Ch 12 – Foreign Exchange

1. Ch 12 – Foreign Exchange “The trick is to stop thinking of it as ‘your' money.” IRS Auditor

2. Ch 12 – Foreign Exchange Foreign Exchange • International purchases require two transactions – • Foreign currency is bought. • Currency is used to buy something. • To buy American goods you need American dollars. • Market where this exchange takes place is called the foreign exchange market. • Very little trading in currency, mostly bank deposit transfers. • Largest and most liquid market in the world, operates 24 hours per day, all over the world.

3. Ch 12 – Foreign Exchange Types of FX Transactions • Spot Transaction • Purchase and sale of foreign currency for cash settlement not more than two days after date of transaction. • Two days gives buyers and sellers time to arrange details of trade. • Aka “immediate delivery” • Agreement to buy or sell currency at current (spot) exchange rate. • Forward Transaction • Traders contract at stipulated (forward) exchange rates for future transactions. • If dealer knows today they will be buying something with yen in six months, the contract today to pay certain agreed upon price to reduce risk of price increase in six months. • More than 2 days in the future (can be months or years). • Exchange rate is fixed when contract is made, but money does not change hands until trade takes place.

4. Ch 12 – Foreign Exchange Types of FX Transactions • Currency Swap • Banks engage in these transactions to trade currencies they currently don’t need for currencies they do. • Conversion on currency to another currency with agreement to reconvert back to original currency at set time in the future. • Rates of both exchanges are agreed upon in advance.

5. Ch 12 – Foreign Exchange Interbank Trading • Small number of large banks have active currency trading operations (London, Tokyo, NY, Hong Kong, Chicago . . .) • Sales to and from consumers, usually less than a million units, called “retail transactions”. • Sales to and from other banks or corporations, usually over a million units, called “wholesale transactions”. • Trade between banks = interbank market • FX market is profit center for banks. Bid rate = price bank will pay (buy price) Offer rate = Price bank will take (sell price) Difference = spread

6. Ch 12 – Foreign Exchange Interbank Trading Bid rate = price bank will pay (buy price) Offer rate = Price bank will take (sell price) Difference = spread Example: $.5851 / .5854 Bid (buy) rate Offer (sell) rate Simultaneously buying and selling one million francs - will pay $585,100, will receive $585,400 – net gain of $300.

7. Ch 12 – Foreign Exchange Interbank Trading Profits can be increased if traders anticipate changes in exchange rates correctly. Example: Suppose trader expects exchange rate of Japanese yen to US dollar to go up (yen will appreciate against the dollar). Today $1.00 = 120 ¥ (1 ¥ = $ .0083) Future $1.00 = 110 ¥ (1 ¥ = $ .009) Dealer will raise bid and offer rates: Raising bid rate persuades other dealers to sell yen. Raising offer rates dissuades other dealer from buying yen. When yen strengthens, dealer sells yen for more than they paid.

8. Ch 12 – Foreign Exchange Exchange Rate Price of one currency expressed in terms of another. ER = $/£ = # dollars needed to purchase one pound. ER = 2 = 2/1 = Requires $2 to purchase £1 ER’ = # pounds required to purchase one dollar ER’ = reciprocal of ER 1/ER = ½ = Requires £1/2 to purchase $1

9. Ch 12 – Foreign Exchange Exchange Rate Price of one currency expressed in terms of another. Examples: 1 euro = 1.19528 USD 1 USD = 1 / 1.19528 = .836625 1 CAD = .74438 USD 1 USD = 1 / .74438 = 1.34340 • Dollar price of a pound increased from Tue to Wed. • Dollar depreciated against the pound. • Pound appreciated against the dollar

10. Ch 12 – Foreign Exchange = 2.3245 = Cross Exchange Rate Used if the desired relative exchanges of currencies does not include US dollar, or a known exchange rate. To find the exchange rate between the British pound and Swiss francs, need to express them in terms of US dollar: $ value of British pound$1.79066 $ value of Swiss francs $0.77034 Each British pound buys 2.3245 Swiss francs.

11. Ch 12 – Foreign Exchange $ price S $2.00 D Q Pounds Arbitrage Opportunities in FX Arbitrage – buying in one market with the intent of immediately reselling in another market to profit from price discrepancies. • In FX markets, exchange rates tend to be consistent between locations within the market. • Exchange arbitrage tends to equalize prices and eliminate further arbitrage opportunities. $ price S $2.05 D Q Pounds London New York

12. Ch 12 – Foreign Exchange Arbitrage Opportunities in FX Arbitrage – buying in one market with the intent of immediately reselling in another market to profit from price discrepancies. • Purchase pounds in NY at $2.00 per pound, resell immediately in London for $2.05 per pound. • Increase in demand in NY will push NY price up, increased supply in London will push London price down. • Arbitrage will force prices to equalize until arbitrage opportunities are gone. $ price $ price S S $2.05 $2.00 D D Q Pounds Q Pounds London New York

13. Ch 12 – Foreign Exchange Effective Exchange Rate (Trade Weighted Dollar) • US dollar may appreciate against some currencies and depreciate against others. • The effective rate is determined by the weighted average between dollar and currencies of most important trading partners. • Weights are given based on relative importance of trading partners. • Reported as an index using 1973 as base year.

