1. International Economics By Robert J. Carbaugh 10th Edition
Chapter 11:
Foreign Exchange

2. Foreign exchange market
Largest and most liquid market in the world
No central market - key markets in several cities around the world (London, New York & Tokyo are the largest)
Most transactions involve transfers of bank deposits, not currency
Participating banks and brokers are in constant contact via phone and computer
Three general types of transaction
Between banks and their customers
Domestic interbank market conducted through brokers
Trading with overseas banks
Carbaugh, Chap. 11

3. Types of FX transactions
Foreign exchange
Types of FX transactions
Spot transactions - executed nearly immediately
Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance
Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning
Carbaugh, Chap. 11

4. Distribution of FX transactions by US banks
Foreign exchange
Distribution of FX transactions by US banks
Carbaugh, Chap. 11

5. Foreign exchange quotations
Exchange rate is the price of one currency in terms of another
One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency)
A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency)
Carbaugh, Chap. 11

6. Foreign exchange quotations
Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar
Carbaugh, Chap. 11

7. Forward markets, futures & options
Foreign exchange markets
Forward markets, futures & options
Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date
Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement
Carbaugh, Chap. 11

8. Forward markets, futures & options
Foreign exchange markets
Forward markets, futures & options
Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date
Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates
Carbaugh, Chap. 11

9. Forward markets, futures & options
Foreign exchange markets
Forward markets, futures & options
Forward Contract
Futures Contract
Issuer
Commercial bank
International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange
Trading
“Over the counter” by telephone
On the IMM’s market floor
Contract size
Tailored to the needs of the exporter/importer/investor; no set size
Standardized in round lots
Date of delivery
Negotiable
Only on particular dates
Contract costs
Based on the bid/offer spread
Brokerage fees for sell and buy orders
Settlement
On expiration date only, at prearranged price
Profits or losses paid daily at close of trading
Carbaugh, Chap. 11

10. Forward markets, futures & options
Foreign exchange markets
Forward markets, futures & options
Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option
Options to buy are called call options, and those to sell are called put options
Options are frequently used to reduce risk from exchange rate changes
Carbaugh, Chap. 11

11. Exchange rate determination
Foreign exchange markets
Exchange rate determination
Carbaugh, Chap. 11

12. Impact of an appreciating US dollar
Foreign exchange
Impact of an appreciating US dollar
Pros
Lower prices on foreign goods
Keeps inflation down
Foreign travel is cheaper
Cons
Exporters’ products become more expensive abroad
Imports-competing firms face price competition
Travel more expensive for foreign tourists
Carbaugh, Chap. 11

13. Impact of a depreciating US dollar
Foreign exchange
Impact of a depreciating US dollar
Pros
Exporters can sell abroad more easily
Less competition for US firms from imports
Foreign tourism is encouraged
Cons
Higher prices on imports
Upward pressure on inflation
Travel abroad more expensive
Carbaugh, Chap. 11

14. Foreign exchange
Exchange rate indexes
To judge the overall value of a currency versus many others, an index is used
A common index for the US dollar is the “trade weighted” index with respect to the currencies of the US’s most important trading partners (in proportion to their share of trade)
To take into account price changes (inflation or deflation), a “real exchange rate” is used
The real exchange rate is the nominal rate multiplied by the ratio of the foreign to domestic price levels
Carbaugh, Chap. 11

15. Exchange rate indexes of the US dollar (March 1973=100)
Foreign exchange
Exchange rate indexes of the US dollar (March 1973=100)
Year
Nominal Exchange Rate Index
Real Exchange Rate Index
1973 (March)
100.0
1980
87.4
91.3
1982
116.6
109.0
1984
138.3
117.7
1986
112.0
99.2
1988
92.7
83.5
1990
89.1
84.7
1992
86.6
81.8
1994
84.0
1996
85.3
1998
95.8
97.7
2000
98.3
103.1
2002
102.9
110.9
2003
88.6
94.6
Carbaugh, Chap. 11

16. Foreign exchange markets
Arbitrage and hedging
Exchange arbitrage involves taking advantage of simultaneous exchange rate differences in different markets to make a profit
Helps equalize exchange rates globally
Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return
Subject to exchange rate risk
Carbaugh, Chap. 11

17. Foreign exchange markets
Arbitrage and hedging
Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions
Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings
Carbaugh, Chap. 11

18. Foreign exchange markets
Speculation
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
Carbaugh, Chap. 11

19. Foreign exchange markets
Speculation
Speculation can either reduce or increase volatility in foreign exchange rates
If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements
If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency
Carbaugh, Chap. 11