Foreign Exchange

1. Foreign Exchange ManEc 358 Prof. Bryson

2. Foreign Exchange Quiz What is foreign exchange? (Trading nations’ moneys.) What is the exchange rate? (The price of one nation’s money in terms of another nation’s money.)

3. Foreign Exchange Quiz What is the spot exchange rate? (The price for “immediate” exchange) What is the forward exchange rate? (The price that will take place sometime in the future.)

4. Wednesday, November 7, 2001 EXCHANGE RATES The New York foreign exchange mid-range rates below apply to trading among banks in amounts of $1 million and more, as quoted at 4 p.m. Eastern time by Reuters and other sources. Retail transactions provide fewer units of foreign currency per dollar. Rates for the 12 Euro currency countries are derived from the latest dollar-euro rate using the ex­change ratios set 1/1/99. U.S. S EQUIV. CURRENCY PER U,S, $ Country Wed Tue Wed TeaArgentina (Peso) i.0005 1.0017 .9995 .9983Aestmlia (Dollar) 5153 .5136 1.9408 1.9472China (Renminhi) 1208 .1208 8.2766 8,2767 Colombia (Peso) '.0004334 .0004331 2307.50 2309.00Czech. Rep. (Koruna) ....Commercial rate 02687 .02575 37.223 37.384Denmark (Krone) 1205 .1203 8,2973 8.3156 Ecuador (US Dollar)-e... 1.0000 1.0000 1.0000 1.0000 Finland (Markka) 1511 .1505 6.6203 6.6466France (Franc) 1369 .1364 7.3038 7.33281-month forward 1367 .1362 73127 7.34253-months for~*ard 1364 .1359 7.3296 7.35836-months forward 1351 .1355 7.3493 7.3777Germany (Mark) 4592 .4574 2.1777 2.18641-month forward 4586 ,4568 2.1804 2.18933-months forward 4576 .4558 2.1854 2.19406-months fcnvard 4564 .4546 2.1913 2.1997Greece (Drachma) 002536 .002625 379.37 380.92Hang Kong (Dollar) 1282 .1282 7.7999 7.7998 .8769 .8804Israel (Shekel) 2347 .2348 4.2610 4.2690Italy (Lim) 0004638 .0004620 2155.96 2164.52Japan (Yen) 008270 .008246 120.92 121.271-month forward 008285 .008261 120.70 121.053-months forward 008312 .008287 120.31 120.68 U.S. $ EQUIV. CURRENCY PER U.S. $ Country Wed Tue Wed ,TunKuwait (Dinar) 3.2744 3.2723 .3054 .3056Lebanon (Pound) 0006606 .0006607 1513.75 f5i~.50 Malaysia (Ringgit)-b 2632 .2632 3,8000 3.~9e0Malta (Lira) 2,2386 2,2326 .4467 , .¢479Mexico (Peso) ................ Floating rate 1085 ,1086 9.2155 9.2105Netherlands (Guilder) 4075 .4059 2.4537 2.4635New Zealand (Dollar) 4196 .4205 2.3832 2.3781Norway (Krone) 1133 ,1126 8.8270 8.8785Pakistan (Rupee) 01642 .01635 60.900 61J~0Peru (new Sol) 2901 2901 3.4468 "3.4475Philippines (Peso) 01928 .01925 51.875 51.960Poland (Zlety)-d 2453 2444 4,0760 4.0910Podugal (Escudo) 004480 .004462 223.23 224.11Russia (Ruble)-a 03362 .03364 29.747 29.7~7 :1=84611-month forward 6114 .6075 1.6356 1.64§13-months forward 6115 .6076 1.6354 : .64596-months forward 6117 .6078 1.6348 1,64~Taiwaa (Dailar) 02899 .02899 34.500 34.500Thailand (Baht) 02239 .02238 44.655 i114.6~5Turkey (Lira)-f 00000064 .00000065 1565000 1540090United Arab (Dirham) 2723 .2723 3.6730 3.6730Uruguay (New Peso) .....Financial 07123 .07123 14.040 t4.040Venezuela (Bolivar) 001345 .001345 743.50 743 50SDR 1.2794 1.2760 .7816 :'.2837Eurn 8981 ,8946 1.1135 11.1178 Special Drawing Rights (SDR) are based on exchange rates for the U.S., German, British, French , and Japanese c~rrerf-cies. Source= International Monetary Fund. a-Russian Central Bank rate. b-Government rate. d-Floating rate; trading band suspended on 4/1 1/OO. e-Adopted U,.9. dollar as of 9/1 i/OO. f-Floating rate, eft. Feb. 22. • , 1 Currency Trading, Wall Street Journal

