1 / 48

Foreign Exchange

11. Foreign Exchange. Outline. Foreign exchange market Function of foreign exchange market Vehicle currency Types of foreign exchange transactions Foreign exchange rate and equilibrium Arbitrage Forward Market Interest arbitrage Foreign exchange rate speculation Summary.

tareq
Télécharger la présentation

Foreign Exchange

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. 11 Foreign Exchange

  2. Outline • Foreign exchange market • Function of foreign exchange market • Vehicle currency • Types of foreign exchange transactions • Foreign exchange rate and equilibrium • Arbitrage • Forward Market • Interest arbitrage • Foreign exchange rate speculation • Summary

  3. Foreign-Exchange Market • Where individuals, businesses, governments and banks buy and sell foreign currencies and other debt instruments • Only small fraction of daily transactions in foreign exchange involve trading of currency. Most foreign-exchange transactions involve the transfer of bank deposits. • Not all currencies are traded for reasons ranging from political instability to economic uncertainty. • 3 of the largest foreign-exchange markets in the world – London, New York & Tokyo.

  4. Functions foreign exchange market • Payment clearance in the case of exports and imports between countries • Facilitates availability of credits for importers and exporters in international trade. • Allows hedging – which required for future transaction when there is uncertainty in exchange rate • Hedging – process of avoiding or covering a foreign-exchange risk.

  5. Foreign-Exchange Market • Functions at three levels: • Transactions between commercial banks and their commercial customers (demander & supplier of foreign exchange) • Domestic interbank market conducted through brokers • Transactions between trading banks and their overseas branches or foreign correspondents

  6. Foreign-Exchange Market • Exporters, importers, investors & tourists buy & sell foreign exchange from and to commercial banks. • Example: Imports of German cars by US dealer. • The dealer is billed for each car it imports at rate of 50,000 Euros per car. • US dealer cannot write check for this amount. • Dealer goes to foreign-exchange department to arrange for the payment. • If exchange rate is 1.1 Euros = $1, the car dealer writes a check for $45,454.55 (50,000/1.1) per car. • The foreign exchange department will make the payment to German manufacturer.

  7. Organization of foreign exchange market Central Bank Foreign exch. brokers (owns large amounts of funds in foreign currencies) Trading banks & money changer (serve as clearance agent between main users & foreign exchange brokers) Exporters, importers, investors & visitors (main users & suppliers of foreign currencies)

  8. Vehicle currency • Currency that is used for trade transactions, especially when it is not the national currency of either the importer or the exporter. • E.g. US $ used by importers from Brazil to pay exporters in Japan. • US $ is the most popular & dominant currency used as vehicle currency for almost all kind of transactions between countries. • A country’s currency that is being used as vehicle currency will enjoy benefits – called as seigniorage (profit or revenue from issuing money or currency)

  9. Types of Foreign-Exchange Transactions • When conducting purchases & sales of foreign currencies, banks promise to pay a stipulated amount of currency to another banks/customers at an agreed upon date. • Banks engage in 3 types of foreign-exchange transactions: • Spot transaction • Forward transaction • Currency swap

  10. Spot transaction • Outright purchase and sale of foreign currency for cash settlement not more than 2 business days after the date of the transaction is recorded – known as immediate delivery • The exchange rate used for spot transaction is called as spot rate • Forward transaction • Based on contracts (1, 3 or 6 months), for future payment receipts. • Used to protect from uncertainty in exchange rate, especially for exporters & importers. Example: • An investor signed agreement on 1 Jan 2008 to buy £100 in 3 months based on forward exchange rate on 1 Jan 2008 : US$2.03 = £1. • No transfer of money involved during the signing of contract. • After 3 months (1 April 2008) the investor will get £100 by giving US$ 203 regardless of the spot rate on 1 April 2008.

  11. Differences between ST and FT • Forward transactions differ from spot transactions in that their maturity date is more than 2 days in the future. • The exchange rate for FT is fixed when the contract is initially made. • No money necessarily changes hands until the transaction actually takes place.

  12. Currency swap • Conversion of one currency to another currencywith an agreement to reconvert it back to the original currency at a specified time in future. • The rate of both exchanges are agreed to in advance. • Swaps provide an efficient mechanismthrough which banks can meet their foreign exchange needs over a period of time. • Example: • New York Bank may have excess of dollars but need pounds to meet the requirements. • At the same time Scotland Bank may have excess pounds and insufficient dollars. • The banks negotiates a swap agreement where NY Bank agrees to exchange $ for £ today and £ for $ in the future.

