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Chapter Nine

Chapter Nine. Foreign Exchange Markets. Foreign Exchange Markets Overview. Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted

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Chapter Nine

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  1. Chapter Nine Foreign Exchange Markets

  2. Foreign Exchange Markets Overview • Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted • Foreign exchange rate - the price at which one currency can be exchanged for another currency • Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates • Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies

  3. Background and History of Foreign Exchange Markets • Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued • Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate • Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate

  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. 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

  6. Role of FIs in Foreign Exchange Transactions • Net exposure - a FIs overall foreign exchange exposure in any given currency • Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given 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

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

  8. 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

  9. 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

  10. Balance of Payment Accounts • Balance of payment accounts - summary of all transactions between citizens of two countries • Current account - the section of the balance of payment table that summarizes foreign trade in goods and services, net investment income, and gifts, grants, or aid given to other countries • Capital accounts - the section of the balance of payment table that summarizes capital flows into and out of a country

  11. 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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