1. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Background and History of Foreign Exchange Markets Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) Smithsonian Agreement II (1973) Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) Smithsonian Agreement II (1973)

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-2 McGraw-Hill/Irwin 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

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-3 McGraw-Hill/Irwin Foreign Exchange Market Trading (in billions of U.S. dollars)

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-4 McGraw-Hill/Irwin Hedging with Forwards Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L 71.875 M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L 71.875 M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-5 McGraw-Hill/Irwin Role of FIs in Foreign Exchange Transactions Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-6 McGraw-Hill/Irwin FI’s overall net foreign exchange (FX) exposure Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position