Abul Kalam Azad

Asst. Professor
International Islamic University Chittagong

2nd Semester
International Business and Globalization
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Areas of Discussion
Definition and Importance of International Business
Purpose of International Business
Considerable Factors of International Business
Modes of International Business
Important Terminologies
Globalization
Topics to be covered

Key Concepts and Definitions
Principal motives and modes of IB
Globalization: concepts,
interpretations & implications

01. DEFINATION OF BUSINESS
Any commercial, industrial or professional activity undertaken by an individual or a group.
A group of people with a same goal creating/adding value asking price for the value is called Business.

02. DEFINATION OF International Business
All business transactions private and governmental that involve two or more countries. There is no border or
barrier for International Business.

03. Why should we study international business? ( Purposes/ Importance)
It comprises a large and growing portion of the worlds total business. Today, almost all companies large or small
are affected by global events and competition.
Why companies engage in international business?
To expand their sales
To acquire resources : Capital
Technology
Information
To diversify their source of sales and supplies
To minimize competitive risk
Reasons for Recent International Business Growth
Rapid increase in and expansion of technology
Liberalization of Cross-border Movements
Development of Supporting Institutional
Arrangements
Increase in Global Competition


04. Factors Influencing International Business
The cultural environments- Example-EU, SAFTA, SARRKC, OIC, OPEC( This org. is maintain one culture)
The political and legal environments- Example- Relation with India is Political & with Israel is Legal.
The economic environment
The geographical advantages

International Business and Globalization
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01.Modes of International Business

02.Important Terminologies



03.

04.Globalization Defined
Globalization: the ongoing social, economic, and political process that deepens and broadens the
relationships and inter-dependencies amongst nationstheir people, their firms, their organizations, and
their governments
International business facilitates the globalization process.


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International Business and Globalization
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09. The Forces Behind Globalization
Increased expansion and technological improvements in transportation and communications
networks
Liberalization of cross-border trade and resource movements
Development of services that support international business activities
Growing consumer demand for foreign products
Increased global competition
Changing political and economic situations
Expanded cross-national treaties and agreements

International Business and Globalization
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International Business and Globalization
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10. Major Globalization Forces
Competitive
Cost
Market
Technological
Political

11. The International Environment
Worldwide Bodies: World Bank
Regional Economic Groupings of Nations: North
American Free Trade Agreement
Organizations Bound by Industry Agreements:
Organization of Petroleum Exporting Countries.

12. Forces in the Environment for Globalization

1) Competitive: kinds and numbers of competitors, their locations, and their activities.
2) Distributive : national and international agencies available for distributing goods and services
3) Economic : variables (such as GNP, unit labor cost, and personal consumption expenditure) that
influence a firms ability to do business
4) Socio economic: characteristics and distribution of the human population.
5) Financial : variables such as interest rates, inflation rates, and taxation
6) Legal : the many foreign and domestic laws governing how international firms must operate
7) Physical : elements of nature such as topography, climate, and natural resources
8) Political : elements of nations political climates such as nationalism, forms of government, and
international organizations
9) Sociocultural : elements of culture (such as attitudes, beliefs, and opinions) important to
international businesspeople
10) Labor : composition, skills, and attitudes of labor
11) Technological : the technical skills and equipment that affect how resources are converted to
products
Environment of International Business
The Cultural, Political and Legal, and Economic Environments
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Cultural Environment
Culture: the specific learned norms of a society that reflect attitudes, values, and beliefs
Major problems of cultural collision are likely to occur if:
-a firm implements practices that do not reflect local customs and values and/or
-employees are unable to accept or adjust to foreign customs.

Cultural Dynamics
Cultures consist of societies, i.e., relatively
homogeneous groups of people, who share
attitudes, values, beliefs, and customs.
Cultures are dynamic; they evolve over time.
Cultural value systems are set early in life, but
may change because of:
o -choice or imposition
o -contact with other cultures.
Cultural Formation and Change
Change by Choice: Societal values and customs
constantly evolve in response to changing realities.
Change by Imposition: Cultural imperialism is
brought about by the imposition of one culture
upon that of another.
Contact with other culture: Certain elements
introduced from outside a culture may be known as
creolization, indigenization, or cultural diffusion.


