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The Foreign Exchange Market Copyright 2013 by Diane S. Docking1 KM.

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Presentation on theme: "The Foreign Exchange Market Copyright 2013 by Diane S. Docking1 KM."— Presentation transcript:

1 The Foreign Exchange Market Copyright 2013 by Diane S. Docking1 KM

2 Learning Objectives What is meant by a foreign exchange rate Different ways that a foreign exchange rate can be quoted – (direct versus indirect; American versus European) Conventions for quoting foreign exchange rates What foreign exchange risk is Cross rates and how to calculate theoretical cross rates IRP & PPP What a forward exchange rate is What arbitrage is: – Triangle arbitrage – Covered interest arbitrage Copyright 2013 by Diane S. Docking2

3 Exchange Rates Copyright 2013 by Diane S. Docking3 KM

4 Foreign Exchange In the foreign exchange marketsevery currency has a price in terms of other currencies Foreign Exchange Rate: a price for a currency denominated in another currency. Foreign exchange rates are the conversion rates between currencies – Spot rate – Forward rate Copyright 2013 by Diane S. Docking 4

5 Foreign Exchange Transactions Copyright 2013 by Diane S. Docking5 Spot foreign exchange transaction: mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency Spot foreign exchange transaction: mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

6 The Foreign Exchange Market While you can buy small amounts of FX at any currency exchange such as those found in international airports, much larger sums of currencies are bought and sold around the clock on the foreign exchange market. The foreign exchange (FX or forex) market: – where currencies are traded, – is a market that is open 24 hours a day during the week, – has no central physical location, and – experiences daily turnover of over $3 trillion. Copyright 2013 by Diane S. Docking 6

7 FX Rate Quotation Conventions Direct vs. Indirect quote: _________quote is the number of units of local currency (LC) needed to buy one foreign unit, e.g., # U.S. dollars per 1 Swiss franc _________quote is the number of units of a foreign currency (FC) needed to buy one unit of LC, e.g., # Swiss francs per $1 – Given a direct quote, we can calculate an indirect quote, which is the reciprocal of the direct quote Copyright 2013 by Diane S. Docking7

8 FX Rate Quotation Conventions American vs. European quote: ____________ terms - quoting in terms of U.S. dollars per unit of foreign currency _____________terms - quoting in terms of the number of units of the foreign currency per U.S. dollar is called If local currency is U.S. dollars, then Direct quote = American terms and Indirect quote = European terms Copyright 2013 by Diane S. Docking8

9 15-9 Copyright 2013 by Diane S. Docking U.S. Dollar Foreign Exchange Rate Quotations Current foreign exchange rates For example: One Euro can be purchased for $1.2310, or equivalently, Euros buy one U.S. dollar. #$/1FC Direct Quote or American Terms #FC/$1 Indirect Quote or European Terms

10 US $ Spot Rates Copyright 2013 by Diane S. Docking 10 #$/1FC Direct Quote or American Terms #FC/$1 Indirect Quote or European Terms US Dollar1 USDIn USD Euro British Pound Indian Rupee Australian Dollar Canadian Dollar UAE Emirati Dirham Swiss Franc Chinese Yuan Renminbi Malaysian Ringgit New Zealand Dollar Top 10 July 31, 2013

11 FX Cross Rates Cross Rates The exchange rate between two countries other than the U.S. can be inferred from their exchange rates with the U.S. dollar The rates thus obtained are known as cross rates Copyright 2013 by Diane S. Docking11

12 Key Currency Cross Rates Copyright 2013 by Diane S. Docking12 DollarEuroPoundSFrancPesoYenCdnDlr Canada Japan Mexico Switzerland U.K Euro U.S July 31, 2013 Snapshot of foreign exchange cross rates at 5 p.m. Eastern time. Source: ICAP plc ; historical data prior to 6/9/11: Thomson Reuters ICAP plc

13 FX Cross Rates Copyright 2013 by Diane S. Docking13 = = £ £ x$1 = = $1 £ £0.6576

14 FX Cross Rates (cont.) Cross-exchange rates are foreign exchange rates of two currencies relative to a currency. Value of one unit of currency A in units of currency B = value of currency A in C divided by value of currency B in C Arbitrage assures that the exchange rates will be the same between the countries Copyright 2013 by Diane S. Docking14

15 Foreign Exchange Risk Copyright 2013 by Diane S. Docking15 KM

16 FOREIGN EXCHANGE RISK Foreign exchange risk, or currency risk, is the risk that a currencys value may change adversely Most exchange rates are a floating rate, which means it changes constantly depending on the quantity supplied and demanded for each currency in the market. Copyright 2013 by Diane S. Docking16

