Chapter 11: Foreign Exchange

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Chapter 11Foreign Exchange
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What we are gonna learn

• Foreign exchange rate definition
• Foreign exchange market
• Forward, future and option markets
• Impacts of changes of dollar exchange rate
• Arbitrage, hedging and speculation

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Foreign exchange quotations
Foreign exchange

• Exchange rate is the price of one currency in
  terms of another.
• i.e. as of Nov. 25, 2007
• 0.0092 dollar/yen
• 108 yen /dollar

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• One countrys currency has depreciated when more
  of it is needed to buy a unit of a foreign
  currency (is worth less relative to the other
  currency)
• A currency has appreciated when less of it is
  needed to buy a foreign currency (is worth more
  relative to the other currency)

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Foreign exchange quotations
Foreign exchange

• Cross exchange rate between two currencies is
  calculated from their exchange rates with a
  third, benchmark currency - frequently the US
  dollar

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Foreign exchange market
Foreign exchange

• Largest and most liquid market in the world
• 1.9 trillion a day, 20 price changes a minute,
  can be 18,000 changes a day.
• No central market - key markets in several cities
  around the world (London, New York Tokyo are
  the largest)

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• Most transactions involve transfers of bank
  deposits, not currency
• Participating banks and brokers are in constant
  contact via phone and computer

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• Three general types of transaction
• Between banks and their customers
• Domestic interbank market conducted through
  brokers
• Trading with overseas banks

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Types of FX transactions
Foreign exchange

• Spot transactions - executed nearly immediately
• Forward transactions - agreement to buy or sell a
  currency at a date in the future, at a rate
  agreed in advance
• Currency swaps - agreement to trade one currency
  for another now, and to trade currencies back
  again later, both at prices agreed at the
  beginning

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Distribution of FX transactions by US banks
Foreign exchange
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Forward markets, futures options
Foreign exchange markets

• Forward contracts obligate buyer to buy or sell a
  certain amount of foreign currency at a future
  date
• Usually made between banks and firms who expect
  to receive or make payments in foreign currency
  the amount of currency and the date are set by
  the agreement

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Forward markets, futures options
Foreign exchange markets

• Futures, traded on special exchanges, are
  contracts to trade given amounts of currencies at
  a specified date
• Only a small number of major currencies can be so
  traded, and only in fixed lots with fixed trade
  dates

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Forward markets, futures options
Foreign exchange markets
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Forward markets, futures options
Foreign exchange markets

• Options provide the holder with the right (but
  not the obligation) to buy or sell foreign
  currencies at an agreed rate within a period of
  time, in return for a fee paid to the seller of
  the option
• Options to buy are called call options, and those
  to sell are called put options
• Options are frequently used to reduce risk from
  exchange rate changes

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Impact of an appreciating US dollar
Foreign exchange

• Pros
• Lower prices on foreign goods
• Keeps inflation down
• Foreign travel is cheaper

• Cons
• Exporters products become more expensive abroad
• Imports-competing firms face price competition
• Travel more expensive for foreign tourists

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Impact of a depreciating US dollar
Foreign exchange

• Pros
• Exporters can sell abroad more easily
• Less competition for US firms from imports
• Foreign tourism is encouraged

• Cons
• Higher prices on imports
• Upward pressure on inflation
• Travel abroad more expensive

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Exchange rate indexes
Foreign exchange

• To judge the overall value of a currency versus
  many others, an index is used
• trade weighted index with respect to the
  currencies of the USs most important trading
  partners (in proportion to their share of trade)
  major currency index.
• To take into account price changes (inflation or
  deflation), a real exchange rate is used
• The real exchange rate is the nominal rate
  multiplied by the ratio of the foreign to
  domestic price levels

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Exchange rate indexes of the US dollar (March
1973100)
Foreign exchange
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Arbitrage and hedging
Foreign exchange markets

• Exchange arbitrage involves taking advantage of
  simultaneous exchange rate differences in
  different markets to make a profit
• Helps equalize exchange rates globally

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Case Study

• Two-point arbitrage
• Euro 1 dollar 2 New York
• Euro 1 dollar 2.01 Paris
• Three-point arbitrage

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Arbitrage and hedging
Foreign exchange markets

• Hedging involves making use of forward contracts
  or options to minimize exchange rate risk in
  international transactions
• Firms which expect to need to make or receive
  payments in the future can use forward contracts
  or options to lock in rates and avoid the
  disruptive effects of sudden exchange rate swings

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Hedge exchange risk with forward market

• Forward rate Premium
• Discount
• Percentage changes
  of one countrys currency value in the future.

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Forward rate and spot rate

• Forward rate is computed based on a countrys
  interest rate.

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Interest Arbitrage

• Uncovered
• Covered
• Step 1 make a purchase of foreign currency
• Step2 purchase a forward contract
• Example 12 interest rate in London and 8 in
  US
• Spot rat 2 USD/pond, three month future 1.99
  USD/Pond

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Forward Rate

• Interest rate increases gt Forward rate decreases

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How forward market functions

• Uncovered and Covered risk
• Importer owe 1million euros payment in the
  future
• Exporter expect 1million euros payment in the
  future

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How forward market functions

• Banks match forward contracts
• Reading assignment How Markel rides
  foreign-exchange fluctuations (pp381-383)

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Speculation
Foreign exchange markets

• Speculation differs from arbitrage, in that it
  involves the purchase or sale of a currency in
  the expectation that its value will change in the
  future

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Speculation
Foreign exchange markets

• Speculation can either reduce or increase
  volatility in foreign exchange rates
• If speculators expect a current trend in rates to
  change, then their purchase or sale moderates the
  price movements
• If they expect a current trend in rates to
  continue, their transactions can accelerate the
  rise or fall of the target currency