1. 1 International Economics Lectured by Yuanfen Tu School of International Trade and Economics Email:jxnctyf@126.com 国际经济学

2. 2 International Economics By Robert J. Carbaugh 13th Edition Chapter 2: Foreign Exchange

3. 3 Main Contents What is the foreign-exchange market? How many tapes of foreign-exchange transactions do banks typically engage in? How to read foreign-exchange quotations? What is depreciation or appreciation? What are the differences among forward markets, futures & options? What determinates the exchange-rate? What are arbitrage, hedge & speculation?

4. Foreign-Exchange Market 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 4

6. Foreign-Exchange Market Foreign-exchange market Not An organized structure; on centralized meeting place; on formal requirements for participation Not limited to any one country Three of the largest foreign –exchange markets London, New York and Tokyo A round-the-clock operation 6

7. Foreign-Exchange Market Foreign-exchange market Transactions between commercial banks and their commercial customers Domestic inter-bank market conducted through brokers Active trading in foreign exchange with banks overseas 7

8. Types of Foreign-Exchange Transactions Spot transaction Make an outright purchase or sale of a currency now, as in “on the spot” the two-day period is known as immediate delivery Simplest way to meet your foreign currency requirements Greatest risk of exchange rate fluctuations 8

9. 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 9

10. 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 10

11. 11 Distribution of foreign-exchange transactions by U.S. banks TABLE 2.1

13. Interbank Trading Retail 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 13

14. 14 Top ten banks by share of foreign- exchange market, 2009 TABLE 2.2

15. 2013 年银行在外汇市场中的市场份 额及排名 1 德意志银行 15.18% 2 花旗银行 14.90% 3 巴克莱 10.24% 4 瑞士联合银行 10.11% 5 汇丰银行 6.93% 6 摩根大通 6.07% 7 苏格兰皇家银行 5.62% 8 瑞士信贷 3.70% 9 摩根士丹利 3.15% 10 美银美林 3.08%

16. 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 Size of the transaction Liquidity of the currencies being traded 16

17. 17 Foreign exchange Interbank trading A banker ’ s bid quote will be less than its offer quote at any time. Citibank might quote bid and offer rates for the Swiss franc at $.5851/.5854, the spread is $.5854-$.5851=$.0003 foreign-exchange dealers attempt to profit by anticipating correctly the future direction of currency movements.

18. 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 18

19. 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) 19

20. 20 Foreign exchange Reading foreign exchange quotations  直接标价法（ direct foreign exchange quotation ）：用一单位外国货币为标准折算出的 本国货币数额。  间接标价法：用一单位本国货币为标准折算出的 外国货币数额。 中国外汇牌价使用的是直接标价法还是间接标价 法？

21. 21 Foreign exchange quotations (a) TABLE 2.3

22. 22 Foreign exchange quotations (b) TABLE 11.3

23. Forward and Futures Markets Spot market Foreign exchange bought and sold for delivery immediately Forward market Foreign exchange bought and sold for future delivery 23

24. Forward and Futures Markets Futures market 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 24

25. 25 Forward contract versus futures contract TABLE 2.4 Forward ContractFutures 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

28. 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 28

29. 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 29

30. 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 30

31. 31 Foreign currency futures, May 13, 2009: selected examples TABLE 2.5

32. Foreign-Currency Options Option 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 32

33. Foreign-Currency Options 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 33

34. 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 34

38. Exchange-Rate Determination Exchange rate in a free market Determined by both supply and demand conditions Demand for foreign exchange Derived demand Driven by domestic demand for foreign goods and assets Corresponds to the debit items on a country’s balance of payments 38

39. 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 39

40. 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. 40 Exchange-rate determination FIGURE 2.1

41. 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 41

42. 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 42

43. 43 Advantages and disadvantages of a strengthening and weakening dollar TABLE 2.6

44. 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 44

45. 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 45

46. 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. 46

47. 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 47

48. 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 48

49. 49 Exchange rate indexes of the U.S. dollar (March 1973 = 100)* TABLE 2.7

50. 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 50

51. Arbitrage Two-point arbitrage Two currencies are traded between two financial centers If ₤1=$2 in New York ₤1=$2.01 in London Foreign-exchange traders will purchase pounds at $2 per pound in New York and immediately resell them in London for $2.01. This arbitrage process will continue until the exchange rate in New York is the same as that in London 51

52. Arbitrage Three-point arbitrage Triangular arbitrage Three currencies and three financial centers Switching funds among three currencies in order to profit from exchange-rate inconsistencies If ₤1=$1.5 in New York, ₤1=4francs in Geneva 1 franc=$0.50 in London Sell $1.5million for ₤1 million Simultaneously, sell ₤1 million for 4 million francs. At the same time, sell 4 million francs for $2 million 52

53. Forward Market Currencies bought and sold now for future delivery Period range from date of transaction Exchange rate agreed on at the time of the contract Payment made only when actual delivery takes place Banks provide this service to earn profits Forward rate Rate of exchange used in the settlement of forward transactions

