INTERNATIONAL ECONOMICS, 15E Robert Carbaugh © 2015 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.

Foreign Exchange Chapter 11 © 2015 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.

Chapter Outline (1 of 2) Foreign Exchange Market Foreign Exchange Market Types of Foreign Exchange Transactions Types of Foreign Exchange Transactions Interbank Trading Interbank Trading Reading Foreign Exchange Quotations Reading Foreign Exchange Quotations Forward and Futures Markets Forward and Futures Markets Foreign Currency Options Foreign Currency Options Exchange Rate Determination Exchange Rate Determination Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates © 2015 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.

Chapter Outline (2 of 2) Arbitrage Arbitrage The Forward Market The Forward Market Interest Arbitrage, Currency Risk, and Hedging Interest Arbitrage, Currency Risk, and Hedging Foreign Exchange Market Speculation Foreign Exchange Market Speculation Foreign Exchange Trading as a Career Foreign Exchange Trading as a Career © 2015 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.

Foreign Exchange Market (1 of 2) Foreign exchange market ◦ Organizational setting in 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 © 2015 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.

Foreign Exchange Market (2 of 2) Foreign exchange market (cont.) ◦ Three of the largest markets are located in ◦ London, New York and Tokyo ◦ Foreign Exchange Market functions at 3 levels:  Transactions between commercial banks and their commercial customers  Domestic interbank market conducted through brokers  Active trading in foreign exchange with banks overseas © 2015 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.

Types of Foreign Exchange Transactions (1 of 3) Banks typically engage in 3 types of foreign exchange transactions: spot, forward, swap ◦ A spot transaction  outright purchase or sale of currency now, as in “on the spot”  Simplest way to meet currency requirements  Greatest risk of exchange rate fluctuations  Payments actually made two days later ◦ Spot market  Foreign exchange bought and sold for delivery immediately © 2015 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.

Types of Foreign Exchange Transactions (2 of 3) Banks typically engage in 3 types of foreign exchange transactions: spot, forward, swap (cont.) ◦ Forward transactions  Receiving or paying an amount of foreign currency on a specific date in the future, months to years from now  Fixed exchange rate  Protects against unfavorable movements in the exchange rate, but will not allow gains to be made should the exchange rate move in your favor ◦ Forward market  Foreign exchange bought/sold for delivery at a future date – exist mainly for widely traded currencies © 2015 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.

Types of Foreign Exchange Transactions (3 of 3) Banks typically engage in 3 types of foreign exchange transactions: spot, forward, swap (cont.) ◦ Currency swaps  Conversion of one currency to another currency at one point in time  An agreement to reconvert it back to the original currency at a specified time in the future  Rates of both exchanges are agreed to in advance  Involves a single transaction in which traders agree to pay/receive stipulated amounts of currencies at specified rates © 2015 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.

Table Global Distribution of Foreign Exchange Transactions, 2013 © 2015 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.

Interbank Trading (1 of 2) 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 © 2015 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.

Interbank Trading (2 of 2) Earning profits in foreign-exchange transactions (24 hour basis) ◦ Bid rate - price that a bank is willing to pay for a unit of foreign currency ◦ Offer rate - price at which a 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 to make a profit © 2015 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.

Table Top Ten Banks by Share of Foreign Exchange Market, 2013 © 2015 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.

Reading Foreign Exchange Quotations (1 of 2) 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 © 2015 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.

Table Foreign Exchange Quotations, 2013 © 2015 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.

Reading Foreign Exchange Quotations (2 of 2) Currency appreciation ◦ It takes fewer units of a nation’s currency to purchase a unit of some foreign currency Currency depreciation ◦ It takes more 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) © 2015 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.

Forward and Futures Markets (1 of 4) Foreign Exchange can be bought & sold now (spot market) or in future (forward market), but also Futures market ◦ Parties agree to future exchanges of currencies, and set applicable exchange rates in advance ◦ Only some leading currencies are traded ◦ Trading takes place in standardized contract amounts and in a specific geographic location © 2015 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.

Forward and Futures Markets (2 of 4) International Monetary Market (IMM) ◦ Chicago Mercantile Exchange, 1972 ◦ An extension of the commodity futures market Size of each contract ◦ On the same line as the currency’s name and country First column ◦ Maturity months © 2015 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.

Table Forward Contract vs. Future Contract © 2015 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.

Table Foreign Currency Futures, October 30, 2013 © 2015 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.

Forward and Futures Markets (3 of 4) Open ◦ Price at which a currency is first sold when the IMM opens 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 © 2015 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.

Forward and Futures Markets (4 of 4) 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 © 2015 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.

Foreign Currency Options (1 of 3) 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 ◦ Writer (seller) has the obligation to fulfill a transaction ◦ Used by firms (speculators) seeking to hedge ◦ against rate risk (to make a profit) © 2015 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.

Foreign Currency Options (2 of 3) 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 © 2015 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.

Foreign Currency Options (3 of 3) 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 © 2015 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.

Exchange Rate Determination (1 of 4) Demand for Foreign Exchange ◦ Exchange rates in a free market  Determined by supply and demand conditions ◦ Demand for foreign exchange  Is a derived demand  Driven by foreigners demand for domestic goods and assets  Corresponds to the debit items on a country’s balance of payments  Varies inversely with price © 2015 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.

