International Economics By Robert J. Carbaugh 9th Edition Chapter 12: Foreign Exchange

Foreign exchange market Largest and most liquid market in the world No central market - key markets in several cities around the world Participating banks and brokers are in constant contact via phone and computer Three general types of transaction Between banks and their customers Domestic interbank market conducted through brokers Trading with overseas banks Carbaugh, Chap. 12

Types of FX transactions Foreign exchange Types of FX transactions Spot transactions - executed nearly immediately Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning Carbaugh, Chap. 12

Foreign exchange quotations Exchange rate is the price of one currency in terms of another One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency) Carbaugh, Chap. 12

Foreign exchange quotations Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar Carbaugh, Chap. 12

Forward markets, futures & options Foreign exchange markets Forward markets, futures & options Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement Carbaugh, Chap. 12

Forward markets, futures & options Foreign exchange markets Forward markets, futures & options Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates Carbaugh, Chap. 12

Forward markets, futures & options Foreign exchange markets Forward markets, futures & options Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option Options to buy are called call options, and those to sell are called put options Options are frequently used to reduce risk from exchange rate changes Carbaugh, Chap. 12

Exchange rate determination Foreign exchange markets Exchange rate determination Carbaugh, Chap. 12

Impact of an appreciating US dollar Foreign exchange Impact of an appreciating US dollar Pros Lower prices on foreign goods Keeps inflation down Foreign travel is cheaper Cons Exporters’ products become more expensive abroad Imports-competing firms face price competition Travel more expensive for foreign tourists Carbaugh, Chap. 12

Impact of a depreciating US dollar Foreign exchange Impact of a depreciating US dollar Pros Exporters can sell abroad more easily Less competition for US firms from imports Foreign tourism is encouraged Cons Higher prices on imports Upward pressure on inflation Travel abroad more expensive Carbaugh, Chap. 12

Foreign exchange markets Arbitrage and hedging Exchange arbitrage involves taking advantage of exchange rate differences in different markets to make a profit Helps equalize exchange rates globally Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return Subject to exchange rate risk Carbaugh, Chap. 12

Foreign exchange markets Arbitrage and hedging Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings Carbaugh, Chap. 12

Foreign exchange markets Speculation Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future Carbaugh, Chap. 12

Foreign exchange markets Speculation Speculation can either reduce or increase volatility in foreign exchange rates If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency Carbaugh, Chap. 12