Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 13 The Foreign- Exchange Market.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 13

The Foreign- Exchange Market

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.13-2

Topics to be Covered

• Foreign Exchange Market

• Exchange Rate

• Types of Exchange Rates:– Spot Rates– Forward Rates– Cross Rates

• Arbitrage and Hedging

• Swaps, Futures, and Options

• Central Bank Intervention

• Black Markets and Parallel Markets


• Economic interactions with the rest of the world require an exchange of currencies

• The exchange of domestic currency for foreign currency occurs in the foreign exchange market

• Who are the major participants in these international flows of capital?

INTRODUCTION


Foreign Exchange Market

• The Foreign Exchange Market (FEM) is a market where one country’s money is traded for that of another country.

• The “money” that is traded is bank deposits or bank transfers of deposits denominated in a foreign currency.

• The FEM consists primarily of large commercial banks in world financial centers such as New York or London. These financial centers operate in different time zones (refer to Figure 13.1).


FIGURE 13.1 The World of Foreign-Exchange Dealing


Features of Foreign Exchange Market

• Refer to Table 11.1 FEM Trading Volume

• The total volume of trade in the foreign exchange market was approximately $4 trillion in 2007.

• The largest markets are the U.K., accounting for 34% of the world market, and the U.S. with a 17% share.


TABLE 11.1 Foreign Exchange Market Trading Volume


Features of FEM (cont.)

• Refer to Table 11.2

• The most traded currency is the U.S. dollar, accounting for 86% of the total amount traded.

• The dollar is followed by the euro, the Japanese yen, and the British pound.


TABLE 11.2 Use of Currencies on One Side of the Transaction as a Percentage of Total Foreign-Exchange Market Volume


Exchange rates play a central role in international trade because they allow us to compare the prices of goods and services produced in different countries. A consumer deciding which of two American cars to buy must compare their dollar prices, for example, $44,000(for a Lincoln Continental) or $22,000 (for a Ford Taurus). But how is the same consumer to compare either of these prices with the 2,500,000 Japanese yen (¥2,500,000) it costs to buy a Nissan from Japan? To make this comparison, he or she must know the relative price of dollars and yen.

Exchange Rates and International Transactions


Definitions of Exchange Rates

• Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. The first of these exchange rate quotations (dollars per foreign currency unit) is said to be is direct (or "American") terms, the second (foreign currency units per dollar) is indirect (or "European") terms.

• Exchange rates allow us to denominate the cost or price of a good or service in a common currency. – How much does a Honda cost? ¥3,000,000– Or, ¥3,000,000 x $0.0098/¥1 = $29,400


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. For example, how many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds (£50)'1 The answer is found by multiplying the price of the sweater in pounds, 50, by the price of a pound in terms of dollars-the dollar's exchange rate against the pound. At an exchange rate of $ 1 .50 per pound (expressed in American terms), the dollar price of the sweater is

• ( 1 .50 $/£) X (£50) $75.


• A change in the dollar/pound exchange rate would alter the sweater's dollar price. At an exchange rate of $ 1 . 25 per pound, the sweater would cost only

• ( 1 .25 $/£) X ( £50) = $ 62.50,

• At an exchange rate of $ 1 .75 per pound, the sweater's dollar price would be higher, equal to

• ( 1 .75 $/£) X ( £50) = $ 87.50.


Depreciation and Appreciation

• Depreciation is a decrease in the value of a currency relative to another currency.

– A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.

– $1/€1 → $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.

– The euro has appreciated relative to the dollar: it is now more valuable.


Depreciation and Appreciation (cont.)

• Appreciation is an increase in the value of a currency relative to another currency.

– An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

– $1/€1 → $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.

– The euro has depreciated relative to the dollar: it is now less valuable.



• A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.– How much does a Honda cost? ¥3,000,000– ¥3,000,000 x $0.0098/¥1 = $29,400– ¥3,000,000 x $0.0100/¥1 = $30,000

• A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.

• A depreciated currency lowers the price of exports relative to the price of imports.



• An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.– How much does a Honda cost? ¥3,000,000– ¥3,000,000 x $0.0098/¥1 = $29,400– ¥3,000,000 x $0.0090/¥1 = $27,000

• An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.

