1. Foreign Exchange Markets

2. Chapter Outline Foreign Exchange Markets and Risk: Chapter Overview Background and History of Foreign Exchange Markets Foreign Exchange Rates and Transactions Interaction of Interest Rates, Inflation and Exchange Rates

3. Foreign Exchange Markets and Risk There are two relevant prices involved in international trade: 1. the price of the good or service purchased 2. and the price of the currency Fluctuating exchange rates, cause risk in international business transactions foreign exchange rate is: the ‘entry fee’ to purchase a country’s financial and real goods and services. the link between economies, reflects the value of the goods and services produced by a given country relative to the value of goods and services produced in another country. Depreciating foreign currencies hurt the home currency value of foreign assets, but also reduce the home currency value of foreign liabilities. The converse is true for appreciating currencies

4. History Bretton Woods System (1944-1971): arose because of the need to foster cooperation among countries and promote trade instead of the competitive devaluations that had occurred during the Depression years The Smithsonian Agreement I (1971) tried to prop up the system, increase range from 1% to 2.25% but the second Smithsonian Agreement (1973) allowed freely floating exchange rates.(gov intervention through interest rates)

5. History (continued) fixed exchange rate system failed because U.S. inflation was greater than the rest of the developed world, BW arose for the need to promote cooperation and trade, As the currency markets grew, governments found it increasingly difficult to maintain a fixed exchange rate

6. Prior to 1972 all forward foreign exchange trading was OTC involving banks. The IMM of the CME began trading foreign currency futures contracts Advantages of trading currency futures on an exchange Disadvantages of using currency futures rather than forwards would

7. EURO: January 1, 1999, January 1, 2002 (12 European countries, expanded to 25 countries). monetary union outlined by the Maastricht Treaty of 1993 Impact of the euro In 2004 the foreign exchange markets were the largest markets in the world with over $1.9 trillion of daily trading activity in essentially a 24-hour market.

8. Foreign Exchange Rates and Transactions Foreign Exchange Rates Rates can be quoted two ways: 1. Dollar value of one unit of foreign currency: £1 = $1.60 (direct) 2. Foreign currency value of the dollar: $1 = £0.625 (indirect) Inverses Currency cross rates dollar appreciates: foreign currency value of the dollar rises but the dollar value of the foreign currency falls For example if we say the pound appreciated 10%, how is the new value of the pound calculated? £1 = $1.60 initially so the new value of the pound is $1.60  1.1 = $1.76. The value of the dollar did not drop 10% however. The inverse of $1.76 is 0.5682 so the $1 = £0.5682, a 9.09% drop.

9. Domestic currency Foreign currency Indirect exchange rate Direct exchange rate AppreciatesDepreciatesIncreasesdecreases DepreciatesAppreciatesdecreasesIncreases Quote in USBidAsk Direct ($/€)1.46931.4694 Indirect (€/$)0.68040.6805 Spread= (Ask-Bid)/ Ask (increases with uncertainty and low trading volumes)

10. Foreign Exchange Transactions: Spot A strong currency can contribute to a current account deficit. Conversely, a weaker currency may improve the current account deficit. Appreciation vs depreciation The dollar fell 33% against the euro from 2002 to 2004, only to regain much of the loss in 2005 and redrop again. What was behind the dollar drop?

11. Foreign Exchange Transactions Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

12. Foreign Exchange Market Trading (in billions of U.S. dollars)

13. Foreign Exchange Risk Example Trade involves the purchase of SF3 million bonds Spot is 0.8639 $/SFOne month spot 0.8514 $/SF Forward.8651 $/SF Thus buy SF and sell USD Spot exchange rate USD for SF is.8639 Convert 3 million * 0.8639 = $2,591,700 After a month spot exchange rate $.8514 and deal not completed Value of the SF 3 million =.8514*3 = $ 2,554,200 Loss = $ 2,554,200 - $2,591,700 = $37,500 Could be avoided if it had bought SF forward for an exchange rate of $.8651: receipt=.8651 * SF 3 million = $ 2,595,300 Profit = $ 2,595,300 - $2,591,700 = $3,600

14. The Return and Risk of Foreign Exchange Transactions Transaction exposure Commitments to purchase goods may be hedged by buying the foreign currency forward. Commitments to sell in a foreign currency may be hedged by selling the currency forward. One of the reason for the creation of longer term swaps...

