1. 1 Lecture 5 & 6

2. 2 Learning Goals What is the Foreign Exchange Market? What is an Exchange Rate? What sort of changes an exchange rate could face? The outcomes of the Case Study: A tale of two Dollars. Who are the main actors in the FEM? Characteristics of the FEM

3. 3 Foreign Exchange Market Money has exchange value because in trade there is a rule: when a country buys products from other country then the payment must be in the currency of the other country or in an international currency. This is how the Foreign Exchange Market created – to settle the debt from international transactions e.g. exports - imports. For instance an American firm buys radios from a German supplier to resell it and must pay the supplier € 160,000 – deposit this amount in supplier’s bank account. Consequently the American company, to do so, must exchange $ to € as the supplier will not accept the currency of the other country. Also to be able to pay, the firm and its bank must know the exchange rate. Firms apart from foreign goods and services can buy financial assets such as euro deposits for investment purpose. The trading of currencies - the trading of bank deposits expressed in particular currencies takes place in the Foreign Exchange Market. Transactions conducted in the FEM determine the rates at which currencies are exchanged.

4. 4 Exchange Rates and International Transactions  Exchange rate is the price of one currency in terms of another. For example the dollar / euro exchange rate. Exchange Rates play an important role in international trade because they allow us to compare the price of goods and services produced in different countries. For e.g. an American citizen wants to decide whether to buy a ford car for $22,000 or a Japanese Nissan for ¥ 2,500,000??To make this comparison he must know the relation price of dollars and yen.

5. 5 Exchange Rates and International Transactions  The relative (relation) prices of currencies are reported daily in newspapers’ financial sections. An exchange rate can be quoted in two ways: (If we supposed that the home country is US) 1. Direct: as the price (cost) of foreign currency in terms of US dollars: $ 0.009421 per ¥ 1 unit of foreign currency worth some amount of U.S. dollars 2. Indirect: as the price (cost) of dollars (home currency) in terms of a foreign currency: ¥ 106.15 per $ 1 unit of U.S. dollars worth some amount of foreign currency The relationship of the two currencies is not mutual/equal.

6. 6 Exchange Rates are useful for comparison: Households and firms use exchange rates to translate foreign prices into domestic currency terms. Once the money prices of domestic goods and imports have been expressed in terms of the same currency, household and firms can calculate the relative prices that affect international trade flows. Domestic and Foreign Prices If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money. Example 1: The dollar price of a British jean which cost £50, when the dollar exchange rate is $1.50 per pound, is: (1.50 $/£) x (£50) = $75. If the dollar/pound exchange rate change to $1.25 this would alter the Jean's dollar price and will cost to Americans only: (1.25 $/£) x (£50) = $62.50. Exchange Rates and International Transactions

7. 7 Exercises 1. What is the exchange rate between the dollar and the British pound if a pair of American jeans cost $50 in NY and £100 in London? Answer: I give 50$ to buy 100 £. The exchange rate is $ to £, $/ £, 50/100 = 0.5 dollars per British pound 2. What is the exchange rate between the dollar and the British pound if a pair of American jeans cost $60 in NY and £30 in London? Answer: I give 60$ to buy 30 £. The exchange rate is $ to £, $/ £, 60/30 = 2 dollars per British pound

8. 8 Exchange Rates are Volatile

9. 9 Two types of changes in exchange rates: Depreciation of currency  A currency falls in value relative to another currency  It makes the goods of the country that its currency fall cheaper for foreigners, and so domestic companies are more competitive in the foreign market, and foreign goods (imports) more expensive for domestic residents.  E.g. 1.50 $/£ became 1.25 $/£ (British pound depreciated) Appreciation of currency  A currency rises in value relative to another currency  It makes the goods of the country that its currency rise more expensive for foreigners,and so domestic companies are less competitive in the foreign market, and foreign goods (imports) cheaper for domestic residents.  E.g. 1.50 $/£ became 1.75 $/£ (British pound appreciated)