14. Ch 12 – Foreign Exchange Forward Market • In spot market, currencies are bought and sold for immediate delivery. • In forward market, currencies are bought and sold for future delivery, usually 1 month, 3 month, 6 month. • Exchange rate is agreed upon at time of transaction, but payment is not made until delivery takes place. • Forward rate – rate of exchange used for forward transactions. • Forward rates reflect market consensus about what the currency will do in the future (what the market believes). • If forward rate is higher than spot rate, currency is said to be trading at a premium. If forward rate is lower than spot rate, currency is trading at a discount.

15. Ch 12 – Foreign Exchange Forward Market • Forward rates indicate what market believes spot rates will be in 1 month, 3 months, 6 months. • Pound is trading at a forward discount against the dollar. • Market believes that the dollar price of the pound will decrease in future.

16. Ch 12 – Foreign Exchange Forward Market • Forward market is used to protect traders, investors, firms, from volatility in currency markets. • Traders can hedge against unexpected dollar appreciation or depreciation. Most helpful for dealers that don’t do huge number of transactions in foreign market (small to midsize firms). • Example: US importer enters into a contract to buy cars from France. If dollar depreciates against euro before money can be paid (euros become more expensive), importer will be worse off. He will protect himself (hedge against depreciation) by locking in at forward rate for money owed. • Many large corporations do not hedge foreign currency trades. They believe gains and losses of foreign currency trades balance over the long run, so they avoid transaction costs of the market by not hedging in forward market (can avoid currency fluctuations by becoming MNE).

17. Ch 12 – Foreign Exchange Speculation in FX Market • Speculation is the attempt to profit by trading on expectations about future prices. • Different from arbitrage – trading in concurrent markets, with little to no risk. • Speculation has risk. • Foreign currency speculators can profit by betting against what the market believes will happen in the future with currency prices. • Long position = Buying low today, selling high tomorrow (aka buy long, go long). • Short position = Borrowing or selling forward before you own the currency (aka buy short, go short).

18. Ch 12 – Foreign Exchange Speculating in the Spot Market • CASE 1: • Speculating on Appreciation of the British Pound • ($ price of £ will increase) • Buy pounds at today’s spot rate, deposit in bank • In future, sell pounds at higher spot rate • Example: • Spot rate today is £1 = $167 • We are betting that the spot rate will increase to $175 • Buy £1,000 today for $1,67000, then sell in future for $1,75000. • Profit = $8000 (if we’re right)

19. Ch 12 – Foreign Exchange Speculating in the Spot Market • CASE 2: • Speculating on Depreciation of the British Pound • ($ price of £ will decrease) • Borrow pounds today and exchange for dollars at current spot rate, deposit dollars in bank. • In future, buy pounds at new lower spot rate and use them to pay back original loan. • Example: • Spot rate today is £1 = $167 • We are betting that the spot rate will decrease to $150 • Borrow £1,000 today, exchange for $1,67000 • Deposit $167000 in bank to earn interest (need to make up interest being paid on borrowed £) • In future when spot rate decreases to $150, buy £1,000 for $1,50000. • Use pounds to pay back original loan. • Profit = $17000 (+/- net interest)

20. Ch 12 – Foreign Exchange Speculating in the Forward Market • Most speculation done in forward market. • Based on belief that the future spot price and the current forward price will be different in the future. • Example: Suppose 30-day forward pound is selling at a 10% premium (market believes 30 days from now spot rate will be 10% higher than today’s spot rate). • To make money in speculation, trader would have to believe that market is wrong.

21. Ch 12 – Foreign Exchange Speculating in the Forward Market • CASE 1: • Speculating that spot rate of British Pound will be higher in 3 months than its current 3-month forward rate • Contract to buy pounds in forward market at 3-month forward rate. • Fill the contract (buy the pounds) in 3 months and immediately resell in spot market at higher spot rate. • Example • 3-month forward rate today is £1 = $167 • We are betting that the spot rate in 3 months will be higher than the forecasted rate, perhaps $175 • Enter into contract to buy £1,000 in 3 months for $1,67000. • Three months from now, buy the contracted £1,000 for the agreed upon $1,67000. • Immediately resell the £1,000 in the spot market for $1,75000. • Profit = $8000 (if we’re right).

22. Ch 12 – Foreign Exchange Speculating in the Forward Market CASE 2: Speculating that the spot rate of British Pound will be lower in 3 months than its current 3-month forward rate • Contract to sell pounds in forward market at 3-month forward rate. • In three months, purchase that quantity of pounds in spot market and use them to fill the forward contract. • Example • 3-month forward rate today is £1 = $167 • We are betting that the spot rate in 3 months will be lower than the forecasted rate, perhaps $150. • Enter into contract to sell £1,000 in 3 months for $1,67000. • In 3 months, buy £1,000 in spot market for $1,50000. • Use these pounds to fill the forward contract. • Profit = $17000 (if we’re right).