15. Net exposure: is the value of exposed assets minus the value of exposed liabilities. can be hedged on or off the balance sheet: net liability exposure to pound, acquire pound assets or buy the pound forward. firms centralize their exchange risk management and net their exposures across subsidiaries at Risk (VAR) can be used to improve hedging efficiency by accounting for the correlation among currencies

16. Currency arbitrage: A currency quote in the U.S. for the £ is: £1 = $1.8302 - $1.8409. A similar quote for the dollar in London may be: $1 = £0.5252 - £0.5288. A currency trader could take advantage of these quotes by selling dollars and buying the pound at the U.S. quote at the ask price of $1.8409 / £. This will yield 1/$1.8409 = £0.5432 per dollar exchanged. The trader can simultaneously buy dollars (sell pounds) at the London ask of £0.5288. This will give £0.5432 / £0.5288 = $1.0272. The trader can accomplish these trades risklessly in a matter of moments. This works because the dollar is valued more highly at the U.S. quote where the trader sold dollars and bought pounds BIDASK

17. Numerical example of covered interest arbitrage A bank has borrowed $1 million at 4% for one year (bullet borrowing). It can convert the dollars to euros at a spot exchange rate of $1.20 per euro. Annual interest rates on euro denominated deposits are 5% and the one year forward rate to sell euros against the dollar is $1.19 The transactions of the arbitrage are Borrow $1 million at 4% for one year. In one year the bank will owe $1 mill * 1.04 = $1,040,000 Convert the $1 million to euro today at the spot of $1.20 / euro: $1,000,000 * € / $1.20 = €833,333 Invest the euros in the deposits paying 5%. In one year the deposits will yield: €833,333 * 1.05 = €875,000 Sell the euros forward to ensure the dollar value in one year: €875,000 * $1.19 / € = $1,041,250 Repay the amount owed of $1,040,000, and clear the difference, $1,250, risklessly without using any of the bank’s money. Return is( $1,041,250 - $1,040,000 )/ $1,040,000 = 0.12% This works because the euro drops in value by less than the difference in interest rates

18. Text examples Assets: $100 million US loan $100 million equivalent UK loan Liabilities: $200 million US CDs in dollars US CD rate is 8% Loans in US are yielding 9% Loans in UK are yielding 15% 1.Exchange rate is $1.60 If pound depreciates to $1.45 If pound appreciates to $1.70 2.Hedging on the Balance Sheet 3.Hedging with forwards : one year forward exchange rate $1.55

19. 1. Sell $100 million for pounds for 62.5 M pounds 2. Invest in UK @15%, at year end revenue=71.875 M pounds 3. Sell the pounds for dollars @ $1.6/pound= $115 M 4. Return is 15%, weighted return on portfolio = (.5)(0.09)+(0.5)(0.15)=12% (4% spread) If pound depreciates to $1.45/ pound Step three changes to $104.22 M Return = 4.22%, and weighted return on portfolio = (.5)(0.09)+(0.5)(0.0422)=6.61% (-1.39% spread) If pound appreciates to $1.70/ pound Step three changes to $122.188 M Return = 22.188%, and weighted return on portfolio = (.5)(0.09)+(0.5)(0.22188)=15.59% (7.5% spread)

20. If pound depreciates to $1.45/ pound Return = 4.22% on British loan, as for the US loan 1. Sell $100M @$1.6/pound 2. End of year pay CD holder I and P = 62.5 M(1.11)=69.375 M pounds 3. Repayment in $ =$100.59 or a cost of 0.59% 4. Average return on assets= (.5)(0.09)+(0.5)(0.0422)=6.61% Average cost of funds= (.5)(0.08)+(0.5)(0.0059)=4.295% Net return=2.315% Assets: $100 M US loan (9%) $100 M equivalent UK loan (15%) Liabilities: $100 M US CDs (8%) $100 M UK CDs (11%) Hedging on the Balance Sheet If pound appreciates to $1.70/ pound Return = 22.188% on British loan, as for the US loan 1. Sell $100M @$1.7/pound 2. End of year pay CD holder I and P = 62.5 M(1.11)=69.375 M pounds 3. Repayment in $ =$117.9375 or a cost of 17.9375% 4. Average return on assets= (.5)(0.09)+(0.5)(0.22188)=15.594% Average cost of funds= (.5)(0.08)+(0.5)(0.179375)=12.969% Net return=2.625%

