1. International Economics
国际经济学
Lectured by Yuanfen Tu
School of International Trade and Economics

2. International Economics By Robert J. Carbaugh 9th Edition
Chapter 12:
Foreign Exchange

3. Foreign Exchange
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
Organizational setting involving transaction of buying and selling foreign currencies and other debt instruments
Transaction conducted by individuals, businesses, governments, and banks
Not all currencies are traded for reasons ranging from political instability to economic uncertainty

5. Foreign-Exchange Market
It is by far the largest and most liquid market in the world.
The estimated worldwide amount of foreign-exchange transactions is around $1.5 trillion a day.
Quoted prices change as often as 20 times a minute.
It is not an organized structure, it has no centralized meeting place and no formal requirements for participation.
It is a round-the –clock operation.

6. Foreign-Exchange Market
Continued
Functions at three levels:
Transactions between commercial banks and their commercial customers
Domestic interbank market conducted through brokers
Transactions between trading banks and their overseas branches or foreign correspondents

7. Types of Foreign-Exchange Transactions
Spot transaction（即期交易）
Outright purchase and sale of foreign currency for cash settlement; immediate delivery
Forward transaction（远期交易）
Based on contracts, for future payment receipts
Currency swap（货币掉期）
Conversion of one currency to another currency
Distribution of foreign-exchange transactions (Table 11.1)

8. Types of Foreign-Exchange transactions
A spot transaction（即期交易） is an outright purchase and sale of foreign currency for cash settlement not more than two business days after the date of the transaction.
The two-day period provides ample time for the two parties to confirm the agreement and arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.

9. Types of Foreign-Exchange transactions
A forward transaction（远期交易） is an outright purchase and sale of foreign currency at a fixed exchange rate but with payment or delivery of the foreign currency at a future date.
A forward-exchange contract’s maturity date can be a few months or even years in the future.

10. Types of Foreign-Exchange transactions
A currency swap（货币掉期） is the 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.
Swaps provide an efficient mechanism through which banks can meet their foreign-exchange needs over a period of time.

11. Interbank Trading（银行同业交易）
Bank transactions with each other
Retail transactions（less than 1 million)
Wholesale transactions (more than 1 million)
Foreign-exchange departments of major commercial banks serve as profit centers
Leading banks trading in the foreign-exchange market (Table 11.2)

12. Interbank Trading Earning profits in foreign-exchange transactions:
Continued
Earning profits in foreign-exchange transactions:
Bid rate（买价）: Price bank is willing to pay for a unit of foreign currency
Offer rate（卖价）: Price at which the bank is willing to sell a unit of foreign currency
Spread（价差）: difference between bid and offer rate
Size of the transaction
Liquidity of the currencies being traded

13. Interbank trading
Foreign exchange
The spread（价差）is the difference between the bid and the offer rate.
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

14. Interbank trading
Foreign exchange
Besides earning profits from a currency’s bid/offer spread, foreign-exchange dealers attempt to profit by anticipating correctly the future direction of currency movements. 16

15. Reading Foreign-Exchange Quotations
Most daily newspapers publish foreign-exchange rates for major currencies
Exchange rate: Price of one currency in terms of another
Exchange rates listed for November 2, 2005, in The Wall Street Journal (Table 11.3)

16. Reading foreign exchange quotations
Exchange rate is the price of one currency in terms of another.
The number of dollars required to purchases 1 British pound. ER=$/₤ if ER=2，then purchasing 1₤ will require 2$.
The number of units of foreign currency required to purchase 1 unit of domestic currency. ER′=₤/$

17. 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？

18. Reading foreign exchange quotations
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)

19. Reading foreign exchange quotations
Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar

20. Forward and Futures Markets
Forward contracts（远期市场）:
Made by those who will receive or make payment in foreign exchange in the weeks or months ahead
The New York foreign-exchange market is a spot market for most currencies of the world (Table 11.3)
Futures market（期货市场）:
Contracting parties agree to future exchanges of currencies; set applicable exchange rates in advance
Example: International Monetary Market (IMM)
Major differences between forward and futures market (Table 11.4)

21. Future Market: International Monetary Market (IMM)
Foreign-exchange trading limited to major currencies
IMM’s futures prices (Table 11.5)
Size of contract on same line as currency’s name and country
First column shows the maturity months of the contract
Open: Price at which yen was first sold
High, low, and settle columns indication of contract’s closing prices for the day
Change compares closing prices
Lifetime high and low
Open interest（未结清权益）: Total number of contracts outstanding

22. Forward and futures markets
Foreign exchange
Open refers to the price at which yen was first sold when the IMM opened on the morning of the fixed day.
The high, low and settle columns indicate the contract’s highest, lowest, and closing prices for the day.
Change compares today’s closing price with the closing price as listed in the previous day’s paper. 27

23. Forward and futures markets
Foreign exchange
Lifetime high and low （期间高点和低点）show the volatility that has occurred in the trading of this particular contract-an indication of risk and reward.
Open interest （未结清权益）refers to the total number of contracts outstanding; that is, those that have not been canceled by offsetting trades. 28

24. Foreign currency options
Foreign exchange
An option (期权）is simply an agreement between a holder (buyer)(持有人） and a writer (seller) （开立人）that gives the holder the right, but not the obligation, to buy or sell financial instruments at any time through a specified date.
Although the holder is not obligated to buy or sell currency, the writer is obligated to fulfill a transaction.