  13. Exchange-Rate Determination • Exchange rate – is the price of one currency in terms of another currency. • Example: ER = $ / £ = number of dollars required to purchase 1 pound. If ER= 2  requires $ 2 to purchase £1 ER’ = number of units of foreign currency required to purchase 1 unit of domestic currency ER’= £/ $ = 0.5 (1 / 2 = 0.5)  Implies that it requires £ 0.5 to buy $1

  14. Exchange-Rate Determination • An exchange rate determined by free-market forces and fluctuates frequently. • If dollar price of pounds increases, for example from $2=£1 to $2.10 = £1 the dollar has depreciatedrelative to pound. • Currency depreciationmeans that it takes more units of a nation’s currency to purchase a unit of some foreign currency.

  15. When the dollar price of pounds decreases from $2=£1 to $1.90 =£1 the dollar has appreciated relative to pound. • Currency appreciationmeans that it takes fewer units of a nation’s currency to purchase a unit of some foreign currency.

  16. Exchange-Rate Determination • Demand for foreign exchange • Derived from the debit items on its balance of payments. E.g US demand for £ may stem from its desire to import British goods & services, make investment & transfer payments. • Supply of foreign exchange • Refers to amount of foreign exchange offered to the market at various exchange rates, all factors held constant. • E.g import goods & services, make investments, repay debts & extend transfer payments.

  17. Equilibrium rate of Exchange • As long monetary authorities do not interfere to stabilize exchange rates  equilibrium exchange rate is determined by the market forces of SS & DD. • When forces underlying SS and DD changes, the demand & supply schedule will shifts  thereby changing the equilibrium level exchange rate.

  18. Exchange rate determination Dollars per pound • Equilibrium exchange rate established at point E . • From US perspectives • 2. Dollar depreciates against £ • UK goods & services becomes more expensive  more $ required to purchase each £ to finance imports   number of imports   DD for £ • 3. Appreciation US$ against £ • UK goods & services becomes cheaper  less $ required to purchase each £ to finance imports   number of imports   DD for £ So Do 3.00 $ Deprec 2.50 E 2.00 $ Apprec 1.50 1.00 0.50 4 5 6 1 2 3 Billions of pounds

  19. Exchange rate determination Dollars per pound • Equilibrium exchange rate established at point E . • From UK perspectives • 2. Dollar depreciates against £ • British will buy more US goods because cheaper  more £ will be offered to buy $ to pay US exporters. • 3. Appreciation US$ against £ • US goods & services becomes expensive  less £ will be offered. So Do 3.00 $ Deprec 2.50 E 2.00 $ Apprec 1.50 1.00 0.50 4 5 6 1 2 3 Billions of pounds

  20. Exchange rate determination Dollars per pound Dollars per pound D1 S2 So Do So Do 3.00 3.00 • E1 S1 E1 2.50 2.50 Dep. Dep. • E 2.00 E App. 2.00 • App. E2 1.50 E2 1.50 1.00 1.00 0.50 0.50 D2 4 5 6 1 2 3 4 5 6 1 2 3 Billions of pounds Billions of pounds a. An increase & decrease in DD for pounds a. An increase & decrease in SS for pounds

  21. Nominal and Real Exchange rate • Nominal exchange-rate index • Based on nominal exchange rates; does not reflect changes in price levels in trading partners • Appreciation loss of competitiveness • Depreciation improvement in international competitiveness • Real exchange rate • Nominal exchange rate adjusted for relative price levels. Formula:

  22. Example: 1. Nominal exchange rate for US & Europe in 2002 is 90 cents per euro, and by 2004 it falls to 80 cents per euro. 2. This is an 11% appreciation (80-90/90*100) of the dollar against euro (indicates drop in competitiveness). 3. Calculate RER – need prices. Suppose 2002 is base year, so prices =100. US prices  to 108 and European prices  to 102. RER = (80 cents X 102 / 108) = 75.6 cents RER implies : US goods are less competitive than what is suggested by NER. Dollar appreciate 16 % (75.6 –90/90*100) and not 11%. RER provide better gauge of international competitiveness than NER

  23. Is a Strong (appreciating) Dollar Always Good and a Weak (depreciating) Dollar Always Bad? • Parties affected by strengthening or weakening dollar: • Consumers • Tourists • Investors • Exporters • Importers

  24. Arbitrage • In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets. • Factor underlying consistency of the exchange rates. 1. Exchange arbitrage • Refers to simultaneous purchase & sale of a currency in different foreign exchange markets in order to profits from exchange rate differentials in the 2 locations. • This process brings about an identical price for the same currency in different locations.

