Foreign Exchange Market

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# Foreign Exchange Market - PowerPoint PPT Presentation

Foreign Exchange Market. Chapter 13. Foreign Exchange Market. Foreign exchange trading refers to trading of one country’s money for that of another country. The need for such trade arises because of: Tourism The buying and selling of goods internationally

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### Foreign Exchange Market

Chapter 13

Foreign Exchange Market
• Foreign exchange trading refers to trading of one country’s money for that of another country.
• The need for such trade arises because of:
• Tourism
• The buying and selling of goods internationally
• Investment across international boundaries.
Foreign Exchange Market
• Foreign exchange market refers to large commercial banks in financial centers such as New York, London and Tokyo, trading foreign-currency denominated deposits with each other.
• Spot market: where currencies are traded for current delivery
Arbitrage
• Since currencies are homogenous goods, it is very easy to compare prices in different markets. Exchange rate tend to be equal worldwide.
• If this were not so, there would be profit opportunities for simultaneously buying a currency in one market while selling in another. This activity is knows as arbitrage.
Arbitrage
• Arbitrage can involve more than two currencies.
• Example: In New York, dollar/pound =\$2
• In London, dollar/Swiss franc = 0.4
• Then pound/Swiss franc = 0.4/2=0.2
• If we observe a market where any of these three exchange rate is out of line, there is an arbitrage opportunity.
Arbitrage
• In Zurich:
• Pound/franc=0.2
• In New York:
• Dollar/franc=0.4
• In London:
• Dollar/pound=\$1.9
• What you can do to make profit under this scenario?
Forward Rates
• A watch importer from U.S. wants to purchase watches from Switzerland.
• He can buy watch now, then he can settle the account by purchasing Swiss franc in the spot market.
• He can to place an order for Swiss watches for delivery in a future date.
• Much of the international trade is contracted in advance for a future delivery and payment.
Forward Rates
• For payment in the future, the importer is faced with exchange rate risk.
• If the dollar depreciate against franc, then it would take more dollars to buy any given amount of francs.
• If the dollar appreciate against franc, then it would take less dollars to buy a given amount of francs.
Forward Rates
• How can the importer avoid the risk of exchange rate fluctuations?
• The importer may want to choose the strategy of waiting for three months to buy Swiss watch.
• Another alternative is to buy franc now and hold or invest them for three months.
• Use of forward exchange rate market to ensure a certain dollar price of franc.
Forward Rates
• If a forward exchange price of a currency exceed the current spot price, that currency is said to be selling at a forward premium.
• A currency is selling at a forward discount when the forward rate is less than the current spot price.
• On January 31, 2003: U.S. dollar per Swiss franc: \$0.7332=1 SF
• Three months forward rate for Swiss franc: \$0.7346=1SF
Swaps
• A foreign exchange swap is a trade that combines both a spot and a forward transaction into one deal.
• Example: Suppose Citibank wants pounds now. It could enter into a swap agreement with another bank. Under the swap agreement, it will trade dollar to the other bank and in return will receive pounds. After the specified time period, the trade is reversed. Citibank will pay out pounds to the other bank and receive dollars.
The Futures Market
• The futures market is a market where foreign currencies may be bought or sold for delivery at a future date.
• The futures market differs from forward market in that only a few currencies are traded, trading occurs in standardized contracts and trading occurs in a specified location, International Monetary Market of the Chicago Mercantile Exchange.
Forward

Are written for any amount of currency

Contracts are typically 30, 90 and 180 days long and maturing everyday of the year.

Futures

Only a few currencies are traded (€, £, ¥, A\$, Can\$, SF, Ps)

Are written for a fixed amount of currency.

All contracts have specific maturity date.

Future vs forward contracts
The Foreign Currency Options
• Besides forward and futures contracts, there is an additional market where future foreign currency can be hedged: the option market.
• A foreign currency option is a contract that provides the right to buy or sell a given amount of currency at a fixed exchange rate on or before maturity date.
The Foreign Currency Options
• A call option gives the right to buy currency and a put option gives the right to sell.
• The price at which currency can be bought or sold is the strike price or exercise price.
The Foreign Currency Options
• How to hedge in the currency market using option:
• Suppose U.S. importer is buying equipment from a German manufacturer with a €1,000,000 payment in three months. The importer can hedge against a € appreciation by buying a call option that confers the right to purchase € over the next three months at the strike price.
Central-Bank Intervention
• So far, we have not explicitly introduced government into the foreign-exchange market;
• In reality, central banks and national treasuries play a large role in the market.
• In the U.S., Federal Reserve buy and sell currencies to drive the value of their currency to levels other than what the free market would establish.
Dollar-pound foreign exchange market

\$/pound

S

S’

C

1.7

B

1.6

A

D’

D

£1

£2

£3

Pounds

Central-Bank Intervention
• As shown in the diagram: in the face of appreciating currency, central bank often sells its own currency in the foreign exchange market.
• Similarly, in the face of depreciating currency, central banks often sell foreign currencies in exchange for domestic currency to halt depreciation.
• For example, in the previous example of appreciating pound, instead of the Bank of England selling pounds to stop the pound appreciation, the Federal Reserve could have sold pounds.
Black Markets and Parallel Markets
• So far, we have discussed the foreign exchange market as a market where currencies are bought and sold openly by individuals, business firms and government.
• The above description is true for major developed countries.
• However, developing countries generally do not permit free markets in foreign exchange and impose many restrictions on foreign-currency transactions.
Black Markets and Parallel Markets
• Because of restrictions in foreign-exchange transactions, illegal markets in foreign exchange develop to satisfy trader demand. These illegal markets are known as black markets.
• Governments defend the need for foreign exchange restrictions based on conserving scare foreign exchange for high-priority use.
Black Markets and Parallel Markets
• Guatemala had an artificially low official exchange rate of one quetzale per dollar for more than three decades. However, a black market was allowed to flourish openly in the face of government.
• In Guatemala, government allowed such activity openly. This sort of government-tolerated alternative to the official exchange market is often referred to as a parallel market.