Foreign Exchange © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted

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Foreign Exchange

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


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Foreign-Exchange Market• Foreign-exchange market • Organizational setting • Within which individuals, businesses, governments,

and banks • Buy and sell foreign currencies and other debt

instruments• Largest and most liquid market in the world• Dominated by four currencies• U.S. dollar, euro, Japanese yen, British pound


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Foreign-Exchange Market• Foreign-exchange market • Transactions between commercial banks and

their commercial customers• Domestic interbank market conducted through

brokers• Active trading in foreign exchange with banks

overseas


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Types of Foreign-Exchange Transactions• Spot transaction • Make an outright purchase or sale of a currency

now, as in “on the spot”• Simplest way to meet your foreign currency

requirements• Greatest risk of exchange rate fluctuations


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Types of Foreign-Exchange Transactions• Forward transaction• Receiving or paying an amount of foreign

currency on a specific date in the future • At a fixed exchange rate

• Protects against unfavorable movements in the exchange rate• Will not allow gains to be made should the

exchange rate move in your favor


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Types of Foreign-Exchange Transactions• Currency swap• Conversion of one currency to another

currency at one point in time• With an agreement to reconvert it back to the

original currency at a specified time in the future• The rates of both exchanges are agreed to in

advance


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Distribution of foreign-exchange transactions by U.S. banks

TABLE 11.1


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Interbank Trading• Retail transactions • Bank purchases from and sales to their

customers • Less than 1 million currency units

• Wholesale transactions• More than 1 million currency units• Between banks or with large corporate

customers


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Top ten banks by share of foreign-exchange market, 2009

TABLE 11.2


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Interbank Trading• Earning profits in foreign-exchange

transactions• Bid rate - price that the bank is willing to pay

for a unit of foreign currency• Offer rate - price at which the bank is willing to

sell a unit of foreign currency• Spread - difference between the bid and the

offer rate• A bank’s bid quote < its offer quote


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Reading Foreign-Exchange Quotations• Exchange rate• Price of one currency in terms of another• Number of units of foreign currency required to

purchase one unit of domestic currency• Exchange rate reported• The midrange between the bid and offer prices

• Currency depreciation• It takes more units of a nation’s currency to

purchase a unit of some foreign currency


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Foreign exchange quotations (a)TABLE 11.3


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Foreign exchange quotations (b)TABLE 11.3


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Reading Foreign-Exchange Quotations• Currency appreciation • It takes fewer units of a nation’s currency to

purchase a unit of some foreign currency• Cross exchange rate • Exchange rate between any two currencies

(such as the franc and the pound)• Derived from the rates of these two currencies

in terms of a third currency (the dollar)


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Forward and Futures Markets• Spot market • Foreign exchange bought and sold for delivery

immediately• Forward market • Foreign exchange bought and sold for future

delivery


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Forward and Futures Markets• Futures market• Contracting parties agree to future exchanges

of currencies• And set applicable exchange rates in advance• Only a limited number of leading currencies are

traded• Trading takes place in standardized contract

amounts and in a specific geographic location


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Forward contract versus futures contractTABLE 11.4Forward Contract Futures Contract

Issuer

Trading

Contract size

Date of delivery

Contract costs

Settlement

Commercial bank

“Over the counter” by telephone

Tailored to the needs of the exporter/importer/investor; no set size

Negotiable

Based on the bid

On expiration date only, at prearranged price /offer spread

International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange

On the IMM’s market floor

Standardized in round lots

Only on particular dates

Brokerage fees for sell and buy orders

Profits or losses paid daily at close of trading


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Forward and Futures Markets• International Monetary Market (IMM)• Chicago Mercantile Exchange, 1972• An extension of the commodity futures markets

• Size of each contract • On the same line as the currency’s name and

country• First column• Maturity months


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Forward and Futures Markets• Open • Price at which the yen was first sold when the