10. 10 Exchange Rates are Volatile Result :When one currency depreciates against another, the second currency must at the same time appreciate against the first. Is becoming stronger. Example 2: At an exchange rate of $1.50 per pound, the pound price of an a American designer bag costing $45 is $45x1 =£30 in terms of pounds $1.50 If a depreciation of the pound occurs and the exchange rate become 1.25 $/£ then the bag, in terms of pounds, will cost: $45x1 =£36 more expensive for British citizens Dollar appreciates $1.25

11. 11 Case Study: A tale of two Dollars: The US and Canadian dollar The close interconnection of US and Canada provide a bright and clear explanation of the effects that an exchange rate alteration causes. borders 1970-1975: approximately US dollar = Canadian dollar equal relationship 1976-1987 : Canadian $ fall against the US $ due to the fact that economies are quit different and the macroeconomics policies each adopt dissimilar and diverse. Exporters were happy because they were selling more easily their products but Importers suffered loss. 1987-1991 : Canadian $ experienced appreciation cycles and Canadian Exporters faced tough competition while Importers enjoyed beneficial trade. Since Canada is a country that attracts mass arrival of tourists exchange rate changes affect the traveling to the country.

12. 12 Case Study: A tale of two Dollars: The US and Canadian dollar 1991 peak point: Canadian $ experienced to a great extent appreciation and many shops in the Canadian site borders closed down while in the American site, malls and restaurants faced high demand of their products and services from Americans and Canadians. Currency Fluctuations can cause problems to companies that base most of their expenses in one country and most of their revenues in other e.g. Toronto Blue Jays baseball organization : American players US dollar salaries Tickets receipts Canadian dollars So financial managers buy American dollars in advance to cover their needs when exchange rate is favorable. (they buy deposits in US $)

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17. 17 The Foreign Exchange Market Important definitions Foreign exchange market: A market for converting the currency of one country into the currency of another. Exchange rate: The rate at which one currency is converted into another Foreign exchange risk: The risk that arises from changes in exchange rates Functions of the foreign exchange market Two functions (purposes): Converting currencies Reducing risk

18. 18 The Foreign Exchange Market The Actors - Main participants in the foreign exchange market 1.Commercial banks: Central participant because every sizable international transaction involves the debiting and crediting of accounts at commercial banks in various financial centers. Buying/selling of deposits in different currencies Recall the American firm which buys radios from a German supplier for €160,000 when the exchange rate is $1.2/€ The American bank pays (deposits) €160,000 to the German Bank and the American firm pays (deposits) the Amer. bank with $192,000. Exchange of $192,000 deposit with €160,000 deposit. Exchange Rates are determined by the interaction of buyers and sellers: households, firms and financial Institutions that buy and sell foreign currencies to make international payments

19. 19 The Foreign Exchange Market A commercial bank quotes - marks -to other banks exchange rates at which it is willing to buy currencies from them and sell currencies to them. Interbank trading is the trading of foreign currency between banks. Interbank rates are the rates that banks charge to each other and no amount less than $1 million is traded at this rates. The rates available to customers are called retail rates and they are less favorable than the wholesale interbank rates. Bank Compensation = Retail – Wholesale Rates By serving many customers a bank is running large scale transactions and therefore economize (spend less) on costs.

20. 20 2. Corporations: Operate in several countries business make or receive payments in currencies different than the one of the country which the firm is based. E.g. an American firm pays workers in Mexico. Buying pesos with dollars. Also companies buy or sell goods, services and assets in the foreign market and for that reason they exchange currencies. Stocks, Bonds Real Estates, Diamonds Gold etc 3. Non-bank financial institutions: Mutual funds, securities firms, insurance companies, pension funds also buy/sell foreign assets for investment. The Foreign Exchange Market

21. 21 The Foreign Exchange Market 4. Central banks: A central bank keeps reserves of international currencies. Central Banks sometimes intervene in foreign exchange markets. While the volume of central bank transactions is typically not large the impact of these transactions may be great. The reason for this is that participants in the FEM watch Central Bank actions closely for clues about future macroeconomic policies that may affect exchange rates. One of the 4 strategies that a Central Bank follows to promote price stability is exchange rate targeting or exchange rate peg. According to this strategy a country fix the value of the domestic currency to that of a large,low inflation country, the anchor country. CB uses margins up and down to be able to have higher or lower inflation from the anchor country if needed. Cyprus followed this strategy before entering EU in 1/1/2008, because is suitable for small open economies.

