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Chapter 11: Foreign Exchange

Chapter 11: Foreign Exchange. What we are gonna learn. Foreign exchange rate definition Foreign exchange market Forward, future and option markets Impacts of changes of dollar exchange rate Arbitrage, hedging and speculation. Foreign exchange. Foreign exchange quotations.

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Chapter 11: Foreign Exchange

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  1. Chapter 11:Foreign Exchange

  2. What we are gonna learn • Foreign exchange rate definition • Foreign exchange market • Forward, future and option markets • Impacts of changes of dollar exchange rate • Arbitrage, hedging and speculation Carbaugh, Chap. 11

  3. Foreign exchange Foreign exchange quotations • Exchange rate is the price of one currency in terms of another. • i.e. as of Nov. 25, 2007 • 0.0092 dollar/yen • 108 yen /dollar Carbaugh, Chap. 11

  4. One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) • A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency) Carbaugh, Chap. 11

  5. Foreign exchange Foreign exchange quotations • Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar Carbaugh, Chap. 11

  6. Foreign exchange Foreign exchange market • Largest and most liquid market in the world • 1.9 trillion a day, 20 price changes a minute, can be 18,000 changes a day. • No central market - key markets in several cities around the world (London, New York & Tokyo are the largest) Carbaugh, Chap. 11

  7. Most transactions involve transfers of bank deposits, not currency • Participating banks and brokers are in constant contact via phone and computer Carbaugh, Chap. 11

  8. Three general types of transaction • Between banks and their customers • Domestic interbank market conducted through brokers • Trading with overseas banks Carbaugh, Chap. 11

  9. Foreign exchange Types of FX transactions • Spot transactions - executed nearly immediately • Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance • Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning Carbaugh, Chap. 11

  10. Foreign exchange Distribution of FX transactions by US banks Carbaugh, Chap. 11

  11. Foreign exchange markets Forward markets, futures & options • Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date • Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement Carbaugh, Chap. 11

  12. Foreign exchange markets Forward markets, futures & options • Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date • Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates Carbaugh, Chap. 11

  13. Foreign exchange markets Forward markets, futures & options Carbaugh, Chap. 11

  14. Foreign exchange markets Forward markets, futures & options • Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option • Options to buy are called call options, and those to sell are called put options • Options are frequently used to reduce risk from exchange rate changes Carbaugh, Chap. 11

  15. Foreign exchange Impact of an appreciating US dollar • Pros • Lower prices on foreign goods • Keeps inflation down • Foreign travel is cheaper • Cons • Exporters’ products become more expensive abroad • Imports-competing firms face price competition • Travel more expensive for foreign tourists Carbaugh, Chap. 11

  16. Foreign exchange Impact of a depreciating US dollar • Pros • Exporters can sell abroad more easily • Less competition for US firms from imports • Foreign tourism is encouraged • Cons • Higher prices on imports • Upward pressure on inflation • Travel abroad more expensive Carbaugh, Chap. 11

  17. Foreign exchange Exchange rate indexes • To judge the overall value of a currency versus many others, an index is used • “trade weighted” index with respect to the currencies of the US’s most important trading partners (in proportion to their share of trade): major currency index. • To take into account price changes (inflation or deflation), a “real exchange rate” is used • The real exchange rate is the nominal rate multiplied by the ratio of the foreign to domestic price levels Carbaugh, Chap. 11

  18. Foreign exchange Exchange rate indexes of the US dollar(March 1973=100) Carbaugh, Chap. 11

  19. Foreign exchange markets Arbitrage and hedging • Exchange arbitrage involves taking advantage of simultaneous exchange rate differences in different markets to make a profit • Helps equalize exchange rates globally Carbaugh, Chap. 11

  20. Case Study • Two-point arbitrage • Euro 1= dollar 2 New York • Euro 1 = dollar 2.01 Paris • Three-point arbitrage Carbaugh, Chap. 11

  21. Foreign exchange markets Arbitrage and hedging • Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions • Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings Carbaugh, Chap. 11

  22. Hedge exchange risk with forward market • Forward rate: Premium Discount Percentage changes of one country’s currency value in the future. Carbaugh, Chap. 11

  23. Forward rate and spot rate • Forward rate is computed based on a country’s interest rate. Carbaugh, Chap. 11

  24. Interest Arbitrage • Uncovered • Covered: • Step 1: make a purchase of foreign currency • Step2: purchase a forward contract Example: 12 % interest rate in London and 8% in US Spot rat 2 USD/pond, three month future 1.99 USD/Pond Carbaugh, Chap. 11

  25. Forward Rate • Interest rate increases => Forward rate decreases Carbaugh, Chap. 11

  26. How forward market functions • Uncovered and Covered risk • Importer: owe 1million euros payment in the future • Exporter: expect 1million euros payment in the future Carbaugh, Chap. 11

  27. How forward market functions • Banks: match forward contracts • Reading assignment: How Markel rides foreign-exchange fluctuations (pp381-383) Carbaugh, Chap. 11

  28. Foreign exchange markets Speculation • Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future Carbaugh, Chap. 11

  29. Foreign exchange markets Speculation • Speculation can either reduce or increase volatility in foreign exchange rates • If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements • If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency Carbaugh, Chap. 11

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