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Chapter Eight

Chapter Eight. Foreign Exchange Markets. Foreign Exchange Markets Overview. Foreign exchange (FX) markets Foreign exchange rate Foreign exchange risk Currency depreciation/appreciation. Background and History of Foreign Exchange Markets.

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Chapter Eight

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  1. Chapter Eight Foreign Exchange Markets

  2. Foreign Exchange Markets Overview • Foreign exchange (FX) markets • Foreign exchange rate • Foreign exchange risk Currency depreciation/appreciation

  3. Background and History of Foreign Exchange Markets • Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) • Smithsonian Agreement II (1973)

  4. Foreign Exchange Transactions Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

  5. Foreign Exchange Market Trading (in billions of U.S. dollars)

  6. Hedging with Forwards • Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market • 1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 = L62.5 M • 2. Bank then lends the L62.5 M to British customer at 15% for one year • 3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year • 4. British borrower repays P & I in L71.875 M • 5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M

  7. The Decline of the U.S. Dollar • Market traders focused on the widening of the U.S. current account deficit • Interest rate differentials across major economies, interest rates higher in Europe • High volume of central bank intervention relative to past practice, especially in Asian countries • Cheap dollar makes exports from other countries more expensive relative to U.S. products

  8. Role of FIs in Foreign Exchange Transactions • Net exposure • Net long (short) in a currency • Four trading activities • purchase/sale of foreign currencies for trade transactions • purchase/sale of foreign currencies for investment • purchase/sale of foreign currencies for hedging • purchase/sale of foreign currencies for speculating

  9. Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)

  10. FI’s overall net foreign exchange (FX) exposure Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position

  11. Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004

  12. Purchasing Power Parity The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change iUS = IPUS + RIRUS and: iS = IPS + RIRS where: iUS = Interest rate in the United States iS = Interest rate in Switzerland then: iUS - iS = IPUS - IPS

  13. Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + iUSt = (1/St)  (1 + iUKt)  Ft where: 1 + iUSt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + iUKt = 1 plus the interest rate on a U.K. investment maturing at time t St = S/L spot exchange rate at time t Ft = S/L forward exchange rate at time t

  14. Balance of Payment Accounts • Balance of payment accounts • Current account • Capital accounts

  15. U.S. Balance of Payment Accounts Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0

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