• An appreciated currency raises the price of exports relative to the price of imports.


Exchange Rate

• Types of Exchange Rates:– Spot XR vs. Forward XR– U.S. $ per foreign currency vs. foreign currency per

U.S. $– Cross XR


Spot Market

• Spot Market is where currencies are traded “on the spot”, that is, for immediate delivery. The exchange rate here is called the spot XR.

• Refer to Table 13.1

• Exchange rates are quoted at a specific day and time.

• The rates are for large, wholesale trades ($1 million or more); the smaller the quantity of foreign exchange purchased (retail transaction), the higher the price.


• The rates are “midrange” quotes or the average of the banks’ buying and selling prices.

• The percentage appreciation or depreciation of the spot rate over time using direct quotes can be measured using

Spot Market

100rate begining

rate endingrate beginningRateSpot in %Δ



TABLE 13.2 International Currency Symbols


Spread

• Spread—the difference between the buying and selling price of a currency.

• The spread will tend to be higher for thinly or low-volume traded currencies or for high-risk currencies.


13-24


Arbitrage

• Arbitrage—the activity of simultaneously buying a currency in

one market while selling in another to take advantage of profit opportunities. for instance, purchase of

€l million in New York for $ 1.1 million and immediately sell the euros in London for $ 1.2 million, making a pure profit of $ 100,000. If all traders tried to cash in on the opportunity, however, their demand for euros in New York would drive up the dollar price of euros there, and their supply of euros in London would drive down the dollar price of euros there. Very quickly, the difference between the New York and London exchange rates would disappear. Since foreign exchange traders carefully watch their computer screens for arbitrage opportunities, the few that arise are small and very short-lived.


Cross Rate

• Cross Rate—the third exchange rate implied by any two exchange rates involving three currencies.

• Since the dollar is actively traded with many currencies, any two exchange rates involving dollars can be used to determine cross rates.


Forward Rates and Forward Exchange Market

• Much of international trade is contracted in advance of delivery and payment.

• What options does the importer have with respect to payment?– Wait until day of delivery of the imported

commodity and then buy the foreign currency.– Buy the foreign currency now and hold or invest

it for the contract period.– Use the forward exchange market.


• Paying for Imports and Exports– Payments in international transactions are

different from payments in a domestic economy

– Cash payments are rare in international trade because of the burden it puts on the buyer (importer)

– Usually imports are paid for using a specific foreign exchange instrument

Forward Rates (cont.)


• There is a substantial period between when the exporter ships the goods and when the importer receives them

• The most common solution to this problem is a cable transfer

• The importer instructs his or her bank to transfer the payment for the imports to the exporter’s account in another country



• The disadvantage of this is that the importer pays in advance for goods not yet received

• A commercial bill of exchange or a bank draft instructs the importer to pay on a certain date a specified amount of money.

• A letter of credit is a guaranty that the commercial bill of exchange or bank draft will be paid by the bank

• These instruments can be sold in the foreign exchange market for slightly less than the face value




• Forward exchange market—where a currency may be bought and sold at a price (i.e., forward rate) agreed upon today but for delivery at a future date.– Forward dates are typically 30, 90, 180, or 360

days in the future.

– Rates are negotiated between two parties in the present, but the exchange occurs in the future.


Forward Premium vs. Forward Discount

• Forward Premium—when the forward exchange rate is greater than the spot rate.

• Forward Discount—when the forward exchange rate is less than the spot rate.

• Flat Currency—when the forward rate and spot rate are equal.


• The percentage discount or premium can be determined for forward rate relative to spot rate when quoted on a direct basis by using the following formula

Forward Premium vs. Forward Discount

[(Forward Rate – Spot Rate)/Spot Rate] (360/N) 100

Where N is the number of days to future delivery in the contract


Foreign Exchange Swap

• Foreign Exchange Swap—an agreement to trade currencies at one date and then reverse the trade at a later date.

• The swap serves as a borrowing and a lending operation combined in one deal.

• These agreements are frequently used by commercial banks for inter-bank trading.