17 Appreciation/Depreciation If depreciation of the domestic currency ($) occurs, then – FC cost more $s – a _____________ of the $ If appreciation of the domestic currency ($) occurs – FC costs less $s – a _____________ of the $ Copyright 2013 by Diane S. Docking17

18 Appreciation/Depreciation When a countrys currency appreciates (rises in value relative to other currencies), the countrys goods in that country become cheaper (holding domestic prices constant in the two countries). Appreciation of a countrys currency can make it harder for domestic manufacturers to sell their goods abroad Exports __________; imports ___________ Copyright 2013 by Diane S. Docking18

19 Appreciation/Depreciation Conversely, when a countrys currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive exports ___________; imports ___________ Copyright 2013 by Diane S. Docking19

20 $/Euro: August 1, 2008 – August 1, Copyright 2013 by Diane S. Docking20

21 $/Pound: August 1, 2008 – August 7, Copyright 2013 by Diane S. Docking21

22 Example FX Risk: L-T Purchase Contract with Foreign Currency Problem: In May 2XX1, when the exchange rate was $1.35 per euro, Mason ordered parts for next years production from Campco. They agreed to a price of 500,000 euros, to be paid when the parts were delivered in one years time. One year later, the exchange rate was $1.55 per euro. What was the actual cost in dollars for Mason when the payment was due? If the price had instead been set at $675,000 (which had equivalent value at the time of the agreement), how many euros would Campco have received? Copyright 2013 by Diane S. Docking 22

23 Solution: Right now, May 2XX1 cost is $1.35 x 500,000 euros = $675,000 With the price set at 500,000 euros, Mason had to pay ($1.55/euro) (500,000 euros) = ___________one year later May 2XX2 This cost is $100,000 higher than it would have been if the price had been set in dollars. Conclusion: Whether the price was set in euros or dollars, one of the parties would have suffered a substantial loss. Since neither knows which will suffer the loss ahead of time, each has an incentive to hedge. Copyright 2013 by Diane S. Docking 23 Example FX Risk: L-T Purchase Contract with Foreign Currency (cont.)

24 Example FX Risk: Traveling and Exchange Rates Problem: Lina was planning a trip to tour Europe for three weeks. The exchange rate cost when she was planning was $1.32 per euro. She planned on expenses and souvenir costs in Europe to be about 7,000. Five months later, when she actually went on her trip, the exchange rate cost had increased to $1.65 per euro. What was Linas estimated cost in euros equal to in U.S. dollars at the time of planning? How many euros did Lina actually end up having once she was on her trip? How could Lina have planned for the differences in exchange rate cost? Copyright 2013 by Diane S. Docking 24

25 Solution: With her costs being in euros, her dollar equivalent cost at planning is: ($1.32/) × (7,000) = ________ On her trip the cost of euro had increased so her final amount was: ($9,240) ÷ ($1.65/) = _________ Or ($9,240) ×[1/($1.65/)] = ($9,240) × (.61/$) = 5,600 Lina ended up having 1,400 less euros once she got to Europe. Copyright 2013 by Diane S. Docking 25 Example FX Risk: Traveling and Exchange Rates (cont.)

26 Conclusion: Lina could have looked at rates, and current rate patterns to estimate the exchange rate cost at her time of the trip to ensure that she had enough money for her costs and souvenirs. However, this is the risk of traveling overseas, since rates are so volatile. Copyright 2013 by Diane S. Docking 26 Example FX Risk: Traveling and Exchange Rates (cont.)

27 Pricing of FX Rates Copyright 2013 by Diane S. Docking27 KM

28 Example FX Pricing: Triangle Arbitrage for Cross-Rates The following quotations are available to you for US dollars ($), Canadian Dollars (CD), and Mexican pesos (Peso). You may either buy or sell at the stated rates: – BancOne: $.76/CD – Imperial Bank: 1.40 pesos/CD – Domino Bank: $.55 / peso Given this information, is a triangle arbitrage possible? If so, explain the steps and compute the profit, assuming you have an initial US $1,000,000 to use. Copyright 2013 by Diane S. Docking28

29 Example FX Pricing: Triangle Arbitrage for Cross-Rates (cont.) Is it possible? Evaluate Copyright 2013 by Diane S. Docking29 BancOneImperial Bank Domino Bank $ CD 1.40 pesos 1 CD $ peso Cross RatesTheoreticalActual 1.40 pesos 1 CD x$ peso =$ CD >$ CD At Bank One Therefore, BankOne X-rate is too LOW. So want to take $CD at BankOnepesos at Imperial Bank$ at Domino Bank YES

