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Understanding Foreign Exchange: Rates, Risks, and Strategies

Learn about foreign exchange, exchange rates, currency risks, forward rates, and currency futures. Discover how to hedge long-term exchange risk and explore the rise of the Euro.

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Understanding Foreign Exchange: Rates, Risks, and Strategies

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  1. Chapter 31 – Foreign Exchange • Every Government Issues Currency • The purchasing power of currencies vary across countries • The exchange rate is the rate at which one currency can buy another currency such that the buying or purchasing power is not changed • The relative value of currencies change over time, some rather rapidly • Currency Risk is the exposure to these changes

  2. Chapter 31 – Foreign Exchange • Exchange Rates • Direct Rate is the home or domestic currency needed to purchase one unit of the foreign currency • $0.008006 can buy one Yen (American) • Indirect Rate is the amount of home currency that can be purchase with a single foreign currency (reciprocal of direct) • 124 Yen can buy $1 (European) • Cross-Rate is the exchange rate of two foreign currencies • Triangular Arbitrage of Exchange Rates or the relationship of cross-rates, direct and indirect rates

  3. Chapter 31 – Foreign Exchange • Forward Rates • Making the international real rate the same • The Spot or Cash Exchange rate is for buying or selling a foreign currency today • The forward rate is the expected spot rate a specific future date • Forward Direct RateT = Spot Rate x (1+ inflation in foreign country over 1 + inflation rate in US ])T • Example…purchasing power the same through investment alternative

  4. Chapter 31 – Foreign Exchange • Currency Futures and Options • Locking in Forward Exchange Rates • Based on the expected inflations rates • Currency Swaps • Hedging Long-term Exchange Risk exposure • Arbitrage based motives • And Now a new multi-country Currency, the Euro

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