Cultural Stabilizer
Language as a Cultural Stabilizer
Isolation from other groups, especially because of
language, tends to stabilize cultures.
Some countries see language as being so important
that they regulate the inclusion of foreign words
and/or mandate the use of the countrys official
language for business purposes.

Religion as a Cultural Stabilizer
Religion is a major source of both cultural
imperatives and cultural taboos.
Major religions include:
-Buddhism
-Christianity
-Hinduism
-Islam
-Judaism

Social Stratification Systems
Ascribed group memberships are defined at birth; they may include gender, family, age, caste, and ethnic or
national origin.
Acquired group memberships are based on ones choice of affiliation, such as political party, religion, and
social and professional organizations.
Social stratification affects both business strategy and operational practices.
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Factors Affecting the Communication
Process
Spoken language
Written language
Silent language
-color associations
-conversational distance
-perception of time
-kinesics [body language and gestures]
Problems in communication may arise, even when
nations share the same basic language (e.g., British,
Canadian, and American English.
Managerial Issues Associated with
Cultural Differences
Accommodation of foreigners
Cultural distance [degree of similarity]
Culture shock and reverse culture shock
Managerial orientations
polycentric
ethnocentric
geocentric

Factors Affecting Strategies for Instituting Cultural Change
Value systems
Cost/benefits of change
Resistance to change
Participation in decision-making
Reward sharing
Role of opinion leaders
Timing
Opportunities to learn from abroad










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Political and Legal Environment
Political System Defined
Political system: the complete set of institutions, political organizations, and interest groups, the relationships
amongst those institutions, and the political norms and rules that govern their functions
The ultimate test of any political system is its ability to hold a society together.

Ways to Assess Political Systems
Individualistic
-people accept the primacy of individual freedoms in the political, economic, and cultural realms
-people believe in minimal government intervention
Collectivist
-people reason that the needs of society take precedence over the needs of the individual
-people believe that it is the governments role to define the needs and priorities of the country
Collectivist paradigms may be either democratic (Japanese) or authoritarian (Chinese) in nature.
Political Ideology Defined
Political ideology: the body of constructs, theories, and aims that constitute a sociopolitical program
Pluralism indicates the coexistence of a variety of ideologies within a particular society.
Shared ideologies create bonds within and between countries; differing ideologies split societies apart.

Types of Political Ideologies:
The Two Extremes
Democracy: widespread citizen participation in the decision-making and governance processes, either
directly or through elected representatives
Totalitarianism: the monopolization of power by a single agent; opposition is neither recognized nor
tolerated
In theocratic totalitarianism, religious leaders are also the political leaders; in secular
totalitarianism, the government imposes order via military power.
Political Risk Defined
Political risk: the expectation, i.e., the likelihood, that the political climate in a country will change in such a way
that a firms operating position or investment value will deteriorate
MNEs do their best to effectively deal with the threat of political risk through active and/or passive
approaches.
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Types of Political Risk
[ranging from the least to the most destructive]
Systemic [a change in public policy]
Procedural [bureaucratic delays, labor disputes, etc.]
Distributive [tax and regulatory revisions]
Catastrophic [random political events
Legal System Defined
Legal system: the mechanism for creating, interpreting, and enforcing the laws in a specified jurisdiction
Generally, differences in the structure of law influence the attractiveness of a particular country as an investment
site.
Types of Legal Systems
Common law [based on precedent]
Civil law [based upon a set of laws that comprise a code]
Theocratic law [based upon religious precepts]
Customary law anchors itself in the wisdom of daily experience or important traditions. A mixed legal
system emerges when two or more legal systems are used within a single country.
Legal Issues in International Business

Operational concerns
o ease of entry and exit
o hiring and firing employees
o contract enforcement
Strategic concerns
o product safety and liability
o marketplace behavior
o product origin
o legal jurisdiction
o arbitration

Intellectual property rights [IPRs]: ownership rights to intangible assets [copyrights, patents, trademarks,
etc.]Generally, less developed countries provide less protection for IPRs than do industrialized nations. Those
countries with a more individualistic orientation view IPRs as intrinsically legitimate, but those with a more
collectivist outlook extol the virtues of shared ownership.




