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FOREIGN EXCHANGE DERIVATIVEMARKETS

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  1. FOREIGN EXCHANGE DERIVATIVEMARKETS CHAPTER 16 Dr David P Echevarria

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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