Foreign Exchange PowerPoint slides prepared by: Andreea Chiritescu Eastern Illinois University © 2011 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 Organizational setting Within 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 © 2011 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 Transactions between commercial banks and their commercial customers Domestic interbank market conducted through brokers Active trading in foreign exchange with banks overseas © 2011 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 Spot transaction Make an outright purchase or sale of a currency now, as in “on the spot” Simplest way to meet your foreign currency requirements Greatest risk of exchange rate fluctuations © 2011 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 Forward transaction Receiving or paying an amount of foreign currency on a specific date in the future At a fixed exchange rate Protects against unfavorable movements in the exchange rate Will not allow gains to be made should the exchange rate move in your favor © 2011 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 Currency swap Conversion of one currency to another currency at one point in time With an agreement to reconvert it back to the original currency at a specified time in the future The rates of both exchanges are agreed to in advance © 2011 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

Distribution of foreign-exchange transactions by U.S. banks TABLE 11.1 Distribution of foreign-exchange transactions by U.S. banks © 2011 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 Retail transactions Wholesale 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 © 2011 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

Top ten banks by share of foreign-exchange market, 2009 TABLE 11.2 Top ten banks by share of foreign-exchange market, 2009 © 2011 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 Earning profits in foreign-exchange transactions Bid rate - price that the bank is willing to pay for a unit of foreign currency Offer rate - price at which the 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 © 2011 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 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 Currency depreciation It takes more units of a nation’s currency to purchase a unit of some foreign currency © 2011 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 quotations (a) TABLE 11.3 Foreign exchange quotations (a) © 2011 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 quotations (b) TABLE 11.3 Foreign exchange quotations (b) © 2011 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 Currency appreciation It takes fewer 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) © 2011 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 Spot market Foreign exchange bought and sold for delivery immediately Forward market Foreign exchange bought and sold for future delivery © 2011 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 Contracting parties agree to future exchanges of currencies And set applicable exchange rates in advance Only a limited number of leading currencies are traded Trading takes place in standardized contract amounts and in a specific geographic location © 2011 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 contract versus futures contract TABLE 11.4 Forward contract versus futures contract Forward Contract Futures Contract Issuer Trading Contract size Date of delivery Contract costs Settlement Commercial bank “Over the counter” by telephone Tailored to the needs of the exporter/importer/investor; no set size Negotiable Based on the bid On expiration date only, at prearranged price /offer spread International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange On the IMM’s market floor Standardized in round lots Only on particular dates Brokerage fees for sell and buy orders Profits or losses paid daily at close of trading © 2011 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 International Monetary Market (IMM) Chicago Mercantile Exchange, 1972 An extension of the commodity futures markets Size of each contract On the same line as the currency’s name and country First column Maturity months © 2011 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 Open Price at which the yen was first sold when the IMM opened 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 © 2011 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 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 © 2011 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 futures, May 13, 2009: selected examples TABLE 11.5 Foreign currency futures, May 13, 2009: selected examples © 2011 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 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 © 2011 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 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 © 2011 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 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 © 2011 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 Exchange rate in a free market Determined by both supply and demand conditions Demand for foreign exchange Derived demand Driven by foreigner demand for domestic goods and assets Corresponds to the debit items on a country’s balance of payments © 2011 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

WEAK DOLLAR IS A BONANZA FOR EUROPEAN TOURISTS When dollar’s exchange value depreciates Foreign tourists realize a good bargain on goods purchased in America Delighted American tourist industry Tourists could afford to stay longer Stay at nicer and more expensive hotels Take more tours Eat at more restaurants Shop with bargain-basement enthusiasm. Air fares to and from the United States declined © 2011 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 Supply of foreign exchange Amount of foreign exchange that will be offered to the market At various exchange rates, all other factors held constant Equilibrium exchange rate Determined by the market forces of supply and demand © 2011 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 FIGURE 11.1 Exchange-rate determination The equilibrium exchange rate is established at the point of intersection of the supply and demand schedules of foreign exchange. The demand for foreign exchange corresponds to the debit items on a nation’s balance-of-payments statement; the supply of foreign exchange corresponds to the credit items. © 2011 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 Increase in the demand for pounds Shift rightward The dollar will depreciate against the pound Decrease in demand for pounds Shift leftward The dollar will appreciate © 2011 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 Increase in the supply of pounds Rightward shift The dollar appreciate against the pound Decrease in the supply of pounds Leftward shift Dollar depreciation © 2011 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

