chpt11,,
darkheaven
chap11.pptxForeign Exchange
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PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
Foreign-Exchange Market
Foreign-exchange market
Organizational setting
Within which individuals, businesses, governments, and banks
Buy and sell foreign currencies and other debt instruments
Largest and most liquid market in the world
Dominated by four currencies
U.S. dollar, euro, Japanese yen, British pound
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Foreign-Exchange Market
Foreign-exchange market
Transactions between commercial banks and their commercial customers
Domestic interbank market conducted through brokers
Active trading in foreign exchange with banks overseas
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Types of Foreign-Exchange Transactions
Spot transaction
Make an outright purchase or sale of a currency now, as in “on the spot”
Simplest way to meet your foreign currency requirements
Greatest risk of exchange rate fluctuations
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Types of Foreign-Exchange Transactions
Forward transaction
Receiving or paying an amount of foreign currency on a specific date in the future
At a fixed exchange rate
Protects against unfavorable movements in the exchange rate
Will not allow gains to be made should the exchange rate move in your favor
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Types of Foreign-Exchange Transactions
Currency swap
Conversion of one currency to another currency at one point in time
With an agreement to reconvert it back to the original currency at a specified time in the future
The rates of both exchanges are agreed to in advance
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Distribution of foreign-exchange transactions by U.S. banks
TABLE 11.1
Interbank Trading
Retail transactions
Bank purchases from and sales to their customers
Less than 1 million currency units
Wholesale transactions
More than 1 million currency units
Between banks or with large corporate customers
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Top ten banks by share of foreign-exchange market, 2009
TABLE 11.2
Interbank Trading
Earning profits in foreign-exchange transactions
Bid rate - price that the bank is willing to pay for a unit of foreign currency
Offer rate - price at which the bank is willing to sell a unit of foreign currency
Spread - difference between the bid and the offer rate
A bank’s bid quote < its offer quote
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Reading Foreign-Exchange Quotations
Exchange rate
Price of one currency in terms of another
Number of units of foreign currency required to purchase one unit of domestic currency
Exchange rate reported
The midrange between the bid and offer prices
Currency depreciation
It takes more units of a nation’s currency to purchase a unit of some foreign currency
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Foreign exchange quotations (a)
TABLE 11.3
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Foreign exchange quotations (b)
TABLE 11.3
Reading Foreign-Exchange Quotations
Currency appreciation
It takes fewer units of a nation’s currency to purchase a unit of some foreign currency
Cross exchange rate
Exchange rate between any two currencies (such as the franc and the pound)
Derived from the rates of these two currencies in terms of a third currency (the dollar)
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Forward and Futures Markets
Spot market
Foreign exchange bought and sold for delivery immediately
Forward market
Foreign exchange bought and sold for future delivery
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Forward and Futures Markets
Futures market
Contracting parties agree to future exchanges of currencies
And set applicable exchange rates in advance
Only a limited number of leading currencies are traded
Trading takes place in standardized contract amounts and in a specific geographic location
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Forward contract versus futures contract
TABLE 11.4
| Forward Contract | Futures Contract | |
| Issuer Trading Contract size Date of delivery Contract costs Settlement | Commercial bank “Over the counter” by telephone Tailored to the needs of the exporter/importer/investor; no set size Negotiable Based on the bid On expiration date only, at prearranged price /offer spread | International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange On the IMM’s market floor Standardized in round lots Only on particular dates Brokerage fees for sell and buy orders Profits or losses paid daily at close of trading |
Forward and Futures Markets
International Monetary Market (IMM)
Chicago Mercantile Exchange, 1972
An extension of the commodity futures markets
Size of each contract
On the same line as the currency’s name and country
First column
Maturity months
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Forward and Futures Markets
Open
Price at which the yen was first sold when the IMM opened in the morning
High
Contract’s highest price for the day
Low
Contract’s lowest price for the day
Settle
Contract’s closing price for the day
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Forward and Futures Markets
Change
Compares today’s closing price with the closing price as listed in the previous day’s paper
(+) means prices ended higher
(-) means prices ended lower
Open interest
Total number of contracts outstanding
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Foreign currency futures, May 13, 2009: selected examples
TABLE 11.5
Foreign-Currency Options
Option
Agreement between a holder (buyer) and a writer (seller)
Holder has the right, but not the obligation, to buy or sell financial instruments at any time through a specified date
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Foreign-Currency Options
Foreign-currency options
Options holder
Right to buy or sell a fixed amount of foreign currency
At a prearranged price, within a specified date
Can choose the exchange rate to guarantee
Can choose length of the contract
Call option
Gives the holder the right to buy foreign currency at a specified price
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Foreign-Currency Options
Put option
Gives the holder the right to sell foreign currency at a specified price
Strike price
Price at which the option can be exercised
Premium
Fee the writer of the options contract receives
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Exchange-Rate Determination
Exchange rate in a free market
Determined by both supply and demand conditions
Demand for foreign exchange
Derived demand
Driven by foreigner demand for domestic goods and assets
Corresponds to the debit items on a country’s balance of payments
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WEAK DOLLAR IS A BONANZA FOR EUROPEAN TOURISTS
When dollar’s exchange value depreciates
Foreign tourists realize a good bargain on goods purchased in America
Delighted American tourist industry
Tourists could afford to stay longer
Stay at nicer and more expensive hotels
Take more tours
Eat at more restaurants
Shop with bargain-basement enthusiasm.
Air fares to and from the United States declined
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GLOBALIZATION
Exchange-Rate Determination
Supply of foreign exchange
Amount of foreign exchange that will be offered to the market
At various exchange rates, all other factors held constant
Equilibrium exchange rate
Determined by the market forces of supply and demand
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The equilibrium exchange rate is established at the point of intersection of the supply and demand schedules of foreign exchange. The demand for foreign exchange corresponds to the debit items on a nation’s balance-of-payments statement; the supply of foreign exchange corresponds to the credit items.
