Chapter 13
The ForeignExchange
Market
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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
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INTRODUCTION
• Economic interactions with the rest of the
world require an exchange of currencies
• The exchange of domestic currency for
foreign currency occurs in the foreign
exchange market
• Who are the major participants in these
international flows of capital?
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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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FIGURE 13.1 The World of
Foreign-Exchange Dealing
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Features of Foreign Exchange
Market
• Refer to Table 11.1 FEM Trading Volume
• The total volume of trade in the foreign
exchange market was approximately $4
trillion in 2007.
• The largest markets are the U.K., accounting
for 34% of the world market, and the U.S.
with a 17% share.
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TABLE 11.1 Foreign Exchange
Market Trading Volume
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Features of FEM (cont.)
• Refer to Table 11.2
• The most traded currency is the U.S. dollar,
accounting for 86% of the total amount
traded.
• The dollar is followed by the euro, the
Japanese yen, and the British pound.
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TABLE 11.2 Use of Currencies on One Side
of the Transaction as a Percentage of Total
Foreign-Exchange Market Volume
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Exchange Rates and International Transactions
Exchange rates play a central role in international trade
because they allow us to compare the prices of goods and
services produced in different countries. A consumer
deciding which of two American cars to buy must compare
their dollar prices, for example, $44,000
(for a Lincoln Continental) or $22,000 (for a Ford Taurus).
But how is the same consumer to compare either of these
prices with the 2,500,000 Japanese yen (¥2,500,000) it
costs to buy a Nissan from Japan? To make this
comparison, he or she must know the relative price of
dollars and yen.
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Definitions of Exchange Rates
• Exchange rates are quoted as foreign currency per
unit of domestic currency or domestic currency per
unit of foreign currency. The first of these exchange
rate quotations (dollars per foreign currency unit) is
said to be is direct (or "American") terms, the
second (foreign currency units per dollar) is indirect
(or "European") terms.
• Exchange rates allow us to denominate the cost or
price of a good or service in a common currency.
– How much does a Honda cost? ¥3,000,000
– Or, ¥3,000,000 x $0.0098/¥1 = $29,400
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Domestic and Foreign Prices
• if we know the exchange rate between two
countries' currencies, we can compute the price of
one country 's exports in terms of the other country
's money. For example, how many dollars would it
cost to buy an Edinburgh Woolen Mill sweater
costing 50 British pounds (£50)'1 The answer is
found by multiplying the price of the sweater in
pounds, 50, by the price of a pound in terms of
dollars-the dollar's exchange rate against the
pound. At an exchange rate of $ 1 .50 per pound
(expressed in American terms), the dollar price of
the sweater is
• ( 1 .50 $/£) X (£50) $75.
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• A change in the dollar/pound exchange rate would
alter the sweater's dollar price. At an exchange rate
of $ 1 . 25 per pound, the sweater would cost only
• ( 1 .25 $/£) X ( £50) = $ 62.50,
• At an exchange rate of $ 1 .75 per pound, the
sweater's dollar price would be higher, equal to
• ( 1 .75 $/£) X ( £50) = $ 87.50.
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Depreciation and Appreciation
• Depreciation is a decrease in the value of a
currency relative to another currency.
– A depreciated currency is less valuable (less
expensive) and therefore can be exchanged for
(can buy) a smaller amount of foreign currency.
– $1/€1 → $1.20/€1 means that the dollar has
depreciated relative to the euro. It now takes
$1.20 to buy one euro, so that the dollar is less
valuable.
– The euro has appreciated relative to the dollar:
it is now more valuable.
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Depreciation and Appreciation
(cont.)
• Appreciation is an increase in the value of
a currency relative to another currency.
– An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for
(can buy) a larger amount of foreign currency.
– $1/€1 → $0.90/€1 means that the dollar has
appreciated relative to the euro. It now takes
only $0.90 to buy one euro, so that the dollar is
more valuable.
– The euro has depreciated relative to the dollar:
it is now less valuable.
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Depreciation and Appreciation
(cont.)
• A depreciated currency is less valuable, and
therefore it can buy fewer foreign produced goods
that are denominated in foreign currency.
– How much does a Honda cost? ¥3,000,000
– ¥3,000,000 x $0.0098/¥1 = $29,400
– ¥3,000,000 x $0.0100/¥1 = $30,000
• A depreciated currency means that imports are
more expensive and domestically produced goods
and exports are less expensive.
• A depreciated currency lowers the price of exports
relative to the price of imports.
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Depreciation and Appreciation
(cont.)
• An appreciated currency is more valuable, and
therefore it can buy more foreign produced goods
that are denominated in foreign currency.
– How much does a Honda cost? ¥3,000,000
– ¥3,000,000 x $0.0098/¥1 = $29,400
– ¥3,000,000 x $0.0090/¥1 = $27,000
• An appreciated currency means that imports are
less expensive and domestically produced goods
and exports are more expensive.
• An appreciated currency raises the price of exports
relative to the price of imports.
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Exchange Rate
• Types of Exchange Rates:
– Spot XR vs. Forward XR
– U.S. $ per foreign currency vs. foreign currency per
U.S. $
– Cross XR
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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.
