1. All Rights Reserved 1 Dr David P Echevarria FOREIGN EXCHANGE DERIVATIVEMARKETS CHAPTER 16

2. All Rights ReservedDr David P Echevarria2 FOREIGN EXCHANGE MARKET FUNCTIONS A.Expand Purchasing Power Beyond National Borders. 1.Demand for foreign goods creates demand for foreign currencies. 2.Demand for foreign currencies drives foreign exchange markets. B.Provide International Trade Credit Facilities. 1.Importers and Exporters need for credit financing. 2.Provide the general procedures for the conduct of credit activities. C.Provide Securities for Minimizing Exchange Rate Risk. 1.Specialized markets for hedging activities. 2.Daily quotations of forward rates.

3. All Rights ReservedDr David P Echevarria3 FOREIGN EXCHANGE MARKET PARTICIPANTS A.Foreign Exchange Dealers 1Banks. 2Nonbanks. 3Profits derived from the Spread: Bid (buy) - Offer (sell). B.Speculators and Arbitrageurs 1Operate for own interest via direct trading in the markets. 2Volume of activities can destabilize currency exchange rates. C.Commercial Firms 1May receive cash payment in foreign currency. 2If open account, steady stream of foreign receipts.

4. All Rights ReservedDr David P Echevarria4 FOREIGN EXCHANGE MARKET PARTICIPANTS D.Individuals 1Foreign travel creates the largest number of individual demands. 2Relatively small volume of individual exchanges results in largest spreads. E.Central Banks and National Treasuries 1Central banks frequently enter markets to manage exchange rate. 2May cooperate with other central banks to maintain Exchange Rate Mechanisms. F.Foreign Exchange Brokers 1Facilitate trade between major dealers (principals). 2Provide exchange quotes and rates.

5. All Rights ReservedDr David P Echevarria5 FOREIGN EXCHANGE MARKETS A.Exchange Rate Quotations 1.Prices as relative prices; dollar to Euro, Euro to UK Pound, etc, and reciprocals 2.One dollar to buy 100 Yen is equal to saying 1 Yen will buy 0.01 dollars B.Types of Exchange Rate Systems 1.Fixed 2.Free Floating 3.Managed C.Types of Exchanges 1.Spot exchanges 2.Forward exchanges

6. All Rights ReservedDr David P Echevarria6 FOREIGN EXCHANGE INSTRUMENTS A.Forward Exchanges: IMM (CME began trading FOREX futures May 16, 1972) 1.Fixed contract amounts (typically $1MM dollars) 2.Speculating and Hedging activity B.Currency Futures Contracts C.Currency Options Contracts

7. All Rights ReservedDr David P Echevarria7 FACTORS AFFECTING EXCHANGE RATE MOVEMENTS A.Differential Inflation Rates B.Differential Interest Rates C.Differential Income Levels D.Government Intervention (interest rates and money supply, pegging exchange rate) E.Use of Dollar Indexes to Track Rate Changes F.Impact of Rate Changes on Trade

8. All Rights ReservedDr David P Echevarria8 HOMEWORK QUESTIONS A.What are the three types of exchange rate systems? B.What role do differentials have in the rate of exchange? 1.Inflation 2.Interest Rates 3.Income levels C.How do institutions manage foreign exchange risk? D.How do arbitrageurs exploit differences in exchange rates?

9. All Rights ReservedDr David P Echevarria9 ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS A.Triangular Arbitrage 1.Exploiting deviations from relative values 2.Profits largely a function of deviation magnitudes and transaction costs 3.Example: EUR/USD = 0.8631, GBP/EUR = 0.6849, USD/GBP = 1.6939: 0.8631*0.6849*1.6939 = 1.001327 The profit opportunity is 0.001327 per dollar of exchange $1,000,000 transaction would yield $1,327 profit.

10. All Rights ReservedDr David P Echevarria10 ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS B.Institutional Participation Foreign Exchange Markets 1.Large dollar volumes Minimal arbitrage opportunities 2.Speculating on short & intermediate changes in exchange and interest rates