Foreign Exchange
PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
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distributed with a certain product or service or otherwise on a password‐protected website for classroom use
1
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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2
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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3
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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4
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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5
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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6
TABLE 11.1 Distribution of foreign-exchange transactions by
U.S. banks
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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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8
TABLE 11.2 Top ten banks by share of foreign-exchange
market, 2009
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9
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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11
TABLE 11.3 Foreign exchange quotations (a)
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TABLE 11.3 Foreign exchange quotations (b)
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13
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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14
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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15
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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16
TABLE 11.4 Forward contract versus futures contract
Forward Contract
Futures Contract
Issuer
Commercial bank
International Monetary Market (IMM) of
the Chicago Mercantile Exchange and
other foreign exchanges such as the
Tokyo International Financial Futures
Exchange
Trading
“Over the counter” by
telephone
Contract size
Tailored to the needs of the
exporter/importer/investor; no
set size
On the IMM’s market floor
Standardized in round lots
Date of delivery Negotiable
Only on particular dates
Contract costs
Based on the bid
Brokerage fees for sell and buy orders
Settlement
On expiration date only, at
prearranged price /offer spread
Profits or losses paid daily at close of
trading
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17
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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18
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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20
TABLE 11.5 Foreign currency futures, May 13, 2009:
selected examples
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21
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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22
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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23
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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24
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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GLOBALIZATION
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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26
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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FIGURE 11.1 Exchange-rate determination
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
• 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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TABLE 11.6 Advantages and disadvantages of a
strengthening and weakening dollar
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31
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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33
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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34
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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35
TABLE 11.7 Exchange rate indexes of the U.S. dollar
(March 1973 = 100)*
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36
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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37
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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38
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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39
TABLE 11.8 Forward exchange rates: selected examples
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40
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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41
The Forward Market
• Relation between the forward rate and spot
rate
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42
The Forward Market
• Managing your foreign exchange risk
• Forward foreign-exchange contract
• And engage in hedging
• Hedging
• Process of avoiding or covering a foreignexchange risk
• Some firms do not hedge
• Currency fluctuations even out over the long
term
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43
TRADE
CONFLICTS
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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44
TABLE 11.9 Return on a three-month German investment
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45
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 exchangemarket cover
• To protect investment proceeds from foreigncurrency fluctuations
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46
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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TABLE 11.10 uncovered interest arbitrage: an example
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48
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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49
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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TABLE 11.11 Covered interest arbitrage: an example
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51
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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52
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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53
TRADE
CONFLICTS
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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54
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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