• Refer to Table 13.1
• Exchange rates are quoted at a specific day and
time.
• The rates are for large, wholesale trades ($1 million
or more); the smaller the quantity of foreign
exchange purchased (retail transaction), the higher
the price.
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Spot Market
• The rates are “midrange” quotes or
the average of the banks’ buying and
selling prices.
• The percentage appreciation or
depreciation of the spot rate over time
using direct quotes can be measured
using
 beginning rate  ending rate 
%Δ in Spot Rate  
100

begining rate


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TABLE 13.2 International Currency
Symbols
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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 highrisk currencies.
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Arbitrage
• Arbitrage—the activity of simultaneously buying a currency in
one market while selling in another to take advantage of profit
opportunities. for instance, purchase of
€l million in New York for $ 1.1 million and immediately sell
the euros in London for $ 1.2 million, making a pure profit of
$ 100,000. If all traders tried to cash in on the opportunity,
however, their demand for euros in New York would drive up
the dollar price of euros there, and their supply of euros in
London would drive down the dollar price of euros there. Very
quickly, the difference between the New York and London
exchange rates would disappear. Since foreign exchange
traders carefully watch their computer screens for arbitrage
opportunities, the few that arise are small and very shortlived.
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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.
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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.
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Forward Rates (cont.)
• Paying for Imports and Exports
– Payments in international transactions are
different from payments in a domestic
economy
– Cash payments are rare in international trade
because of the burden it puts on the buyer
(importer)
– Usually imports are paid for using a specific
foreign exchange instrument
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Forward Rates (cont.)
• There is a substantial period between
when the exporter ships the goods and
when the importer receives them
• The most common solution to this
problem is a cable transfer
• The importer instructs his or her bank to
transfer the payment for the imports to
the exporter’s account in another
country
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Forward Rates (cont.)
• The disadvantage of this is that the importer
pays in advance for goods not yet received
• A commercial bill of exchange or a bank draft
instructs the importer to pay on a certain date a
specified amount of money.
• A letter of credit is a guaranty that the
commercial bill of exchange or bank draft will be
paid by the bank
• These instruments can be sold in the foreign
exchange market for slightly less than the face
value
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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.
– Forward dates are typically 30, 90, 180, or 360
days in the future.
– Rates are negotiated between two parties in the
present, but the exchange occurs in the future.
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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.
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Forward Premium vs.
Forward Discount
• The percentage discount or premium
can be determined for forward rate
relative to spot rate when quoted on a
direct basis by using the following
formula
[(Forward Rate – Spot Rate)/Spot Rate]  (360/N)  100
Where N is the number of days to future delivery
in the contract
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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 53% of the volume of
trading activity in the foreign exchange
market (refer to Table 13.3).
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Swap
• A foreign exchange swap is a spot sale of a currency
combined with a forward repurchase of the
currency. For example, suppose the Toyota auto
company has just received $ 1 million from
American sales and knows it will have to pay those
dollars to a California supplier in three months.
Toyota's asset-management department would
meanwhile like to invest the $1 million in euro
bonds. A three-month swap of dollars into euros
may result in lower brokers‘ fees than the two
separate transactions of selling dollars for spot
euros and selling the euros for dollars on the
forward market.
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TABLE 13.3 Average Daily Volume of
Bank Foreign-Exchange Market Activity
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Hedging
• Hedging—an activity to offset or avoid risk
in the market.
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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
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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( these are known as American
options, European may be exercised only at
maturity).
• Call Option—an option to buy currency.
• Put Option—an option to sell currency.
• Strike or Exercise Price—the price at
which currency can be bought or sold.
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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.
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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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FIGURE 13.2 The Dollar/Pound
Foreign-Exchange Market
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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.
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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.
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Flexible Exchange Rate
• Flexible Exchange Rate—where the
exchange rate is determined by free-market
forces of demand and supply.
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Exchange Rate Index
• Refer to Global Insights 13.1
• Exchange Rate Index – a weighted average
of a currency’s value relative to other
currencies, where the weights are based on
the relative trade importance of each
currency.
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Black Market
• Black Market—an illegal market in foreign
exchange. Usually a result of restrictive
government policies on foreign exchange
transactions.
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Parallel Market
• Parallel Market—a free market allowed by
government to coexist with the official
market.
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An exchange rate index is a way of measuring the performance of a currency against a
basket of other currencies.
US Dollar Index
For example, the US dollar index measures the US dollar against 6 main currencies.
1. Euro (EUR) – 12 members of EU.
2. Japanes Yen (JPY)
3. Pound Sterling (GBP) 4. Loonie (CAD) – Canada
5. Kronas (SEK) – Sweden
6. Francs (CHF) – Switzerland
These are weighted. This means the exchange rate movements also depend on the
relative importance of trade with these currencies. Therefore an appreciation against the
Swedist Krona, only accounts for a small % of US trade. A devaluation against the Euro
will have much more impact and weighting.
The Decline in the US Dollar Index.
The US dollar index is currently 77.5 (link). The index was set at 100 in 2000.
Therefore, there has been a 22.5% decrease in the value of the dollar since 2000.
See: Reasons for falling dollar
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