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Spot Delivery Agreement

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									Ch 12 – Foreign Exchange




   “The trick is to stop thinking
      of it as „your' money.”

                        IRS Auditor
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.
Ch 12 – Foreign Exchange

     Types of FX Transactions
     1. 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.
     2. 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.
Ch 12 – Foreign Exchange

     Types of FX Transactions


     3. Currency Swap
             •   Banks engage in these transactions to trade currencies they
                 currently don‟t 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.
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
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.
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.
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
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


                                                 Currency per
                       US $ Equivalent               US $
                           Tue      Wed         Tue          Wed
           Pound        $1.6370 $1.6425           .6109         .6088

              Dollar price of a pound increased from Tue to Wed.
                       • Dollar depreciated against the pound.
                       • Pound appreciated against the dollar
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    =   2.3245
     $ value of Swiss francs        $0.77034


     Each British pound buys 2.3245 Swiss francs.
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                  $ price             S


                                              $2.05
  $2.00
                                                                      D
                               D

                                   Q Pounds                           Q Pounds
             New York                                   London
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                  S               $ price
                                                                        S

                                            $2.05
  $2.00

                                D                                       D


                                Q Pounds                                Q Pounds
             New York                                    London
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.
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.
Ch 12 – Foreign Exchange

     Forward Market

                                                      Currency per
                              US $ Equivalent             US $
          Pound - Spot                 $1.4266                   .7010
                 1-month                 1.4239                  .7023
                 forward
                3-months                 1.4190                  .7047
                  forward
                6-months                 1.4123                  .7081
                  forward

      • 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.
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 don‟t 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).
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).
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 today’s 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 we’re right)
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)
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 today’s spot rate).

        To make money in speculation, trader would have to believe
         that market is wrong.
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 we’re right).
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 we’re right).

								
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