©2007, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Background and History of Foreign Exchange Markets Bretton Woods Agreement ( ) Smithsonian Agreement (1971) Smithsonian Agreement II (1973) Bretton Woods Agreement ( ) Smithsonian Agreement (1971) Smithsonian Agreement II (1973)

©2007, The McGraw-Hill Companies, All Rights Reserved 8-2 McGraw-Hill/Irwin Foreign Exchange Transactions Spot foreign exchange transaction: mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency Spot foreign exchange transaction: mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

©2007, The McGraw-Hill Companies, All Rights Reserved 8-3 McGraw-Hill/Irwin Foreign Exchange Market Trading (in billions of U.S. dollars)

©2007, The McGraw-Hill Companies, All Rights Reserved 8-4 McGraw-Hill/Irwin Hedging with Forwards Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $ M Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $ M

©2007, The McGraw-Hill Companies, All Rights Reserved 8-5 McGraw-Hill/Irwin Role of FIs in Foreign Exchange Transactions Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating

©2007, The McGraw-Hill Companies, All Rights Reserved 8-6 McGraw-Hill/Irwin FI’s overall net foreign exchange (FX) exposure Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position