Chapter 17: The Foreign Exchange Market

Chapter 17: The Foreign Exchange Market

Basics of Currency Trading

  • Foreign Exchange (Forex): Trading different nations' currencies.

  • Exchange Rate: Price of one nation's money in terms of another nation's money.

    • Spot Exchange Rate: Price for immediate exchange of currencies.

    • Forward Exchange Rate: Price set now for an exchange to take place in the future.

Exchange Rates

  1. Price of Foreign Currency in Domestic Terms: e.g., 1 US Dollar = 1.41 Canadian Dollars.

  2. Price of Domestic Currency in Foreign Terms: e.g., 1 Canadian Dollar = 0.70 US Dollars.

Exchange Rate Quotations (May 5, 2022)

  • Sample rates in USD:

    • Argentina Peso: 0.008609

    • Australian Dollar: 1.4015

    • Bahrain Dinar: 2.6525

    • … (full list continues with various currencies and their respective rates).

Foreign Exchange Market

  • Definition: Market where exchange rates are determined.

  • Spot Transaction: Immediate (two-day) exchange of bank deposits; uses the spot exchange rate.

  • Forward Transaction: Exchange of bank deposits at a specified future date; uses the forward exchange rate.

Exchange Rate Changes

  • Depreciation: Fall in market price (exchange-rate value) of a currency.

  • Appreciation: Rise in market price of a currency.

  • Devaluation: Official reduction in fixed par value of a currency.

  • Revaluation: Official increase in fixed par value of a currency.

Importance of Exchange Rates

  • Affects relative price of domestic and foreign goods.

    • Example: French wine priced at 1000 Euros; at $1.50 CDN/EUR, costs $1,500 in Canada. If Euro appreciates to $1.60, wine costs $1,600.

  • Effects on currency appreciation:

    • Exported goods become more expensive abroad.

    • Goods imported become cheaper locally.

Foreign Exchange Trading

  • Not traded on standard exchanges (e.g., Toronto Stock Exchange); organized as an over-the-counter (OTC) market.

    • Companies and banks act as dealers buying/selling foreign currencies.

    • Competitive environment with a retail market for small transactions.

Demand and Supply Analysis for Foreign Exchange

  • Exchange Rate: Price of domestic assets in terms of foreign assets.

  • Determinants: Most important determinant is the relative expected return of domestic assets.

Trading Parts in the Market

  • Retail Market: Nonfinancial companies, institutions, etc., making small trades through banks.

  • Interbank Market: Banks actively trading among themselves.

    • Size of FX market: Approximately $7 trillion per day.

  • Vehicle Currency: U.S. dollars are often exchanged even if exchanging between two other currencies.

Spot Foreign Exchange Market

  • Provides clearing services for payments between parties using different currencies.

Interbank Foreign Exchange Trading

  • Participation allows banks to obtain conditions, prices; helps in quick position adjustments.

  • About half of trading occurs through brokers; mostly electronic systems.

Floating Exchange Rates

  • Set by market forces of demand and supply for currencies.

  • Market clears through price mechanism.

Fixed Exchange Rates

  • Maintained by government monetary authorities, pegging the value to a certain level (central or par value).

Current Arrangements

  1. Major currencies like US Dollar, Euro, etc., have floating rates.

  2. Some countries manage floats with some official intervention.

  3. Fixed rates maintained by countries such as Hong Kong, Saudi Arabia, etc.

  4. Other countries peg their currencies to the Euro (e.g., Denmark, Serbia).

Arbitrage in the Spot Exchange Market

  • Definition: Buying and selling to make riskless profit; ensures exchange rates are uniform across locations.

  • Triangular Arbitrage: Involves three exchange rates (two dollar rates, one cross-rate) to ensure consistency.

Example of Triangular Arbitrage

  1. Start with 150 USD with given rates:

    • e1 = 1.60 $/pound

    • e2 = 0.5 $/SF

    • e3 = 3 SF/pound.

  2. Convert 150 USD to SF: 150 × 2 SF/USD = 300 SF.

  3. Convert SF to pounds: 300 × (1/3) = 100 pounds sterling.

  4. Convert pounds back to USD: 100 × 1.60 = 160 USD.

  5. Profit: 160 - 150 = $10.

Implied Exchange Rate Calculations

  • Example to calculate implied exchange rates using given rates between USD, GBP, and EUR.

  • Actual arbitrage transactions detailed, such as:

    • Sell USD to buy JPY at JPY/USD = 100.

    • Sell JPY to buy GBP at JPY/GBP = 140.

    • Convert GBP back to USD at USD/GBP = 1.60 to realize profits.