Download Foreign Exchange Market

Chapter 13
The Foreign
Exchange Market
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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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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Exchange Rate
• Exchange Rate (XR)—the price of one
money in terms of another.
• Types of Exchange Rates:



Spot XR vs. Forward XR
US $ equivalent vs. foreign currency per US $
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.
• Table 13.1 refers to the New York FEM.
• Exchange rates are quoted at a specific day
and time.
• The rates are for large, wholesale trades
($1 million or more) among banks; the smaller
the quantity of foreign exchange purchased
(retail transaction), the higher the price.
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Spot Market (cont.)
• The different exchange rates are expressed
either as: (1) U.S. $ per unit of the foreign
currency; (2) Foreign currency per U.S. $
(or the reciprocal).
• The rates are “midrange” quotes or
the average of the banks’ buying and
selling prices.
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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 high-risk currencies (refer to Table
13.2 Currency spreads).
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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.
• Arbitrage could involve more than
two currencies.
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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.)
• 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.
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Depreciation vs. Appreciation
• Depreciation—when the value of one
currency falls relative to another. For
example, if the U.S. dollar depreciates
against the Swiss franc, then it takes
more dollars to buy one franc.
• Appreciation—when the value of one
currency rises relative to another.
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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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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 over 50% of the volume of
trading activity in the foreign exchange market
(refer to Table 13.4).
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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.
• Call Option—an option to buy currency.
• Put Option—an option to sell currency.
• Striking or Exercise Price—the price of the
currency stated in an option contract.
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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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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 freemarket forces of demand and supply.
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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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