Foreign Exchange

Chapter 11

Copyright 2009 South-Western, a division of Cengage Learning. All rights reserved.

Foreign Exchange Market

o definition organizational setting within which

individuals, businesses, governments, and
banks buy and sell foreign currencies
o no single, central meeting place
o largest foreign exchange markets: London,
New York and Tokyo
o transactions between:
commercial banks and their commercial
customers
banks conducted by brokers
trading banks and their overseas branches

Types of Transactions

o spot transaction - outright purchase & sale

of foreign currency with immediate delivery
meaning within two business days
o forward transaction agreement for
purchase & sale at a specified rate at some
point in the future
more than two business days
months or even years in the future
o currency swap conversion of one currency
to another at one point in time with agreement
to reconvert back at a specified future time

Interbank Trading
o most U.S. transactions conducted by a few
large banks
o retail transactions bank to customers; less
than $1MM
o wholesale
transactions
bank to bank
or bank to
corporate
customers;
more than
$1MM

Bank Profits on Transactions

o banks quote two rates on transactions:

bid rate price bank is willing to pay for foreign

currency
offer rate price at which bank is willing to sell
foreign currency

o spread difference between the bid and offer

o other profits:
o anticipating appreciation => bank raises bid & offer
to buy more of that currency => resells later at high
price making a profit
o anticipating depreciation => bank lowers bid & offer
to sell more of that currency => buys back later at
lower price creating profits

Foreign Exchange Quotations

o 2nd and 3rd columns indicate number of dollars

needed to buy foreign currency
[0.03046 U.S. dollars for one Taiwan dollar]

o 4th and 5th columns indicate units of foreign

currency needed to buy dollar
[32.83 Taiwan dollars for one U.S. dollar]

Cross Exchange Rate

o most quotations expressed in terms of U.S. dollar
o cross exchange rate determines value of two
currencies in terms of a third
o example:

$ value of Taiwan dollar

= $.03046 = 27.9681
$ value of S. Korean won
$.0010891

Therefore, each Taiwan dollar buys approximately

28 South Korean won.

Forward Versus Futures

Difference
Associated
with
Futures
Market:
Markets

o only at specific locations such as International

Monetary Market of Chicago Mercantile
Exchange and Tokyo International Financial
Futures Exchange
o only major currencies
o contracts limited to specific dates (3rd Wed.
March, June, September & December)
o fixed amounts
o profit/loss paid at close of trading as opposed
to the contract date

Foreign Currency Options

o definition agreements between holder

(buyer) and writer (seller) giving the holder the
right to buy or sell a fixed amount of foreign
currency at a specified price within a specified
time period
o call option provides right to buy
o put option provides right to sell
o strike price price at which the option can be
exercised
o holder not obligated to use contract; writer
obligated if holder proceeds with transaction

Exchange-Rate
o demand for foreign currency corresponds to
Determination
balance of payments debits [U.S. imports; U.S.
foreign investment; foreign transfer payments]
o supply of foreign
currency equal to
balance of payment
credits [U.S.
exports; foreign
investment in U.S.;
transfer payments
to U.S.]

Appreciation of U.S. Dollar

Advantages:
1) U.S. consumers see lower prices on foreign
goods
2) lower prices on foreign goods limit U.S. inflation
3) U.S. consumers benefit during foreign travel
Disadvantages:
1) U.S. firms find it harder to compete in foreign
markets
2) U.S. firms find it harder to compete with imports
3) foreign tourists find it more expensive to vacation
in the U.S.

Depreciation of U.S. Dollar

Advantages:
1) U.S. firms find it easier to sell goods in foreign
markets
2) firms in the U.S. face less pressure to keep
prices low
3) more foreign tourists can afford to visit U.S.
Disadvantages:
1) U.S. consumers face higher prices on foreign
goods
2) higher foreign prices can lead to inflation in U.S.
3) U.S. consumers find foreign travel more costly

Nominal Exchange Rate

o exchange rate index weighted average of

exchange rates between the domestic currency
and nations most important trading partners
o major currency index
average exchange
rate for dollar versus
seven major U.S.
trading partners
o nominal index such
as this is not adjusted
for changes in U.S. or
foreign price levels

Real Exchange Rate

o accounting for changes in the price levels:

Real Exchange Rate = Nominal Exch. Rate Foreign Countrys Price Level
Home Countrys Price Level

o better indication
of purchasing
power of dollar
o increase in real
exchange rate
will make it
more difficult for
U.S. firms to
compete

Arbitrage

o exchange arbitrage simultaneous purchase

and sale of currency in different foreign
exchange markets in order to profit from
exchange rate differential in two locations
o two or three point arbitrage possible
assume: 1 = $1.50; 1 = 4 francs; 1 franc = $0.50
sell $1.5 million for 1 million
sell 1 million for 4 million francs
sell 4 million francs for $2 million

$500,000 profit

o such transactions shift supply & demand for

currencies eliminating opportunities for profits
and establishing consistent exchange rates

Forward Market

o currency worth more in forward market than spot

market => premium
o currency worth less in forward market than spot
market => discount
ForwardRate SpotRate
12
premium

SpotRate
SpotRateNo.MonthsForward

Relationship Between
Forward Rate & Spot Rate

interest rate differentials - comparable securities

higher U.S. interest rates
o investors sell foreign currency for dollars
driving down spot price
o use dollars to purchase U.S. Treasury bills
o investors obtain forward contract allowing
foreign currency to be bought back with dollars
driving up forward price
o result: foreign currency at premium in forward
market

Relationship Between
Forward Rate & Spot Rate

lower
U.S. interest rates
(cont.)
o investors buy foreign currency with dollars
driving up spot price
o use foreign currency to purchase foreign
Treasury securities
o investors obtain forward contract allowing
dollars to be bought back with foreign currency
driving down forward price
o result: foreign currency at discount in forward
market

Managing Foreign Exchange

o hedging process of avoiding or covering a
Risk
foreign exchange risk
o U.S. importer hedging against depreciation
must pay in foreign currency in the future
contract to purchase foreign currency in the
forward market
does not require importer to tie up funds
o exporter hedging against appreciation
will receive foreign currency in the future
contract to sell foreign currency in the
forward market
o both eliminate risks of fluctuating spot rates

Uncovered Interest Arbitrage

o moving funds
into foreign
currency to take
advantage of
higher rate of
return without
forward contract
o extra return:

UK
U.S.
Percentage
= Interest - Interest Appreciation/Depreciation
Rate
Rate
of Pound

Covered Interest Arbitrage

1) purchase foreign currency at spot rate and use it
to finance foreign investment
2) contract in the forward market to sell amount of
foreign currency that will be received

because of activity in the forward market such

investment opportunities quickly disappear

Foreign Exchange Market

o speculation attempt to profit by trading on
Speculation

expectations about prices in the future

o different from arbitrage where trader buys &
sells simultaneously; speculator buys at one
time and sells at a different time
o stabilizing speculation goes against
market forces by moderating changes in
exchange rates
o destabilizing speculation goes with market
forces by reinforcing fluctuations in exchange
rates