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Economic Environment
Key Economic Forces
The general economic framework of a country
Its degree of economic stability
The existence and role of capital markets
The presence of factor endowments
Market size
The existence of economic infrastructure

Gross National Income
Gross National Income (GNI): The market value of all final goods and services produced by a countrys domestically-
owned firms in a given year.
Purchasing Power Parity
Purchasing power parity: the number of units of a countrys currency required to buy the same amount of goods
and services in the domestic market that one unit of income would buy in another country.
Purchasing power parity [PPP] is estimated by calculating the value of a universal basket of goods that can be
purchase with one unit of a countrys currency.
Second-order Indicators of Economic Development and Potential
Inflation
Unemployment rate
Debt
Internal
external
Income distribution
Poverty rate
Balance of payments
The Consumer Price Index (CPI) measures the average change in consumer prices over time in a
fixed market basket of goods and services; the misery index represents the sum of a countrys inflation and
unemployment rates.
The Balance of Payments
reports the total of all money flowing into a country less all money flowing out of that country to any other
country during a given period of time
records a countrys international transactions amongst companies, governments, and/or individuals during
a given period of time
The Balance of Payments [BOP] is officially known as the Statement of International Transactions.
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Surpluses and Deficits
A trade surplus indicates that the value of exports exceeds the value of imports.
A trade deficit indicates that the value of imports exceeds the value of exports.
Trends in balance of payments data can reveal important strategic implications with respect to
a countrys economic environment and potential economic policies.
Economic System Defined
Economic system: the set of structures and processes that guides the allocation of scarce resources and shapes the
conduct of business activities in a nation



Types of Economic Systems
Market Economy: a free-market (capitalistic) economy built upon the private ownership and control of the
factors of production
Command Economy: a centrally-planned economy built upon government ownership and control of the
factors of production
Mixed Economy: an economy in which economic decisions are largely market-driven and ownership is
largely private, but significant government intervention is still evident


Theories of International Business
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Mercantilism, Absolute Advantage. Comparative Advantage, Competitive Advantage, Product Life Cycle & Two-
Factor Theory
Why Theories are Important?
What is a theory?
In common usage, people often use the word theory to signify an assumption, an opinion, or a speculation.
A set of logical explanations about patterns of human social life
A theory is a statement or set of statements pertaining to the relationships among variables. Often, the expectation
involves the idea of causation.
A set of statements or principles devised to explain a group of facts or phenomena, especially one that has been
repeatedly tested or is widely accepted and can be used to make predictions about the phenomena



The Importance of Theory & Trade/Business Theory
Theories help to analyze and understand facts. Trade
theory helps managers and government policymakers
focus on three critical questions:
What products should be imported and exported?
How much should be traded?
With whom should they trade?
While descriptive (vivid) theories suggest a liberal
treatment of trade, prescriptive (rigid) theories suggest
that governments should influence trade patterns.
Trade and Investment Policies
import substitution: a policy of developing
domestic industries to manufacture goods and
provide services that would otherwise be
imported
Strategic trade policy: the identification and
development of targeted domestic industries in
order to improve their competitiveness at home
and abroad.
Interventionist Trade Theories
Interventionist trade theories prescribe government action with
respect to the international trade process.
Mercantilism: an age-old zero-sum game that purports
that a countrys wealth is measured by its holdings of
treasure (usually gold)
To amass a surplus (a favorable balance of trade), a country
must export more than it imports and then collect gold and
other forms of wealth from countries that run trade deficits
(unfavorable balances of trade).

