1. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-1 Chapter Eight Foreign Exchange Markets

2. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-2 Chapter Outline 1.Overview 2.Foreign Exchange Transactions 3.Role of FIs in Foreign Exchange 4.Interest Rate Parity 1.Overview 2.Foreign Exchange Transactions 3.Role of FIs in Foreign Exchange 4.Interest Rate Parity

3. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-3 1. Foreign Exchange Markets Overview Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies

4. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-4 Background and History of Foreign Exchange Markets Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate

5. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-5 2. 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

6. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-6 Foreign Exchange Market Trading (in billions of U.S. dollars)

7. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-7 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

8. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-8 3. Role of FIs in Foreign Exchange Transactions Net exposure - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given 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 - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given 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

9. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-9 Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)

10. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-10 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

11. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-11 Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004

12. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-12 4. Purchasing Power Parity The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = Interest rate in the United States i S = Interest rate in Switzerland then: i US - i S = IP US - IP S The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = Interest rate in the United States i S = Interest rate in Switzerland then: i US - i S = IP US - IP S

13. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 9-13 Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t