Foreign Exchange Foreign Exchange Market Exchange Rate Appreciation/Depreciation Effective Exchange Rate Trade Weighted Dollar Real Exchange Rate Interbank Market: Dealers / Brokers Spot Market Bid Rate / Ask Rate / Spread Cross Exchange Rates Exchange Arbitrage: 2 point / 3 point Forward Market/Swaps Discount / Premium Covered Interest Arbitrage Uncovered Interest Arbitrage Futures Market IMM Options Market Call Option / Put Option Strike Price / Duration Hedging Speculation: Long position / Short position Stabilizing Speculation Destabilizing Speculation

Foreign Exchange Markets Major players: 1.Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies … banks hold inventories of foreign currencies to meet customer demands 2.Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. 3.Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. 4.Central banks: conduct official international reserves transactions. Daily volumes of foreign exchange transactions $600 billion in 1989/$1.9 trillion in 2004/$3.2 trillion in  Major “markets”: London/New York/Tokyo  Other “markets”: Chicago/Frankfurt/Hong Kong/Singapore  About 90% of transactions involve US dollars.

Spot Market: (Wholesale Prices) Foreign Exchange Markets: Interbank Market Players

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

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 purchase of foreign assets (bonds) 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

Flavors of exchange rates and contracts Spot rates: for currency exchanges “on the spot” Forward rates: for currency exchanges that will occur at a future (“forward”) date. – Forward contracts can be customized. Forward dates are typically 30, 90, 180, or 360 days in the future. Rates are negotiated between two parties in the present, but the exchange occurs in the future. Foreign exchange swaps: a combination of a spot sale with a forward repurchase. Futures contracts: designed by a third party for a standard amount of foreign currency delivered/received on a standard date. – Contracts can be bought and sold in markets – Only the current owner is obliged to fulfill the contract. Options contracts: designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. – Pay a premium for the option, but not obligation, to buy (call option) or sell a currency (put option) at a strike price before the option’s expiration date.

Nominal and Real Exchange Rates Real Exchange Rate Index = Nominal Index x (Our CPI/Their CPI) If our prices are rising faster than foreign prices yet our nominal exchange rate hasn’t depreciated, we’re really getting a better deal