Exchange Rate Determination (2 of 4) Supply of Foreign Exchange ◦ Amount of foreign exchange that is offered in the market ◦ Increases at various exchange rates, all other factors held constant Equilibrium Rate of Exchange ◦ Determined by the market forces of supply and demand © 2015 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.

Figure Exchange Rate Determination © 2015 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.

Exchange Rate Determination (3 of 4) Increase in the demand for pounds ◦ Shift rightwards ◦ The dollar will depreciate against the pound Decrease in demand for pounds ◦ Shift leftwards ◦ The dollar will appreciate © 2015 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.

Exchange Rate Determination (4 of 4) Increase in the supply of pounds ◦ Rightward shift ◦ The dollar will appreciate against the pound Decrease in the supply of pounds ◦ Leftward shift ◦ Dollar depreciation © 2015 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.

Table Advantages & Disadvantages of a Strengthening & Weakening Dollar © 2015 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.

Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (1 of 3) Exchange-rate index ◦ Effective exchange rate or trade-weighted dollar ◦ Weighted average of the exchange rates between the domestic currency and the  Nation’s most important trading partners  Weights are determined by the relative importance of a nation’s trade with each of it’s trading partners ◦ Nominal exchange rates do not reflect changes in price levels in trading partners © 2015 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.

Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (2 of 3) Nominal exchange-rate index ◦ Average value of the dollar  Not adjusted for changes in price levels in the U.S. and its trading partners ◦ An increase means the dollar appreciates relative to other currencies in the index  Loss of U.S. competitiveness ◦ A decrease means the dollar depreciates relative to the other currencies in the index  Improves U.S. competitiveness © 2015 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.

Table Exchange Rate Indexes of the U.S. Dollar (March 1973=100) © 2015 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.

Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (3 of 3) Real exchange-rate index ◦ Embodies the changes in prices in the countries in the calculations; real exchange rate ◦ 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 © 2015 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.

Arbitrage (1 of 2) Exchange arbitrage ◦ Simultaneous purchase and sale of a currency  In different foreign-exchange markets  Goal is to profit from exchange-rate differentials in the two locations ◦ Leads eventually to an identical price for the same currency in different locations ◦ Results in one market © 2015 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.

Arbitrage (2 of 2) 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 © 2015 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.

The Forward Market (1 of 7) Forward market ◦ Currencies bought and sold now for future delivery – typically one month, 3 or 6 months ◦ Exchange rate agreed at the time of the contract ◦ Payment is made when the future delivery actually takes place ◦ Banks provide this service to earn profits © 2015 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.

The Forward Market (2 of 7) The Forward Rate ◦ Rate of exchange used in the settlement of forward transactions 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 © 2015 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.

The Forward Market (3 of 7) The Forward Rate © 2015 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.

Table Forward Exchange Rates: Selected Examples © 2015 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.

The Forward Market (4 of 7) Relation Between the Forward Rate and Spot Rate © 2015 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.

The Forward Market (5 of 7) Managing Your Foreign Exchange Risk: Forward Foreign Exchange Contract (cont.) ◦ 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 © 2015 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.

The Forward Market (6 of 7) Managing Your Foreign Exchange Risk: Forward Foreign Exchange Contract ◦ Forward foreign-exchange contract ◦ Engage in hedging ◦ Hedging  Process of avoiding or covering a foreign-exchange risks ◦ Some firms do not hedge  Rationalize that currency fluctuations even out over the long term – no need to hedge © 2015 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.

The Forward Market (7 of 7) Does Foreign Currency Hedging Pay Off? ◦ Many businesses that conduct business abroad try to eliminate half their currency risk ◦ Companies with narrow profit margins may hedge 4/5ths of their known foreign exchange requirements ◦ But when currencies fluctuating dramatically, it may be too expensive ◦ 3M does not hedge, believing the ups and downs of the market even out over time © 2015 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.

Interest Arbitrage, Currency Risk, and Hedging (1 of 2) Interest arbitrage ◦ the process of 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 © 2015 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.

Table Uncovered Interest Arbitrage: An Example © 2015 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.

Interest Arbitrage, Currency Risk, and Hedging (2 of 2) Covered interest arbitrage (Reducing Currency Risk) ◦ Investor exchanges domestic currency for foreign currency - at the current spot rate  Uses foreign currency to finance a foreign investment ◦ Investor contracts in the forward market  Sell an amount of the foreign currency that will be received as proceeds from an investment  Delivery date to coincide with the maturity of the investment © 2015 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.

Table Covered Interest Arbitrage: An Example © 2015 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.

Foreign Exchange Market Speculation (1 of 2) Speculation ◦ Attempt to profit by trading on expectations about prices in the future ◦ Deliberate assumptions of exchange rate risks Stabilizing speculation ◦ Works against market forces by moderating or reversing a rise/fall in a currency’s exchange rate ◦ Useful function for bankers and businesses, that seek stable exchange rates © 2015 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.

Foreign Exchange Market Speculation (2 of 2) Destabilizing speculation ◦ Works along with market forces by amplifying and reinforcing fluctuations in a currency’s exchange rate ◦ Can disrupt international transactions  High cost of hedging – impedes international trade  Disrupts international investment activity © 2015 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.

Foreign Exchange Trading as a Career Foreign exchange traders hired by ◦ Commercial Banks ◦ Companies ◦ Central Banks A trader studies factors that affect local economies and rates of exchange, then takes advantage of any misvaluations of currencies by buying & selling in different foreign exchange markets © 2015 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.