30 Example FX Pricing: Triangle Arbitrage for Cross-Rates Steps in Triangle Arbitrage Copyright 2013 by Diane S. Docking30 Convert $1 mill. to CDs at $0.76/CD = $1 mill. /0.76 = 1,315,789 CDs Convert 1,315,789 CDs to pesos at Imperial 1.40 peso/CD = 1,315,789 CDs x 1.40 = 1,842,105 pesos Convert 1,842,105 pesos to $s at Domino $0.55/peso = 1,842,105 pesos x 0.55 = $1,013, BancOne $ CD Imperial Bank CD peso Domino Bank peso $ Riskless Arbitrage Profit: $1,013,158 - $1,000,000 $ 13,158

31 Purchasing Power Parity Copyright 2013 by Diane S. Docking31 The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change. The PPP theorem states that the change in the exchange rate between two countries currencies is proportional to the difference in the inflation rates in the countries Formula using Direct quote & $ as domestic currency: The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change. The PPP theorem states that the change in the exchange rate between two countries currencies is proportional to the difference in the inflation rates in the countries Formula using Direct quote & $ as domestic currency:

32 Purchasing Power Parity Copyright 2013 by Diane S. Docking32 Formula using Indirect quote & $ as domestic currency: Formula using Indirect quote & $ as domestic currency:

33 Fundamental Determinant of FX rates The basic fundamental determinant of exchange rates between countries is purchasing power parity, or the relative degrees of inflation among countries – E.g.: If the U.S. has greater inflation than the European Union, the dollar will ____________ relative to the euro (will take more $s to buy a euro) Copyright 2013 by Diane S. Docking33

34 Example: PPP Given the following and based on PPP: S $/£ = $2/£ or S £/$ = 0.50£/$ E(Inflation UK )= 4% E(Inflation US )= 3% 1)Will you expect the dollar to appreciate or depreciate against the pound? By how much (percentage change)? What would be the expected new Spot rate to be, i.e.: S $/£ ? 2)What is expected Forward exchange rate; i.e.: F $/£ as given by PPP? Copyright 2013 by Diane S. Docking34

35 1)Since expecting inflation is England to be greater than inflation in US, then it should take fewer $s to buy a £ (or more £s to buy a $). The $ should appreciate against the £ by 1%. Since current S $/£ = $2 /£ then expected new rate should be $1.98/£. The dollar has appreciated against the pound. Copyright 2013 by Diane S. Docking35 Example: PPP (cont.)

36 2)What is expected Forward exchange rate; i.e.: F $/1£ as given by PPP? Conclusion: If π US is expected to be > π FC ; then $ will depreciate against the FC (the FC appreciates against the $) If π US is expected to be < π FC ; then $ will appreciate against the FC (the FC depreciates against the $) Copyright 2013 by Diane S. Docking36 Example: PPP (cont.)

37 Interest Rate Parity Copyright 2013 by Diane S. Docking37 The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency. Formula using Direct quote & $ as domestic currency: The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency. Formula using Direct quote & $ as domestic currency:

38 Interest Rate Parity Copyright 2013 by Diane S. Docking38 Formula using Indirect quote & $ as domestic currency:

39 Interest Rate Parity Copyright 2013 by Diane S. Docking39 Rearranging this formula: Direct quote & $ as domestic currency. Used to find theoretical Forward rates. Helpful with determining arbitrage opportunities. Indirect quote & $ as domestic currency. Rearranging this formula: Direct quote & $ as domestic currency. Used to find theoretical Forward rates. Helpful with determining arbitrage opportunities. Indirect quote & $ as domestic currency.

40 Theoretical parity is rarely attained, since it is based on several assumptions – There are no transactions costs for executing an arbitrage strategy – Investors can borrow and lend at the same rate – There are no tax differences between different economies – There are no barriers to capital mobility between economies Copyright 2013 by Diane S. Docking40 Interest Rate Parity

41 Example: Computing Forward Rates Using IRP Given the following and based on IRP: S $/£ = $2/£ ( S £/$ =.50 £/$ ) i UK = 6% i US = 5% What is the 1-year Forward rate? Conclusion: If i US are expected to be > i FC ; then $ will depreciate against the FC (the FC appreciates against the $) If i US are expected to be < i FC ; then $ will appreciate against the FC (the FC depreciates against the $) Copyright 2013 by Diane S. Docking41