Neomercantilism: the more recent strategy of countries
that use protectionist trade policies in an attempt to run
favorable balances of trade and/or accomplish particular
social or political objectives
Mercantilism
An economic theory that states a nation becomes strong by
keeping strict control over its trade. It also states that a
nation should have more exports than imports.
Occurred with the shift form barter economies to
exchange economies.
Specie (gold and silver) was the accepted medium of
exchange.
International trade was conducted under the authority of
governments.
The Pursuit of Gold:
World exploration grew rapidly in the pursuit of new
Sources of gold and treasure.

Mercantilism
Early mercantilist writers embraced bullionism, the belief
that those quantities of gold and silver were the measure
of a nation's wealth. Later mercantilists developed a
somewhat more sophisticated view.
European economists between 1500 and 1750 are today
generally considered mercantilists.

Mercantilism
Adam Smith and David Hume are considered to be the
founding fathers of anti-mercantilist thought. .
Mercantilists failed to understand the notions of absolute
advantage and comparative advantage and the benefits
of trade.
David Hume famously noted the impossibility of the
mercantilists' goal of a constant positive balance of trade.
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Free Trade Theories: Absolute & Comparative Advantage
The theories of absolute and comparative advantage
demonstrate how economic growth can occur via
specialization and trade.
Free trade (a positive-sum game) implies specialization
and requires that nations neither artificially limit imports
nor artificially promote exports.
The invisible hand of the market determines which
competitors survive, as customers buy those products
that best serve their needs.
Nations specialize in the production of certain products, some of
which may be exported; export earnings can in turn be used to pay
for imported goods and services.

Theory of Absolute Advantage
Absolute advantage [- by Adam Smith, 1776]:
A country can -
(i) Maximize its own economic well being by
specializing in the production of those goods
and services that it produces more efficiently
than any other nation and
(ii) Enhance global efficiency through its
participation in free trade.
Smith reasoned that:
workers become more skilled by repeating the same
tasks
workers do not lose time in switching from the
production of one kind of product to another
Longer production runs provide greater incentives
for the development of more effective working
methods.
Natural vs. Acquired Advantages
A natural advantage may exist because of:
-given climatic conditions
-access to particular resources
-the availability of labor, etc.
An acquired advantage may exist because of:
superior skills
-better technology
-greater capital assets, etc.

Real income depends on the output of products
as compared to the resources used to produce them.

Production Possibilities with Absolute Advantage

Theory of Comparative Advantage
Comparative advantage [- by David Ricardo, 1817]:
A country can (i) maximize its own economic well-being
by specializing in the production of those goods and
services it can produce relatively efficiently and (ii)
enhance global efficiency via its participation in free
trade.
Ricardo also reasoned that:
a country can simultaneously have an absolute
and a comparative advantage in the production of a
given product
by concentrating on the production of the product in
which it has the greater advantage, a country can further
enhance both global output and its own economic well-
being

Production Possibilities with Comparative Advantage

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Assumptions and Limitations of the Free Trade
Theories
The theories of absolute and comparative advantage both
make assumptions that may not be entirely valid.
Full employment of resources
Exclusive pursuit of economic efficiency objectives
Equitable division of gains from specialization
Only two countries and two commodities
Exclusion of transport costs
A static rather than a dynamic view
Exclusion of services
Unrestricted factor mobility

Product Life Cycle (PLC) Theory
The optimal location for the production of certain types
of goods and services shifts over time as they pass
through the stages of: (i) introduction, (ii) growth, (iii)
maturity, and (iv) decline.

Exceptions to the typical pattern of the PLC would
include:
products that have very short life cycles
luxury goods and services
products that require specialized labor
products that are differentiated from competitive
offerings
products for which transportation costs are relatively
high

During the decline stage, a product is often imported by
the country where it was initially developed; however,
the importing firm may or may not be the innovating
firm.
Porters Diamond of National Competitive
Advantage [1990]
The Porter Diamond theorizes that national competitive
advantage is embedded in four determinants:
factor endowments (gifts)
demand conditions
related and supporting industries
firm strategy, structure, and rivalry
All four determinants are interlinked and generally must
be favorable for a given national industry to attain
global competitiveness.
At times, determinants can be affected by the roles
of chance and government.