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Exchange-rate determination
FIGURE 11.1
Exchange-Rate Determination
Increase in the demand for pounds
Shift rightward
The dollar will depreciate against the pound
Decrease in demand for pounds
Shift leftward
The dollar will appreciate
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Exchange-Rate Determination
Increase in the supply of pounds
Rightward shift
The dollar appreciate against the pound
Decrease in the supply of pounds
Leftward shift
Dollar depreciation
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Advantages and disadvantages of a strengthening and weakening dollar
TABLE 11.6
Nominal and Real Exchange Rates
Exchange-rate index
Effective exchange rate; trade-weighted dollar
Weighted average of the exchange rates between the domestic currency
And the nation’s most important trading partners
With weights given by relative importance of the nation’s trade with each of these trade partners
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Nominal and Real Exchange Rates
Nominal exchange-rate index of the U.S. dollar
Average value of the dollar
Not adjusted for changes in prices levels
In the U.S. and its trading partners
if increasing
Dollar appreciation relative to the currencies of the other nations in the index
Loss of competitiveness for the U.S.
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Nominal and Real Exchange Rates
Nominal exchange-rate index of the U.S. dollar
If decreasing
Dollar depreciation relative to the other currencies in the index
Improvement in U.S. international competitiveness
Based on nominal exchange rates that do not reflect changes in price levels in trading partners
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Nominal and Real Exchange Rates
Real exchange-rate index of the U.S. dollar
Embodies the changes in prices in the countries in the calculation
Nominal exchange rate adjusted for relative price levels
Average value of the dollar based on real exchange rates
An appreciation of the dollar - higher index
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Exchange rate indexes of the U.S. dollar (March 1973 = 100)*
TABLE 11.7
Arbitrage
Exchange arbitrage
Simultaneous purchase and sale of a currency
In different foreign-exchange markets
To profit from exchange-rate differentials in the two locations
Brings about an identical price for the same currency in different locations
Results in one market
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Arbitrage
Two-point arbitrage
Two currencies are traded between two financial centers
Three-point arbitrage
Triangular arbitrage
Three currencies and three financial centers
Switching funds among three currencies in order to profit from exchange-rate inconsistencies
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The Forward Market
Forward market
Currencies are bought and sold now for future delivery
The exchange rate is agreed on at the time of the contract
Payment is made when the future delivery actually takes place
Forward rate
Rate of exchange used in the settlement of forward transactions
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Forward exchange rates: selected examples
TABLE 11.8
The Forward Market
At a premium
When a foreign currency is worth more in the forward market than in the spot market
At a discount
When a foreign currency is worth less in the forward market than in the spot market
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The Forward Market
Relation between the forward rate and spot rate
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The Forward Market
Managing your foreign exchange risk
Forward foreign-exchange contract
And engage in hedging
Hedging
Process of avoiding or covering a foreign-exchange risk
Some firms do not hedge
Currency fluctuations even out over the long term
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Exchange-rate risk: the hazard of investing abroad
Exchange-rate fluctuations
Can substantially change the returns on assets denominated in a foreign currency
Interest rates
Key role in determining the relative attractiveness of assets denominated in domestic and foreign currencies
Effects of exchange-rate changes
Can swamp the effects of interest-rate differentials
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TRADE CONFLICTS
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Return on a three-month German investment
TABLE 11.9
Interest Arbitrage
Interest arbitrage refers
Moving funds into foreign currencies
To take advantage of higher investment yields abroad
Uncovered interest arbitrage
When an investor does not obtain exchange-market cover
To protect investment proceeds from foreign-currency fluctuations
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Interest Arbitrage
A U.S. investor’s extra rate of return
On an investment in the United Kingdom as compared to the U.S.
= interest-rate differential adjusted for any change in the value of the pound
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uncovered interest arbitrage: an example
TABLE 11.10
Interest Arbitrage
Covered interest arbitrage
Investor exchanges domestic currency for foreign currency - at the current spot rate
And uses the foreign currency to finance a foreign investment
Investor contracts in the forward market
To sell the amount of the foreign currency that will be received as the proceeds from the investment
With a delivery date to coincide with the maturity of the investment
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Interest Arbitrage
Forward discount or premium
On one currency against another
Reflects the difference in the short-term interest rates between the two nations
Forward discount
The currency of the higher-interest-rate nation
Forward premium
The currency of the lower-interest-rate nation
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Covered interest arbitrage: an example
TABLE 11.11
Foreign-Exchange Market Speculation
Speculation
Attempt to profit by trading on expectations about prices in the future
Deliberate assumption of exchange risk
Stabilizing speculation
Goes against market forces by moderating or reversing a rise or fall in a currency’s exchange rate
Useful function for bankers and businesspeople, who desire stable exchange rates
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Foreign-Exchange Market Speculation
Destabilizing speculation
Goes with market forces by reinforcing fluctuations in a currency’s exchange rate
Can disrupt international transactions
High cost of hedging – impeding international trade
Disrupt international investment activity
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How to play the falling (rising) dollar
Depreciating dollar
Purchase foreign currency
Purchase bonds denominated in a foreign currency
Purchase stocks of foreign corporations, denominated in foreign currencies
Savings account denominated in a foreign currency
Variety of currency derivatives
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TRADE CONFLICTS
Foreign Exchange Trading as a Career
Foreign exchange traders
Commercial Banks
Companies
Central Banks
Professional traders
Amateurs speculating in foreign currencies
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