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FOREIGN EXCHANGE DERIVATIVEMARKETS. CHAPTER 16. FOREIGN EXCHANGE MARKET FUNCTIONS. Expand Purchasing Power Beyond National Borders. Demand for foreign goods creates demand for foreign currencies. Demand for foreign currencies drives foreign exchange markets.

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FOREIGN EXCHANGE DERIVATIVEMARKETS

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Foreign exchange derivativemarkets

FOREIGN EXCHANGE DERIVATIVEMARKETS

CHAPTER 16

Dr David P Echevarria


Foreign exchange market functions

FOREIGN EXCHANGE MARKET FUNCTIONS

  • Expand Purchasing Power Beyond National Borders.

    • Demand for foreign goods creates demand for foreign currencies.

    • Demand for foreign currencies drives foreign exchange markets.

  • Provide International Trade Credit Facilities.

    • Importers and Exporters need for credit financing.

    • Provide the general procedures for the conduct of credit activities.

  • Provide Securities for Minimizing Exchange Rate Risk.

    • Specialized markets for hedging activities.

    • Daily quotations of forward rates.

Dr David P Echevarria


Foreign exchange market participants

FOREIGN EXCHANGE MARKET PARTICIPANTS

  • Foreign Exchange Dealers

    • Banks.

    • Nonbanks.

    • Profits derived from the Spread: Bid (buy) - Offer (sell).

  • Speculators and Arbitrageurs

    • Operate for own interest via direct trading in the markets.

    • Volume of activities can destabilize currency exchange rates.

  • Commercial Firms

    • May receive cash payment in foreign currency.

    • If open account, steady stream of foreign receipts.

Dr David P Echevarria


Foreign exchange market participants1

FOREIGN EXCHANGE MARKET PARTICIPANTS

  • Individuals

    • Foreign travel creates the largest number of individual demands.

    • Relatively small volume of individual exchanges results in largest spreads.

  • Central Banks and National Treasuries

    • Central banks frequently enter markets to manage exchange rate.

    • May cooperate with other central banks to maintain Exchange Rate Mechanisms.

  • Foreign Exchange Brokers

    • Facilitate trade between major dealers (principals).

    • Provide exchange quotes and rates.

Dr David P Echevarria


Foreign exchange markets

FOREIGN EXCHANGE MARKETS

  • Exchange Rate Quotations

    • Prices as relative prices; dollar to Euro, Euro to UK Pound, etc, and reciprocals

    • One dollar to buy 100 Yen is equal to saying 1 Yen will buy 0.01 dollars

  • Types of Exchange Rate Systems

    • Fixed

    • Free Floating

    • Managed

  • Types of Exchanges

    • Spot exchanges

    • Forward exchanges

Dr David P Echevarria


Foreign exchange instruments

FOREIGN EXCHANGE INSTRUMENTS

  • Forward Exchanges: IMM (CME began trading FOREX futures May 16, 1972)

    • Fixed contract amounts (typically $1MM dollars)

    • Speculating and Hedging activity

  • Currency Futures Contracts

  • Currency Options Contracts

Dr David P Echevarria


Factors affecting exchange rate movements

FACTORS AFFECTING EXCHANGE RATE MOVEMENTS

  • Differential Inflation Rates

  • Differential Interest Rates

  • Differential Income Levels

  • Government Intervention (interest rates and money supply, pegging exchange rate)

  • Use of Dollar Indexes to Track Rate Changes

  • Impact of Rate Changes on Trade

Dr David P Echevarria


Homework questions

HOMEWORK QUESTIONS

  • What are the three types of exchange rate systems?

  • What role do differentials have in the rate of exchange?

    • Inflation

    • Interest Rates

    • Income levels

  • How do institutions manage foreign exchange risk?

  • How do arbitrageurs exploit differences in exchange rates?

Dr David P Echevarria


Arbitrage in the foreign exchange markets

ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS

  • Triangular Arbitrage

    • Exploiting deviations from relative values

    • Profits largely a function of deviation magnitudes and transaction costs

    • Example: EUR/USD = 0.8631, GBP/EUR = 0.6849, USD/GBP = 1.6939:

      0.8631*0.6849*1.6939 = 1.001327

      The profit opportunity is 0.001327 per dollar of exchange

      $1,000,000 transaction would yield $1,327 profit.

Dr David P Echevarria


Arbitrage in the foreign exchange markets1

ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS

  • Institutional Participation Foreign Exchange Markets

    • Large dollar volumes Minimal arbitrage opportunities

    • Speculating on short & intermediate changes in exchange and interest rates

Dr David P Echevarria


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