L3_FEXMarket - Recap of Last Lecture 1. Statistical...

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1 Recap of Last Lecture 1. Statistical description of open economies 2. Markets develop to help countries capture gains from trade: • Gains from exchanging goods • Gains from trading over time • Gains from trading risk 2 The Foreign Exchange Market Overview Reference: Levich, Chapter 3 • Origins of the market • Products and activities in this market (*) • Empirical facts about this market • Risks in this market
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3 Origins of the Market Buying and selling goods internationally Investment across international boundaries Tourism ± Key reason: only domestic currency is acceptable for domestic transactions. 4 Products in FOREX Market Spot contracts Forward contracts Swaps
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5 Spot Contract ---1 Spot contract: an agreement to exchange currencies at spot rate usually within two days • spot exchange rate: relative price of one currency to another currency for immediate delivery •E g : S $/euro = 0.81 (# of dollars it takes to buy a Euro) • used by individuals, firms and banks for transactions 6 Spot Contracts --- 2 The exchange rate quotes are based on large trades (1 million or more). The smaller the quantity of foreign exchange purchased, the higher the price.
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7 Spot Contracts ---3 The exchange rate quotes are mid-range rates (banks buy at lower and sell at higher rates). • The “bid” price is the price that banks are willing to pay you • The “ask” price is the price that you must pay the bank • The difference between the bid and ask price is call the “bid-ask spread.” 8 Spot Contracts Table 3.1 Average Spreads, January 31, 2003 1.3571-1.3576 Swiss franc 119.03-119.09 Japanese yen 1.5280-1.5285 Canadian dollar 1.6535-1.6543 British pound 1.0813-1.0815 Euro
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9 Forward Contract • an agreement to exchange currencies at relative price set today at a pre-specified date in the future ± common maturities: 1, 2, 3, 6, 12 months ± Ex: F t,6mo = price of a forward contract at t for foreign exchange 6 months from t. ± used by corporations to manage their exposures to foreign exchange risk 10 Forward Premium or Discount •FP i = 100 * (F $/i, t, T -S $/i, t )/ S $/i, t ± Positive: currency i has a forward premium. ± Negative: currency i has a forward discount. ± Example: British pound spot: $0.6604/GBP 180-day forward: $0.6690/GBP The 180-day forward premium for GBP: (0.6690 - 0.6604) / 0.6604 * 100 = 1.3022%
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11 Foreign Exchange Swap • simultaneous sale of currency for spot delivery and purchase of that currency for forward delivery • sell ¥ now (get $ now) buy ¥ forward (sell $ forward) • Used by dealers to manage the maturity structure of their currency positions • Why do this? Must believe that ¥ will not increase its value relative to dollar as much as the forward market price suggests it will. 12 • Suppose S $/¥ = 0.01. • Spot market - exchange 100 ¥ for $1 • Suppose 1-week forward rate is F $/¥ = 0.009.
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This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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L3_FEXMarket - Recap of Last Lecture 1. Statistical...

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