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Background and History of Foreign Exchange Markets

Background and History of Foreign Exchange Markets. Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) Smithsonian Agreement II (1973). Foreign Exchange Transactions. Spot foreign exchange transaction:

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Background and History of Foreign Exchange Markets

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  1. Background and History of Foreign Exchange Markets • Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) • Smithsonian Agreement II (1973) McGraw-Hill/Irwin

  2. 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 McGraw-Hill/Irwin

  3. Foreign Exchange Market Trading (in billions of U.S. dollars) McGraw-Hill/Irwin

  4. 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 McGraw-Hill/Irwin

  5. 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 McGraw-Hill/Irwin

  6. 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 McGraw-Hill/Irwin

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