5. Foreign Exchange, Banks and Demand • Where does most foreign exchange occur? (In banks located in London, New York and Tokyo.) • Who trades most of the money on international exchanges? (Banks again.)

6. Foreign Exchange, Banks and Demand • Whence comes the demand for foreign exchange? (From people, institutions and firms who want to make purchases abroad.)

7. Foreign Exchange, Banks and Demand • What do the following flows produce a demand for? U.S. exports of goods and services (demand for dollars) U.S. capital outflows (demand for foreign currencies) U.S. capital inflows (a supply of foreign currency and a demand for dollars.)

8. Foreign Exchange: The Rate • What determines the exchange rate then? (Supply and demand for foreign exchange.) • What kind of market type do we have here? (Competitive, because of the immediate market response to price. No product differentiation in foreign exchange markets.)

9. Foreign Exchange: The Rate • What is a floating exchange rate system? (One where markets, rather than bank interventions, determine prices of foreign exchange.)

10. Traders and Arbitrage • How do foreign exchange traders function? (See the case study on p. 404) • What is arbitrage? (Making two markets, by buying and selling between them, a single market.)

11. Arbitrage An arbitrager, usually a large bank, may notice that in N.Y. 1 £ = $2.42 and in London, 1 £ = $2.40. An agent will buy pounds in London (for $2.4 billion) and sell them in N.Y. (for $2.42 billion), earning a quick $20 million. The increased demand in London pulls the price up, and the increased supply in New York pushes the price down, equalizing the pound/dollar price.

12. Interbank Foreign Exchange Trading About 90% of foreign exchange trading is in the Interbank part of the market.

13. Interbank Foreign Exchange Trading Provides continuous information on the foreign exchange market— • Talking with traders at other banks. • Observing prices (exchange rates) being quoted.

14. Exchange Rate and Risk • What is exchange rate risk exposure? (Earning a lot less than you expected, or paying a lot more than you expected when payment is made in the future at different exchange rates than originally prevailed.) • What is hedging? (Reducing or eliminating a net asset or net liability position in foreign currency.)

15. Exchange Rate and Risk • What is speculation? Taking a net asset or “long” position (holding net assets in a foreign currency in excess of one’s anticipated transactions needs), or taking a net liability or “short” position in a currency (owing more in a currency than one owns or holds).

16. Exchange Rate and Risk If the forward rate of a currency, (the French franc) is lower than the spot rate (4;1, say, rather than 5:1), the market expects the value of the franc to rise against the dollar. There is a premium on forward (usually 90 days) francs and a discount on 90-day forward dollars.

17. Foreign Exchange and Forward Contracts • What is a forward foreign exchange contract? (An agreement to exchange one currency for another on some date in the future at a price set now [the forward exchange rate]).

18. Foreign Exchange and Forward Contracts • How can the bank afford to do that? (This is a question of balance and offsetting contracts.)

19. Exchange Contracts under Risk Currency Futures: -- Traded on organized exchanges -- The contract locks in the price. -- The buyer must put up a margin, which grows if rates keep changing adversely for the seller. -- Profits and Losses Accrue Daily (marking to market)

20. Exchange Contracts under Risk Currency Options: -- Buyer has right, seller has obligation to a future price set today, the “exercise” or “strike” price. -- The buyer pays a fee (“premium“) to exercise the option. -- Size of any loss is limited to premium

21. Exchange Contracts under Risk Currency Swap -- A contract to exchange flows during a time period. -- Foreign currency earnings traded for domestic currency. -- A set of spot and forward exchange rates in one contract.