Ch 12 Foreign Exchange

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Ch 12 Foreign Exchange

• The trick is to stop thinking
• of it as your' money.
• IRS Auditor

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Ch 12 Foreign Exchange

• Foreign Exchange
• International purchases require two transactions
  
• Foreign currency is bought.
• Currency is used to buy something.
• To buy American goods you need American dollars.
• Market where this exchange takes place is called
  the foreign exchange market.
• Very little trading in currency, mostly bank
  deposit transfers.
• Largest and most liquid market in the world,
  operates 24 hours per day, all over the world.

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Ch 12 Foreign Exchange

• Types of FX Transactions
• Spot Transaction
• Purchase and sale of foreign currency for cash
  settlement not more than two days after date of
  transaction.
• Two days gives buyers and sellers time to arrange
  details of trade.
• Aka immediate delivery
• Agreement to buy or sell currency at current
  (spot) exchange rate.
• Forward Transaction
• Traders contract at stipulated (forward) exchange
  rates for future transactions.
• If dealer knows today they will be buying
  something with yen in six months, the contract
  today to pay certain agreed upon price to reduce
  risk of price increase in six months.
• More than 2 days in the future (can be months or
  years).
• Exchange rate is fixed when contract is made, but
  money does not change hands until trade takes
  place.

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Ch 12 Foreign Exchange

• Types of FX Transactions
• Currency Swap
• Banks engage in these transactions to trade
  currencies they currently dont need for
  currencies they do.
• Conversion on currency to another currency with
  agreement to reconvert back to original currency
  at set time in the future.
• Rates of both exchanges are agreed upon in
  advance.

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Ch 12 Foreign Exchange

• Interbank Trading
• Small number of large banks have active currency
  trading operations (London, Tokyo, NY, Hong Kong,
  Chicago . . .)
• Sales to and from consumers, usually less than a
  million units, called retail transactions.
• Sales to and from other banks or corporations,
  usually over a million units, called wholesale
  transactions.
• Trade between banks interbank market
• FX market is profit center for banks.
• Bid rate price bank will pay (buy price)
• Offer rate Price bank will take (sell price)
• Difference spread

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Ch 12 Foreign Exchange

• Interbank Trading
• Bid rate price bank will pay (buy price)
• Offer rate Price bank will take (sell price)
• Difference spread
• Example
• .5851 / .5854

Bid (buy) rate
Offer (sell) rate
Simultaneously buying and selling one million
francs - will pay 585,100, will receive
585,400 net gain of 300.
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Ch 12 Foreign Exchange

• Interbank Trading
• Profits can be increased if traders anticipate
  changes in
• exchange rates correctly.
• Example
• Suppose trader expects exchange rate of Japanese
  yen to US dollar to go up (yen will appreciate
  against the dollar).
• Today 1.00 120 (1 .0083)
• Future 1.00 110 (1 .009)
• Dealer will raise bid and offer rates
• Raising bid rate persuades other dealers to
  sell yen.
• Raising offer rates dissuades other dealer from
  buying yen.
• When yen strengthens, dealer sells yen for
  more than they paid.

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Ch 12 Foreign Exchange

• Exchange Rate
• Price of one currency expressed in terms of
  another.
• ER / dollars needed to purchase one
  pound.
• ER 2 2/1 Requires 2 to purchase 1
• ER pounds required to purchase one dollar
• ER reciprocal of ER
• 1/ER ½ Requires 1/2 to purchase 1

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Ch 12 Foreign Exchange
Exchange Rate Price of one currency expressed in
terms of another. Examples 1 euro 1.19528
USD 1 USD 1 / 1.19528 .836625 1 CAD
.74438 USD 1 USD 1 / .74438 1.34340

• Dollar price of a pound increased from Tue to
  Wed.
• Dollar depreciated against the pound.
• Pound appreciated against the dollar

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Ch 12 Foreign Exchange
Cross Exchange Rate Used if the desired relative
exchanges of currencies does not include US
dollar, or a known exchange rate. To find the
exchange rate between the British pound and Swiss
francs, need to express them in terms of US
dollar value of British pound 1.79066
value of Swiss francs 0.77034
Each British pound buys 2.3245 Swiss francs.
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Ch 12 Foreign Exchange

• Arbitrage Opportunities in FX
• Arbitrage buying in one market with the intent
  of immediately reselling in another market to
  profit from price discrepancies.
• In FX markets, exchange rates tend to be
  consistent between locations within the market.
• Exchange arbitrage tends to equalize prices and
  eliminate further arbitrage opportunities.

price
S
2.05
D
Q Pounds
London
New York
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Ch 12 Foreign Exchange

• Arbitrage Opportunities in FX
• Arbitrage buying in one market with the intent
  of immediately reselling in another market to
  profit from price discrepancies.
• Purchase pounds in NY at 2.00 per pound, resell
  immediately in London for 2.05 per pound.
• Increase in demand in NY will push NY price up,
  increased supply in London will push London price
  down.
• Arbitrage will force prices to equalize until
  arbitrage opportunities are gone.

price
price
S
S
2.05
2.00
D
D
Q Pounds
Q Pounds
London
New York
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Ch 12 Foreign Exchange

• Effective Exchange Rate (Trade Weighted Dollar)
• US dollar may appreciate against some currencies
  and depreciate against others.
• The effective rate is determined by the weighted
  average between dollar and currencies of most
  important trading partners.
• Weights are given based on relative importance of
  trading partners.
• Reported as an index using 1973 as base year.

