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Foreign Exchange Market


The price at which currency can be bought or sold is the strike price or exercise price. ... U.S. importer is buying equipment from a German manufacturer with ... – PowerPoint PPT presentation

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Title: Foreign Exchange Market

Foreign Exchange Market
  • Chapter 13

Foreign Exchange Market
  • Foreign exchange trading refers to trading of one
    countrys money for that of another country.
  • The need for such trade arises because of
  • Tourism
  • The buying and selling of goods internationally
  • Investment across international boundaries.

Foreign Exchange Market
  • Foreign exchange market refers to large
    commercial banks in financial centers such as New
    York, London and Tokyo, trading foreign-currency
    denominated deposits with each other.
  • Spot market where currencies are traded for
    current delivery

  • Since currencies are homogenous goods, it is very
    easy to compare prices in different markets.
    Exchange rate tend to be equal worldwide.
  • If this were not so, there would be profit
    opportunities for simultaneously buying a
    currency in one market while selling in another.
    This activity is knows as arbitrage.

  • Arbitrage can involve more than two currencies.
  • Example In New York, dollar/pound 2
  • In London, dollar/Swiss franc 0.4
  • Then pound/Swiss franc 0.4/20.2
  • If we observe a market where any of these three
    exchange rate is out of line, there is an
    arbitrage opportunity.

  • In Zurich
  • Pound/franc0.2
  • In New York
  • Dollar/franc0.4
  • In London
  • Dollar/pound1.9
  • What you can do to make profit under this

Foreign Exchange Cross Rates
Forward Rates
  • A watch importer from U.S. wants to purchase
    watches from Switzerland.
  • He can buy watch now, then he can settle the
    account by purchasing Swiss franc in the spot
  • He can to place an order for Swiss watches for
    delivery in a future date.
  • Much of the international trade is contracted in
    advance for a future delivery and payment.

Forward Rates
  • For payment in the future, the importer is faced
    with exchange rate risk.
  • If the dollar depreciate against franc, then it
    would take more dollars to buy any given amount
    of francs.
  • If the dollar appreciate against franc, then it
    would take less dollars to buy a given amount of

Forward Rates
  • How can the importer avoid the risk of exchange
    rate fluctuations?
  • The importer may want to choose the strategy of
    waiting for three months to buy Swiss watch.
  • Another alternative is to buy franc now and hold
    or invest them for three months.
  • Use of forward exchange rate market to ensure a
    certain dollar price of franc.

Forward Rates
  • If a forward exchange price of a currency exceed
    the current spot price, that currency is said to
    be selling at a forward premium.
  • A currency is selling at a forward discount when
    the forward rate is less than the current spot
  • On January 31, 2003 U.S. dollar per Swiss franc
    0.73321 SF
  • Three months forward rate for Swiss franc

  • A foreign exchange swap is a trade that combines
    both a spot and a forward transaction into one
  • Example Suppose Citibank wants pounds now. It
    could enter into a swap agreement with another
    bank. Under the swap agreement, it will trade
    dollar to the other bank and in return will
    receive pounds. After the specified time period,
    the trade is reversed. Citibank will pay out
    pounds to the other bank and receive dollars.

The Futures Market
  • The futures market is a market where foreign
    currencies may be bought or sold for delivery at
    a future date.
  • The futures market differs from forward market in
    that only a few currencies are traded, trading
    occurs in standardized contracts and trading
    occurs in a specified location, International
    Monetary Market of the Chicago Mercantile

Future vs forward contracts
  • Forward
  • Most currencies are traded.
  • Are written for any amount of currency
  • Contracts are typically 30, 90 and 180 days long
    and maturing everyday of the year.
  • Futures
  • Only a few currencies are traded (, , , A,
    Can, SF, Ps)
  • Are written for a fixed amount of currency.
  • All contracts have specific maturity date.

The Foreign Currency Options
  • Besides forward and futures contracts, there is
    an additional market where future foreign
    currency can be hedged the option market.
  • A foreign currency option is a contract that
    provides the right to buy or sell a given amount
    of currency at a fixed exchange rate on or before
    maturity date.

The Foreign Currency Options
  • A call option gives the right to buy currency and
    a put option gives the right to sell.
  • The price at which currency can be bought or sold
    is the strike price or exercise price.

The Foreign Currency Options
  • How to hedge in the currency market using option
  • Suppose U.S. importer is buying equipment from a
    German manufacturer with a 1,000,000 payment in
    three months. The importer can hedge against a
    appreciation by buying a call option that confers
    the right to purchase over the next three
    months at the strike price.

Central-Bank Intervention
  • So far, we have not explicitly introduced
    government into the foreign-exchange market
  • In reality, central banks and national treasuries
    play a large role in the market.
  • In the U.S., Federal Reserve buy and sell
    currencies to drive the value of their currency
    to levels other than what the free market would

Dollar-pound foreign exchange market
Central-Bank Intervention
  • As shown in the diagram in the face of
    appreciating currency, central bank often sells
    its own currency in the foreign exchange market.
  • Similarly, in the face of depreciating currency,
    central banks often sell foreign currencies in
    exchange for domestic currency to halt
  • For example, in the previous example of
    appreciating pound, instead of the Bank of
    England selling pounds to stop the pound
    appreciation, the Federal Reserve could have
    sold pounds.

Black Markets and Parallel Markets
  • So far, we have discussed the foreign exchange
    market as a market where currencies are bought
    and sold openly by individuals, business firms
    and government.
  • The above description is true for major developed
  • However, developing countries generally do not
    permit free markets in foreign exchange and
    impose many restrictions on foreign-currency

Black Markets and Parallel Markets
  • Because of restrictions in foreign-exchange
    transactions, illegal markets in foreign exchange
    develop to satisfy trader demand. These illegal
    markets are known as black markets.
  • Governments defend the need for foreign exchange
    restrictions based on conserving scare foreign
    exchange for high-priority use.

Black Markets and Parallel Markets
  • Guatemala had an artificially low official
    exchange rate of one quetzale per dollar for more
    than three decades. However, a black market was
    allowed to flourish openly in the face of
  • In Guatemala, government allowed such activity
    openly. This sort of government-tolerated
    alternative to the official exchange market is
    often referred to as a parallel market.