25. Foreign currency options
Foreign exchange
Two types of foreign currency options:
A call option gives the holder the right to buy foreign currency at a specified price.
A 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（协定价格）

26. Foreign currency options
Foreign exchange
The holder of a foreign-currency option has the right to exercise the contract but may chose not to do so if it turns out to be unprofitable.
The writer of the options contract must deliver the foreign if called on by a call-holder or must buy foreign currency if it is put them by a put-holder.
The writer of the options contract receives a premium, or fee (the option price)

27. Foreign currency options
Foreign exchange
An option on a foreign-currency futures contract （外汇期权）provides the holder the right to buy or sell a futures contract.
This instrument is especially attractive to small trader who desire to make large trades and who find it difficult to deal in the spot or forward market.

28. Foreign currency options
Foreign exchange
Options are frequently used to reduce risk from exchange rate changes.
If Boeing submits a bid（投标） for the sale of jet planes on an airline company in Japan. Boeing must deal not only with the uncertainty of winning the bid but also with exchange risk.
It can offset the exchange-risk by purchasing put options.

29. Exchange-Rate Determination
Demand for foreign exchange
Derived from the debit items on its balance of payments
Varies inversely with its price
Supply of foreign exchange
All factors held constant, amount of foreign exchange offered to the market at various exchange rates
Relationship between demand and supply (Figure 11.1)

30. Exchange-Rate Determination
Continued
Equilibrium rate of exchange
Determined by the market forces of supply and demand
Exchange-market equilibrium occurs at point E (Figure 11.1)

31. Exchange-Rate Determination
Foreign exchange
A nation’s demand for foreign exchange is derived from, or corresponds to, the debit items on its balance of payments.
The supply of pounds results from the transactions that appear on the credit side of the balance of payments. 37

32. Is a Strong Dollar Always Good and a Weak Dollar Always Bad?
Parties affected by strengthening or weakening dollar:
Consumers
Tourists
Investors
Exporters
Importers
Effects of strengthening and weakening (Table 11.6)

33. Is a Strong Dollar Always Good and a Weak Dollar Always Bad?
Cases for discussion
High Sierra Sport Co., a leather-goods manufacturer in Illinois
Trek Bicycle Inc., a bike manufacturer in Wisconsin
Computer Network Technology Inc., a producer of network systems in Minnesota
Sony Computer Entertainment, Inc., a U.S.-based unit of Sony Corp.

34. Indexes of the Foreign-Exchange Value of the Dollar
Nominal exchange rate（名义汇率）
Real exchange rate（实际汇率）
Nominal exchange rate adjusted for relative price levels
Formula:
Real exchange-rate index (Table 11.7)

35. Indexes of the foreign exchange value of the dollar
Overall international competitiveness of manufactured goods depends not on the behavior of nominal exchange rates, but on the movements in nominal exchange rate relative to prices. (取决于名义汇率相对于价格水平的变动情况）
Real exchange rate（实际汇率）is the nominal exchange rate adjusted for relative price levels.（名义汇率经过价格水平调整后得到的汇率） 42

36. Indexes of the Foreign-Exchange Value of the Dollar
Effective Exchange-Rate (weighted average)
Direct comparison of dollar’s exchange rate over time including all bilateral changes
Referred to as: dollar’s exchange-rate index, or the effective exchange rate, or the trade-weighted dollar
Nominal exchange-rate index
Based on nominal exchange rates; does not reflect changes in price levels in trading partners
Nominal exchange-rate index (Table 11.7)

39. Arbitrage(套汇）
Foreign exchange
The price for the same currency in different country will be identical.
The factor underlying the consistency(一致性） of the exchange rates is exchange arbitrage.(套汇）
Exchange arbitrage refers to simultaneous (同时）purchase and sale of a currency in different foreign-exchange market in order to profit from exchange-rate differentials（差异） in the two locations. 47

40. Arbitrage Factor underlying consistency of the exchange rates
Exchange arbitrage
Two-point arbitrage
Three-point (triangular) arbitrage
Result of this activity:
Currency exchange rates consistent throughout the world
Only minimal deviations due to transaction costs

