The Foreign- Exchange Market Chapter 12 The Foreign- Exchange Market

Topics to be Covered Spot Rates Forward Rates Arbitrage Swaps The Futures Market Foreign Currency Options The Foreign Exchange Market and the BOP

Foreign Exchange Market The Foreign Exchange Market (FEM) is the market where one country’s money is traded for that of another country. The FEM is a network of large commercial banks in world financial centers such as New York and London. The FEM is almost always open (refer to Figure 12.1). The FEM is the most efficient, a prime example of a perfectly competitive market with daily trade volume of $4 trillion. The price of a country’s money in terms of another is called the exchange rate. The “money” is bank deposits or bank transfers of deposits denominated in a foreign currency.

Exchange Rate Exchange Rate (XR)—the price of one money in terms of another. The XR helps to determine the value of a product priced in a different currency. Types of Exchange Rates: Spot XR vs. Forward XR U.S. $ per foreign currency (dollar price of the euro, yen, yuan) vs. foreign currency per U.S. $ Cross XR

Spot Market Spot Market is where currencies are traded “on the spot”, that is, for immediate delivery. Currencies are delivered within two working days. The exchange rate here is called the spot XR. Refer to Table 12.1 The exchange rates are the average of the banks’ buying (bid) and selling (offer) prices. Exchange rates are expressed in US$ per foreign currency (dollar price of foreign currency) and in its reciprocal.

TABLE 12.1 Exchange Rate Valuesa

TABLE 12.1 Exchange Rate Valuesa

TABLE 12.1 Exchange Rate Valuesa

TABLE 12.1 Exchange Rate Valuesa

TABLE 12.1 Exchange Rate Valuesa

TABLE 12.1 Exchange Rate Valuesa

Spread Spread—the difference between the buying (bid) and selling (offer) price of a currency. The spread will tend to be higher for low-volume traded currencies or for high-risk currencies.

Forward Rates Forward rate – the price of foreign money for delivery at a future date (one, three or six months later). Forward exchange rates help facilitate international trade and serve as a hedge against foreign exchange risk.

Forward Premium vs. Forward Discount Forward Premium—when the forward exchange rate is greater than the spot rate. Forward Discount—when the forward exchange rate is less than the spot rate. Flat Currency—when the forward rate and spot rate are equal. Forward rates are determined by major financial institutions in the foreign exchange market using a formula called the covered interest rate parity.

Covered Interest Rate Parity Covered interest rate parity (CIRP) results from arbitrage behavior in the FEM. Assume U.S. and Japanese investments are equally risky and have identical liquidity. A U.S. investor deciding between investing in the U.S. or in Japan must consider: The interest rates, i$ and i¥ The spot exchange rate, E , (in $/¥ ) The forward exchange rate, F, (in $/¥)

Covered Interest Rate Parity (cont.) By investing at home, the U.S. investor can earn a rate of return of i$. Or, the U.S. investor can invest in Japan and earn i¥. Since future spot rates are unknown, the investor can eliminate the uncertainty over the future dollar value of the investment with a forward exchange contract.

Covered Interest Rate Parity (cont.) The covered percentage rate of return from investing in Japan is: i¥ + (F-E)/E. If F > E, investor will earn F-E dollars from this transaction on every dollar converted into yen. Thus the percentage rate of return is (F-E)/E. Investment decision: - Invest in U.S. if i$ > i¥ + (F-E)/E - Invest in Japan if i$ < i¥ + (F-E)/E

Covered Interest Rate Parity (cont.) The CIRP condition is thus: i$ = i¥ + (F-E)/E or F = E x (i$ - i¥ + 1) This is the formula used by financial institutions to set the forward rate. The covered interest rate parity arises due to arbitrage behavior (based on risk-free assets) which determines the forward exchange rate.

Foreign Exchange Swap Foreign Exchange Swap—an agreement to trade currencies at one date and then reverse the trade (repurchase or resale) at a later date. The swap combines activity in both spot and forward markets. These agreements are frequently used by banks to hedge against foreign exchange risk. Hedging: an activity to offset or avoid risk in the market. Swaps account for 47% of the volume of trading activity in FEM (refer to Table 12.2).

TABLE 12.2 Average Daily Volume of Foreign-Exchange-Market Activity in 2010

Foreign Exchange Futures Market Futures market is similar to the forward market where currencies may be bought and sold for future delivery. The futures market differs from the forward market in that: Only a few currencies are traded (British pound, Aus. Dollar, Ca. dollar, Jap. yen, Swiss franc, MX. Peso and the euro) Trading occurs in standardized contracts (62,500 pound, 100,000 Ca. dollar, etc) and matures (maturity dates) on the 3rd Wed. of Mar, Jun, Sep. and Dec. Trading occurs in a specific location such as the Chicago Mercantile Exchange

Foreign Currency Options A contract that provides the right to buy or sell a currency at a fixed exchange rate  reduce uncertainty for future payments Foreign currency options were first traded in December 1982 at the Philadelphia Stock Exchange. Call Option—gives right to buy currency. Put Option—gives right to sell currency. Strike or Exercise Price—the price of the currency stated in an option contract.

Foreign Currency Options (cont.) The options contracts cover only a few foreign currencies (A$, pound, Can$, yen, euro, Swiss franc) and their fixed amounts are smaller than those of futures contracts. Unlike a forward or futures contract, the option offers the right to buy or sell if desired in the future and is not an obligation. Example: The US importer needs to pay 1M franc in 3 months  Given spot rate of $0.83, buy a call option with a small cost at a strike price of $0.85  3 months later, spot price of franc is higher than $0.85  Exercise the option contracts, otherwise not to exercise (=The option will be expired with a small cost paid)

Supply of and Demand for Foreign Currency Demand for pounds curve Comes from the U.S. demand for British goods, services, and financial assets. E ($ price of pounds) decreases  pounds become cheaper  more demand for UK goods and more demand for pounds by Americans Supply of pounds curve Comes from the British demand for U.S. goods, services, and financial assets. E ($ price of pounds) rises  pounds become expensive  more demand for US goods and more supply of pounds by Britons Equilibrium exchange rate—found at the intersection of the demand and supply curves.

FIGURE 12.2 Currency Supply

Flexible Exchange Rate System Flexible Exchange Rate—where the exchange rate is determined by free-market forces of demand and supply.

Depreciation vs. Appreciation Depreciation—when the value of one currency falls relative to another. For example, if the U.S. dollar depreciates against the British pound, then more dollars are needed to buy one pound. Appreciation—when the value of one currency rises relative to another. See Figure 12.3

Figure 12.3 Flexible Exchange Rates

Fixed Exchange Rate System Fixed Exchange Rate— the rate is set by government and the central bank actively intervenes in the foreign exchange market so as to keep the exchange rate from changing. To keep the fixed rate, central bank must supply additional amounts of pounds by selling off its international reserves. Its foreign reserves fall which implies a deficit in the country’s official settlement balance.

Figure 12.4 Fixed Exchange Rates