  25. Arbitrage 2. Two-point arbitrage (2 currencies are traded) • In which 2 currencies are traded between 2 financial centers. Example: • Suppose $/ £ is £ 1 = $2 in New York but £ 1 = $2.01 in London. • Will be profitable to purchase £ in New York and immediately resell in London for $2.01 = a profit of 1 cents.  known as two-point arbitrage • As DD for £  in NY, dollar price per £ will  above $2 and as SS of £  in London, dollar price per £ will fall below $2.01.

  26. Three-point arbitrage • Involves switching funds among three currencies in order to profit from exchange-rate inconsistencies. Example 1: • US dollar, Swiss franc & British pound • Rates of exchange: 1) £ 1 = $1.50 2) £ 1 = 4 francs 3) 1 franc = $0.50

  27. Thus an arbitrager with $1.5 million make profit as follows: • Sell $1.5 million for £ 1 million (in NY) • Simultaneously sell £ 1 million for 4 million francs (Geneva) • Sell 4 million francs for $2 million (in London) The arbitrager made risk-free profit = $500,000 £ 1= $1.50 in NY ( sell $ ) £ 1= 4 francs in Geneva ( sell £ ) 1 franc = $0.50 in London (sell franc )

  28. Example 2 • Suppose 3 currencies – dollars ($), pounds (£) & Deutsche Mark (DM) traded in NY, London and Frankfurt with rates: • $1.96 = £1 in NY • £ 0.2 = DM1 in London • DM2.5 = $1 in Frankfurt $1.96 = £1 in NY (buy pounds) £0.2 = DM1 in London (buy DM) DM2.5 = $1in Frankfurt (buy dollars)

  29. First the arbitrageur buys £1 for $1.96 in NY. Then use £1 to buy DM5 in London (£0.20=DM1 so £0.20 X 5 = DM5). Then sell DM5 to buy $2 in Frankfurt. Profit = $0.04 for each pound.

  30. Forward Market • Foreign exchange markets, may be spot or forward. • In spot market – currencies are bought and sold for immediate delivery (2 business days) • In forward markets - currencies bought and sold now for future delivery (1, 3 & 6 months from date of transaction) • Exchange rate agreed on at the time of the contract. • Payment made only when actual delivery takes place. • Banks provide this service to earn profits.

  31. Forward Rate • Rate of exchange used in the settlement of forward transactions. • Premium: Foreign currency worth more in the forward market than in the spot market • Discount: Currency is worth less in the forward market than in the spot market If the result is a negative forward premium, it means that the currency is at forward discount.

  32. Example 1 (based on table 11.8) • Suppose 1-month forward Swiss franc was selling at $0.7844 • Whereas spot price of the franc = $0.7822 • Because forward price of franc > spot price  the franc was at a 1-month forward premium of 0.22 cents or at 3.38% forward premium per year against dollar. • Premium = FR – SR X 12 SR No. of months forward $0.7844 - $0.7822 X 12 $0.7822 1 = 0.0338

  33. Example 2 (based on table 11.8) • Similarly the franc was at a 3-month premium of 0.68 cents or at a 3.48 % forward premium per year against the dollar. • Premium = FR – SR X 12 SR No. of months forward $0.7890 - $0.7822 X 12 $0.7822 3 = 0.0348 • As for the British pound, the 6-month forward pound was at discount of 0.07% per year against the dollar:$1.7760 - $1.7766 X 12 $1.7766 6 = - 0.007

  34. Forward Market Functions • The forward market can be used to protect international traders and investors from the risks involved in fluctuations of the spot rate. • Hedging: Protects international traders and investors from risks involved in fluctuations of spot rate. • Main concerns for people who expect to make payment or receive payments in foreign currency at a future date  as changes in spot rate will make them pay more or receive less.

