Foreign Exchange

Chapter 11

Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Foreign Exchange Marketo definition – organizational setting within which

individuals, businesses, governments, and banks buy and sell foreign currencies

o no single, central meeting placeo largest foreign exchange markets: London,

New York and Tokyoo transactions between:• commercial banks and their commercial

customers• banks conducted by brokers• trading banks and their overseas branches

Types of Transactionso spot transaction - outright purchase & sale

of foreign currency with ‘immediate delivery’ meaning within two business days

o forward transaction – agreement for purchase & sale at a specified rate at some point in the future• more than two business days• months or even years in the future

o currency swap – conversion of one currency to another at one point in time with agreement to reconvert back at a specified future time

Interbank Tradingo most U.S. transactions conducted by a few

large bankso retail transactions – bank to customers; less

than $1MMo wholesale

transactions – bank to bank or bank to corporate customers; more than $1MM

Bank Profits on Transactionso banks quote two rates on transactions:

• bid rate – price bank is willing to pay for foreign currency

• offer rate – price at which bank is willing to sell foreign currency

o spread – difference between the bid and offer o other profits:

o anticipating appreciation => bank raises bid & offer to buy more of that currency => resells later at high price making a profit

o anticipating depreciation => bank lowers bid & offer to sell more of that currency => buys back later at lower price creating profits

Foreign Exchange Quotations

o 2nd and 3rd columns indicate number of dollars needed to buy foreign currency

[0.03046 U.S. dollars for one Taiwan dollar]

o 4th and 5th columns indicate units of foreign currency needed to buy dollar

[32.83 Taiwan dollars for one U.S. dollar]

Cross Exchange Rateo most quotations expressed in terms of U.S. dollaro cross exchange rate determines value of two

currencies in terms of a thirdo example:

= = 27.9681

Therefore, each Taiwan dollar buys approximately 28 South Korean won.

$ value of Taiwan dollar $ value of S. Korean won

$.03046$.0010891

Forward Versus Futures MarketsDifference Associated with Futures Market:o only at specific locations such as International

Monetary Market of Chicago Mercantile Exchange and Tokyo International Financial Futures Exchange

o only major currencieso contracts limited to specific dates (3rd Wed.

March, June, September & December)o fixed amountso profit/loss paid at close of trading as opposed

to the contract date

Foreign Currency Optionso definition – agreements between holder

(buyer) and writer (seller) giving the holder the right to buy or sell a fixed amount of foreign currency at a specified price within a specified time period

o call option – provides right to buyo put option – provides right to sello strike price – price at which the option can be

exercisedo holder not obligated to use contract; writer

obligated if holder proceeds with transaction

Exchange-Rate Determinationo demand for foreign currency corresponds to

balance of payments debits [U.S. imports; U.S. foreign investment; foreign transfer payments]

o supply of foreign currency equal to balance of payment credits [U.S. exports; foreign investment in U.S.; transfer payments to U.S.]

Appreciation of U.S. DollarAdvantages:1) U.S. consumers see lower prices on foreign

goods2) lower prices on foreign goods limit U.S. inflation3) U.S. consumers benefit during foreign travel

Disadvantages:1) U.S. firms find it harder to compete in foreign

markets2) U.S. firms find it harder to compete with imports3) foreign tourists find it more expensive to vacation

in the U.S.

Depreciation of U.S. DollarAdvantages:1) U.S. firms find it easier to sell goods in foreign

markets2) firms in the U.S. face less pressure to keep

prices low3) more foreign tourists can afford to visit U.S.

Disadvantages:1) U.S. consumers face higher prices on foreign

goods2) higher foreign prices can lead to inflation in U.S.3) U.S. consumers find foreign travel more costly

Nominal Exchange Rateo exchange rate index – weighted average of

exchange rates between the domestic currency and nation’s most important trading partners

o major currency index – average exchange rate for dollar versus seven major U.S. trading partners

o nominal index such as this is not adjusted for changes in U.S. or foreign price levels

Real Exchange Rateo accounting for changes in the price levels:

Real Exchange Rate = Nominal Exch. Rate ×

o better indication of purchasing power of dollar

o increase in real exchange rate will make it more difficult for U.S. firms to compete

Foreign Country’s Price Level Home Country’s Price Level

Arbitrageo exchange arbitrage – simultaneous purchase

and sale of currency in different foreign exchange markets in order to profit from exchange rate differential in two locations

o two or three point arbitrage possible

assume: £1 = $1.50; £1 = 4 francs; 1 franc = $0.50

sell $1.5 million for £1 millionsell £1 million for 4 million francssell 4 million francs for $2 million

o such transactions shift supply & demand for currencies eliminating opportunities for profits and establishing consistent exchange rates

$500,000 profit

Forward Market

o currency worth more in forward market than spot market => premium

o currency worth less in forward market than spot market => discount

Forward Months No. Rate Spot12

Rate SpotRate SpotRate Forward

premium

Relationship Between Forward Rate & Spot Rate

interest rate differentials - comparable securities

higher U.S. interest rateso investors sell foreign currency for dollars

driving down spot priceo use dollars to purchase U.S. Treasury billso investors obtain forward contract allowing

foreign currency to be bought back with dollars driving up forward price

o result: foreign currency at premium in forward market

Relationship Between Forward Rate & Spot Rate (cont.)

lower U.S. interest rateso investors buy foreign currency with dollars

driving up spot priceo use foreign currency to purchase foreign

Treasury securitieso investors obtain forward contract allowing

dollars to be bought back with foreign currency driving down forward price

o result: foreign currency at discount in forward market

Managing Foreign Exchange Risko hedging – process of avoiding or covering a

foreign exchange risk

o U.S. importer hedging against depreciation• must pay in foreign currency in the future• contract to purchase foreign currency in the

forward market• does not require importer to tie up funds

o exporter hedging against appreciation• will receive foreign currency in the future• contract to sell foreign currency in the

forward marketo both eliminate risks of fluctuating spot rates

Uncovered Interest Arbitrageo moving funds into

foreign currency to take advantage of higher rate of return without forward contract

o extra return:

UK U.S. Percentage= Interest - Interest ± Appreciation/Depreciation Rate Rate of Pound

Covered Interest Arbitrage1) purchase foreign currency at spot rate and use it

to finance foreign investment2) contract in the forward market to sell amount of

foreign currency that will be received

because of activity in the forward market such investment opportunities quickly disappear

Foreign Exchange Market Speculationo speculation – attempt to profit by trading on

expectations about prices in the futureo different from arbitrage where trader buys &

sells simultaneously; speculator buys at one time and sells at a different time

o stabilizing speculation – goes against market forces by moderating changes in exchange rates

o destabilizing speculation – goes with market forces by reinforcing fluctuations in exchange rates