Advantages and disadvantages of a strengthening and weakening dollar TABLE 11.6 Advantages and disadvantages of a strengthening and weakening dollar © 2011 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

Nominal and Real Exchange Rates Exchange-rate index Effective exchange rate; trade-weighted dollar Weighted average of the exchange rates between the domestic currency And the nation’s most important trading partners With weights given by relative importance of the nation’s trade with each of these trade partners © 2011 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

Nominal and Real Exchange Rates Nominal exchange-rate index of the U.S. dollar Average value of the dollar Not adjusted for changes in prices levels In the U.S. and its trading partners if increasing Dollar appreciation relative to the currencies of the other nations in the index Loss of competitiveness for the U.S. © 2011 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

Nominal and Real Exchange Rates Nominal exchange-rate index of the U.S. dollar If decreasing Dollar depreciation relative to the other currencies in the index Improvement in U.S. international competitiveness Based on nominal exchange rates that do not reflect changes in price levels in trading partners © 2011 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

Nominal and Real Exchange Rates Real exchange-rate index of the U.S. dollar Embodies the changes in prices in the countries in the calculation 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 © 2011 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 indexes of the U.S. dollar (March 1973 = 100)* TABLE 11.7 Exchange rate indexes of the U.S. dollar (March 1973 = 100)* © 2011 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 Exchange arbitrage Simultaneous purchase and sale of a currency In different foreign-exchange markets To profit from exchange-rate differentials in the two locations Brings about an identical price for the same currency in different locations Results in one market © 2011 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 Two-point arbitrage Three-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 © 2011 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 Forward market Forward rate Currencies are bought and sold now for future delivery The exchange rate is agreed on at the time of the contract Payment is made when the future delivery actually takes place Forward rate Rate of exchange used in the settlement of forward transactions © 2011 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 exchange rates: selected examples TABLE 11.8 Forward exchange rates: selected examples © 2011 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 At a premium At a discount 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 © 2011 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 Relation between the forward rate and spot rate © 2011 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 Managing your foreign exchange risk Hedging Forward foreign-exchange contract And engage in hedging Hedging Process of avoiding or covering a foreign-exchange risk Some firms do not hedge Currency fluctuations even out over the long term © 2011 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 risk: the hazard of investing abroad 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 © 2011 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

Return on a three-month German investment TABLE 11.9 Return on a three-month German investment © 2011 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 Interest arbitrage refers 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 © 2011 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 A U.S. investor’s extra rate of return On an investment in the United Kingdom as compared to the U.S. = interest-rate differential adjusted for any change in the value of the pound © 2011 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

uncovered interest arbitrage: an example TABLE 11.10 uncovered interest arbitrage: an example © 2011 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 Covered interest arbitrage Investor exchanges domestic currency for foreign currency - at the current spot rate And uses the foreign currency to finance a foreign investment Investor contracts in the forward market To sell the amount of the foreign currency that will be received as the proceeds from the investment With a delivery date to coincide with the maturity of the investment © 2011 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 Forward discount or premium On one currency against another Reflects the difference in the short-term interest rates between the two nations Forward discount The currency of the higher-interest-rate nation Forward premium The currency of the lower-interest-rate nation © 2011 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

Covered interest arbitrage: an example TABLE 11.11 Covered interest arbitrage: an example © 2011 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 Attempt to profit by trading on expectations about prices in the future Deliberate assumption of exchange risk Stabilizing speculation Goes against market forces by moderating or reversing a rise or fall in a currency’s exchange rate Useful function for bankers and businesspeople, who desire stable exchange rates © 2011 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 Destabilizing speculation Goes with market forces by reinforcing fluctuations in a currency’s exchange rate Can disrupt international transactions High cost of hedging – impeding international trade Disrupt international investment activity © 2011 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

How to play the falling (rising) dollar Depreciating dollar Purchase foreign currency Purchase bonds denominated in a foreign currency Purchase stocks of foreign corporations, denominated in foreign currencies Savings account denominated in a foreign currency Variety of currency derivatives © 2011 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 Commercial Banks Companies Central Banks Professional traders Amateurs speculating in foreign currencies © 2011 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