Foreign Exchange Markets Overview

1
Foreign Exchange Markets Overview

• Foreign exchange (FX) markets - markets in which
  cash flows from the sale of products or assets
  denominated in a foreign currency are transacted
• Foreign exchange rate - the price at which one
  currency can be exchanged for another currency
• Foreign exchange risk - risk that cash flows will
  vary as the actual amount of U.S. dollars
  received on a foreign investment changes due to a
  change in foreign exchange rates
• Currency depreciation/appreciation - when a
  countrys currency falls/rises in value relative
  to other currencies

2
Background and History of Foreign Exchange Markets

• Bretton Woods Agreement (1944-1977) - called for
  exchange rate of one currency for another to be
  fixed around a specific rate with government
  intervention - led to some currencies being
  overvalued and some undervalued
• Smithsonian Agreement (1971) - major countries
  allowed the dollar to be devalued and boundaries
  of exchange rate could fluctuate
• Smithsonian Agreement II (1973) - exchange rate
  boundaries eliminated altogether, free-floating
  exchange rate

3
Foreign Exchange Transactions
4
FX Transaction Example

• Situation US financial institution plans to
  invest 100 million in loans in England for one
  year.
• Spot exchange rate 1.6/
• British interest rate 15
• One year forward rate 1.55/
• The FI has 100/1.6 62.5 million to invest.
• In one year it will have 62.51.15 71.875
  million
• What will be the return in ?

5
FX Transaction Example

• Return in depends on the exchange rate at the
  end of the year.
• If spot rate 1.6/ then
• 71.8751.6/ 115 return 15
• If spot rate 1.45/ then
• 71.8751.45/ 104.22 return 4.22
• If spot rate 1.7/ then
• 71.8751.7/ 122.19 return 22.19

6
Forward Markets

• Forward contract
• an agreement to transact involving the future
  exchange of a set amount of assets at a set price
• participants hedge the risk that future spot
  prices on an asset will move against them

7
Hedging with Forwards

• Transactional steps when FI hedges its FX risk by
  immediately selling one-year sterling loan
  proceeds in forward FX market
• 1. U.S.bank sells 100 M for pounds at spot
  exchange rate today and receives 100 M/1.6
  ?62.5 M
• 2. Bank then lends the 62.5 M to British
  customer at 15 for one year
• 3. Bank sells expected proceeds from the sterling
  loan forward for dollars at todays forward rate
  of 1.55/ for one year
• 4. British borrower repays in 71.875 M
• 5 Bank delivers the sterling to buyer of one-year
  forward contract and receives 111.406 M
• FI has guaranteed return of 11.41

8
Role of FIs in Foreign Exchange Transactions

• Net exposure - a FIs overall foreign exchange
  exposure in any given currency
• Net long (short) in a currency - a position of
  holding more (fewer) assets than liabilities in a
  given currency
• Four trading activities
• purchase/sale of foreign currencies for trade
  transactions
• purchase/sale of foreign currencies for
  investment
• purchase/sale of foreign currencies for hedging
• purchase/sale of foreign currencies for
  speculating

9
Purchasing Power Parity
The theory explaining the change in foreign
currency exchange rates as inflation rates in the
countries change iUS
IPUS RIRUS and iF
IPF RIRF where iUS Interest rate
in the United States iF Interest
rate in France then iUS -
iF IPUS - IPF
10
Interest Rate Parity
The theory that the domestic interest rate should
equal the foreign interest rate minus the
expected appreciation of the domestic currency
1 iUSt (1/St) ? (1 iUKt)
? Ft where 1 iUSt 1 plus the
interest rate on a U.S. investment
maturing at time t 1 iUKt
1 plus the interest rate on a U.K. investment
maturing at time t
St S/L spot exchange rate at time t
Ft S/L forward exchange rate at time t
11
Balance of Payment Accounts

• Balance of payment accounts - summary of all
  transactions between citizens of two countries
• Current account - the section of the balance of
  payment table that summarizes foreign trade in
  goods and services, net investment income, and
  gifts, grants, or aid given to other countries
• Capital accounts - the section of the balance of
  payment table that summarizes capital flows into
  and out of a country