• Swaps account for 53% of the volume of trading activity in the foreign exchange market (refer to Table 13.3).


Swap

• A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of the currency. For example, suppose the Toyota auto company has just received $ 1 million from American sales and knows it will have to pay those dollars to a California supplier in three months. Toyota's asset-management department would meanwhile like to invest the $1 million in euro bonds. A three-month swap of dollars into euros may result in lower brokers‘ fees than the two separate transactions of selling dollars for spot euros and selling the euros for dollars on the forward market.


TABLE 13.3 Average Daily Volume of Bank Foreign-Exchange Market Activity


Hedging

• Hedging—an activity to offset or avoid risk in the market.


Foreign Exchange Futures Market

• Futures market is similar to the forward market where currencies may be bought and sold for future delivery.

• The futures market differs from the forward market in that:– Only a few currencies are traded– Trading occurs in standardized contracts– Trading occurs in a specific geographic location such as the

International Monetary Market of the Chicago Mercantile Exchange

– Futures contracts are for smaller amounts of currency and are a useful hedging tool for smaller firms


Foreign Currency Option

• Foreign Currency Option—a contract that provides the right to buy or sell a currency at a fixed exchange rate on or before the maturity date( these are known as American options, European may be exercised only at maturity).

• Call Option—an option to buy currency.

• Put Option—an option to sell currency.

• Strike or Exercise Price—the price at which currency can be bought or sold.


Foreign Currency Option (cont.)

• Foreign currency options were first traded in December 1982 at the Philadelphia Stock Exchange.

• The options contracts cover only a few foreign currencies and their fixed amounts are smaller than those of futures contracts.

• Unlike a future or forward contract, the option offers the right to buy or sell if desired in the future and is not an obligation.


Supply of and Demand for Foreign Currency

• Refer to Figure 13.2 Dollar/Pound Market

• Demand for pounds curve—arises from the U.S. demand for British goods, services, and financial assets.

• Supply of pounds curve—comes from the British demand for U.S. goods, services, and financial assets.

• Equilibrium exchange rate—found at the intersection of the demand and supply curves.


FIGURE 13.2 The Dollar/Pound Foreign-Exchange Market


Central Bank Intervention

• Central banks, such as the Federal Reserve, buy and sell foreign exchange to influence the values of their currencies.

• Suppose the U.S. demand for British goods increases, which causes the demand for pounds to shift to the right. As a result, the dollar depreciates and pound appreciates.

• Either the Bank of England or the Fed may intervene to stop the pound appreciation by selling pounds in the foreign exchange market.


Fixed Exchange Rate

• Fixed Exchange Rate—where a central bank actively intervenes in the foreign exchange market so as to keep the exchange rate from changing.


Flexible Exchange Rate

• Flexible Exchange Rate—where the exchange rate is determined by free-market forces of demand and supply.


Exchange Rate Index

• Refer to Global Insights 13.1• Exchange Rate Index – a weighted average

of a currency’s value relative to other currencies, where the weights are based on the relative trade importance of each currency.


Black Market

• Black Market—an illegal market in foreign exchange. Usually a result of restrictive government policies on foreign exchange transactions.


Parallel Market

• Parallel Market—a free market allowed by government to coexist with the official market.


An exchange rate index is a way of measuring the performance of a currency against a basket of other currencies.US Dollar IndexFor example, the US dollar index measures the US dollar against 6 main currencies.1. Euro (EUR) – 12 members of EU.2. Japanes Yen (JPY)3. Pound Sterling (GBP) -4. Loonie (CAD) – Canada5. Kronas (SEK) – Sweden6. Francs (CHF) – SwitzerlandThese are weighted. This means the exchange rate movements also depend on the relative importance of trade with these currencies. Therefore an appreciation against the Swedist Krona, only accounts for a small % of US trade. A devaluation against the Euro will have much more impact and weighting.The Decline in the US Dollar Index.The US dollar index is currently 77.5 (link). The index was set at 100 in 2000. Therefore, there has been a 22.5% decrease in the value of the dollar since 2000.See: Reasons for falling dollar

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 13 The Foreign- Exchange Market.

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