FOREIGN EXCHANGE DERIVATIVEMARKETS CHAPTER 16 All Rights Reserved Dr David P Echevarria

FOREIGN EXCHANGE MARKET FUNCTIONS Expand Purchasing Power Beyond National Borders. Demand for foreign goods creates demand for foreign currencies. Demand for foreign currencies drives foreign exchange markets. Provide International Trade Credit Facilities. Importers and Exporters need for credit financing. Provide the general procedures for the conduct of credit activities. Provide Securities for Minimizing Exchange Rate Risk. Specialized markets for hedging activities. Daily quotations of forward rates. All Rights Reserved Dr David P Echevarria

FOREIGN EXCHANGE MARKETS Exchange Rate Quotations Direct Quotes Indirect Quotes Types of Exchange Rate Systems Fixed Free Floating Managed Types of Exchanges Spot exchanges Forward exchanges All Rights Reserved Dr David P Echevarria

FOREIGN EXCHANGE MARKET PARTICIPANTS Foreign Exchange Dealers Banks. Nonbanks. Profits derived from the Spread: Bid (buy) - Offer (sell). Commercial Firms May receive cash payment in foreign currency. If open account, steady stream of foreign receipts. All Rights Reserved Dr David P Echevarria

FOREIGN EXCHANGE INSTRUMENTS Forward Exchanges: IMM (CME began trading FOREX futures May 16, 1972) Fixed contract amounts (typically $1MM dollars) Speculating and Hedging activity Currency Futures Contracts Currency Options Contracts All Rights Reserved Dr David P Echevarria

FACTORS AFFECTING EXCHANGE RATE MOVEMENTS Differential Inflation Rates Differential Interest Rates Differential Income Levels Government Intervention (interest rates and money supply, pegging exchange rate) Trade Imbalances: When Exports < Imports, Importer’s currency loses value All Rights Reserved Dr David P Echevarria

ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS Triangular Arbitrage Exploiting deviations from relative values Profits largely a function of deviation magnitudes and transaction costs Example: EUR/USD = 0.8631, USD/GBP = 1.6939, GBP/EUR = 0.6849: 0.8631*0.6849*1.6939 = 1.001327 The profit opportunity is 0.001327 per dollar of exchange $1,000,000 transaction would yield $1,327 profit. All Rights Reserved Dr David P Echevarria

ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS Institutional Participation Foreign Exchange Markets Large dollar volumes Minimal arbitrage opportunities Speculating on short & intermediate changes in exchange and interest rates All Rights Reserved Dr David P Echevarria

FOREIGN EXCHANGE MARKET PARTICIPANTS Individuals Foreign travel creates the largest number of individual demands. Relatively small volume of individual exchanges results in largest spreads. Central Banks and National Treasuries Central banks frequently enter markets to manage exchange rate. May cooperate with other central banks to maintain Exchange Rate Mechanisms. Foreign Exchange Brokers Facilitate trade between major dealers (principals). Provide exchange quotes and rates. All Rights Reserved Dr David P Echevarria

HOMEWORK QUESTIONS What are the three types of exchange rate systems? What role do differentials have in the rate of exchange? Inflation Interest Rates Income levels How do institutions manage foreign exchange risk? How do arbitrageurs exploit differences in exchange rates? All Rights Reserved Dr David P Echevarria