CH. 14.: FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES
  •    Foreign exchange markets.
  •    Foreign exchange rates.
  •    Spot and forward rates, currency swaps, futures and options.
  •    Foreign exchange risks, hedging and speculation.
  •    Interest arbitrage.
  •    (Eurocurrency markets).

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  • Foreign exchange markets.

    • -Foreign currency can be bought and sold in London, Paris, Zurich, Frankfurt, Singapore, Hong Kong and New York.

    -Foreign exchange market is the largest one in the world (in 1998, $1.5 trillion PER DAY).

    -U.S. dollar is a dominant vehicle currency (foreign exchange trading, international loans, international bonds and reserves are mostly in U.S. dollars.).
    -U.S. dollar used as foreign exchange reserves by most central banks (DM and Yens also used).
    -Many commodities priced in U.S. dollars (Oil, coffee ...)
    -Euros will compete with the dollar (Euro exist as of Jan. 1, 1999.  Notes will be used Jan. 1 2002).
     
     

  • Foreign exchange rates

    • -2 ways to define bilateral exchange rates
    (1) Value of domestic currency: $1=x units of foreign currency
    (2) Value of foreign currency:    1fc = $x

        (1) = 1/(2)

    -Foreign Exchange Rates (Value of U.S. dollar against many currencies)

    -Flexible exchange rates: determined by supply and demand.: Deprecation vs. Appreciation

    Demand for Euros from the U.S.: the lower the value of euro => european goods cheaper and more is demanded => more Euros demanded.
    Supply of Euros from Europe: the higher the value of euro=>U.S. goods cheaper and more is demanded=> supply more Euros.

    -Fixed exchange rates: rates set by government: Devaluation vs. Revaluation.
        -If Demand changes for Euros, the Fed's international reserves may increase or decrease.
        -Example:  Demand for Euros increases: If Fed wants to maintain the previous exchange rate, it must supply Euros (by reducing its reserves of Euros).
        Example: Mexico Peso crisis and falling reserves.

    -Managed floating exchange rates:  Flexible exchange rates with central banks' intervention (but given the size of the foreign exchange market

    -Effective exchange rates (weighted average of bilateral rates): SUM 1,N Wi*Ri
        where N is number of countries, Wi is the weight of country i, R is the bilateral exchange rate of country i.
        -Weights are =  (trade with country i)/(total trade)

    -Cross exchange rates and arbitrage.
    -If cross exchange rates are not consistent then profits can be made (arbitrage). BUY LOW, SELL HIGH.
    -Arbitrage guarantees that cross exchange rates are consistent across foreign exchange markets.
    -Example:
        DM 1.5 = $1  in New York
        DM 1 = $1 in London.
            => Sell $1 in NY and receive DM 1.5.  Sell DM 1.5 in London and receive $1.5.

    -Example: Triangular arbitrage
        DM 1.5  = $1  in New York
        $ 1.6      = 1 british pound in London.
        BP 0.5   =  DM 1 in Frankfurt.
    Arbitrage opportunities??
        The first 2 exchange rates imply that DM X = 1 BP (N.Y: $1.6 = 2.4DM ; $1.6=1BP in London = > DM 2.4 = 1 BP or DM1=0.4166 BP which implies value of DM higher in Frankfurt).
            => 1. Sell $1 in NY for 1.5 DM.
                 2.  Sell the 1.5 DM in Frankfurt and receive 0.75 BP.
                 3.  Sell the 0.75 Pounds in London and receive $1.20 (20 cents profit).

    -Transaction cost may sometimes limit these opportunities.
     
     

  • Spot and forward rates, currency swaps, futures and options

    • -Spot rates (today's rates).
    -Forward rates: Exchange rates can be "locked in", up to 6 months.
        Annualized Forward Discount or F. Premium (in percentages)
            = (Forward rate - Spot rate)/(Spot rate) * X *100
                    X=12 if 1 month contract, 4 if 3 month & 2 if 6 months.
    -Exercise:
     Use the spot and forward exchange rates in a recent WSJ and compute the Annualized Forward Discounts/Premiums for the U.S. dollar (1, 3 and 6 months) for the following currencies:
    British Pound,
    Canadian Dollar
    Japanese Yen.

    -The reason why FD/FP is mostly because of interest rate differentials (Ch. 15).

    -Currency Swaps
     

    -Futures and Options
    -Future contracts are standardized (62,500 pound, 100,000 canadian dollars) forward contract.
    -Futures contracts can be sold at any time until maturity (unlike forward contracts).

    -Call Option:  Right to buy a currency at a certain price.
    -Put Option:   Right to sell a currency at a certain price.
    -Example:
    If you expect foreign payment=> buy a put option to protect against currency fluctuations.
    If you expect to pay in foreign currency=> buy a call option for country's currency.
     

  • Foreign exchange risks, hedging and speculation

    • -Fact: exchange rates fluctuate wildly (p. 480).
    -How can exporters/importers hedge (avoid the foreign exchange rate risk) against this volatility?
    -Examples:
    -An importer in the U.S. must pay 100,000 Euros in 3 months.
    To protect against currency fluctuations, the importer can borrow U.S. dollars, convert them into Euros and deposit the Euros in a European Bank.
    OR buy a call option to buy DM (Euros) at a certain price.
    OR buy the DM in the forward market.

    -An exporter who expects payments in 3 months can borrow Euros in a European bank and convert it into dollars at the spot rate.  In 3 months when euro payment is made repay the loan in the European bank.
    OR buy a put option (the right to sell the Euros at a certain dollar price).
    OR sell the DM in the forward market.

    -Speculation
    Stabilizing speculation: Buy (sell) when the currency's value is low (high): Reduces fluctuations.
    Destabilizing speculation: Buy (sell) when the currency's value is low (high):  Increases fluctuations.
     

  •  Interest arbitrage

    • -Uncovered interest arbitrage: No hedging against currency risk.

    -Covered interest arbitrage: Use forward contracts to hedge currency risk.
    -Interest rate differentials determine the forward rates (determined by supply and demand):
    U.S. domestic country.
        (i-i*)=Forward Discount (of foreign currency) if i<i*
     i.e. since foreign interest rates are higher => to make up for the difference the U.S. dollar must appreciate (i.e. the foreign currency must depreciate, thus, sold at a discount in the forward market.

     (i-i*)=Forward Premium (of foreign currency) if i<i*.

    IMPLICATION:
    If a foreign currency is sold at a discount (premium) in the forward market => interest rate in that country must be higher (lower).