1. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Eight Foreign Exchange Markets

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-2 McGraw-Hill/Irwin Foreign Exchange Markets Overview Foreign exchange (FX) markets Foreign exchange rate Foreign exchange risk Currency depreciation/appreciation Foreign exchange (FX) markets Foreign exchange rate Foreign exchange risk Currency depreciation/appreciation

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-3 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)

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-4 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

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-5 McGraw-Hill/Irwin Foreign Exchange Market Trading (in billions of U.S. dollars)

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-6 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

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-7 McGraw-Hill/Irwin The Decline of the U.S. Dollar Market traders focused on the widening of the U.S. current account deficit Interest rate differentials across major economies, interest rates higher in Europe High volume of central bank intervention relative to past practice, especially in Asian countries Cheap dollar makes exports from other countries more expensive relative to U.S. products Market traders focused on the widening of the U.S. current account deficit Interest rate differentials across major economies, interest rates higher in Europe High volume of central bank intervention relative to past practice, especially in Asian countries Cheap dollar makes exports from other countries more expensive relative to U.S. products

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

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-9 McGraw-Hill/Irwin Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-10 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

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-11 McGraw-Hill/Irwin Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-12 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-13 McGraw-Hill/Irwin 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

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-14 McGraw-Hill/Irwin Balance of Payment Accounts Balance of payment accounts Current account Capital accounts Balance of payment accounts Current account Capital accounts

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-15 McGraw-Hill/Irwin U.S. Balance of Payment Accounts Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0 Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0