IMM opened in the morning• High• Contract’s highest price for the day

• Low• Contract’s lowest price for the day

• Settle• Contract’s closing price for the day


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Forward and Futures Markets• Change • Compares today’s closing price with the closing

price as listed in the previous day’s paper• (+) means prices ended higher• (-) means prices ended lower

• Open interest • Total number of contracts outstanding


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Foreign currency futures, May 13, 2009: selected examples

TABLE 11.5


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Foreign-Currency Options• Option• Agreement between a holder (buyer) and a

writer (seller) • Holder has the right, but not the obligation, to

buy or sell financial instruments at any time through a specified date


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Foreign-Currency Options• Foreign-currency options • Options holder• Right to buy or sell a fixed amount of foreign

currency • At a prearranged price, within a specified date• Can choose the exchange rate to guarantee• Can choose length of the contract

• Call option • Gives the holder the right to buy foreign

currency at a specified price


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Foreign-Currency Options• Put option• Gives the holder the right to sell foreign

currency at a specified price• Strike price• Price at which the option can be exercised

• Premium• Fee the writer of the options contract receives


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Exchange-Rate Determination• Exchange rate in a free market • Determined by both supply and demand

conditions• Demand for foreign exchange• Derived demand• Driven by foreigner demand for domestic goods

and assets • Corresponds to the debit items on a country’s

balance of payments


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GLOBALIZATION WEAK DOLLAR IS A BONANZA FOR EUROPEAN TOURISTS

• When dollar’s exchange value depreciates• Foreign tourists realize a good bargain on goods

purchased in America• Delighted American tourist industry • Tourists could afford to stay longer• Stay at nicer and more expensive hotels• Take more tours• Eat at more restaurants• Shop with bargain-basement enthusiasm.

• Air fares to and from the United States declined


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Exchange-Rate Determination• Supply of foreign exchange• Amount of foreign exchange that will be

offered to the market • At various exchange rates, all other factors held

constant• Equilibrium exchange rate • Determined by the market forces of supply and

demand


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The equilibrium exchange rate is established at the point of intersection of the supply and demand schedules of foreign exchange. The demand for foreign exchange corresponds to the debit items on a nation’s balance-of-payments statement; the supply of foreign exchange corresponds to the credit items.

Exchange-rate determinationFIGURE 11.1


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Exchange-Rate Determination• Increase in the demand for pounds• Shift rightward• The dollar will depreciate against the pound

• Decrease in demand for pounds• Shift leftward• The dollar will appreciate


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Exchange-Rate Determination• Increase in the supply of pounds• Rightward shift• The dollar appreciate against the pound

• Decrease in the supply of pounds• Leftward shift• Dollar depreciation


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Advantages and disadvantages of a strengthening and weakening dollar

TABLE 11.6


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Nominal and Real Exchange Rates• Exchange-rate index• Effective exchange rate; trade-weighted dollar • Weighted average of the exchange rates

between the domestic currency • And the nation’s most important trading partners• With weights given by relative importance of the

nation’s trade with each of these trade partners


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Nominal and Real Exchange Rates• Nominal exchange-rate index of the U.S. dollar• Average value of the dollar• Not adjusted for changes in prices levels• In the U.S. and its trading partners

• if increasing • Dollar appreciation relative to the currencies of the

other nations in the index• Loss of competitiveness for the U.S.


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Nominal and Real Exchange Rates• Nominal exchange-rate index of the U.S. dollar• If decreasing• Dollar depreciation relative to the other currencies

in the index • Improvement in U.S. international competitiveness

• Based on nominal exchange rates that do not reflect changes in price levels in trading partners


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Nominal and Real Exchange Rates• Real exchange-rate index of the U.S. dollar• Embodies the changes in prices in the countries

in the calculation• Nominal exchange rate adjusted for relative

price levels• Average value of the dollar based on real

exchange rates• An appreciation of the dollar - higher index


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Exchange rate indexes of the U.S. dollar(March 1973 = 100)*