Porters The Diamond of National Advantage


Factor Mobility
Factor mobility concerns the free movement of factors
of production, such as labor and capital, across national
borders.

While capital is the most internationally mobile
factor, short-term capital is the most mobile of all.
Capital is primarily transferred because of differences in
expected returns, but firms may also respond to
government incentives.
People transfer internationally in order to work
abroad, either on a temporary or on a permanent
basis.
Brain drain occurs when educated citizens leave a
country, but a nation may in turn gain from the
remittances that citizens who are working abroad send
home.
International Trade and Factor MobilityPotential
Effects
Substitution: the inability to gain sufficient access
to foreign production factors may stimulate efficient
methods of domestic substitution, such as the
development of alternatives for traditional
production methods
Complementarily: factor mobility via foreign direct
investment may stimulate foreign trade because of
the need for equipment, components, and/or
complementary products in the destination country
While immigrants add to the base of a countrys skills, thus
enabling competition in new areas, inflows of capital can be
used to develop infrastructure and natural and other acquired
advantages, thus enabling increased participation in the
international trade arena.


Government Influence on Trade
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Introduction
No country permits unregulated flow of goods and services across its borders
Governments place restrictions on imports and occasionally on exports
Governments may provide direct and indirect subsidies to improve the competitive position
of some industries.
Protectionism
Government restrictions on imports and occasionally on exports that frequently give direct or indirect subsidies to
industries to enable them to compete with foreign production either at home or abroad.
Physical and Societal Influences on Protectionism and Companies Competitive Environment

Conflicting Results of Trade Policies
Objectives may conflict
Economic, social, and political goals of a country often conflict
May be impossible to help some industries without hurting others
Proposed reforms of trade regulations results in heated debates among pressure groups
Rationales for Governmental Intervention





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Unemployment
Unemployed can form effective pressure group for
import restrictions
Problems stemming from restricting imports to create
jobs in the domestic economy
Retaliation by other countries
less tendency to retaliate against small
countries
restricting country will gain jobs in one place
and lose them somewhere else
Pressure against protectionism among workers in
industries dependent on imports
Import restrictions indirectly cause loss of export
income
Potential costs of import restrictions include both
higher prices and higher taxes
such costs should be compared with those
of unemployment

Infant-Industry Argument
The infant industry argument holds that a
government should shield an emerging industry from
foreign competition by guaranteeing it a large share of
the domestic market until it is able to compete on its
own.
Initial output costs may make products noncompetitive
in world markets
Over time costs will decrease due to:
greater economies of scale
greater worker efficiency
Problems with argument
Hard to identify industries with high probability of
success
even when industries can be identified, not
clear that government should provide
protection
Protection may serve as disincentive for managers
to adopt innovations needed to become competitive
Economic Relationships with Other Countries
Balance-of-payments adjustments governments
attempt to modify import or export movement in a free
market
Comparable access or fairness
In industries in which increased production will
greatly decrease cost, producers that lack equal
access to a competitors market will have a
disadvantage in becoming cost competitive
Equal access discussed in terms of fairness
o arguments against fairness doctrine
there are advantages of freer trade, even if
imposed unilaterally
may escalate economic tensions among
trading partners
cumbersome and expensive to negotiate
separate agreements for all products that
could be traded internationally
Industrialization Argument
Countries seek protection to promote industrialization
because that type of production:
Bringing faster growth than agriculture
Brings in investment funds
Diversifies the economy
Brings more income than primary products do
Reduces imports and promotes exports
Helps the nation building process

Price-control objectives
Export restrictions may:
raise costs of smuggling prevention
lead to substitution
keep domestic prices down by increasing
domestic supply
give producers less incentive to increase
output
shift foreign production and sales