21. 1. US FI sells $100 M@ $1.6/pound=62.5 M pounds 2. Lend to British @15% 3. FI also sells proceeds forward @ $1.55=62.5M(1.15)*$1.55/pound=$111.406 M 4. End of year British pay US FI, P + I = 71.875 M pounds 5. FI delivers 71.875 M pounds to the buyer of forward and receives $111.406 M FI return= 11.406% Overall return to FI portfolio= (0.5)(0.09)+(0.5)(0.11406)=10.203% Hedging with forwards : one year forward exchange rate $1.55

22. The Role of Financial Institutions in Foreign Exchange Transactions: Banks Trading is now done electronically with Reuters and electronic brokerage systems (EBS) dominating activity. Banks’ Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) Positive exposure implies that a FI is net long in a currency; negative exposure is net short in a currency U.S. non-bank FIs also have currency exposures FIs participate in foreign currency market for four reasons…

23. Interaction of Interest Rates, Inflation and Exchange Rates Purchasing Power Parity (PPP): law of one price If relative purchasing power parity (PPP) holds then differences in inflation rates between two countries are perfectly adjusted for by changes in exchange rates to maintain constant purchasing power. (holds over the long term) if the nominal $/¥ exchange rate is $0.009091/¥ and the U.S. has 3% inflation and Japan has 1%; the nominal exchange rate would adjust to ¥1 = $0.009091  1.03/1.01 = $0.009271. With the new stronger yen one could purchase exactly the same amount of U.S. goods and services as before, i.e. the real exchange rate; $0.009271  1.01/1.03 = $0.009091 is unchanged. Relationship 1: S 1 / S 0 = (1 + IP US ) / (1+ IP F ) Relationship 1: (S 1 – S 0 ) / S 0 = IP US – IP F.Approximate version exchange rates must be in the form of U.S. dollars per unit of foreign currency. The Fisher effect states that i US = IP US + RIR US Relationship 2: i US – i F = IP US - IP F for any foreign country F.

24. Interest Rate Parity: Relationship 1 and Relationship 2 together yields the Interest Rate Parity Theorem (IRPT) for any time t: Relationship 3: IRPT: (1 + i US ) / (1 + i F ) = Forward t / S t The text version is: (i US - i F ) / (1 + i F ) = (Forward t - S t )/ S t parity holds when the discounted value of the difference in interest rates equals the percentage change in the exchange rate. If parity holds no covered interest arbitrage is possible. Hence, the steps of a covered interest arbitrage strategy can be used to explain the parity condition.

25. suppose a bank sees that U.S interest rates are lower than Swiss rates. The entrepreneurial bank could borrow U.S. $, convert the $ to Swiss francs (Sfr) at the spot rate and invest the money in the Sfr denominated investment. The catch is the bank will owe dollars and will earn Sfrs. Thus to cover the interest arbitrage the bank sells the Swiss francs forward at the forward rate. Parity holds if this strategy does not make money. Outlining the transactions yields the following: Borrow U.S. dollars with a single payment loan. At year end the bank will owe (per $ borrowed): $1  (1 + i US ) Convert the dollar to Sfr and invest it in the Switzerland. In a year this will yield 1/S t  (1 + i Sfr ) Cover the future receipt of Swiss francs by selling them forward: 1 / S t  (1 + i Sfr )  Forward t If this amount equals $1  (1 + i US ) then no arbitrage is possible and parity holds. Thus: $1  (1 + i US ) = 1 / S t  (1 + i Sfr )  Forward t This is the IRPT shown before.

26. Banks set forward rates in relationship to differences in interest rates so that they are not the source of a profitable arbitrage. For instance suppose U.S. interest rates are 9%, British interest rates are 11% and the current spot rate is £1 = $1.60. Unless the forward rate offsets the difference in interest rates, investors will wish to borrow in the U.S. and invest in the U.K. Suppose the bank sets the forward rate at £1 = $1.55. This is a 3.125% drop in value of the pound. The drop is greater than the interest rate differential. U.S. investors would borrow at 11% in the U.K., owing £1.11 pounds at year end. They would then sell the pound spot and invest in the U.S. This would yield $1.60  1.09 = $1.744. The £1.11 pounds owed would be bought forward at $1.55 a pound for a dollar cost of $1.7205. The net gain is $1.744 - $1.7205 = $0.0235 per pound borrowed.

27. Factors Affecting Exchange Rates The interaction of supply and demand then sets the exchange rate between the foreign currency and the dollar What factors affect DD and SS of the dollar provided for foreign exchange?

28. Risk is also a major determinant of a currency’s value; hence, other factors that can affect a currency’s value