Foreign exchange

International EconomicsBy Robert J. Carbaugh

8th Edition

Chapter 12:

Foreign Exchange

Foreign exchange

Foreign exchange market

• Largest and most liquid market in the world• No central market - key markets in several

cities around the world• Participating banks and brokers are in constant

contact via phone and computer• Three general types of transaction

– Between banks and their customers– Domestic interbank market conducted through brokers– Trading with overseas banks

Foreign exchange

Types of FX transactions

• 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

Foreign exchange transactions by US banks, 1998

Interbank market

By type

Spot 47%Swap 42Forward 11

By foreign currency

German mark 25%Japanese yen 22British pound 8Swiss franc 7French franc 4Canadian dollar 4Australian dollar 2Other 28

Foreign exchange

Foreign exchange quotations

• Exchange rate is the price of one currency in terms of another

• One country’s 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)

Foreign exchange

Foreign exchange quotations

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

Foreign exchange markets

Forward markets, futures & options

• 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



• 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



• 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

Exchange rate determinationForeign exchange markets

Foreign exchange

Impact of an appreciating US dollar

• Pros– Lower prices on

foreign goods– Keeps inflation down

– Foreign travel is cheaper

– Less expensive to invest abroad

• Cons– Exporters’ products

become more expensive abroad

– Imports-competing firms face price competition

– Travel more expensive for foreign tourists

– Slows inflow of foreign investment

Foreign exchange

Impact of a depreciating US dollar

• Pros– Exporters can sell

abroad more easily– Less competition for

US firms from imports

– Foreign tourism is encouraged

– US capital markets more attractive

• Cons– Higher prices on

imports– Upward pressure on

inflation

– Travel abroad more expensive

– Harder for US firms to expand into foreign markets


Arbitrage and hedging

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

• Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return– Subject to exchange rate risk


Arbitrage and hedging

• 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


Speculation

• 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


Speculation

• 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

Foreign exchange

Economy & Finance

Transcript of Foreign exchange