Import restrictions may:
prevent dumpingexports priced below cost or
home-country price
get other countries to bargain away restrictions
get foreign producers to lower their prices
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Non economic Relations for Government Intervention
I. Maintaining Essential Industries
Protecting domestic industries during peacetime so that
country is not dependent on foreign sources of supply
during war
Popular argument to support import restrictions
Countries must
determine which industries are essential
consider costs and alternatives
consider political consequences
II. Dealing with Unfriendly countries
Prevention of exports that might be acquired by
potential enemies
May lead to retaliation that prevents securing other
essential goods
Trade controls on non defense goods also may be used
as a weapon of foreign policy
III. Maintaining Spheres of Influence
Governments may:
Provide aid and credits to, and encourage imports
from, countries that are political allies
Impose trade restrictions to coerce foreign countries
to follow certain political actions

IV. Preserving Cultures and National Identity
Countries have a common sense of identity that
separates them from other nationalities
May limit foreign products and services to
protect their separate identity


Instruments of Trade Control
Tariffsa tax governments levy on goods shipped internationally
Most common type of trade control
export tariff- collected by exporting country
transport tariff- collected by country through which
the goods have passed
import tariff collected by importing country
most common type of tariff
Used to protect domestically produced goods
Used as a source of governmental revenue
specific duty tariff assessed on per unit basis
ad valorem duty assessment is a percentage of the
value of the item
compound duty combination of specific duty and
ad valorem duty on the same product
Trade Restrictions Based on Tariffs






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Nontariff Barriers: Direct Price Influences
Subsidiesdirect government payments to
domestic companies to compensate them for
losses incurred from selling abroad
other types of government assistance makes it
cheaper or more profitable to sell abroad
potential exporters provided with an
array of services
subsidies to overcome market imperfections are
least controversial
there is little agreement on what a subsidy is
there has been a recent increase in export-credit
assistance
Aid and loans given to other countries with
the proviso that the funds be spent in the donor
country
repayment insurance for exporters
Customs valuation procedures for assessing
value when customs agents levy tariffs
may be based on
I. invoice price
II. value of identical goods
III. similar goods coming in at the same time
IV. final sales value or on reasonable cost
valuation problems created by the large number
of products that are traded
Other direct price influences
I. special fees
II. customs deposits
III. minimum price levels

Trade Restrictions Based on Available
Supply

Nontariff Barriers: Quantity Controls
Quotaslimits the quantity of a product allowed to be
imported in a given year
Most-common restriction based on quantity
amount frequently reflects guarantee that domestic
producers will have access to a certain percentage of the
domestic market
problems with quotas
transshipping goods among countries
transforming product into one for which there is
no quota
export quotas
assure domestic consumers a supply of goods at
low price
prevent depletion of natural resources
raise export prices
Embargoquota that prohibits all trade
Buy local legislation governments favor purchasing
goods produced domestically
legislation that prescribes a minimum percentage of
domestic value
Standardsclassification, labeling, and testing standards
limit sales of foreign products
Specific permission requirements
import licensepotential importers or exporters require
governmental permission before conducting trade
transactions
foreign-exchange controlimporter required to apply to a
governmental agency to secure foreign currency to pay for
a product
Administrative delays intentional delays that create
uncertainty and raise the cost of carrying inventory
Reciprocal requirements governmental requirements
that
exporters take merchandise in lieu of money
exporters promise to buy merchandise or services in the
country to which they export
countertrade or offsetbarter transaction
Restriction on services
exist for three reasons
countries do not want to depend on foreign companies for
strategic services
Standards ensure qualifications of providers
little reciprocal recognition in licensing from one country
to another
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Immigrationprotect employment of countrys own
citizens
require local search for qualified personnel before hiring a
foreigner

General Agreement on Tariffs and Trade (GATT)
Created in 1947 by 23 countries
Intended to negotiate reductions in trade restrictions
and develop common procedures for handling
imports and exports
Efforts led to a number of multilateral reductions in
tariffs and nontariff barriers for member countries
across-the-board reductions
each country negotiated exceptions to its
reductions
Codes of conduct developed in each of five areas
Inherent weakness of GATT
Cumbersome negotiations
Most-favored nation trade
concessions applied to all trading
partners
No mechanism to assure
compliance with negotiated
agreements

