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Section 2 The Foreign Exchange Market

Section 2 The Foreign Exchange Market

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Section 2 The Foreign Exchange Market

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  1. Section 2The Foreign Exchange Market

  2. Content • Objectives • Exchange Rates • The Foreign Exchange Market • Interest Parity Conditions • Equilibrium in the ForEx Market • Imperfect Markets • Summary

  3. Objectives • To know how to define and quote an exchange rate. • To know how to classify exchange rates by types of transactions and by maturity. • To know about triangular arbitrage • To understand the interest parity conditions. • To know how to determine the spot exchange rate in the foreign exchange market equilibrium.

  4. Exchange Rates • An exchange rate is the price of a currency in terms of another currency. • The price of a car is $20 000/car. • The price of a Canadian dollar is USD 0.7649/CAD. • The price of a US dollar in CAD is CAD 1.3074/USD • So, S(USD/CAD) = 1/S(CAD/USD) • An exchange rate quote is an announcement of a price at which a currency can be traded for another.

  5. Exchange Rates • Direct versus Indirect Quotes • A direct quote is the amount of home currency per unit of foreign currency. • An indirect quote is the amount of foreign currency per unit of home currency. • Example: In the U.S., S(USD/CAD) = USD 0.72/CAD is a direct quote for the Canadian dollar, but an indirect quote for the U.S. dollar.

  6. Exchange Rates • Terminology: • Depreciation: A fall in the foreign exchange value of a floating currency. • Devaluation: A fall in the foreign exchange value of a currency pegged to another currency. • Soft or Weak: A currency that is expected to devalue or depreciate relative to major currencies. • The exchange rate is the price of the currency in the denominator: S = USD 0.75/CAD

  7. Exchange Rates • Exchange rate by types of transactions: • Bid rate: exchange rate at which financial institutions will buy a foreign currency from you. We denote it Sb. • Ask rate: exchange rate at which financial institutions will sell a foreign currency to you. We denote it Sa. • The bid and ask rate are related by:

  8. Exchange Rates • The bid rate is use to sell a foreign currency or purchase the home currency: • The ask rate is use to purchase a foreign currency or sell the home currency:

  9. Exchange Rates • The spread (Sa – Sb) ensures that financial institutions make revenues from foreign exchange transactions. • These revenues are required to cover transaction costs incurred by acting as a financial intermediary between parties buying and selling currencies. • These revenues are also essential to make some profits.

  10. Exchange Rates • Triangular Arbitrage and Cross Rates: • I trade EUR z to obtain USD x: • USDx = EUR z S(USD/EUR) • I trade USD x to obtain CAD y: • CAD y = USD x/S(USD/CAD) • I trade EUR z to obtain CAD y: • CAD y = EUR z S(CAD/EUR) • So,

  11. Exchange Rates

  12. Exchange Rates • Domestic and Foreign Prices • The exchange rate enables us to compute the foreign currency price of goods in terms of home currency. • Example: The USD price of a CAD 20 compact disc with an exchange rate of USD 0.75/CAD is (USD 0.75/CAD) x (CAD 20) = USD 15 .

  13. Exchange Rates • A depreciation of the home country’s currency • A rise in the price of a foreign currency • Raises the home currency price of foreign goods • Example: If the exchange rate is USD 0.80/CAD, the USD price of a CAD 20 compact disc is (USD 0.80/CAD) x (CAD 20) = USD 16 .

  14. Exchange Rates • An appreciation of the home country’s currency • A reduction in the price of a foreign currency • Reduces the home currency price of foreign goods • Example: If the exchange rate is USD 0.70/CAD, the USD price of a CAD 20 compact disc is (USD 0.70/CAD) x (CAD 20) = USD 14 .

  15. Exchange Rates • An appreciation of a country’s currency: • Raises the relative price of its goods (exports) • Lowers the relative price of foreign goods (imports) • Depreciation of a country’s currency: • Lowers the relative price of its goods (exports) • Raises the relative price of foreign goods (imports)

  16. The Foreign Exchange Market • Exchange rates are determined in the foreign exchange market. • Geographically, the foreign exchange market spans the globe. • The market is most liquid early in the European afternoon, when the markets of both Europe and the U.S. East coast are open. • The market is thinnest at the end of the day in California, when the markets in Asia are about to open.

  17. The Foreign Exchange Market • The BIS estimated that in 1992, the daily volume of trading on the foreign exchange market was about 5 to 10 times that of international trade in goods and services. • The volume has ballooned in recent years. • New technologies are used in the major trading centers (London, New York, Tokyo, Frankfurt, and Singapore). • In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.

  18. The Foreign Exchange Market • The main functions are: • Transfer of purchasing power • Provision of credit • Minimizing Foreign Exchange Risk

  19. The Foreign Exchange Market • The major participants are: • Commercial banks • International corporations • Nonbank financial institutions • Central banks • Speculators and arbitragers • Interbank trading accounts for most of the volume.

  20. The Foreign Exchange Market • Spot exchange rates (S) • A spot transaction requires almost immediate delivery of foreign exchange.  • Forward exchange rates (F) • A forward transaction requires delivery at a future date of a specified amount of a currency for a specified amount of another currency.

