12 Week (Thursday, 11/3/2011)
Chapter 17
The Foreign Exchange Market
Outline
The foreign exchange market
Definition
The participants
The basics of exchange rates
Definition
Depreciation, appreciation
Devaluation, revaluation
Spot and Forward Markets
Spot exchange rate
Forward exchange rate
Forward premium and discount
Foreign Exchange (FX) Market
The FX market is the market in which
national moneys are traded for other
national moneys.
Two currencies are involved
Nearly all transactions consist of the
exchange of bank deposits.
CitiBank
Deutsche Bank
The Participants
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in
different currencies for investment purposes.
2. Non-bank financial institutions (mutual funds, hedge
funds, securities firms, insurance companies, pension
funds) may buy/sell foreign assets for investment.
3. Non-financial businesses (e.g., multinational
companies) conduct foreign currency transactions to
buy/sell goods, services and assets.
4. Central banks: conduct official international
reserves transactions.
Large Customers: Ford, GM, Shell, BP and other large multinationals
Citibank,
Bank of
America
NEW YORK
Barclays,
LONDON
Approximately 20 large banks dominate the interbank
market
$1 million is smallest transaction
Wells Fargo
Insurance Cos.
Regional Banks
Mutual Funds
Hedge funds
Commercial Banks Rule
Buying and selling in the foreign exchange
market are dominated by commercial and
investment banks.
Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more
per transaction.
About 50% of all transactions occur only between
banks in the interbank market
Central banks sometimes intervene, but the direct
effects of their transactions are small and transitory in
many countries.
Other Aspects
Completely integrated.
Computer and telecommunications technology
transmit information rapidly and have integrated
markets.
The integration of markets implies that there is no
significant arbitrage between markets. (Arbitrage:
buying at a low price and selling at a high price for a profit.)
Open 24 hours
Major financial centers:
Tokyo, Frankfurt, London, New York
50% of all trades go through London and NY
Total volume: approximately $3 trillion
daily
Definition of the Exchange Rate
Price of one currency in terms of another.
Quoted in two ways:
Ef/d = # of units of f.c. per one unit of d.c.
Emex/usd = 10.3 Mexican Pesos per
one US$
Ejpy/usd
= 80 Japanese yen per
one US$
Ed/f = # of units of d.c. per unit of f.c.
Eusd/mex
Peso
= 0.098 US$ per Mexican
Currency Codes and Symbols
http://fx.sauder.ubc.ca/currencies.html
How Used?
Permits price comparisons.
An exchange rate makes it possible to
express price of a good/service in a
common currency.
Suppose a Honda costs: P=
3,000,000
With exchange rate, convert to dollars:
3,000,000 x $0.0098/1 = $29,400
Does It Matter How Quoted?
NO
one is the reciprocal of the other.
However, careful how you interpret a change
in the value of the exchange rate.
Suppose both rise:
Ejpy/usd = 80 yen per US$
90 yen per US$
Eusd/mex = 0.098 US$ per Mexican
Peso
0.200 US$ per
Mexican Peso
Terms
Changes in exchange rate due to market
forces:
Appreciation
Depreciation
Change in fixed exchange rate by
government:
Revaluation
Depreciation Devaluation
Depreciation
is a decrease in the value of a
currency relative to another currency.
A depreciated currency is less valuable (less expensive) and
therefore can be exchanged for (can buy) a smaller amount of
foreign currency.
Suppose:
$1/1 $1.20/1
This means that the dollar has depreciated relative to the
euro.
It now takes $1.20 to buy one euro, so that the dollar is
less valuable.
At the same time, the euro has appreciated relative to the
dollar: it is now more valuable.
Consequences of Depreciation
A depreciated currency is less valuable, and therefore it
can buy fewer foreign produced goods that are
denominated in foreign currency.
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0100/1 = $30,000
A depreciated currency means that imports are more
expensive and domestically produced goods and exports
are less expensive:
Pm
Px
Discourages M and spurs X
Appreciation
Appreciation is an increase in the value of a
currency relative to another currency.
An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for (can buy)
a larger amount of foreign currency.
Suppose:
$1/1 $0.90/1
This means that the dollar has appreciated relative to
the euro.
It now takes only $0.90 to buy one euro, so that the
dollar is more valuable.
At the same time, the euro has depreciated relative to
the dollar: it is now less valuable.
Consequences of Appreciation
An appreciated currency is more valuable, and therefore
it can buy more foreign produced goods that are
denominated in foreign currency.
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0050/1 = $15,000
An appreciated currency means that imports are less
expensive and domestically produced goods and exports
are more expensive:
Pm
Px
Spurs M and discourages X
Devaluation and Revaluation
Devaluation is a decrease in the value of a
currency announced by the government.
Suppose Mexico fixes Peso to US$:
12 Mex Pesos per US$ 14 Mex Pesos
per US$
Revaluation is an increase in the value of a
currency brought about by the government.
Suppose China fixes Renminbi to US$:
7 yuans per US$ 5 yuans per per US$
Closer Look at Table
U.K pound
1-mos forward
3-mos forward
6-mos forward
In U.S. dollars
2.5078
2.5068
2.5047
2.5005
FX Market has Time Dimension
Contracts can be made for the exchange
of two currencies within one or two days or
months into the future.
Spot market
Forward market
Spot Rates and Forward Rates
Spot rates are exchange rates for currency
exchanges on the spot, or when trading is
executed in the present (within 2 business days;
1 in N. America).
Forward rates are exchange rates for currency
exchanges that will occur at a future (forward)
date.
Forward dates are typically 30, 90, 180, or 360 days
in the future.
Rates are negotiated between two parties in the
present, but the exchange occurs in the future.
Terminology
U.K pound
1-mos forward
falling
3-mos forward
6-mos forward
If
In U.S. dollars
2.5078
2.5068
US$ cost
2.5047
2.5005
F3$/ > E$/, then pound is selling at a
forward premium
If
F3$/ < E$/, then the pound is selling at a
forward discount
Types of Transactions
Spot
Forward
Swap
33%
12%
55%
Next Lecture
Demand and Supply Model of Foreign
Exchange Market