA must use the dollars to purchase euros from a commercial bank. The bank in turn is now short in euros and long in dollars. To square its position, the bank must sell dollars for euros in the foreign exchange market. Each sale can be transacted on either a spot or forward basis.
When a contract is settled in a third currency, the multiple effects of that single transaction on foreign exchange trading become more apparent. The following example of a Japanese importer who contracts to purchase iron ore from Australia with US dollars illustrates the process.
At the outset, the Japanese importer who has made the contract in US dollars is short in US dollars. To fulfill his end of the transaction he must sell Japanese yen to purchase US dollars. These US dollars must then be remitted to Australia. The Australian exporter is now long in US dollars. He must in turn sell US dollars and buy Australian dollars. In this case, both the importer and exporter need to participate in the foreign exchange market.
When a transaction requires a third currency settlement, the foreign exchange volume is set at least double the trade volume. Additionally the commercial banks may also trade in either the spot or forward foreign exchange market to square their positions. Therefore, one dollar of trade can result in multiple foreign exchange transactions equaling many times the value of that dollar of trade.
The global foreign exchange market has three primary groups of participants. First there are the large international corporations whose trade and investment activities create the need for foreign exchange transactions. These corporations participate in the foreign exchange market through the next group of participants, large commercial banks. Their role is crucial in the foreign exchange market.
Commercial banks act as go-betweens for their corporate clients. Under normal conditions, they also make the market by virtue of their ability to buy and sell any amount of currency, at any time.
In the most developed foreign exchange markets, the two major parties requiring exchange transactions are brought together by brokers. Generally brokers do not trade for their own account. They only arrange for transactions between other parties. Consequently, they are not actual participants in the foreign exchange market. Nonetheless, their role is important. Finally there are the central banks that in essence act as international clearing houses for foreign exchange transactions. They may also intervene in the foreign exchange market to try to maintain orderly markets. Furthermore central banks take positions and act as intermediaries for other government agencies.
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