22. 22 Characteristics of the Foreign Exchange Market The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years: In April 2004 the daily global value of foreign exchange trading was $1.9 trillion. Foreign Exchange Trade takes place in many financial centers. The biggest volume of trade occurs in major cities as: London (the largest market) $753 billion daily in April 2004 New York $461 billion Tokyo $199 billion Frankfurt Singapore New technologies, such as Internet links, direct phone, fax are used among the major foreign exchange trading centers. The FEM never close is open 24 h a day and traders may deal from their homes with financial centers in other continent.

23. 23 Characteristics of the Foreign Exchange Market London’s dominance is explained by: History (capital city of the first main industrialized nation). Geography (between Tokyo, Singapore and New York).

24. 24 Characteristics of the Foreign Exchange Market Arbitrage: someone takes advantage of a temporary price difference in two locations to make profits buying at a lower price and selling at a high price for a profit. For example if the euro were selling for $1.1 in New York and $1.2 in London a trader could buy €1 million n NY for $1.1 and sell it immediately in London for $1.2 making a pure profit of $ 100,000. But due to the fact that computer and telecommunications technology transmit information rapidly, markets have integrated and information travels quickly. So if all traders demand more € in NY the price of euros in terms of dollars would rise and the supply of € in London would drive down that price. So this implies that there can be no significant arbitrage. Prices in both locations change until equilibrium (one price) returns.

25. 25 Characteristics of the Foreign Exchange Market Vehicle currency US dollar is a vehicle currency because US is important to the world economy and the volume of international transactions involving dollars is so great that is really easy to find parties willing to trade dollars against other currencies. A vehicle currency is the one that is widely used to invoice an international trade transaction made by parties (importer- exporter) who do not live in the country that issues the vehicle currency. Although a foreign exchange transaction much any two currencies, most transactions between banks are exchanges of foreign currencies for U.S dollars, For e.g. a bank wishes to sell Swiss francs and buy Israeli shekels. It is cheaper for the bank to exchange Swiss francs with dollars than trying to find a holder of Israel currency who wishes to buy Swiss Francs. A simple example of the importance of dollar. Table 1: In 2004 90% of foreign exchange transactions involved exchanges of foreign currencies with US dollars.

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27. 27  Spot Rates and Forward Rates SPOT TRANSACTION: All the foreign transactions take place ‘On the spot’: two parties agree to an exchange of bank deposits and execute the deal at the present. exchange rate = spot exchange rate = current exchange rate In reality the value date for a spot transaction – the date on which the parties actually receive the funds they have purchased – occurs two business days after the deal is made because the payment instructions need two days to be cleared through the banking system. Characteristics of the Foreign Exchange Market

28. 28 FORWARD FOREIGN EXCHANGE CONTACT: Foreign exchange deals sometimes specify a value date farther away than two days: 30 days,90 days,180 days,360 days or even several years. The exchange rate in this case is quoted as forward exchange rate and is different than the spot rate. Forward foreign exchange contracts is an agreement at the present beginning by you to buy or sell a specific amount of foreign currency at a certain fixed rate on a future (‘forward’) date. Characteristics of the Foreign Exchange Market

