Chapter Nine
Foreign Exchange
Markets
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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
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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
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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
Exchange Rate Agreed
between Buyer and Seller
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3 mo
Buyer Pays Forward Price
Seller delivers currency
9-4
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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 = L62.5 M
– 2. Bank then lends the L62.5 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 L71.875 M
– 5 Bank delivers the sterling to buyer of one-year forward
contract and receives $111.406 M
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Role of FIs in Foreign Exchange
Transactions
• Net exposure - a FIs overall foreign exchange
exposure in any given currency
• Net long (short) in a currency - a position of holding
more (fewer) assets than liabilities in a given
currency
• Four trading activities
–
–
–
–
purchase/sale of foreign currencies for trade transactions
purchase/sale of foreign currencies for investment
purchase/sale of foreign currencies for hedging
purchase/sale of foreign currencies for speculating
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Liabilities to and Claims on Foreigners Reported
by Banks in U.S., Payable in Foreign Currencies ($M)
120000
100000
80000
60000
40000
20000
0
1993
1996
1999
2001
Banks' liabilities
Banks' claims
Claims of banks' domestic customers
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Purchasing Power Parity
The theory explaining the change in foreign currency
exchange rates as inflation rates in the countries change
iUS = IPUS + RIRUS
and:
iS = IPS + RIRS
where:
iUS = Interest rate in the United States
iS = Interest rate in Switzerland
then:
iUS - iS = IPUS - IPS
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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 + iUSt = (1/St)  (1 + iUKt)  Ft
where:
1 + iUSt = 1 plus the interest rate on a U.S. investment
maturing at time t
1 + iUKt = 1 plus the interest rate on a U.K. investment
maturing at time t
St = S/L spot exchange rate at time t
Ft = S/L forward exchange rate at time t
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Balance of Payment Accounts
• Balance of payment accounts - summary of all
transactions between citizens of two countries
• Current account - the section of the balance of
payment table that summarizes foreign trade in
goods and services, net investment income, and
gifts, grants, or aid given to other countries
• Capital accounts - the section of the balance of
payment table that summarizes capital flows into
and out of a country
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U.S. Balance of Payment Accounts
Current Accounts
Exports of good, services, and income
Imports of goods, services, and income
Unilateral transfers, net
Total current accounts
Balance on goods
Balance on services
Balance on investment income
Capital Accounts
U.S. assets abroad, net
Foreign assets in the U.S., net
Statistical discrepancy
Total capital accounts
Sum of current and capital accounts
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$1,298,392
-1,665,325
-50,501
-$ 417,429
-426,615
78,805
-19,118
-$439,563
896,185
-39,193
$417,429
$
0
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.