1. Chapter 31 THE MARKET FOR FOREIGN EXCHANGE RATE RISK CONTROL INSTRUMENTS

2. Foreign Exchange Rates zThe amount of one currency that can be exchanged for a unit of another currency zExchange Rate Quotation Conventions yDirect quote yIndirect quote

3. Foreign Exchange Risk zForeign exchange risk refers to the risk of adverse movements in the exchange rate. yAssets denominated in a foreign currency expose investors to exchange rate risk. yLiabilities denominated in foreign currency expose borrowers to exchange rate risk.

4. Spot Market zThe market for the settlement of foreign exchange transactions within two business days. yAppreciation yDepreciation yAmerican terms yEuropean terms

5. Spot Exchange Rates zForeign exchange rates between major currencies are free to float, with market forces determining the relative value of a currency. zSpot exchange rates adjust to compensate for the relative inflation rate between two countries.

6. Cross rates zThe exchange rate between two countries except the U.S. Dollar price of currency X Dollar price of currency Y zCross rate mispricing leads to triangular arbitrage yit involves positions in three currencies

7. Foreign Exchange Dealers zLarge international banks act as dealers in the foreign exchange market zDealers are linked by telephone and cable and various information transfer services zRevenue sources: yBid-ask spread yCommissions yTrading profits

8. The Euro zEuropean Union y15 European member countries zTreaty on European Union (1992) yestablished monetary union zMaastricht Treaty ysingle currency and monetary policy yEuropean Central Bank (ECB) zEconomic and Monetary Union (EMU)

9. Entry Requirements zThe annual fiscal deficit not to exceed 3% of GDP. zCumulative public debt not to exceed 60% of GDP. zOther economic, political, and social requirements zApproval by voters of a country seeking membership

10. The Euro zAdopted on January 1, 1999 yfixed conversion rate against member country’s national currencies and relative to euro yfree to fluctuate against all other currencies zJanuary 1, 2002 yphysical replacement of member countries’ currencies with euro

11. Outcomes Since Birth of Euro zThe euro has been viable and fairly stable. zIt has developed a very large public and cooperate capital market denominated in euros. zSince its inception at $1.17, the euro has weakened considerably, reaching a low of $0.8229 on October 27, 2000. zPotential participants include the U.K. and Sweden; Denmark voted against joining the EMU on September 28, 2000.

12. Instruments for Hedging Foreign Exchange Risk zCurrency Forward Contracts zCurrency Futures Contracts zCurrency Options zCurrency Swaps

13. Currency Forward Contracts zForward Contract Maturities ymaturity of less than two years ylonger dated forward contracts have large bid-ask spreads

14. Pricing Currency Forward Contracts zThe forward exchange rate is determined from the spot exchange rate and the interest rates in the two countries. zInterest rate parity implies that, by hedging in the forward market, an investor will receive the same domestic return whether investing domestically or in a foreign country.

15. Interest Rate Parity zRelationship between the spot exchange rate, the interest rates in two countries, and the forward rate. zThe arbitrage process which forces interest rate parity is called covered interest arbitrage.

16. Currency Futures Contracts zTrading Locations zUnderlying Currencies zContract Size zContract Maturity

17. Currency Option Contracts zUnderlying Currencies yspot currency ycurrency futures zCurrency Options Trading yorganized exchange yover-the-counter zTrading Locations zContract Specifications

18. Currency Swaps zA package of currency forward contracts. zAllows hedging of long-dated foreign exchange risk. zMore traditionally efficient than futures or forward contracts. zUsed to arbitrage opportunities in global financial markets for raising funds at lower cost than in the domestic market.