42 Example: Computing Interest Rates Using IRP Given the following and based on IRP: S $/£ = $2/£; ( S £/$ =.50 £/$) F $/£ = $1.98/£; ( F £/$ = £/$) i UK = 6% What are current interest rates in the US? Copyright 2013 by Diane S. Docking42

43 Covered Interest Arbitrage Covered interest arbitrage activity makes Forward rate approximately equal to the differential in interest rates between two countries Given actual spot and interest rates, compute the theoretical Forward rate {E(F $/FC )} using the IRP formula: If the theoretical forward rate does not equal the actual forward rate, covered interest arbitrage is possible If the theoretical forward rate equals the actual forward rate, there are no opportunities for arbitrage Copyright 2013 by Diane S. Docking43

44 Covered Interest Arbitrage (cont.) Covered interest arbitrage activity creates a relationships between spot rates, interest rates and forward rates. Today: – Borrow dollars in US at i US – Convert the dollars to the foreign currency (FC) using the spot rate (S) – SELL forward contract for return of FC back into dollars at forward rate (F) – Invest FC in foreign country at i Foreign Country Later: – Receive FC principal and interest from investment in foreign country – Exercise forward contract and convert FC back to $ at forward rate (F) – Repay US loan principal and interest in dollars Could do the reverse - depends Ideally no profit should exist due to arbitrage forces. Copyright 2013 by Diane S. Docking44

45 Example: Covered Interest Arbitrage/Parity In May 2XX1, the current spot exchange rate (S 0 ) is $1.35/ and the current 1-year forward rate (F 1 ) is $1.40/. Current 1-year interest rates are 4.9% for dollars and 4.3% for euros. Explain how one can make an arbitrage profit assuming you either borrow $675,000 or 675,000 euros. What must the 1-year Forward FX rate must be to create parity. Copyright 2013 by Diane S. Docking 45

46 For no-arbitrage opportunity to exist, the 1-yr forward exchange (F 1 ) must equal: Since the actual F 1 of $1.40/ > the theoretical F 1 of $ /, an arbitrage opportunity exists. Actual rate is too high, so want to borrow $, convert to euros, invest in euros, then convert back to $ at F 1. Interest rates in U.S. are too low. Copyright 2013 by Diane S. Docking46 Solution to Example: Covered Interest Arbitrage/Parity

47 Solution to Example: Covered Interest Arbitrage/Parity (cont.) Do a cash-and-carry strategy. Copyright 2013 by Diane S. Docking 47 Today May 2XX1:CFs Borrow $675,000 in US at i US = 4.9% for 1-yr. Convert the $675,000 to S 0 = $1.35/: $675,000/$1.35 = 500,000 s Invest 500,000 s in foreign country at i For.Ctry = 4.3% for 1 year. ____________ a 1-yr. forward contract for return of 521,500s A back into $ at forward rate (F 1 =$1.40/ ) A P+I on investment = 500,000 (1.043) 1 = 521,500 s

48 Solution to Example: Covered Interest Arbitrage/Parity (cont.) You made an arbitrage profit of $730,100 – 708,075 = ______________ Copyright 2013 by Diane S. Docking 48 1 Year later on May 2XX2:CFs Receive 521,500s P&I from investment in foreign country Exercise forward contract and convert 521,500s back to (F 1 =$1.40/ ) 521,500 x $1.40/ = $730,100 Repay US loan P&I = $675,000 x (1.049) 1 = $708,075 Arbitrage profit

49 9-49Copyright 2013 by Diane S. Docking Foreign Exchange Risk Firms can hedge their foreign exchange exposure either on or off the balance sheet On-balance-sheet hedging involves matching foreign assets and liabilities – as foreign exchange rates move any decreases in foreign asset values are offset by decreases in foreign liability values (and vice versa) Off-balance-sheet hedging involves the use of forward contracts – forward contracts are entered into (at t = 0) that specify exchange rates to be used in the future (i.e., no matter what the prevailing spot exchange rates are at t = 1) Firms can hedge their foreign exchange exposure either on or off the balance sheet On-balance-sheet hedging involves matching foreign assets and liabilities – as foreign exchange rates move any decreases in foreign asset values are offset by decreases in foreign liability values (and vice versa) Off-balance-sheet hedging involves the use of forward contracts – forward contracts are entered into (at t = 0) that specify exchange rates to be used in the future (i.e., no matter what the prevailing spot exchange rates are at t = 1)


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