41. Arbitrage(套汇） If ₤1=$2 in New York ₤1=$2.01 in London.
Foreign exchange
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 .
The demand for pounds in New York will increase, the pounds will rise above $2 , and the supply of pound in London will increase, the pound will fall below $2.01.
This arbitrage process will continue until the exchange rate in New York is the same as that in London 49

42. Arbitrage(套汇） If ₤1=$1.5 in New York, ₤1=4francs in Geneva
Foreign exchange
If ₤1=$1.5 in New York, ₤1=4francs in Geneva
1 franc=$0.50 in London
An arbitrage with $1.5million could make a profits as follow:
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.
The result of arbitrage is that currency exchange rates tend to be consistent throughout the world, with only minimal deviations due to transaction costs. 50

43. 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

44. Forward Rate
Rate of exchange used in the settlement of forward transactions
Premium: Foreign currency worth more in the forward market than in the spot market
Discount: Currency is worth less in the forward market than in the spot market
Examples of forward rates (Table 11.8)

45. Forward Rate Differs from the Spot 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

46. Forward market functions
Foreign exchange
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 55

47. Does Foreign-Currency Hedging Pay Off?
Beneficial for firms that realize more than half of its sales in profits in foreign currencies
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

48. Interest Arbitrage（套利）
Process of moving funds into foreign currencies to take advantage of higher investment yields abroad
Uncovered interest arbitrage(非抵补套利)
Investor does not obtain exchange-market cover to protect investment proceeds from fluctuations
Example: Table 11.9

49. Uncovered interest Arbitrage (非抵补套利）
Foreign exchange
If the pound depreciates against the dollar, the investor makes less; if the pound appreciates against the dollar ,the investor makes more!
Extra return=(U.K. interest rate-U.S. interest)-% depreciation of the pound
Extra return=(U.K. interest rate-U.S. interest)+% appreciation of the pound 59

50. Covered interest Arbitrage (抵补套利）
Foreign exchange
Covered interest arbitrage refers to the process of moving funds into foreign currencies to take advantage of higher investment yields abroad, while avoiding exchange-rate risk. 60

51. Interest Arbitrage Steps in covered interest arbitrage:
Investor exchanges domestic currency for foreign currency
At the current spot rate
Uses the foreign currency to finance a foreign investment
Investor contracts in the forward market to sell the amount of the foreign currency received as the proceeds from the investment
Delivery date to coincide with the maturity of the investment
Example: Table 11.10

52. Covered interest Arbitrage (抵补套利）
Foreign exchange
The theory of foreign exchange suggests that the forward discount or premium on one currency against another reflects the difference in the short-term interest rates between the two nations.
The currency of the higher-interest-rate nation should be at a forward discount while the currency of the lower-interest-rate nation should be at a forward premium. 63

53. Interest Arbitrage International differences in interest rates
Continued
International differences in interest rates
Exerts a major influence on the relationship between the spot and forward rates because:
Changes in interest-rate differentials do not always induce an immediate investor response
Investors sometimes transfer funds on an uncovered basis
Factors (governmental exchange controls and speculation) may weaken the connection between the interest-rate differential, and the spot and forward rates

54. Foreign-exchange market speculation
Speculation（投机）is the 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
A speculator's goal is to buy a currency at one moment and sell that currency at a higher price in the future. 65

55. Speculation in the spot market
Foreign exchange
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. 66

56. Speculation in the spot market
Foreign exchange
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. 67

57. Speculation in the forward market
Foreign exchange
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. 68

58. Speculation in the forward market
Foreign exchange
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. 69

59. Speculation in the forward market
Foreign exchange
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. 70

60. Speculation in the forward market
Foreign exchange
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. 71

61. Foreign-Exchange Market Speculation
Speculation: Attempt to profit by trading on expectations about prices in the future
Stabilizing speculation: Goes against market forces by moderating or reversing a rise or fall in a currency’s exchange rate
Destabilizing speculation: Goes with market forces by reinforcing fluctuations in a currency’s exchange rate

62. Speculation and exchange-market stability
Foreign exchange
Capital flight(资本外逃）is a slight variation of the concept of foreign marker speculation.
It is motivated not by the expectation of profit but rather by the fear of exchange-market loss.
Capital flight may be induced by fear of currency devaluation, political instability, or government restrictions on foreign-exchange movements. 73

63. Should speculators be shot?
Foreign exchange
There is no doubt that the volume of currency trading has mushroomed relative to trade.
Much currency trading occurs for reasons other than to provide liquidity for world trade.
But speculators do not attack currencies that are underlain by credible economic policies although the currency markets are not perfect. They are vulnerable to bubbles and excess waves of optimism followed by excessive pessimism. 74