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Dive into spot and forward rates, arbitrage opportunities, and the futures market in the world's largest foreign exchange market. Learn about exchange rates, cross rates, and how forward rates are determined through covered interest parity.
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Chapter 12 The Foreign- Exchange Market
Topics to be Covered • Spot Rates • Forward Rates • Arbitrage • The Futures Market • The Foreign Exchange Market and the BOP
Foreign Exchange Market • The Foreign Exchange Market (FEM) is the market where one country’s money is traded for that of another country. • The price of a country’s money in terms of another is called the exchange rate. • The “money” that is traded is bank deposits or bank transfers of deposits denominated in a foreign currency. • The FEM is a network of large commercial banks in world financial centers such as New York and London. The FEM is almost always open (refer to Figure 12.1).
Foreign Exchange Market (cont.) • The foreign exchange market is the world’s largest market with daily trade volume of $4 trillion. • The FEM is also the most efficient, a prime example of a perfectly competitive market.
Exchange Rate • Exchange Rate (XR)—the price of one money in terms of another. • The XR helps determine the value of a product priced in a different currency. • Types of Exchange Rates: • Spot XR vs. Forward XR • U.S. $ per foreign currency vs. foreign currency per U.S. $ • Cross XR
Spot Market • Spot Market is where currencies are traded “on the spot”, that is, for immediate delivery. The exchange rate here is called the spot XR. • Refer to Table 12.1 • Exchange rates are quoted at a specific day and time. • Exchange rates are expressed in U.S.$ per foreign currency and in its reciprocal, i.e., foreign currency per U.S. $.
Spot Market (cont.) • The exchange rates are the average of the banks’ buying (bid) and selling (offer) prices. • The rates are for large, wholesale trades ($1 million or more); the smaller the quantity of foreign exchange purchased (retail transaction), the higher the price.
Spread • Spread—the difference between the buying (bid) and selling (offer) price of a currency. • The spread will tend to be higher for thinly or low-volume traded currencies or for high-risk currencies.
Exchange Rate Index • Refer to Global Insights 12.1 • Exchange Rate Index – a weighted average of a currency’s value relative to other currencies, where the weights are based on the relative trade importance of each currency.
Forward Rates • Forward rate – the price of foreign money for delivery at a future date (one, three or six months later). • Forward exchange rates help facilitate international trade and serve as a hedge against foreign exchange risk.
Forward Premium vs. Forward Discount • Forward Premium—when the forward exchange rate is greater than the spot rate. • Forward Discount—when the forward exchange rate is less than the spot rate. • Flat Currency—when the forward rate and spot rate are equal.
Cross Rate • Cross Rate — the price of one non-U.S. dollar currency in terms of another. • Since the dollar is actively traded with many currencies, any two exchange rates involving dollars can be used to determine cross rates. Thus, the U.S. dollar serves as an intermediary currency.
How are Forward Rates Determined? • Forward rates are determined by major financial institutions in the foreign exchange market using a formula called the covered interest parity.
Covered Interest Parity Covered interest rate parity results from arbitrage behavior in the FEM. Assume U.S. and Japanese investments are equally risky and have identical liquidity. A U.S. investor deciding between investing in the U.S. or in Japan must consider: The interest rates, i$ and i¥ The spot exchange rate, E , (in $/¥ ) The forward exchange rate, F, (in $/¥)
Covered Interest Parity (cont.) By investing at home, the U.S. investor can earn a rate of return of i$. Or, the U.S. investor can invest in Japan and earn i¥. Since future spot rates are unknown, the investor can eliminate the uncertainty over the future dollar value of the investment with a forward exchange contract.
Covered Interest Parity (cont.) The covered percentage rate of return from investing in Japan is: i¥ + (F-E)/E. Investment decision: - Invest in U.S. if i$ > i¥ + (F-E)/E - Invest in Japan if i$ < i¥ + (F-E)/E
Covered Interest Parity (cont.) The covered interest parity condition is thus: i$ = i¥ + (F-E)/E or F = E x (i$ - i¥ + 1) This is the formula used by financial institutions to set the forward rate.
Arbitrage • Arbitrage—the activity of simultaneously buying a currency in one market while selling in another to take advantage of profit opportunities. • Arbitrage could involve more than two currencies. • Arbitrage guarantees that forward rates are set according to the covered interest parity formula.
Foreign Exchange Swap • Foreign Exchange Swap—an agreement to trade currencies at one date and then reverse the trade at a later date. • The swap combines activity in both spot and forward markets. • These agreements are frequently used by banks to hedge against foreign exchange risk. • Swaps account for 47% of the volume of trading activity in FEM (refer to Table 12.2).
TABLE 12.2 Average Daily Volume of Foreign-Exchange-Market Activity in 2010
Hedging • Hedging—an activity to offset or avoid risk in the market.
Foreign Exchange Futures Market • Futures market is similar to the forward market where currencies may be bought and sold for future delivery. • The futures market differs from the forward market in that: • Only a few currencies are traded • Trading occurs in standardized contracts • Trading occurs in a specific geographic location such as the International Monetary Market of the Chicago Mercantile Exchange • Futures contracts are for smaller amounts of currency and provide opportunities for hedging and speculation
Foreign Currency Options • Foreign Currency Option—a contract that provides the right to buy or sell a currency at a fixed exchange rate on or before the maturity date. • Call Option—gives right to buy currency. • Put Option—gives right to sell currency. • Strike or Exercise Price—the price of the currency stated in an option contract.
Foreign Currency Options (cont.) • Foreign currency options were first traded in December 1982 at the Philadelphia Stock Exchange. • The options contracts cover only a few foreign currencies and their fixed amounts are smaller than those of futures contracts. • Unlike a futures or forward contract, the option offers the right to buy or sell if desired in the future and is not an obligation.
Supply of and Demand for Foreign Currency • Refer to Figure 12.2 • Demand for pounds curve—arises from the U.S. demand for British goods, services, and financial assets. • Supply of pounds curve—comes from the British demand for U.S. goods, services, and financial assets. • Equilibrium exchange rate—found at the intersection of the demand and supply curves.
Flexible Exchange Rate System • Flexible Exchange Rate—where the exchange rate is determined by free-market forces of demand and supply.
Depreciation vs. Appreciation • Depreciation—when the value of one currency falls relative to another. For example, if the U.S. dollar depreciates against the British pound, then it takes more dollars to buy one pound. • Appreciation—when the value of one currency rises relative to another. • See Figure 12.3
Fixed Exchange Rate System • Fixed Exchange Rate— the rate is set by government and the central bank actively intervenes in the foreign exchange market so as to keep the exchange rate from changing.
Central Bank Intervention • Central banks, such as the Federal Reserve, buy and sell foreign exchange to influence the values of their currencies. • Suppose the U.S. demand for British goods increases, which causes the demand for pounds to shift to the right. As a result, the dollar depreciates and pound appreciates. • Either the Bank of England or the Fed may intervene to stop the pound appreciation by selling pounds in the foreign exchange market. See Figure 12.4.
