Foreign Exchange

1
Foreign Exchange
Global Trade Finance Prof. Bryson, Marriott
School
2
Foreign Exchange Quiz

• What is foreign exchange?
• (Trading nations moneys.)
• What is the exchange rate?
• (The price of one nations money in terms of
  another nations money.)

3
Foreign Exchange Quiz

• What is the spot exchange rate?
• (The price for immediate exchange)
• What is the forward exchange rate?
• (The price that will take place sometime in
  the future.)

4
Currency Trading, Wall Street Journal

• U.S. EQUIV. CURRENCY PER U.S.
• Country Wed Tue Wed ,TunKuwait (Dinar)
  3.2744 3.2723 .3054 .3056Lebanon (Pound)
  0006606 .0006607 1513.75 f5i.50
• Malaysia (Ringgit)-b 2632 .2632 3,8000 3.9e0Mal
  ta (Lira) 2,2386 2,2326 .4467 , .479Mexico
  (Peso) ................
• Floating rate 1085 ,1086 9.2155 9.2105Netherland
  s (Guilder) 4075 .4059 2.4537 2.4635New Zealand
  (Dollar) 4196 .4205 2.3832 2.3781Norway (Krone)
  1133 ,1126 8.8270 8.8785Pakistan (Rupee)
  01642 .01635 60.900 61J0Peru (new Sol)
  2901 2901 3.4468 "3.4475Philippines (Peso)
  01928 .01925 51.875 51.960Poland (Zlety)-d
  2453 2444 4,0760 4.0910Podugal (Escudo)
  004480 .004462 223.23 224.11Russia (Ruble)-a
  03362 .03364 29.747 29.77 184611-month
  forward 6114 .6075 1.6356 1.6413-months
  forward 6115 .6076 1.6354 .64596-months
  forward 6117 .6078 1.6348 1,64Taiwaa (Dailar)
  02899 .02899 34.500 34.500Thailand (Baht)
  02239 .02238 44.655 i114.65Turkey (Lira)-f
  00000064 .00000065 1565000 1540090United Arab
  (Dirham) 2723 .2723 3.6730 3.6730Uruguay (New
  Peso) .....Financial 07123 .07123 14.040 t4.040
  Venezuela (Bolivar) 001345 .001345 743.50 743
  50SDR 1.2794 1.2760 .7816 '.2837Eurn
  8981 ,8946 1.1135 11.1178
• Special Drawing Rights (SDR) are based on
  exchange rates for the U.S., German, British,
  French , and Japanese crrerf-cies. Source
  International Monetary Fund. a-Russian Central
  Bank rate. b-Government rate. d-Floating rate
  trading band suspended on 4/1 1/OO. e-Adopted
  U,.9. dollar as of 9/1 i/OO. f-Floating rate,
  eft. Feb. 22. , 1

• Wednesday, November 7, 2001
• EXCHANGE RATES
• The New York foreign exchange mid-range rates
  below apply to trading among banks in amounts of
  1 million and more, as quoted at 4 p.m. Eastern
  time by Reuters and other sources. Retail
  transactions provide fewer units of foreign
  currency per dollar. Rates for the 12 Euro
  currency countries are derived from the latest
  dollar-euro rate using the exchange ratios set
  1/1/99.
• U.S. S EQUIV. CURRENCY PER U,S,
• Country Wed Tue Wed TeaArgentina (Peso)
  i.0005 1.0017 .9995 .9983Aestmlia (Dollar)
  5153 .5136 1.9408 1.9472China (Renminhi)
  1208 .1208 8.2766 8,2767
• Colombia (Peso) '.0004334 .0004331 2307.50 2309.0
  0Czech. Rep. (Koruna) ....Commercial rate
  02687 .02575 37.223 37.384Denmark (Krone)
  1205 .1203 8,2973 8.3156
• Ecuador (US Dollar)-e... 1.0000 1.0000 1.0000 1.0
  000
• Finland (Markka) 1511 .1505 6.6203 6.6466France
  (Franc) 1369 .1364 7.3038 7.33281-month forward
  1367 .1362 73127 7.34253-months forard
  1364 .1359 7.3296 7.35836-months forward
  1351 .1355 7.3493 7.3777Germany (Mark)
  4592 .4574 2.1777 2.18641-month forward
  4586 ,4568 2.1804 2.18933-months forward
  4576 .4558 2.1854 2.19406-months fcnvard
  4564 .4546 2.1913 2.1997Greece (Drachma)
  002536 .002625 379.37 380.92Hang Kong (Dollar)
  1282 .1282 7.7999 7.7998 .8769 .8804Israel
  (Shekel) 2347 .2348 4.2610 4.2690Italy (Lim)
  0004638 .0004620 2155.96 2164.52Japan (Yen)
  008270 .008246 120.92 121.271-month forward
  008285 .008261 120.70 121.053-months forward
  008312 .008287 120.31 120.68

5
Foreign Exchange, Banks and Demand

• Where does most foreign exchange occur?
• (In banks located in London, New York and
  Tokyo.)
• Who trades most of the money on international
  exchanges?
• (Banks again.)

