2 - Ch. 9 - Foreign Exchange Markets

Definition: Foreign Exchange (FX) Markets

Places for transactions of currencies

These currencies are cash flows from sales/purchases of products, services, assets denominated in a foreign currency

Definition: Foreign Exchange Rate (ER) (FX Rate)

Price of one currency in another currency

Price at which one currency can be exchanged for another currency

Definition: Foreign Exchange Risk

The unexpected change in value of cash flows denominated in foreign currencies when converted to the domestic currency

FOREX History: Class Gold Standard

1875 to 1914

Currency issuers guaranteed to redeem notes in an equivalent amount of gold

FOREX History: Bretton Woods Agreement

1944 to 1971

Exchange rates to be fixed within narrow bands within government intervention

FOREX History: Contemporary Period (emerging era)

Since 1997

FOREX Regime: Free Floating

US Dolllar (USD), British Pound (GBP), Japanese Yen (JPY)

FOREX Regime: Managed Floating

Thai Bhat (THB)

FOREX Regime: Pegged/Crawling Pegged

Chinese Yuan(CNY)

FOREX Regime: Fixed/Semi-Fixed

old German Mark (GMM)

Definition: Currency Unions

Intergovernmental agreement to share the same currency

Ex. Euro, Eastern Caribbean Dollar

Currency Union: The Euro

Began Jan 1, 199

Today 19 out 27 EU members use Euro as official currency

Non-Members: UK, Switzerland

Definition: Dollarization

Use of a foreign currency in parallel to the local currency

Can occur officially or unofficially

Advantages: financial stability, lower inflation

FX Rate: Direct Quote - USD and EUR

USD received for one unit of foreign currency exchange

Ex. EUR/USD = 1.1235 meaning 1 EUR = 1.1235 USD (1 unit of foreign currency)

FX Rate: Indirect Quote

Foreign currency received for each USD exchanged (per $)

Ex. USD/JPY = 111.11 meaning 1 USD = 111.11 JPY (1 unit of domestic currency)

FX Rate: Priority Ranking

Decides which currency is the base currency

EUR > GBP > AUD > NZD > USD > CAD > CHF > JPY > Others

FX Rate: Spot FX Transactions

The immediate exchange of currencies at the current (or spot) exchange rate

Payment/delivery usually made within 2 days

FX Rate: Forward FX Transactions

The exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future)

Agreement is made today for specified rate/amount/date of delivery

Payment/delivery made in future, in 1,3, or 6 months

Used for hedging

Foreign currency depreciating is a risk to:

American exporters

The value of revenues denominated in a foreign currency will decrease

Foreign currency appreciating is a risk to:

American importers

The value of expenses denominated in a foreign currency will increase

FX Risk comes from:

• The unexpected fluctuation of spot exchange rate

• Holding assets and liabilities on the balance sheet that are denominated in foreign currency

• Tariffs

• Trade Barriers

• Restrictions on Capital Movements

• Regulatory & Government Intervention

• Cross-Country differences in real rate of interest

• International differentials in real prices

Especially affects international/universal banks

FX Hedging - On-Balance Sheet

A financial institution matching its foreign asset & liability book can lock in a positive return/profit spread whichever direction exchange rates change over the investment period

Currency Derivatives: Currency Forwards

Commitment to buy or sell

• Applicable to uncommon currencies, smaller contracts, irregular terms

Currency Derivatives: Currency Futures

Standardized and traded on exchanges

• Applicable to common currencies, larger contracts, regular terms

• Having a margin account that are matched on a daily basis

Currency Derivatives: Currency Options

The right but not the obligation to buy or sell

• Call option - right to buy

• Put option - right to sell

Currency Derivatives: Currency Swaps

Commitment to exchange currencies now and back later

• Usually the principal amounts are not exchanged, only periodical interest payments

International Parities - Purchasing Power Parity (PPP)

Foreign currency exchange rates between two countries adjust to reflect changes in each country’s price levels as consumers & importers switch their demands for goods from high inflation rate countries to lower ones

International Parities

The relationships between exchange rates, inflation rates, and interest rates

The Law of One Price

In an efficient market, identical goods and services produced in different countries should have a single price

Definition: Devaluation

A reduction in the value of a currency with respect to other monetary units