Foreign Exchange Markets
Objectives: to understand
• The organization of the Foreign Exchange Market
(FEM) and the distinction between spot and
forward markets
• How to calculate forward premiums and discounts
• How forward markets can be used to reduce
exchange risk
• The major participants the FEM and their motives
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Organization of FEM
• Interbank market (95% of transactions, 20
major banks)
– Spot market [40%]
– Forward market [10%]
– Swaps [50%]
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Participants
•
•
•
•
•
Brokers
Arbitrageurs
Traders
Hedgers
Speculators
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Foreign Exchange Risk
Foreign Exchange Risk
• Foreign exchange risk is the risk that the
value of an asset or liability will change
because of a change in exchange rates.
• Because these international obligations span
time, foreign exchange risk can arise.
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Sources of Risk
• Transaction Exposure: The risk that the domestic
cost or proceeds of a transaction may change.
• Translation Exposure: The risk that the translation
of value of foreign-currency-denominated assets is
affect by exchange rate changes.
• Economic Exposure: The risk that exchange rate
changes may affect the present value of future
income streams.
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Hedging and Speculating
• Hedging is the act of offsetting an exposure
to risk.
• Speculation generates and exposure to risk.
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Long and Short Positions
• People are long in a foreign currency if the
value of their foreign-currency-denominated
assets exceeds the value of their foreigncurrency-denominated liabilities.
• People are short in a foreign currency if the
value of their foreign-currency-denominated
assets is less than the value of their foreigncurrency-denominated liabilities.
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Hedging
• There are a number of instruments that can
be used to hedge foreign exchange risk.
• Chapter 8 deals with the forward markets,
while Chapter 9 introduces foreign
exchange futures, options, and swaps.
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Forward Exchange Contracts
The market for future delivery of a
currency.
Forward Market
• The forward market is the market for the future
delivery of a currency.
• Typical maturity is 1, 3, 6, 9 and 12 months.
• The forward rate is determined by market
participants’ expectations of the future spot value
of the currency which, in turn, depends on other
economic variables.
• Hence, the forward market may provide some
information about future spot price movements.
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Forward Premium
• The difference between the spot and
forward rates is expressed as the standard
(or annualized) forward premium or
discount.
• The standard premium is calculated as the
difference between the two rates as a
percent of the spot rate, which is then
annualized (simple basis).
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Example
• For example, suppose the spot rate is 1.6035
($/£) and the 3-month forward rate is
1.6050.
• The forward premium on the pound is:
[(1.6050-1.6035)/1.6035]*(12/3)*100 =
0.37%
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International Interest Arbitrage
• Taking advantage of interest rate
differentials.
• “Borrow Low - Lend High”
• Covered interest arbitrage involves the use
of a forward contract.
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Covered Interest Arbitrage
• Suppose the three-month Swiss franc
eurocurrency rate is 2.75% and the threemonth U.S. dollar eurocurrency rate is
5.625%.
• The spot rate is 1.4898 Sfr/$.
• The three-month forward rate is 1.4641.
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Covered Interest Arbitrage
• (1+i) = (1+i*)(F/S)
• The interest rates and forward rates must be
for the same period. For our example, we
take the interest rate and convert it to a
quarterly rate.
• So i is actually i/(12/n).
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Example Continued
• Substitute the values into the condition:
[1+(0.0275/4)]=[1+(0.05625/4)](1.4641/1.4898)
(1.006875)=(1.0140625)(0.98275)
1.006875 > 0.99656
• Would you want to borrow the dollar and
lend the franc or vice versa?
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Example Continued
• Borrow one dollar at 1.40625% for three months.
• Buy Sfr1.4898 spot.
• Lend Sfr1.4898 at 0.6875%. Will receive:
Sfr1.4898(1.006875) = Sfr1.5000.
Sell Sfr1.5000 forward at 1.4641. Will receive:
Sfr1.5000/1.4641 = $1.02452
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Example Continued
• Repay dollar loan at a cost of;
$1(1.0140625) = $1.0140625.
• Profit of $1.02452 - $1.0140625 = $0.0105,
or 1.05%.
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Covered Interest Parity
Covered Interest Parity
• Covered interest parity is a condition that
relates interest differentials to the forward
premium or discount.
• It begins with the interest parity condition:
(1+R) = (1+R*)(F/S)
• The condition can be rewritten, and with a
slight approximation, yields:
R - R* = (F-S)/S.
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Covered Interest Parity
• CIP is helpful in understanding short-term
market movements.
• As an equilibrium condition, it aids in our
understanding of potential adjustments in
various financial markets.
• These adjustments occur if there is a flow of
savings from one nation to another.
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Example
• Suppose the 90-day U.S. interest rate is 5.5%
while the U.K. rate on a similar instrument is 5.0%
(both expressed as annual rates).
• The current spot rate is 1.4546 ($/£) and the threemonth forward rate is 1.4900.
• To use the uncovered interest parity condition, we
must convert the interest rates to quarterly values:
(0.055)/(12/3) = 0.01375 and (0.05)/(12/3) = 0.0125.
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Example
• Now substitute the values into the CIP
condition:
0.01375 - 0.0125 = (1.4900-1.4546)/1.4546,
0.00125 < 0.0243.
• Though the interest rate on the U.S. instrument
is higher than that on the U.K. instrument, the
difference is outweighed by the depreciation
(forward discount) of the dollar over the time
interval.
