FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES
Bank deposits denominated in a foreign exchange
Most foreign exchange transactions involve purchases & sales of bank deposits.
Foreign currency itself Other short-term claims on foreigners expressed in foreign currencies
Foreign Exchange Market
Where foreign exchange is bought & sold. Largest market in the world. Daily trading volume over $1.5 trillion. Quoted prices change as often as 20 times a minute. Most active exchange rates can change up to 18,000 time during a single day. Transactions do not generally involve a physical exchange of currencies across geographic border. Foreign exchange market never closes.
Market Participants
Commercial banks Foreign exchange brokers Central banks Speculators
Commercial Banks
Hold foreign exchange inventories with banks in foreign countries. Bear the risks of exchange rate fluctuations.
Foreign Exchange Brokers
Bring together banks that want to buy foreign exchange with those that are selling. Do not own foreign exchange.
Central Banks
Support domestic currencies by buying or selling foreign exchange through brokers.
Speculators
Attempts to profit from changes in exchange rates.
Types of Foreign Exchange Transactions
Spot: Currencies bought & sold for immediate delivery & payment (1-2 day delay). Currency swap: Conversion of currency with an agreement to reconvert back to original currency at a specified time at an agreed upon exchange rate. Forward: Currencies bought & sold for future delivery & payment
Seller agrees to deliver & receive payment for the foreign exchange at a specific date at an exchange rate (F) specified today. Most customer transactions in foreign exchange involve forward transactions.
Tracing Out a Foreign Exchange Transaction (Buying £)
Call the bank for spot buying & selling prices (1.4985 &1.5000). Spread = (Ps - Pb)/Ps . 100 (usually less than 0.1%). Bank examines its position statement (bank's assets & liabilities) in £.
Bank’s Position Statement
Closed position: assets equal liabilities. Open position
Long: Assets exceed liabilities
• Bank makes the payment
Short: Liabilities exceed assets
• Bank calls a foreign exchange broker • He will either quote the price or put the trader on hold & call major banks in New York
Foreign Exchange Rate Quotations
Selling price for bank transfers in U.S. at 4 p.m. Eastern Time in $. Sale of foreign exchange in the interbank foreign exchange market in NY. In the retail market, banks charge a higher price.
Futures Market Versus Forward Market
Trading is limited to major currencies. Trading takes place in standardized contract amounts. Contracts are set for delivery on 3rd Wednesday of March, June, September & December.
Foreign Currency Options
Agreement between holder & writer that gives holder right, but not obligation, to buy/sell at any time through a specified date. Call: right to buy Put: right to sell Strike price: Price at which option can be exercised.
Exchange Rate
Price of one currency vis-a-vis another Domestic currency price of a foreign currency (Nominal bilateral exchange rate).
http://www.bloomberg.com/markets/index.html
Appreciation of domestic currency
Decrease in exchange rate
Depreciation of domestic currency
Increase in exchange rate
Arbitrage
Simultaneous purchase & sale in different markets to obtain a sure profit from the differential between buying & selling price.
Bilateral Trade-weighted Index
Weight is assigned on the basis of the extent of its bilateral trade with U.S.
Effective Exchange Rate
Through out the day, dollar value may change relative to the values of any number of currencies under market determined exchange rates. Direct comparison of dollar’s exchange rate over time thus requires a weighted average of all the bilateral exchange rates. Effective exchange rate (also known as exchange rate index) is the weighted average of all the bilateral exchange rates.
Major Currency Index
Constructed by the U.S. Federal Reserve Board of Governors. It reflects the impact of changes in the dollar’s exchange rate on U.S. exports & imports with 7 major U.S. trading partners. The base period of the index is March 1973. http://www.federalreserve.gov/releases /H10/Summary/indexnc_m.txt
Effective Exchange Rate
Index allows us to evaluate a currency's value vis-a-vis other currency in a multi-currency world. Ceteris Paribus, a depreciation of $ vis-a-vis other currencies improves U.S. price competitiveness. A full measure of price competitiveness must take into account nominal exchange rate changes as well as price changes. This is what the real exchange rate does. http://www.bis.org/statistics/eer/index. htm
Real Exchange Rate
Price adjusted nominal exchange rate, r: r = eP*/P where P* (P) represents relevant indices of foreign (domestic) prices.
Forward Premium
Difference between forward & spot exchange rate: f = (F - e)/e
Uncovered Interest Arbitrage
Investors are not covered to protect returns of investment from exchange rate movements. If e = 2, i = .1 & i* = .12, where to invest? Invest $1 in U.S. Rus = $1.10 after 1 year Buy £ in spot market, get £.5 & invest in U.K. Ruk = £.56 after 1 year If invested in U.K.
Winner if £.56 > $1.10, i.e. e > 1.96 after 1 year Loser if £.56 < $1.10, i.e. e < 1.96 after 1 year
i - i* = anticipated rate of depreciation of domestic currency
Covered Interest Arbitrage
Given e = 2, F = 1.9, i = .1 & i* = .12 Invest $1 in U.S.
Rus = $1.1 after 1 year
Buy £ in spot market, get £.5 & invest in U.K.
Ruk = £.56 after 1 year Make a forward contract to sell £.56 one year from now for $1.064.
In Symbols
Invest in U.S. Rus = 1 + i (interest on U.S. Treasury bills) Buy £ in spot market & get 1/e £s for a $ Invest in U.K.
Will get (1+i*).1/e £ at the end of 1 year
Sell forward future £ proceeds Ruk = (1 + i*). F/e
Covered Interest Differential (CD)
Ruk – Rus = (1 + i*)F/e - (1 + i) = F/e – 1 + i*F/e – I f + i* - i i* : interest gain f: : exchange gain f + i* : return from engaging in a covered investment in U.K.
Covered Interest Parity Condition
Assets that share the same characteristics should yield the same return in equilibrium: f = i - i*
Divergence from Covered Parity
Close to 6% occurs because of
Transaction costs Gathering & processing information Govt. intervention & regulation Financial constraints & capital market imperfections Non-comparability of assets
Speculation
Speculation can either reduce or increase volatility in foreign exchange rates. If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements. If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency.