Chapter 13 The Foreign Exchange Market

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Topics to be Covered Foreign Exchange Market Exchange Rate Types of Exchange Rates:  Spot Rates  Forward Rates  Cross Rates Arbitrage and Hedging Swaps, Futures, and Options Central Bank Intervention Black Markets and Parallel Markets

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market The Foreign Exchange Market (FEM) is a market where one country’s money is traded for that of another country. The “money” that is traded is bank deposits or bank transfers of deposits denominated in a foreign currency. The FEM consists primarily of large commercial banks in world financial centers such as New York or London. These financial centers operate in different time zones (refer to Figure 13.1).

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Exchange Rate Exchange Rate (XR)—the price of one money in terms of another. Types of Exchange Rates:  Spot XR vs. Forward XR  US $ equivalent vs. foreign currency per US $  Cross XR

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Spot Market Spot Market is where currencies are traded “on the spot”, that is, for immediate delivery. The exchange rate here is called the spot XR. Table 13.1 refers to the New York FEM. Exchange rates are quoted at a specific day and time. The rates are for large, wholesale trades ($1 million or more) among banks; the smaller the quantity of foreign exchange purchased (retail transaction), the higher the price.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Spot Market (cont.) The different exchange rates are expressed either as: (1) U.S. $ per unit of the foreign currency; (2) Foreign currency per U.S. $ (or the reciprocal). The rates are “midrange” quotes or the average of the banks’ buying and selling prices.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Spread Spread—the difference between the buying and selling price of a currency. The spread will tend to be higher for thinly or low-volume traded currencies or for high-risk currencies (refer to Table 13.2 Currency spreads).

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Arbitrage Arbitrage—the activity of simultaneously buying a currency in one market while selling in another to take advantage of profit opportunities. Arbitrage could involve more than two currencies.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Cross Rate Cross Rate—the third exchange rate implied by any two exchange rates involving three currencies. Since the dollar is actively traded with many currencies, any two exchange rates involving dollars can be used to determine cross rates.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Forward Rates and Forward Exchange Market Much of international trade is contracted in advance of delivery and payment. What options does the importer have with respect to payment?  Wait until day of delivery of the imported commodity and then buy the foreign currency.  Buy the foreign currency now and hold or invest it for the contract period.  Use the forward exchange market.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Forward Rates (cont.) Forward exchange market—where a currency may be bought and sold at a price (i.e., forward rate) agreed upon today but for delivery at a future date.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Depreciation vs. Appreciation Depreciation—when the value of one currency falls relative to another. For example, if the U.S. dollar depreciates against the Swiss franc, then it takes more dollars to buy one franc. Appreciation—when the value of one currency rises relative to another.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Forward Premium vs. Forward Discount Forward Premium—when the forward exchange rate is greater than the spot rate. Forward Discount—when the forward exchange rate is less than the spot rate. Flat Currency—when the forward rate and spot rate are equal.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Swap Foreign Exchange Swap—an agreement to trade currencies at one date and then reverse the trade at a later date. The swap serves as a borrowing and a lending operation combined in one deal. These agreements are frequently used by commercial banks for inter-bank trading. Swaps account for over 50% of the volume of trading activity in the foreign exchange market (refer to Table 13.4).

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Hedging Hedging—an activity to offset or avoid risk in the market.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Futures Market Futures market is similar to the forward market where currencies may be bought and sold for future delivery. The futures market differs from the forward market in that:  Only a few currencies are traded  Trading occurs in standardized contracts  Trading occurs in a specific geographic location such as the International Monetary Market of the Chicago Mercantile Exchange  Futures contracts are for smaller amounts of currency and are a useful hedging tool for smaller firms

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Currency Option Foreign Currency Option—a contract that provides the right to buy or sell a currency at a fixed exchange rate on or before the maturity date. Call Option—an option to buy currency. Put Option—an option to sell currency. Striking or Exercise Price—the price of the currency stated in an option contract.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Currency Option (cont.) Foreign currency options were first traded in December 1982 at the Philadelphia Stock Exchange. The options contracts cover only a few foreign currencies and their fixed amounts are smaller than those of futures contracts. Unlike a future or forward contract, the option offers the right to buy or sell if desired in the future and is not an obligation.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Supply of and Demand for Foreign Currency Refer to Figure 13.2 Dollar/Pound Market Demand for pounds curve—arises from the U.S. demand for British goods, services, and financial assets. Supply of pounds curve—comes from the British demand for U.S. goods, services, and financial assets. Equilibrium exchange rate—found at the intersection of the demand and supply curves.

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Central Bank Intervention Central banks, such as the Federal Reserve, buy and sell foreign exchange to influence the values of their currencies. Suppose the U.S. demand for British goods increases, which causes the demand for pounds to shift to the right. As a result, the dollar depreciates and pound appreciates. Either the Bank of England or the Fed may intervene to stop the pound appreciation by selling pounds in the foreign exchange market.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Fixed Exchange Rate Fixed Exchange Rate—where a central bank actively intervenes in the foreign exchange market so as to keep the exchange rate from changing.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Flexible Exchange Rate Flexible Exchange Rate—where the exchange rate is determined by free- market forces of demand and supply.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Black Market Black Market—an illegal market in foreign exchange. Usually a result of restrictive government policies on foreign exchange transactions.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Parallel Market Parallel Market—a free market allowed by government to coexist with the official market.