  35. Example • Suppose the spot rate = RM5.80 / $1.00. Assume Malaysia imported goods from US worth $100,000. • The payment will be made after 3 months in US dollars (RM needed is RM580,000). • Assume also Malaysia exports to US valued $100,000 and will receive payments in 3-months. • No problem as long as the 3-months spot rate remain unchanged.

  36. Case 1 : Suppose spot rate for 3-months increase to RM6.40/$1.00 (implying that RM depreciates) • Malaysia’s importers need to pay RM640,000 for $100,000 (instead RM580,000 initially). Suffers loss = RM60,000. • Malaysia’s exporters receives RM640,000 for $100,000 worth of exports (instead of RM580,000). Exporters gains = RM60,000.

  37. Case 2 : Suppose spot rate for 3-months decrease to RM5.50/$1.00 (implying that RM appreciates) • Malaysia’s importers need only pay RM550,000 for $100,000 (instead RM580,000 initially). Gains = RM30,000. • Malaysia’s exporters will only receives RM550,000 for $100,000 worth of exports (instead of RM580,000). Loss = RM30,000.

  38. Interest Arbitrage • Investors make their financial decisions by comparing the rates of return of foreign investment with those of domestic investment. • Process of moving funds into foreign currencies to take advantage of higher investment yields abroad – known as interest arbitrage. • But investors assume a risk when they have foreign investments, especially when the profits are converted back into home currency (their value may fall because of fluctuations). • Investors can eliminate exchange risk by obtaining “cover” in the forward market.

  39. Two types: • Uncovered interest arbitrage • Investor does not obtain exchange-market cover to protect investment proceeds from fluctuations. • Covered interest arbitrage • The process of moving funds into foreign currencies to take advantage of higher investment returns abroad, while avoiding exchange-rate risks.

  40. Suppose interest rate on 3-month TB is 6% in US and 10% in UK. • Spot rate = $2 per pound. • US investor would seek profit by exchange dollar for pound to purchase UK TB  earn 4% more per year or 1% per 3-months. • The amount of return will be only realized if the exchange rate value of pound remain unchanged. • If pound depreciates – US investors will make less when converting profit back to US dollars. • If pound appreciates – investors will make more.

  41. Covered Interest Arbitrage • Investing funds in foreign financial center involves exchange rate risk. • To avoid risk – investors adopt covered interest arbitrage. There are 2 steps in covered interest arbitrage: 1. Investor exchanges domestic currency for foreign currency • At the current spot rate • Uses the foreign currency to finance a foreign investment 2. Investor contracts in the forward market to sell the amount of the foreign currency received as the proceeds from the investment • Delivery date to coincide with the maturity of the investment

  42. Suppose interest rate on 3-month TB is 12 % in UK and 8 in US. • Interest differential in favors of UK TB = 4% per year or 1% per 3-month. • Suppose spot rate = $2 per pound, while 3-month forward pound sells at $1.99 – meaning that 3-month forward pound is at 0.5 % discount.

  43. Interest Arbitrage • International differences in interest rates • Exerts a major influence on the relationship between the spot and forward rates because: • Changes in interest-rate differentials do not always induce an immediate investor response. • Investors sometimes transfer funds on an uncovered basis. • Factors (governmental exchange controls and speculation) may weaken the connection between the interest-rate differential, and the spot and forward rates.

  44. Foreign-Exchange Market Speculation • Besides used for financing commercial transactions & investments, foreign exchange market also used for exchange-rate speculation. • Speculation: Attempt to profit by trading on expectations about prices in the future. • Speculators buy currencies that they expect to go up in value and sell the currencies that they expect to go down in value. • Differs from arbitrage – simultaneously buy & sell currencies. While speculators buy at one moment & sell that currencies at higher price in the future.

  45. Speculation can exert a stabilizing or destabilizing influence on foreign exchange market. 1.Stabilizing speculation: • Goes against market forces by moderating or reversing a rise or fall in a currency’s exchange rate. • Speculators buys foreign currencies when depreciates – hoping that the domestic price of foreign currencies will increase, thus leading to profit. 2.Destabilizing speculation: • Goes with market forces by reinforcing fluctuations in a currency’s exchange rate. • Speculators sells foreign currencies when it depreciates, on the expectation that it will depreciate further in future  disrupts international transactions & investment activity.

More Related