  21. The Foreign Exchange Market • Foreign Exchange Swaps • A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

  22. The Foreign Exchange Market • Futures contract • A promise that a specified amount of foreign currency will be delivered on a specified date in the future. • Options contract • Gives the right (not the obligation) to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.

  23. Interest Parity Conditions • Covered Interest Parity • This is an application of the law of one price. • Assets that have same maturity, liquidity, and risk should have the same price. • The rate of return of an asset is inversely related to its price. • Example: The rate of return on a risk-free asset that promises to pay 1 unit tomorrow for a price q units today is:

  24. Interest Parity Conditions • Consider the return from purchasing a home money market instrument that pays in a year. • I purchase USD x of the asset. I get in a year: • The return is

  25. Interest Parity Conditions • Consider the return from purchasing a Canadian money market instrument that pays in a year. • I purchase CAD y: • I purchase CAD y of the asset. I get in a year

  26. Interest Parity Conditions • I sell CADY to obtain USDX • I use a forward contract to remove or cover foreign exchange risk. • The return is

  27. Interest Parity Conditions

  28. Interest Parity Condition • Covered Interest Parity: • Two assets with the same maturity and risk must yield the same return.

  29. Interest Parity Conditions • How are forward contracts priced? • Forward Premiums?

  30. Interest Parity Conditions • Efficient Market Hypothesis: • The forward rate is an unbiased predictor of future spot rates. • Empirical studies on market efficiency have yielded conflicting results. There appears to be an important risk premium on the forward market.

  31. Interest Parity Conditions • Uncovered Interest Parity: • The linear version of UIP is sometimes useful:

  32. Equilibrium in the ForEx Market • The uncovered interest parity condition is the workhorse of open-economy macroeconmics. • It contains: • Home returns: • Foreign returns:

  33. S S (1+i*)Se/S 1+i USD Returns Equilibrium in the ForEx Market (1+i) = (1+i*)Se/S

  34. S S i* + (Se – S)/S i USD Rates of Returns Equilibrium in the ForEx Market i = i* + (Se – S)/S

  35. Equilibrium in the ForEx Market • The effect of changing interest rates on the exchange rate • A rise in USD interest rates causes the USD to appreciate. • A rise in CAD interest rates causes the USD to depreciate.

  36. S S S (1+i*)Se/S 1+i 1+i USD Returns Equilibrium in the ForEx Market An increase in home interest rates

  37. S S S (1+i*)Se/S 1+i USD Returns Equilibrium in the ForEx Market An increase in foreign interest rates

  38. Equilibrium in the ForEx Market • The effect of changing expectations on the exchange rate • A rise in the expected future exchange rate raises the current exchange rate. • A fall in the expected future exchange rate reduces the current exchange rate.

  39. S S S (1+i*)Se/S 1+i USD Returns Equilibrium in the ForEx Market A rise in expected future exchange rates

  40. Imperfect Markets • In reality, we have bid-ask spreads. • This influences the notion of arbitrage used to construct cross-rates and covered interest parity.

  41. Imperfect Markets • Cross-rates:

  42. Imperfect Markets

  43. Imperfect Markets • It must not be possible to make any arbitrage profits. • Suppose that the relation between the cross rates and actual rates are: • A) No arbitrage opportunity Scb--------------Sca Sb--------------Sa • B) No arbitrage opportunity Scb-----------------Sca Sb--------Sa

  44. Imperfect Markets • C) Arbitrage opportunity Scb-------Sca Sb--------Sa • You can purchase the currency at price Sa and resell it at price Scb, and make a profit of (Scb -Sa) per units of currency purchased.

  45. Imperfect Markets • International investments are also affected. • It must not be possible to make any arbitrage profits. • There are bid-ask rates in the foreign exchange market. • Borrowing rates (ia) are larger than lending rates (ib). So, ia > ib

  46. Imperfect Markets

  47. Imperfect Markets • Example: The manager of a U.S. firm intends to buy Canadian maple syrup in 1 year. The syrup is worth CAD 1 m. International prices are as follows: • Spot rate: USD 0.66----0.80/CAD • Forward rate: USD 0.65----0.77/CAD • Interest rates (Canada): 8---10 percent per annum • Interest rates (U.S.): 5---6 percent per annum • How much money should the manager put aside today for this purchase?

  48. Imperfect Markets • Investing in the US: CADYT = USDxt (1+ib,us)/Fa(USD/CAD) or USDxt = CADYT Fa(USD/CAD)/(1+ib,us) USDxt = CAD 1m (USD 0.77/CAD)/(1+0.05) = USD 0.73 m

  49. Imperfect Markets • Investing in Canada: CADYT = USDxt (1+ib,c)/Sa(USD/CAD) USDxt = CADYT Sa(USD/CAD)/(1+ib,c) = CAD 1m (USD 0.80/CAD)/(1+0.08) = USD 0.74m • The manager should set aside USD 0.73 m, and invest it in the US.

  50. Imperfect Markets • Is there an arbitrage opportunity? • To answer this question, we construct the USD return to borrowing and investing abroad. • Then, we can compare the rates obtained abroad to those in the US.