World Trade Organization (WTO)
Created in 1995 to replace GATT
Negotiating process
Ongoing negotiations about
restrictions on trade in services
nontariff barriers to trade
protection of intellectual-property rights
investment policies that affect trade
Granting of normal trade relations
Apply to WTO members
Eliminates the free-rider complaint raised
during GATT negotiations
Certain exceptions recognized
Settlement of disputes
Clearly defined settlement mechanism
Sanctions may be applied to countries that do
not comply with rulings


Dealing with Governmental Trade Influences
When faced with import competition, companies may
I. Move production to a lower-cost country
II. Concentrate on market niches in which there is
less international competition
III. Effect internal adjustments
Companies may require assistance of government to
limit imports or open foreign markets
Governments deny some requests for assistance
companies attitudes differ toward protectionism
Companies likely to lose from protectionism
those that depend heavily on trade
those that have integrated production in
different global locations
Companies likely to gain from protectionism have
single or multidomestic production facilities


Global Foreign Exchange Markets

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Contents
Foreign Exchange: Basic Concepts
The Foreign Exchange Market: Major Segments
Why US Dollar is the most widely circulated
currency
Location of the Foreign Exchange Market
Foreign Exchange Terms and Conventions
Types of Foreign Exchange Markets

Exchange-based vs. Over-the-Counter Fx
Instruments
Foreign Exchange Convertibility
The Uses of Foreign Exchange
The Fx Trading Process
OTC Market and Commercial and Investment
Banks

Foreign Exchange: Basic Concepts
Foreign exchange (Fx): money denominated in the currency of another nation or group of nations
[a financial instrument issued by a foreign country]
Exchange rate: the price of one currency expressed in terms another currency
[the number of units of a given currency needed to buy one unit of another currency]
Foreign exchange market: banks and currency exchanges that buy and sell foreign currencies and other exchange
instruments
[A market for converting the currency of one country into that of another country]
The Foreign Exchange Market: Major Segments
Over-the-counter (OTC) market: commercial and investment banks
[Most foreign exchange activity occurs here]
Exchange-traded market: specialized securities exchanges where particular types of foreign-exchange
instruments are traded
[Instruments such as futures and options are exchange-traded]
US dollar - is the most widely traded currency
Because US Dollar serves as:
an investment currency in many capital markets
a reserve currency held by many central banks
a transaction currency in many international
commodity markets
an invoice currency in many contracts

an intervention currency employed by monetary
authorities in market operations to influence their
own exchange rates
The most frequently traded currency pairs are:
- the U.S. dollar/euro [28%]
- the U.S. dollar/yen [17%]


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Location of the Foreign Exchange Market
London is the largest foreign exchange market (followed by New York, Tokyo, and Singapore) because of its
strategic location between Asia and the Americas.
Market activity first heightens when Europe and Asia are open and again when Europe and the United States
are open.
Cross-trading: using the U.S. dollar as a vehicle currency for trades between two other currencies
- Cross rate: the exchange rate between two non-U.S. dollar currencies that is computed from the exchange
rate of each currency in relation to the U.S. dollar
[Use currency A to buy currency C (US $1), and then use currency C to buy currency B.]
The Circadian Rhythms of the Fx Market

Foreign Exchange Terms and Conventions
Bid: the price at which a trader is willing to buy a foreign currency
Offer: the price at which a trader is willing to sell a foreign currency
Spread: the difference between the bid and the offer rates, i.e., the traders profit
American terms: the U.S. point of view, i.e., the number of U.S. dollars per unit of foreign currency
European terms (indirect quote): the number of units of foreign currency per U.S. dollar
A quote in American terms (US$/Fx) is always the reciprocal of a quote in European terms (Fx/US$).
$1.00/.009430 106.04/$1.00
Base currency: the quoted, underlying, or fixed currency

Traders always quote the base currency (the denominator) first, followed by the terms currency (the
numerator)
An example:
Dollar-yen quote: dollar =base, yen =terms
Oct. 10, 2004 April 28, 2005
110.96/$1.00 106.04/$1.00
The dollar (base) weakened; the yen (terms) strengthened.

