1. FOREIGN EXCHANGE DERIVATIVEMARKETS
CHAPTER 16
All Rights Reserved
Dr David P Echevarria

2. FOREIGN EXCHANGE MARKET FUNCTIONS
Expand Purchasing Power Beyond National Borders.
Demand for foreign goods creates demand for foreign currencies.
Demand for foreign currencies drives foreign exchange markets.
Provide International Trade Credit Facilities.
Importers and Exporters need for credit financing.
Provide the general procedures for the conduct of credit activities.
Provide Securities for Minimizing Exchange Rate Risk.
Specialized markets for hedging activities.
Daily quotations of forward rates.
All Rights Reserved
Dr David P Echevarria

3. FOREIGN EXCHANGE MARKETS
Exchange Rate Quotations
Direct Quotes
Indirect Quotes
Types of Exchange Rate Systems
Fixed
Free Floating
Managed
Types of Exchanges
Spot exchanges
Forward exchanges
All Rights Reserved
Dr David P Echevarria

4. FOREIGN EXCHANGE MARKET PARTICIPANTS
Foreign Exchange Dealers
Banks.
Nonbanks.
Profits derived from the Spread: Bid (buy) - Offer (sell).
Commercial Firms
May receive cash payment in foreign currency.
If open account, steady stream of foreign receipts.
All Rights Reserved
Dr David P Echevarria

5. FOREIGN EXCHANGE INSTRUMENTS
Forward Exchanges: IMM (CME began trading FOREX futures May 16, 1972)
Fixed contract amounts (typically $1MM dollars)
Speculating and Hedging activity
Currency Futures Contracts
Currency Options Contracts
All Rights Reserved
Dr David P Echevarria

6. FACTORS AFFECTING EXCHANGE RATE MOVEMENTS
Differential Inflation Rates
Differential Interest Rates
Differential Income Levels
Government Intervention (interest rates and money supply, pegging exchange rate)
Trade Imbalances: When Exports < Imports, Importer’s currency loses value
All Rights Reserved
Dr David P Echevarria

7. ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS
Triangular Arbitrage
Exploiting deviations from relative values
Profits largely a function of deviation magnitudes and transaction costs
Example: EUR/USD = , GBP/EUR = , USD/GBP = :
0.8631*0.6849* =
The profit opportunity is per dollar of exchange
$1,000,000 transaction would yield $1,327 profit.
All Rights Reserved
Dr David P Echevarria

8. HOMEWORK QUESTIONS What are the three types of exchange rate systems?
What role do differentials have in the rate of exchange?
Inflation
Interest Rates
Income levels
How do institutions manage foreign exchange risk?
How do arbitrageurs exploit differences in exchange rates?
All Rights Reserved
Dr David P Echevarria

9. FOREIGN EXCHANGE MARKET PARTICIPANTS
Individuals
Foreign travel creates the largest number of individual demands.
Relatively small volume of individual exchanges results in largest spreads.
Central Banks and National Treasuries
Central banks frequently enter markets to manage exchange rate.
May cooperate with other central banks to maintain Exchange Rate Mechanisms.
Foreign Exchange Brokers
Facilitate trade between major dealers (principals).
Provide exchange quotes and rates.
All Rights Reserved
Dr David P Echevarria

10. ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS
Institutional Participation Foreign Exchange Markets
Large dollar volumes Minimal arbitrage opportunities
Speculating on short & intermediate changes in exchange and interest rates
All Rights Reserved
Dr David P Echevarria