# The Foreign Exchange Market Exchange Rates n 11201

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The Foreign Exchange Market

Exchange Rates n 1/12/01 n n n German Mark: Japanese Yen: British Pound: EMU Euro: DM 2. 0554 per US dollar ¥ 118. 53 per US dollar \$1. 4778 per £ \$0. 95222 per € European terms: the foreign currency prices of a dollar American terms: the dollar price of a unit of foreign exchange

Appreciation and Depreciation E\$/¥ = the price of the yen in terms of dollars n A rise in E\$/¥ Appreciation of the yen against the dollar; Depreciation of the dollar against the yen n A fall in E\$/¥ Depreciation of the yen against the dollar; Appreciation of the dollar against the yen n

Example n n n In Munich, a bratwurst costs € 2 = PB€ In Boston, a hot dog costs \$1 = PH\$ If E\$/€ =1. 5, then PB\$ = E\$/€ PB€ = 1. 5 x 2 = \$3. 0. So PB\$/ PH\$ =3. 0/1. 0 = 3. 0 hot dog per bratwurst If E\$/€ =1. 25, then PB\$/ PH\$ =(1. 25 x 2)/1. 0 = 2. 5 hot dog per bratwurst A hot dog become more expensive relative to a bratwurst.

Euro € n n Jan. 1999 ~ EU: Austria, Belgium, Germany, Finland, France, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain. Not participate: Britain, Sweden, Denmark 2002: euro completely replaces national currencies.

Appreciation and Depreciation (cont’d) n n An appreciation of a country’s currency makes its goods more expensive foreigners, and makes foreigners’ goods less expensive for the country’s residents. An appreciation of a country’s currency raises the relative price of domestic goods and lowers the relative price of foreign goods.

Foreign Exchange (FX) Market n n The FX market is an over-the-counter market. i. e. there is no physical location where traders get together to exchange currencies. Rather traders are located in the offices of major commercial banks around the world and communicate using computer terminals, telephones, telexes, and other information channels.

FX market (cont’d) n n The FX market is almost a 24 hour market. The major foreign exchange trading centers are in n n London, New York, and Tokyo ---60% Zurich, Singapore, and Hong Kong --- 20%

FX market (cont’d) n Participants n n n Importers and exporters, portfolio managers Commercial banks Foreign currency brokers Central banks Size: \$1. 5 trillion per day in 1998.

Market-makers n n n Traders in the major money center banks around the world who deal in two-way prices. They announce bid and offer prices at which they will exchange two currencies. The difference between the two prices is referred to as the bid/asked spread, which is traders’ profits. Bid (ask or offer) price = a price at which a trader is willing to buy (sell).

Brokers n Individuals who match up buy and sell orders from two different parties. n About 85% of all FX trading is between market-makers. Less than 15% is commercial business (by companies engaged in trade, by tourists etc. ) n

FX trading n n n Inter-bank traders are major players in FX market. 90% of trading take place with respect to the US dollars. The reasons for quoting most exchange rates against a common currency (a “vehicle currency”) n n Avoid informational complexity Avoid the possibility of triangular arbitrage

Three types of transactions 1. 2. 3. Spot Forward Swap

Spot transaction n An agreement on price today, with settlement usually two business days later. Settlement = actual delivery of currency for currency In the case of the US dollar for the Canadian dollar (or the Mexican peso), settlement is on the next day of the transaction.

Forward transaction n n An agreement on price today for settlement at some date (called the “value date”) in the future (one or two weeks, or 1 ~ 12 months). Example n Exxon has a scheduled payment of £ 25 million in 8 months and buys that amount of British pounds forward today. No money will change hands now.

Swap n n n A sale (purchase) of a foreign currency with a simultaneous agreement to repurchase (resell) it at some date in the future. Usually in the inter-bank market Example n Citibank buys DM 2. 5 million from Deutsch Bank for \$1 million, with a simultaneous agreement to sell the DM back in 6 months for \$1. 05 million. \$50, 000 = swap rate.