54. 54 Forward exchange rates: selected examples TABLE 2.8

55. The Forward Market At a premium 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 55

56. Forward Rate What determines the forward rate? Interest-rate differentials between countries Why might it be at a premium or discount compared to the spot rate? One country’s interest rates higher than another’s, currency is a forward discount One country’s interest rates lower than another country’s, currency is a forward premium

57. The Forward Market Relation between the forward rate and spot rate Interest rate on six-month treasury bills is five percent in the U.S. and three percent in Swiss 57

58. 58 Foreign exchange Forward market functions Hedging ( 套期保值 )refers to the process of avoiding or covering a foreign-exchange risk.  Case 1: U.S. importer hedges against a dollar depreciation import purchase foreign currency in the forward market in advance  Case 2: U.S. exporter hedges against a dollar appreciation export sell foreign currency in the forward market in advance

59. Does Foreign-Currency Hedging Pay Off? Standard argument for hedging: Increased stability of cash flows and earnings Reasons companies may not view hedging as a benefit: Locks in an exchange rate costs up to half a percentage point per year of the revenue being hedged Fluctuations in a firm’s business can detract from the effectiveness of foreign-currency hedging The ups and downs for currencies would even out over the long run

60. 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 60

61. 61 Return on a three-month German investment TABLE 2.9

62. 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 62

63. 63 uncovered interest arbitrage: an example TABLE 2.10

64. 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 64

65. 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 65

66. 66 Covered interest arbitrage: an example TABLE 2.11

67. 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 67

68. Foreign-Exchange Market Speculation Speculation Attempt to profit by trading on expectations about prices in the future Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future Deliberate assumption of exchange risk With arbitrage, a currency trader simultaneously buys a currency at a low price and sells that currency at a high price. 68

69. Foreign-Exchange Market Speculation 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 69

70. 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 70

71. 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 71

72. Foreign Exchange Trading as a Career Foreign exchange traders Commercial Banks Companies Central Banks Professional traders Amateurs speculating in foreign currencies 72

73. 73 Foreign exchange Speculation in the spot market  Given: spot price is $0.40 per franc  Assumption: in 3 months, the spot price of the franc will rise to $0.50.  Procedure: 1.Purchase francs at $0.40 per franc and deposit them in a bank. 2.In 3 months, sell the francs at $0.50 per franc.

74. 74 Foreign exchange Speculation in the spot market  Given: spot price is $0.40 per franc  Assumption: in 3 months, the spot price of the franc will fall to $0.25  Procedure: 1.Borrow francs today, exchange them for dollars at $0.40 per franc, and deposit the dollars in a bank 2.In 3 months, buy the francs at $0.25 per franc and use them to pay back the loan.

75. 75 Foreign exchange Speculation in the forward market  Forward market speculation occurs when a speculator believes that a currency’s spot price at some future date differ from today’s forward price for that same date.

76. 76 Foreign exchange Speculation in the forward market  Given: current price of the 3-month forward franc is $0.40 per franc  Assumption: in 3 months, the prevailing spot price of the franc will be $0.50.  Procedure: 1.Contract to purchase a specified amount of francs in the forward market, at $0.40 per franc, for 3- month delivery. 2.In 3 months, sell the francs at $0.50 per franc in the spot market.

77. 77 Foreign exchange Speculation in the forward market  Given: current price of the 3-month forward franc is $0.40 per franc  Assumption: in 3 months, the prevailing spot price of the franc will be $0.30.  Procedure: 1. Contract to sell a specified amount of francs in the forward market, at $0.40 per franc, for 3- month delivery. 2.In 3 months, purchase an identical amount of franc in the spot market at $0.30 per franc and deliver them to fulfill the forward contract.

78. 78 Foreign exchange Speculation in the forward market  Long position （多头） is the position speculator take when they purchase a foreign currency on the spot or forward market with the anticipation of selling it at a higher future spot price.  Short position （空头） is the position speculator take when they borrow or sell forward a foreign currency with the anticipation of purchasing it at a lower price to repay the foreign-exchange loan or fulfill the forward sale contract.

84. 套期保值的基本特征是，在现货市场和期货市场对同一种 类的商品同时进行数量相等但方向相反的买卖活动，即在 买进或卖出实货的同时，在期货市场上卖出或买进同等数 量的期货，经过一段时间，当价格变动使现货买卖上出现 的盈亏时，可由期货交易上的亏盈得到抵消或弥补。从而 在 " 现 " 与 " 期 " 之间、近期和远期之间建立一种对冲机制，以 使价格风险降低到最低限度。期货市场毕竟是不同于现货 市场的独立市场，它还会受一些其他因素的影响，因而期 货价格的波动时间与波动幅度不一定与现货价格完全一致 ；加之期货市场上有规定的交易单位，两个市场操作的数 量往往不尽相等，这些就意味着套期保值者在冲销盈亏时 ，有可能获得额外的利润或亏损。