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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 McGraw-Hill/Irwin

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

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

  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 McGraw-Hill/Irwin

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

  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 McGraw-Hill/Irwin

  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 McGraw-Hill/Irwin

  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 McGraw-Hill/Irwin

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

  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 McGraw-Hill/Irwin

  11. Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004 McGraw-Hill/Irwin

  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 McGraw-Hill/Irwin

  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 McGraw-Hill/Irwin

  14. Balance of Payment Accounts • Balance of payment accounts • Current account • Capital accounts McGraw-Hill/Irwin

  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 McGraw-Hill/Irwin

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