29. 29 Example 3 : Forward foreign exchange contracts: Home country in example is England. Imagine you will need to purchase components worth €100 each from a German supplier in 1 month time. One euro might currently be worth 95 Pence (€1=£0.95), meaning the goods would theoretically cost £95 each (100x0.95). You are planning to sell each good for £105. So your profit will be £105-£95=£10 for each good. However, if the euro increases in value against the pound (appreciate) to107 pence over the month (€1=£1.07), the components would then cost you £107 each. And then instead of gain you will face loss of -£2 per good. If the euro is expected to increase in value, you might agree a forward foreign exchange contract with Bank of England to buy € for £0.98 pence on a specified date (in 1 month from today). Of course, you'll lose out if the euro falls in value. So the cost will be £98 each and the profit £7 each. Result: You have a guaranteed profit of £7 each Characteristics of the Foreign Exchange Market

30. 30 Forward foreign exchange contracts: Advantages 1. You’re protected against any possibility of unpleasant movements in the exchange rate that may turn a profitable import deal into loss. 2. You can set budgets knowing exactly how much the transaction costs. Disadvantages 1. You have to go ahead with the contract once you have arranged it, regardless of whether your circumstances change. 2. Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate. Characteristics of the Foreign Exchange Market

31. 31 Forward and spot exchange rates, although are not necessarily equal, do move closely together.

32. 32  Other methods of currency exchange: 1.Foreign exchange swaps: a combination of a spot sale with a forward repurchase of the currency for a temporary time. Swaps allow one currency to be periodically swapped – changed, exchanged - for another at a specified exchange rate. Swaps often result in lower transaction fees because they combine two transactions. Example: An American company received $1 million from sales but in 3 months time has to pay a supplier. It can take advantage of the intervening time and invest the money in euro-bonds with the agreement to repurchase it in 3 months. 2.Future Contacts: The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future. Characteristics of the Foreign Exchange Market

33. 33 Differences of a future contract with a forward contract. Although a Futures Contract is similar to a Forward Contract because both are agreements to trade on a set future date, there are some significant differences. Future contracts are highly standardized, while each Forward contract is personalized and unique. The profit or loss on a Future contract can be exchanged in cash every day. With the Forwards contract, the profit or loss is realized only at the time of settlement. The Futures contract does not specify to whom the delivery of a physical asset must be made; in a Forwards contract it is clearly specified who receives the delivery. Future contracts are publically and freely traded while Forward contracts are Traded privately Characteristics of the Foreign Exchange Market

34. 34 3. Foreign Exchange Options: The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date. The option’s seller – the other party - is required to sell or buy the foreign currency at the discretion of the option’s owner, who is under no obligation to exercise this right. It gives the owner the option, but not obligation, of buying or selling currency if the need arises. Characteristics of the Foreign Exchange Market

35. 35 Reducing risk in FEM: Insuring against foreign exchange risk Spot exchange rate: rate of currency exchange on a particular day Forward exchange rate: two parties agree to exchange currencies on a specific future date Currency swap: immediate purchase and sale of equal amounts of one currency for another with two different value dates (spot and forward) A foreign exchange swap consists of two legs: a spot foreign exchange transaction – invest-, and a forward foreign exchange transaction -repurchase. These two legs are executed at the same time for the same quantity, Characteristics of the Foreign Exchange Market

36. 36  Bid & Ask Quotes Foreign currency dealers provide two quotes: Bid Price: Price at which the Bank is willing to buy foreign currency from you. Ask Price: Price at which the Bank is willing to sell foreign currency to you.  It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread.  The less traded and more volatile a currency, the greater is the spread. Characteristics of the Foreign Exchange Market

37. 37 Exercises 1.How many British Pounds would it cost to buy a pair of shoes of an American designer costing $45 if the exchange rate is 1.60 dollars per British pound? 2.Compute how many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing £50 British pounds for the following exchange rates? a) $1.25/ £ b) $1.40/ £ c) $1.75/ £

38. 38 Solutions 1. £28.125 2. a) $62.50 b) $70 c) $87.50

39. 39 Appendix: Government Policies toward the Exchange Rates Floating Exchange Rates: Price determined only by demand and supply of the currency – no government intervention Fixed Exchange Rates: The value of a currency fixed in relation to an anchor currency – not allowed to fluctuate Dirty Floating or Managed Exchange Rate: – rate influenced by government via central bank around a preferred rate