6
Foreign Exchange, Banks and Demand

• Whence comes the demand for foreign exchange?
• (From people, institutions and firms who want
  to make purchases abroad.)

7
Foreign Exchange, Banks and Demand

• What do the following flows produce a demand for?
• U.S. exports of goods and services
• (demand for dollars)
• U.S. capital outflows
• (demand for foreign currencies)
• U.S. capital inflows
• (a supply of foreign currency and a demand for
  dollars.)

8
Foreign Exchange The Rate

• What determines the exchange rate then?
• (Supply and demand for foreign exchange.)

9
Foreign Exchange The Rate

• What kind of market type do we have here?
• (Competitive, because of the immediate market
  response to price. No product differentiation in
  foreign exchange markets.)

10
Foreign Exchange The Rate

• What is a floating exchange rate system?
• (One where markets, rather than bank
  interventions, determine prices of foreign
  exchange.)

11
Traders and Arbitrage

• How do foreign exchange traders function?
• (They are wheelers and dealers by phone and
  computer, watching for price differentials.)
• What is arbitrage?
• (Making two markets, by buying and selling
  between them, a single market.)

12
Arbitrage

• An arbitrager, usually a large bank, may notice
  that in N.Y. 1 2.42 and in London, 1
  2.40.
• An agent will buy pounds in London (for 2.4
  billion) and sell them in N.Y. (for 2.42
  billion), earning a quick 20 million.
• The increased demand in London pulls the price
  up, and the increased supply in New York pushes
  the price down, equalizing the pound/dollar price.

13
Arbitrage
Buy in this market (low)
Sell in this market (high)
S1
S2
S
D2
D
D1
14
Interbank Foreign Exchange Trading

• About 90 of foreign exchange trading is in the
  Interbank part of the market.

15
Interbank Foreign Exchange Trading

• Provides continuous information on the foreign
  exchange market
• Talking with traders at other banks.
• Observing prices (exchange rates) being quoted.

16
Exchange Rate and Risk

• What is exchange rate risk exposure?
• (Earning a lot less than you expected, or
  paying a lot more than you expected when payment
  is made in the future at different exchange rates
  than originally prevailed.)
• What is hedging?
• (Reducing or eliminating a net asset or net
  liability position in foreign currency.)

17
Exchange Rate and Risk

• What is speculation?
• Taking a net asset or long position (holding
  net assets in a foreign currency in excess of
  ones anticipated transactions needs), or
• taking a net liability or short position in a
  currency (owing more in a currency than one owns
  or holds).

18
Exchange Rate and Risk

• If the forward rate of a currency, (the French
  franc) is lower than the spot rate (41, say,
  rather than 51), the market expects the value of
  the franc to rise against the dollar. There is a
  premium on forward (usually 90 days) francs and a
  discount on 90-day forward dollars.

19
Foreign Exchange and Forward Contracts

• What is a forward foreign exchange contract?
• (An agreement to exchange one currency for
  another on some date in the future at a price set
  now the forward exchange rate).

20
Foreign Exchange and Forward Contracts

• How can the bank afford to do that?
• (Question of balance and offsetting contracts.)

21
Exchange Contracts under Risk

• Currency Futures
• -- Traded on organized exchanges
• -- The contract locks in the price.
• -- The buyer must put up a margin, which grows
  if rates keep changing adversely for the seller.
• -- Profits and Losses Accrue Daily (marking to
  market)

22
Exchange Contracts under Risk

• Currency Options
• -- Buyer has right, seller has obligation to a
  future price set today, the exercise or
  strike price.
• -- The buyer pays a fee (premium) to exercise
  the option.
• -- Size of any loss is limited to premium

23
Exchange Contracts under Risk

• Currency Swap
• -- A contract to exchange flows during a time
  period.
• -- Foreign currency earnings traded for
  domestic currency.
• -- A set of spot and forward exchange rates in
  one contract.