Foreign Exchange Markets and Exchange Rates

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Lecture 3

• Foreign Exchange Markets and Exchange Rates

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Chapter 14 Foreign Exchange Markets and Exchange
Rates

• 14.1 introduction
• 14.2 Functions of the Foreign Exchange Markets
• 14.3 Foreign Exchange Rates
• 14.4 Spot and Forward Rates, Currency Swaps,
  Futures, and Options
• 14.5 Foreign Exchange Risks, Hedging, and
  Speculation
• 14.6 Interest Arbitrage and the Efficiency of
  Foreign Exchange Markets
• 14.7 Eurocurrency or Offshore Financial Markets

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14.1 introduction

• Foreign Exchange Market
• is the market in which individuals, firms, and
  banks buy and sell foreign currencies or foreign
  exchange.

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14.2 Functions of the Foreign Exchange Markets

• The transfer of funds or purchasing power from
  one nation and currency to another.
• Demand for foreign currencies
• -Import/expenditures abroad/investment
  abroad
• Supply of foreign currencies
• -Export/earnings from tourism/receipt of
  foreign investments
• the credit function
• the facilities for hedging and speculation

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Four levels of transactors or participants

• Immediate users and suppliers of foreign
  currencies-importers/exporters/
  tourists/investors
• Clearinghouses-commercial bank
• Foreign exchange brokers-interbank / wholesale
  market
• The nations central bank-lender of last resort

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14.3 Foreign Exchange Rates
FIGURE 14-1 The Exchange Rate Under a Flexible
Exchange Rate System.
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FIGURE 14-2 Disequilibrium Under a Fixed and
Flexible Exchange Rate System.
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Middle Exchange Rate of RMB
Date Dollar Euro Yen Pound
2009-3-24 683.01 933.74 6.992 1002.52
2009-3-23 683.04 931.46 7.1024 990.34
2009-3-20 682.93 932.71 7.2149 990.18
2009-03-19 683.01 918.96 7.0863 972.98
2009-03-18 683.19 888.8 6.9208 959.3
2009-03-17 683.27 886.13 6.9389 961.36
2009-03-16 683.49 879.96 6.9478 954.25

Source www.safe.gov.cn
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14.4 Spot and Forward Rates, Currency Swaps,
Futures, and Options

• 14.4a Spot and Forward Rates
• 14.4b Currency Swaps
• 14.4c Foreign Exchange Futures and Options

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14.4a Spot and forward rates

• Spot transaction-Spot rate
• The most common type of foreign exchange
  transaction involves the payment and receipt of
  the foreign exchange within two business days
  after the day the transaction is agreed upon.
• The two-day period gives adequate time for the
  parties to send instructions to debit and credit
  the appropriate bank accounts at home and abroad.

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Forward transaction-Forward rate

• A forward transaction involves an agreement today
  to buy or sell a specified amount of a foreign
  currency at a specified future date at a rate
  agreed upon today.
• One month Three months six months
• Forward contracts can be renegotiated for one or
  more periods when they become due.

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• FD (forward discount)
• If the forward rate is below the present spot
  rate, the foreign currency is said to be at a
  forward discount with respect to the domestic
  currency.
• FP (forward premium)
• If the forward rate is above the present spot
  rate, the foreign currency is said to be at a
  forward premium with respect to the domestic
  currency.

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14.4b Currency swaps

• Refer to a spot sale of a currency combined with
  a forward repurchase of the same currency-as part
  of a single transaction.
• Swap rate is the difference between the spot and
  forward rates in the currency swap. (a yearly
  basis)

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14.4c Foreign exchange futures and options

• A foreign exchange futures
• is a forward contract for standardized currency
  amounts and selected calendar dates traded on an
  organized market (exchange).

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A foreign exchange option

• Is a contract giving the purchaser the right, but
  not the obligation, to buy (a call option) or to
  sell (a put option) a standard amount of a traded
  currency on a stated date (the European option)
  or at any time before a stated date (the American
  option) and at a stated price (the strike or
  exercise price)
• The buyer pays the seller a premium (the option
  price) ranging from 1 to 5 percent of the
  contracts value for this privilege when he or
  she enters the contract.

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14.5 Foreign Exchange Risks, Hedging, and
Speculation

• 14.5a Foreign Exchange Risks
• 14.5b Hedging
• 14.5c Speculation

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14.5a Foreign exchange risk

• Foreign exchange shift
• Changes in tastes for domestic and foreign
  products in the nation and abroad
• Different growth and inflation rates in different
  nations
• Changes in relative rates of interest
• Changing expectations

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14.5b Hedging

• Refers to the avoidance of a foreign exchange
  risk, or the covering of an open position.
• At spot market
• At forward market
• At futures and options markets

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14.5c Speculation

• The opposite of hedging.
• A speculator accepts and even seeks out a foreign
  exchange risk, or an open position, in the hope
  of making a profit.
• Speculation can take place in the spot, forward,
  futures, or options markets

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• Long position when a speculator buys a foreign
  currency on the spot, forward, or futures market,
  or buys an option to purchase a foreign currency
  in the expectation of reselling it at a higher
  future spot rate.
• Short position when a speculator borrows or
  sells forward a foreign currency in the
  expectation of buying it at a future lower price
  to repay the foreign exchange loan or honor the
  forward sale contract or option.