FX transaction n n n 65% of transactions: spot 33% of transactions : swap 2% : (outright) forward Spot against forward Tomorrow next Forward-forward

Forward Premium and Discount n n If the value of a foreign currency is greater (less) forward than it is spot, the foreign currency is said to be at a premium (discount). Example The spot DM is DM 2. 0554 = \$1 in Jan. 12, 2001, and the one-month forward DM is DM 2. 0536 = \$1. So the one-month forward DM is at a premium. It takes less DM to buy \$1 forward than it takes to buy \$1 spot.

Futures Contract n A bet on the direction of price (exchange rate) movement of the underlying currency. n If you buy (sell) a futures contract or go long (go short), and the futures price goes up (down), you make money. n If you stop an FX futures bet prior to the end of trading on the last trade date, you do not have to buy or deliver currency. n Profits and losses are paid over every day at the end of trading.

Futures Contract n Example Suppose a £ 62, 500 futures contract is opened during Day 1 at a negotiated price of \$1. 4500/£ and the settlement prices are Opening price: \$1. 4500/£ Settlement price, Day 1: \$1. 4460 Settlement price, Day 2: \$1. 4510 then the cash flows for long and short positions are _____Long Short Day 1: (1. 4460 -1. 4500)x 62, 500 = -\$250 +\$250 Day 2: (1. 4510 -1. 4460)x 62, 500 = +\$312. 50 -\$312. 50

Futures Contract (cont’d) n n The brokerage firm requires a certain amount of cash deposited with it as a security bond (this is called margin). The brokerage firm will in turn post margin with a clearing house, which will then guarantee both sides of the futures contract against default by the other party. International Monetary Market (IMM) of Chicago Mercantile Exchange (CME) Trading on a floor for standardized contracts 4 value dates: the 3 rd Wednesday of March, June, September, and December. Example: 125, 000 marks, 100, 000 Can dollars, 62, 500 pounds, 12, 500, 000 yen.

Futures Contract (cont’d) n Quotes are always in American terms. n Prices not allowed to vary more than a certain amount in a given day (limit moves). n London International Financial Futures Exchange (LIFFE)

Differences between Forward contracts and Futures contracts n The daily cash flows take place on a futures contract. In a forward contract, no money will change hands until the contract expires. n Because the time pattern of cash flow is different, your opportunity cost is different.

To read futures price quotation: n n n n Open: the price of a contract at the beginning of the day High: the highest price during the day Low: the lowest price during the day Settle: the price at which contracts are settled at the close Change: change from settlement price the previous day Lifetime High (Low): the highest (lowest) price this contract has ever traded Open Interest: the number of contracts outstanding the previous day

Hedging with futures n n Suppose you have accounts receivable denominated in British pounds. There is an exchange risk: The dollar value of the account receivable will drop if the British pound loses value with respect to the dollar. To hedge this risk, you go short pound futures. If the pound loses value in dollar terms, you will make money, which will offset the loss in the value of your account receivable.

Foreign Currency Options n Option: The right (but not obligation) to buy or sell something at a specified price (strike price). You want to use the contract if you want to. Potential loss is limited. n Option to buy: Call Option to sell: Put n n n At a specified date: European option At any time prior to a specified date (expiration date, maturity): American option

Foreign Currency Options (cont’d) n Example An importer has to make a 31, 250 Br. pounds payment in 90 days. He buys a call option at \$. 0422 per pounds in FILX. The strike price is \$1. 975. Thus, the importer pays \$1, 318. 75 for the right to buy pounds any time within 90 days at \$1. 975 per Br. Pound. Suppose that at the end of 90 days the pound is at \$2. 05. Then the importer saves 2. 05 x 31, 250 – 1, 318. 75 – 1. 975 x 31, 250 = \$1, 025 He makes a windfall profit.

Foreign Currency Options (cont’d) n A Call (Put) on Futures The call (put) buyers pays the premium to the writer in order to acquire the right (but not obligation) to go long (short) an exchange —traded FX futures at the strike price. n Foreign currency options on spot and futures can be considered types of insurance against adverse exchange rate movements.

What else? n Central-Bank Intervention To drive the value of their currencies to certain desirable levels, the central banks sometimes buy or sell currencies in the FX market. CBs often use swap arrangements for this purpose, which are facilitated by the Fed in many cases. n n In developing countries, governments often restrict foreign exchange transactions. black market The government allows a free market to coexist with the official market. parallel market