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Chapter Eight

Chapter Eight. Foreign Exchange Markets. Chapter Outline. Overview Foreign Exchange Transactions Role of FIs in Foreign Exchange Interest Rate Parity. 1. Foreign Exchange Markets Overview.

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Chapter Eight

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  1. Chapter Eight Foreign Exchange Markets

  2. Chapter Outline • Overview • Foreign Exchange Transactions • Role of FIs in Foreign Exchange • Interest Rate Parity

  3. 1. 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

  4. 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

  5. 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

  6. Foreign Exchange Market Trading (in billions of U.S. dollars)

  7. 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

  8. 3. 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

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

  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

  11. Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004

  12. 4. 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

  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

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