Lecture 3 Foreign Exchange Markets and Exchange Rates

Chapter 14 Foreign Exchange Markets and Exchange Rates 14.1 introduction 14.2 Functions of the Foreign Exchange Markets 14.3 Foreign Exchange Rates 14.4 Spot and Forward Rates, Currency Swaps, Futures, and Options 14.5 Foreign Exchange Risks, Hedging, and Speculation 14.6 Interest Arbitrage and the Efficiency of Foreign Exchange Markets 14.7 Eurocurrency or Offshore Financial Markets

14.1 introduction Foreign Exchange Market: –is the market in which individuals, firms, and banks buy and sell foreign currencies or foreign exchange.

14.2 Functions of the Foreign Exchange Markets  The transfer of funds or purchasing power from one nation and currency to another. Demand for foreign currencies -Import/expenditures abroad/investment abroad Supply of foreign currencies -Export/earnings from tourism/receipt of foreign investments  the credit function  the facilities for hedging and speculation

Four levels of transactors or participants 1.Immediate users and suppliers of foreign currencies-importers/exporters/ tourists/investors 2.Clearinghouses-commercial bank 3.Foreign exchange brokers-interbank / wholesale market 4.The nation’s central bank-lender of last resort

14.3 Foreign Exchange Rates FIGURE 14-1 The Exchange Rate Under a Flexible Exchange Rate System.

FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange Rate System.

Middle Exchange Rate of RMB DateDollarEuroYenPound Source:

14.4 Spot and Forward Rates, Currency Swaps, Futures, and Options 14.4a Spot and Forward Rates 14.4b Currency Swaps 14.4c Foreign Exchange Futures and Options

14.4a Spot and forward rates Spot transaction-Spot rate –The most common type of foreign exchange transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. –The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad.

Forward transaction-Forward rate A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today. One month; Three months; six months Forward contracts can be renegotiated for one or more periods when they become due.

FD (forward discount) If the forward rate is below the present spot rate, the foreign currency is said to be at a forward discount with respect to the domestic currency. FP (forward premium) If the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium with respect to the domestic currency.

14.4b Currency swaps Refer to a spot sale of a currency combined with a forward repurchase of the same currency-as part of a single transaction. Swap rate: is the difference between the spot and forward rates in the currency swap. (a yearly basis)

14.4c Foreign exchange futures and options A foreign exchange futures: – is a forward contract for standardized currency amounts and selected calendar dates traded on an organized market (exchange).

A foreign exchange option Is a contract giving the purchaser the right, but not the obligation, to buy (a call option) or to sell (a put option) a standard amount of a traded currency on a stated date (the European option) or at any time before a stated date (the American option) and at a stated price (the strike or exercise price) The buyer pays the seller a premium (the option price) ranging from 1 to 5 percent of the contract’s value for this privilege when he or she enters the contract.

14.5 Foreign Exchange Risks, Hedging, and Speculation 14.5a Foreign Exchange Risks 14.5b Hedging 14.5c Speculation

14.5a Foreign exchange risk Foreign exchange shift 1.Changes in tastes for domestic and foreign products in the nation and abroad 2.Different growth and inflation rates in different nations 3.Changes in relative rates of interest 4.Changing expectations

14.5b Hedging Refers to the avoidance of a foreign exchange risk, or the covering of an open position. –At spot market –At forward market –At futures and options markets

14.5c Speculation The opposite of hedging. A speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit. Speculation can take place in the spot, forward, futures, or options markets

Long position: when a speculator buys a foreign currency on the spot, forward, or futures market, or buys an option to purchase a foreign currency in the expectation of reselling it at a higher future spot rate. Short position: when a speculator borrows or sells forward a foreign currency in the expectation of buying it at a future lower price to repay the foreign exchange loan or honor the forward sale contract or option.