McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-1 Chapter Nine Foreign Exchange Markets

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-2 Foreign Exchange Markets Overview Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-3 Background and History of Foreign Exchange Markets Bretton Woods Agreement ( ) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate Bretton Woods Agreement ( ) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-4 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

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-5 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

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-6 Role of FIs in Foreign Exchange Transactions Net exposure - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given 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 - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given 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

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-7 Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-8 Purchasing Power Parity The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = Interest rate in the United States i S = Interest rate in Switzerland then: i US - i S = IP US - IP S The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = Interest rate in the United States i S = Interest rate in Switzerland then: i US - i S = IP US - IP S

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 9-9 Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Balance of Payment Accounts Balance of payment accounts - summary of all transactions between citizens of two countries Current account - the section of the balance of payment table that summarizes foreign trade in goods and services, net investment income, and gifts, grants, or aid given to other countries Capital accounts - the section of the balance of payment table that summarizes capital flows into and out of a country Balance of payment accounts - summary of all transactions between citizens of two countries Current account - the section of the balance of payment table that summarizes foreign trade in goods and services, net investment income, and gifts, grants, or aid given to other countries Capital accounts - the section of the balance of payment table that summarizes capital flows into and out of a country

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved U.S. Balance of Payment Accounts Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0 Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0