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Ch 12 Foreign Exchange

• Forward Market
• In spot market, currencies are bought and sold
  for immediate delivery.
• In forward market, currencies are bought and sold
  for future delivery, usually 1 month, 3 month, 6
  month.
• Exchange rate is agreed upon at time of
  transaction, but payment is not made until
  delivery takes place.
• Forward rate rate of exchange used for forward
  transactions.
• Forward rates reflect market consensus about what
  the currency will do in the future (what the
  market believes).
• If forward rate is higher than spot rate,
  currency is said to be trading at a premium. If
  forward rate is lower than spot rate, currency is
  trading at a discount.

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Ch 12 Foreign Exchange
Forward Market

• Forward rates indicate what market believes spot
  rates will be in 1 month, 3 months, 6 months.
• Pound is trading at a forward discount against
  the dollar.
• Market believes that the dollar price of the
  pound will decrease in future.

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Ch 12 Foreign Exchange

• Forward Market
• Forward market is used to protect traders,
  investors, firms, from volatility in currency
  markets.
• Traders can hedge against unexpected dollar
  appreciation or depreciation. Most helpful for
  dealers that dont do huge number of transactions
  in foreign market (small to midsize firms).
• Example US importer enters into a contract to
  buy cars from France. If dollar depreciates
  against euro before money can be paid (euros
  become more expensive), importer will be worse
  off. He will protect himself (hedge against
  depreciation) by locking in at forward rate for
  money owed.
• Many large corporations do not hedge foreign
  currency trades. They believe gains and losses
  of foreign currency trades balance over the long
  run, so they avoid transaction costs of the
  market by not hedging in forward market (can
  avoid currency fluctuations by becoming MNE).

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Ch 12 Foreign Exchange

• Speculation in FX Market
• Speculation is the attempt to profit by trading
  on expectations about future prices.
• Different from arbitrage trading in concurrent
  markets, with little to no risk.
• Speculation has risk.
• Foreign currency speculators can profit by
  betting against what the market believes will
  happen in the future with currency prices.
• Long position Buying low today, selling high
  tomorrow (aka buy long, go long).
• Short position Borrowing or selling forward
  before you own the currency (aka buy short, go
  short).

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Ch 12 Foreign Exchange

• Speculating in the Spot Market
• CASE 1
• Speculating on Appreciation of the British Pound
• ( price of will increase)
• Buy pounds at todays spot rate, deposit in bank
• In future, sell pounds at higher spot rate
• Example
• Spot rate today is 1 167
• We are betting that the spot rate will increase
  to 175
• Buy 1,000 today for 1,67000, then sell in
  future for 1,75000.
• Profit 8000 (if were right)

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Ch 12 Foreign Exchange

• Speculating in the Spot Market
• CASE 2
• Speculating on Depreciation of the British Pound
• ( price of will decrease)
• Borrow pounds today and exchange for dollars at
  current spot rate, deposit dollars in bank.
• In future, buy pounds at new lower spot rate and
  use them to pay back original loan.
• Example
• Spot rate today is 1 167
• We are betting that the spot rate will decrease
  to 150
• Borrow 1,000 today, exchange for 1,67000
• Deposit 167000 in bank to earn interest (need to
  make up interest being paid on borrowed )
• In future when spot rate decreases to 150, buy
  1,000 for 1,50000.
• Use pounds to pay back original loan.
• Profit 17000 (/- net interest)

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Ch 12 Foreign Exchange

• Speculating in the Forward Market
• Most speculation done in forward market.
• Based on belief that the future spot price and
  the current forward price will be different in
  the future.
• Example Suppose 30-day forward pound is selling
  at a 10 premium (market believes 30 days from
  now spot rate will be 10 higher than todays
  spot rate).
• To make money in speculation, trader would have
  to believe that market is wrong.

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Ch 12 Foreign Exchange

• Speculating in the Forward Market
• CASE 1
• Speculating that spot rate of British Pound will
  be higher in 3 months than its current 3-month
  forward rate
• Contract to buy pounds in forward market at
  3-month forward rate.
• Fill the contract (buy the pounds) in 3 months
  and immediately resell in spot market at higher
  spot rate.
• Example
• 3-month forward rate today is 1 167
• We are betting that the spot rate in 3 months
  will be higher than the forecasted rate, perhaps
  175
• Enter into contract to buy 1,000 in 3 months for
  1,67000.
• Three months from now, buy the contracted 1,000
  for the agreed upon 1,67000.
• Immediately resell the 1,000 in the spot market
  for 1,75000.
• Profit 8000 (if were right).

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Ch 12 Foreign Exchange

• Speculating in the Forward Market
• CASE 2
• Speculating that the spot rate of British Pound
  will be lower in 3 months than its current
  3-month forward rate
• Contract to sell pounds in forward market at
  3-month forward rate.
• In three months, purchase that quantity of pounds
  in spot market and use them to fill the forward
  contract.
• Example
• 3-month forward rate today is 1 167
• We are betting that the spot rate in 3 months
  will be lower than the forecasted rate, perhaps
  150.
• Enter into contract to sell 1,000 in 3 months
  for 1,67000.
• In 3 months, buy 1,000 in spot market for
  1,50000.
• Use these pounds to fill the forward contract.
• Profit 17000 (if were right).