Foreign Exchange Chapter 11 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Foreign Exchange Market o definition – organizational setting within which individuals, businesses, governments, and banks buy and sell foreign currencies o no single, central meeting place o largest foreign exchange markets: London, New York and Tokyo o transactions between: commercial banks and their commercial customers banks conducted by brokers trading banks and their overseas branches

Types of Transactions o spot transaction - outright purchase & sale of foreign currency with ‘immediate delivery’ meaning within two business days o forward transaction – agreement for purchase & sale at a specified rate at some point in the future more than two business days months or even years in the future o currency swap – conversion of one currency to another at one point in time with agreement to reconvert back at a specified future time

Interbank Trading o most U.S. transactions conducted by a few large banks o retail transactions – bank to customers; less than $1MM o wholesale transactions – bank to bank or bank to corporate customers; more than $1MM

Bank Profits on Transactions o banks quote two rates on transactions: bid rate – price bank is willing to pay for foreign currency offer rate – price at which bank is willing to sell foreign currency o spread – difference between the bid and offer o other profits: o anticipating appreciation => bank raises bid & offer to buy more of that currency => resells later at high price making a profit o anticipating depreciation => bank lowers bid & offer to sell more of that currency => buys back later at lower price creating profits

Foreign Exchange Quotations o 2 nd and 3 rd columns indicate number of dollars needed to buy foreign currency [ U.S. dollars for one Taiwan dollar] o 4 th and 5 th columns indicate units of foreign currency needed to buy dollar [32.83 Taiwan dollars for one U.S. dollar]

Cross Exchange Rate o most quotations expressed in terms of U.S. dollar o cross exchange rate determines value of two currencies in terms of a third o example: = = Therefore, each Taiwan dollar buys approximately 28 South Korean won. $ value of Taiwan dollar $ value of S. Korean won $ $

Forward Versus Futures Markets Difference Associated with Futures Market: o only at specific locations such as International Monetary Market of Chicago Mercantile Exchange and Tokyo International Financial Futures Exchange o only major currencies o contracts limited to specific dates (3 rd Wed. March, June, September & December) o fixed amounts o profit/loss paid at close of trading as opposed to the contract date

Foreign Currency Options o definition – agreements between holder (buyer) and writer (seller) giving the holder the right to buy or sell a fixed amount of foreign currency at a specified price within a specified time period o call option – provides right to buy o put option – provides right to sell o strike price – price at which the option can be exercised o holder not obligated to use contract; writer obligated if holder proceeds with transaction

Exchange-Rate Determination o demand for foreign currency corresponds to balance of payments debits [U.S. imports; U.S. foreign investment; foreign transfer payments] o supply of foreign currency equal to balance of payment credits [U.S. exports; foreign investment in U.S.; transfer payments to U.S.]

Appreciation of U.S. Dollar Advantages: 1)U.S. consumers see lower prices on foreign goods 2)lower prices on foreign goods limit U.S. inflation 3)U.S. consumers benefit during foreign travel Disadvantages: 1)U.S. firms find it harder to compete in foreign markets 2)U.S. firms find it harder to compete with imports 3)foreign tourists find it more expensive to vacation in the U.S.

Depreciation of U.S. Dollar Advantages: 1)U.S. firms find it easier to sell goods in foreign markets 2)firms in the U.S. face less pressure to keep prices low 3)more foreign tourists can afford to visit U.S. Disadvantages: 1)U.S. consumers face higher prices on foreign goods 2)higher foreign prices can lead to inflation in U.S. 3)U.S. consumers find foreign travel more costly

Nominal Exchange Rate o exchange rate index – weighted average of exchange rates between the domestic currency and nation’s most important trading partners o major currency index – average exchange rate for dollar versus seven major U.S. trading partners o nominal index such as this is not adjusted for changes in U.S. or foreign price levels

Real Exchange Rate o accounting for changes in the price levels: Real Exchange Rate = Nominal Exch. Rate × o better indication of purchasing power of dollar o increase in real exchange rate will make it more difficult for U.S. firms to compete Foreign Country’s Price Level Home Country’s Price Level

Arbitrage o exchange arbitrage – simultaneous purchase and sale of currency in different foreign exchange markets in order to profit from exchange rate differential in two locations o two or three point arbitrage possible assume: £1 = $1.50; £1 = 4 francs; 1 franc = $0.50 sell $1.5 million for £1 million sell £1 million for 4 million francs sell 4 million francs for $2 million o such transactions shift supply & demand for currencies eliminating opportunities for profits and establishing consistent exchange rates $500,000 profit

Forward Market o currency worth more in forward market than spot market => premium o currency worth less in forward market than spot market => discount

Relationship Between Forward Rate & Spot Rate interest rate differentials - comparable securities higher U.S. interest rates o investors sell foreign currency for dollars driving down spot price o use dollars to purchase U.S. Treasury bills o investors obtain forward contract allowing foreign currency to be bought back with dollars driving up forward price o result: foreign currency at premium in forward market

Relationship Between Forward Rate & Spot Rate (cont.) lower U.S. interest rates o investors buy foreign currency with dollars driving up spot price o use foreign currency to purchase foreign Treasury securities o investors obtain forward contract allowing dollars to be bought back with foreign currency driving down forward price o result: foreign currency at discount in forward market

Managing Foreign Exchange Risk o hedging – process of avoiding or covering a foreign exchange risk o U.S. importer hedging against depreciation must pay in foreign currency in the future contract to purchase foreign currency in the forward market does not require importer to tie up funds o exporter hedging against appreciation will receive foreign currency in the future contract to sell foreign currency in the forward market o both eliminate risks of fluctuating spot rates

Uncovered Interest Arbitrage o moving funds into foreign currency to take advantage of higher rate of return without forward contract o extra return: UK U.S. Percentage = Interest - Interest ± Appreciation/Depreciation Rate Rate of Pound

Covered Interest Arbitrage 1)purchase foreign currency at spot rate and use it to finance foreign investment 2)contract in the forward market to sell amount of foreign currency that will be received because of activity in the forward market such investment opportunities quickly disappear

Foreign Exchange Market Speculation o speculation – attempt to profit by trading on expectations about prices in the future o different from arbitrage where trader buys & sells simultaneously; speculator buys at one time and sells at a different time o stabilizing speculation – goes against market forces by moderating changes in exchange rates o destabilizing speculation – goes with market forces by reinforcing fluctuations in exchange rates