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Conclusion
• Our finding for the previous example
indicates that funds would flow from the
United States to the United Kingdom.
• This flow of funds would affect interest
rates in both countries, the forward
exchange rate, and/or the spot rate.
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The Flow of Funds
• The various scenarios that are possible can be
summarized in a single diagram, the CIP parity
grid.
• The CIP grid graphs the interest differential on the
horizontal axis and the forward premium /
discount on the vertical axis.
• Points on a 45 degree line bisecting the grid
indicate points where UIP holds.
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(FN-S)/S
45o
Funds Flow to the
Foreign Economy
Previous
example

R-R*
Funds Flow to the
Domestic Economy
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The Flow of Funds
• The flow of funds from the United States to
the United Kingdom potentially can cause
changes in the spot rate, the forward rate,
and interest rates in both countries.
• The following slides illustrate the diagrams
for each.
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Increase in Demand for the Pound
S ($/£)
S£
S1
S0
D’£
D£
Q0
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Q1
Quantity£
The Spot Market
• Savers reallocate funds to pounddenominated financial instruments.
• This results in an increase in the demand for
the pound (as the demand for the pound is a
derived demand).
• The demand curve shifts to the right and the
pound appreciates relative to the dollar.
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Increase in the Supply of the Pound in
the Forward Market
F ($/£)
S£
S’£
F0
F1
D£
Q0
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Q1
Quantity£
The Forward Market
• Because saver are now long the pound, to
cover their position they must sell the pound
forward.
• This causes an increase in the supply of the
pound in the forward market, and the value
of the pound in the forward market declines.
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Increase in the Supply of Loanable
Funds in the U.K.
R*
SLF
S’LF
R*0
R*1
DLF
Q0
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Q1
QuantityLF
Loanable Funds in the U.K.
• As funds flow into the United Kingdom, the
supply of loanable funds increases.
• This causes the interest rate to decline in the
U.K.
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Decrease in the Supply of the Loanable
Funds in the U.S.
R
S’LF
SLF
R1
R0
DLF
Q1
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Q0
QuantityLF
Loanable Funds in the U.S.
• As funds flow out of the U.S., the supply of
loanable funds in the United States declines.
• This causes the interest rate to rise in the
United States.
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Uncovered Interest Parity
Uncovered Interest Parity
• UIP is a condition relating interest
differentials to an expected change in the
spot exchange rate of the domestic currency.
• If foreign exchange risk is not hedged when
purchasing a foreign financial instrument,
the transaction is said to be uncovered.
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Uncovered Interest Parity
• If a savings decision is uncovered, the
individual is basing their decision on their
expectation of the future spot exchange rate.
• The expected future spot exchange rate is
e
expressed as S +1.
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Uncovered Interest Parity
• Using this expression for the expected
future spot rate, UIP can be written as:
e
R – R* = (S +1 – S)/S.
• In words, the right-hand-side of the UIP
condition is the expected change in the spot
rate over the relevant time period.
• We can express the expected change in the
spot rates as Se.
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Uncovered Interest Parity
• Hence, UIP is expressed as:
R – R* = Se.
• According to UIP, if the domestic interest
rate is greater than the foreign interest rate,
the domestic currency is expected to
depreciate over the relevant time period.
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Uncovered Interest Parity
• Likewise, if the domestic interest rate is less
than the foreign interest rate, the domestic
currency is expected to appreciate over the
relevant time period.
• UIP can be useful in understanding why
funds may flow from one economy to
another.
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UIP as an Equilibrium Condition
• Consider the following situation:
R – R* > Se, with both sides positive.
The interest differential in favor of the domestic
financial instrument exceeds the expected
depreciation of the domestic currency. In this
case, and ignoring transaction costs, the saver
would be induced to reallocate their funds and we
would expect funds to flow to the domestic
economy.
Fred Thompson
UIP as an Equilibrium Condition
• Consider the following situation:
R – R* < Se, with both sides positive.
The interest differential in favor of the domestic
financial instrument is less than the expected
depreciation of the domestic currency. In this
case, and ignoring transaction costs, the saver
would be induced to reallocate their funds and we
would expect funds to flow to the foreign
economy economy.
Fred Thompson
UIP as an Equilibrium Condition
• The various scenarios that are possible can be
summarized in a single diagram, the UIP parity
grid.
• The UIP grid graphs the interest differential on the
horizontal axis and the expected change in the spot
exchange rate on the vertical axis.
• Points on a 45 degree line bisecting the grid
indicate points where UIP holds.
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Se
45o
Funds Flow to the
Foreign Economy
R-R*
Funds Flow to the
Domestic Economy
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Deviations from UIP
• To examine the performance of UIP, we can
rewrite the basic interest arbitrage equation:
(1+R) = (1+R*)(Se+1/S),
As
Se+1 = S(1+R)/(1+R*).
• Se+1 is then the UIP spot rate, which can be
compared to the actual spot rate that prevailed at
time period +1.
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Example
• Suppose the the spot rate of exchange
between the dollar and the pound is 1.664
$/£.
• The interest rate on a 3-month U.S.
financial instrument is 5.5 percent and the
interest rate on a similar U.K. financial
instrument is 6.5 percent.
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Example
• Using the formula
Se+1 = S(1+R)/(1+R*),
the expected spot rate is:
Se+1 = 1.664(1.01375)/(1.01625)
= 1.6599.
• Suppose the actual rate is 1.60. UIP, therefore,
indicates that the pound is undervalued.
Fred Thompson