TABLE 11.7


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Arbitrage• Exchange arbitrage• Simultaneous purchase and sale of a currency• In different foreign-exchange markets • To profit from exchange-rate differentials in the two

locations• Brings about an identical price for the same

currency in different locations • Results in one market


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Arbitrage• Two-point arbitrage• Two currencies are traded between two

financial centers• Three-point arbitrage• Triangular arbitrage• Three currencies and three financial centers• Switching funds among three currencies in

order to profit from exchange-rate inconsistencies


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The Forward Market• Forward market• Currencies are bought and sold now for future

delivery• The exchange rate is agreed on at the time of

the contract• Payment is made when the future delivery

actually takes place• Forward rate • Rate of exchange used in the settlement of

forward transactions


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Forward exchange rates: selected examplesTABLE 11.8


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The Forward Market• At a premium• When a foreign currency is worth more in the

forward market than in the spot market• At a discount• When a foreign currency is worth less in the

forward market than in the spot market


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The Forward Market• Relation between the forward rate and spot

rate


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The Forward Market• Managing your foreign exchange risk• Forward foreign-exchange contract• And engage in hedging

• Hedging• Process of avoiding or covering a foreign-

exchange risk• Some firms do not hedge• Currency fluctuations even out over the long

term


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TRADE CONFLICTS

Exchange-rate risk: the hazard of investing abroad

• Exchange-rate fluctuations • Can substantially change the returns on assets

denominated in a foreign currency• Interest rates • Key role in determining the relative

attractiveness of assets denominated in domestic and foreign currencies

• Effects of exchange-rate changes • Can swamp the effects of interest-rate

differentials


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Return on a three-month German investmentTABLE 11.9


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Interest Arbitrage• Interest arbitrage refers • Moving funds into foreign currencies• To take advantage of higher investment yields

abroad• Uncovered interest arbitrage • When an investor does not obtain exchange-

market cover • To protect investment proceeds from foreign-

currency fluctuations


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Interest Arbitrage• A U.S. investor’s extra rate of return • On an investment in the United Kingdom as

compared to the U.S.• = interest-rate differential adjusted for any change

in the value of the pound


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uncovered interest arbitrage: an exampleTABLE 11.10


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Interest Arbitrage• Covered interest arbitrage • Investor exchanges domestic currency for

foreign currency - at the current spot rate• And uses the foreign currency to finance a foreign

investment• Investor contracts in the forward market • To sell the amount of the foreign currency that will

be received as the proceeds from the investment• With a delivery date to coincide with the maturity

of the investment


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Interest Arbitrage• Forward discount or premium • On one currency against another • Reflects the difference in the short-term

interest rates between the two nations• Forward discount• The currency of the higher-interest-rate nation

• Forward premium• The currency of the lower-interest-rate nation


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Covered interest arbitrage: an exampleTABLE 11.11


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Foreign-Exchange Market Speculation• Speculation• Attempt to profit by trading on expectations

about prices in the future• Deliberate assumption of exchange risk

• Stabilizing speculation • Goes against market forces by moderating or

reversing a rise or fall in a currency’s exchange rate• Useful function for bankers and businesspeople,

who desire stable exchange rates


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Foreign-Exchange Market Speculation• Destabilizing speculation • Goes with market forces by reinforcing

fluctuations in a currency’s exchange rate• Can disrupt international transactions• High cost of hedging – impeding international trade• Disrupt international investment activity


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TRADE CONFLICTS How to play the falling (rising) dollar

• Depreciating dollar• Purchase foreign currency• Purchase bonds denominated in a foreign

currency• Purchase stocks of foreign corporations,

denominated in foreign currencies• Savings account denominated in a foreign

currency• Variety of currency derivatives


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Foreign Exchange Trading as a Career• Foreign exchange traders • Commercial Banks• Companies• Central Banks• Professional traders • Amateurs speculating in foreign currencies

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Foreign Exchange © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted