Foreign Exchange Markets and Exchange Rates

Foreign Exchange Markets A network of systems and mechanisms through which currencies are traded Market actors: Banks Brokers (Brokerage firms) Business entities (merchants, corporations, etc.) Individuals Governments Central banks International organizations

Foreign Exchange Rates A foreign exchange rate is the price of (one unit of) a currency in terms of another currency There are nearly 200 currencies of which few than 50 are commonly traded internationally Most currency trades take place in the form of transfer of bank deposits and clear without actual currency notes changing hands

Currency Quotes Today: UK pound: $/Pd: 1.83 Pd/$: Euro: $/Er: 1.25 Er/$: 0.80 A year ago: UK pound: $/Pd: 1.64 Pd/$: Euro: $/Er: 1.08 Er/$: Currency cross rates

FX and Portfolio Management An asset portfolio is a set or basket of assets owned by an individual or a business entity An asset has a value if it brings returns either in the form of incomes (earnings) or pleasure A portfolio containing FX denominated assets could change in value as FX rates change

Types of FX Transactions Spot transactions Forward and futures transactions Transactions in FX derivatives (options) Forward and futures transactions: Buying or selling a certain amount of a currency at a predetermine (agreed upon) price for future delivery Currency options: Buying and selling options to buy or options to sell specific amounts of a currency at a preset price in the future

The Reasons Behind FX Trading Clearing transactions Arbitrage transactions: taking advantage of rate differentials (discrepancies) in different markets Hedging transactions: Long and short positions Hedging in the spot market Other types of hedging Speculation: Taking a long or a short position in a currency in the hope of profiting from a favorable change in the exchange rate A person having a long position in the British pound hopes to see the pound appreciate.

Hedging Hedging: A transaction made for the purpose of avoiding or reducing a business (FX fluctuation) risk. Positions in FX: No position Long position Short position Balanced or closed position Hedging could be done in the spot market as well as in other FX markets

Hedging in the Forward Market Suppose an American merchant has purchased five full container loads of German beer at a total price of € 150,000. She has agreed to pay for the merchandise 90 days after the merchandise is placed aboard the ship; she holds a short position in the euro. To close her position she can purchase €150,000 in the forward market today. That would enable her to buy the amount of euros she would need in 90 days at a pre-determined rate. The forward contract would protect her from FX risk.

FX Markets and FX Rates: How Are FX Rates Determined? The Interest Parity Model: A note: A currency forward rate is an agreed-upon rate of exchange at which a certain amount of a currency is traded (bought or sold) on a certain (agreed-upon) day in the future. In the forward market a currency could be at a “premium” or at a “discount” e f - e s Discount or premium (rate)= p = (12/n) e s Discount: p < 0 Premium: p > 0

I. Uncovered Interest Arbitrage Comparing rates of returns on assets denominated in different currencies: Suppose: US interest rate: 12% UK interest rate: 16% One-year CDs in US vs. One-year CDs in UK Spot rate: 1.80 Expected (future) spot rate in a year: 1.70

Interest differential vs. Currency Appreciation or Depreciation Interest differential: (i $ - i £ ) %Change in e = (e e – e s )/e s

$1000 invested in US, after 12 months: = $1000 ( 1+.12) = $1120 $1000 invested in UK, after 12 months: Assuming e= 1.80 e e = 1.75 = (1000/e ) (1+.16) e e = 1128  Invest in pound-denominated assets

$1000 invested in US, after 12 months: = $1000 ( 1+.12) = $1120 $1000 invested in UK, after 12 months: Assuming e= 1.80 e e = 1.70 = (1000/e ) (1+.16) e e = 1095  Invest in pound-denominated assets

What are we comparing? Interest in the US, i $, and the return on a pound- denominated asset; this return is affected not only by the UK interest rate, but also the (expected) change in the exchange rate: That is: i £ (e e /e) + (e e –e )/e If i $ < i £ (e e /e) + (e e –e )/e, investors will invest in pound-denominated assets. If i $ > i £ (e e /e) + (e e –e )/e, investors will invest in $-denominated assets.

Alternatively, We can compare (i $ - i £ ) and (e e –e )/e If (i $ - i £ ) > (e e –e )/e, dollar denominated assets will be chosen At parity : (i $ - i £ ) = (e e –e )/e

Covered Interest Parity Investing a dollar in the US at %10: After 12 months: =$1 (1+ i $ ) = $1.10 Investing the same dollar in a pound-denominated asset (at 16%) and covering in the forward market, assuming e = 1.80 and e f = 1.75: = ($1/e) ( 1+ i £ ) e f = (e f /e) + (e f /e) i £ = $1 (1+ i $ ) < (e f /e) + (e f /e) i £ 1.10 < 1.127

Or, (1+ i $ ) ? (e f /e) + (e f /e) i £ Subtract 1 from both sides i $ ? (e f /e) + (e f /e) i £ - 1 i $ ? ([e f –e]/e) + (e f /e) i £ Assuming (e f /e)  1, and subtraction i £ from both sides, we write (i $ - i £ ) ? ([e f –e]/e) If (i $ - i £ ) < ([e f –e]/e), funds will..? If (i $ - i £ ) > ([e f –e]/e), funds will..? At parity: (i $ - i £ ) = ([e f –e]/e),

Does interest parity hold? The effects of changes in i $, i £, e e, and e f on e? Recall: (i $ - i £ ) = (e e –e )/e and (i $ - i £ ) = (e f –e )/e For example, if i £ increases, other things unchanged, e must rise. ($depreciation) Or, if e f decreases, other things unchanged, e must fall. ($appreciation)

FX Markets: Supply of and Demand for FX Asset Demand Transaction Demand Asset demand: Recall that the return on a FX asset: ([e f –e]/e) + (e f /e) i £ or ([e e –e]/e) + (e e /e) i £, given i $, i £, e e, and e f, is inversely related to FX rate, e. As “e” increases the return on the FX asset decreases, making it less attractive.

Demand for and Supply of FX 0 e($/£) D {i $, i £, e e,e f } S £

Shifts in the Demand Curve US interest rates : (-) UK interest rates: (+) The pound forward rate (+) The expected future £ spot rate (+)

FX Rate Regimes Flexible (floating) rates »Appreciation »Depreciation Fixed (pegged) rates »Revaluation »Devaluation Managed floating rates Exchange control

The Effective Exchange Rate A bilateral exchange rate of a currency may not reflect the real value of a currency. A currency may appreciate against some currencies while depreciating against others The effective exchange rate of a currency is a weighted index reflecting the value of a currency relative to a multiple ( basket) of other currencies. (Often the currencies of the country’s major trading partners)