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Types of Foreign Exchange Markets
Spot market: the market in which foreign exchange transactions occur on the spot, i.e., for delivery within
two business days following the date of agreement to trade
Spot rate: the rate quoted for transactions that require immediate delivery, i.e. within two days
Forward market: the market in which foreign exchange transactions occur at a set rate for delivery beyond
two business days following the date of agreement to trade
Forward rate: a contractually established exchange rate between a foreign exchange trader and the
traders client for delivery of foreign currency on a specified date

Forward discount: the forward rate is less than the spot rate
Forward premium: the forward rate is higher than the spot

Forward/Future Instruments
Forward contract: a contract between a firm or individual and a bank to deliver foreign currency at a
specific exchange rate on a future date

Outright forward: a forward contract that is not connected to a spot transaction, i.e., a contact to deliver
foreign currency beyond two days following the date of agreement at the forward rate

Fx swap: a simultaneous spot and forward trans-action, i.e., one currency is swapped for another on one
date and then swapped back on a future date

Currency swap: the exchange of principal and interest payments via interest-bearing OTC financial
instruments (e.g., bonds)

Futures contract: an agreement between two parties to buy or sell a given currency at a given (negotiated)
price on a particular future date, as specified in a standardized contact to all participants in that currency
futures exchange [not as flexible as a forward contract]

Option: an instrument traded both OTC and on exchanges that gives the purchaser the right (but not the
obligation) to buy or sell a certain amount of foreign currency at a specified exchange rate within a specified
amount of time [more expensive but also more flexible than a forward contract]
Strike price: the exchange rate specified in the option, i.e., the exercise price
Premium: the fee paid to the writer of the option

Exchange-based vs. Over-the-Counter Fx Instruments


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Foreign Exchange Convertibility

Convertibility: the ability of residents and nonresidents to purchase foreign currency with a given (domestic)
currency without government restrictions

External convertibility: the ability of non- residents to purchase foreign currency with a given currency without
government limitations

Nonconvertibility: the inability of residents and nonresidents to convert a given currency into foreign currency
because of government limitations

Fully convertible currencies are those that governments allow both residents and nonresidents to purchase in
unlimited amounts, i.e., they are freely traded and accepted by central banks.
Hard currencies are fully convertible, relatively stable, and tend to be comparatively strong. Soft (weak) currencies
are not fully convertible.
A government may control the convertibility of its currency through:
licensing
a multiple exchange rate system
advance import deposits
quantity controls
Currency controls add to the cost of doing business and thus serve as serious impediments to trade and investment.

The Uses of Foreign Exchange
The role of commercial banks:
buy and sell foreign exchange
serve as vehicles for payments
between domestic and foreign
customers
lend money in foreign denominations
Business purposes:
settlement of international business
transactions
hedging [risk reduction through loss
protection]
speculation [currency trading on expectations
of future prices]
arbitrage [risk-free profit based on price
differentials]
o interest arbitrage

The Fx Trading Process
To settle foreign exchange balances, companies may work through:
local banks
commercial and investment banks (OTC market)
securities exchange brokers
Banks deal with each other in the interbank market, primarily through foreign-exchange brokers.
Brokers are specialist intermediaries who facilitate transactions in the interbank market by matching the
best bid and offer quotes.

Banks fx dealers can trade foreign exchange:
directly with other dealers
through voice brokers
through electronic brokerage systems



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Structure of Foreign Exchange Markets



The Over-the-Counter Market: Commercial
and Investment Banks
Top banks in the interbank forex markets are so ranked
because of their ability to:
trade in specific market locations
handle major currencies
handle major cross trades
deal in specific currencies
handle derivatives (forwards, options, futures, swaps)
conduct key market research

Foreign Exchange Transactions



Top OTC and Commercial and
Investment Banks: Fx Trades