360-13 - Chapter 13 The Foreign-Exchange Market The market...

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Chapter 13 – The Foreign-Exchange Market The market for foreign exchange arises for tourism, exports/import, and international investment. Usually only tourism requires actual currency, the majority of the market for foreign exchange involves the transfer of bank deposits. For example, if GM needs to purchase €10m to pay for an order of foreign car parts, or needs to sell €10m it received for the sale of car engines, it won’t actually use currency, it will use a bank transfer of funds. Most foreign exchange trading is done through an international network of large commercial banks, like JP Morgan Chase, to facilitate international trade for MNCs. Currency trading is virtual - automated and electronic, like NASDAQ, using computer terminals and telephones, with no physical market or trading. SPOT RATES Like many markets (commodities, stock indexes, T-bonds, currency), there is a) the spot (cash) market, where spot (cash) rates are quoted for immediate delivery (two days to clear for currency); and b) the forward or futures market, where forward rates are quoted for future delivery. Spot rates for foreign exchange are quoted in Table 13.1 on p. 337 (Jan. 31, 2003) and in the WSJ handout. Swiss francs are selling for $.7332/SF, and dollars are selling for SF1.3639/$, in amounts of $1m or more. For smaller amounts, the price will be higher. Example, an importer needs to buy $10,000 worth of SF, price might be $.75/SF instead of $.7332. $10,000 / ($.75/SF) = SF13,333.33. Or equivalently, $.75/SF = SF1.3333/$, so $10,000 x 1.3333 = SF13,333.33. General Rule: To convert $10,000 to a foreign currency, DIVIDE by the ex-rate if quoted as $/SF and MULTIPLY by the ex-rate if quoted as SF/$. Point: We want the dollars to cancel. The ex-rates in Table 13.1 are quoted as “mid-range rates,” which is the average of the bid (buying rate) – ask (selling rate) spread. See Table 13.2 on p. 338 for the average spreads. For the SF, the bank will pay SF1.3571 to buy dollars and would sell dollars for SF1.3576, making . 0005SF per dollar, or SF500 per $1m, and the mid-range quote would be SF1.3574. At the bid quote, SF500 / SF1.3571 ≈ $368. Note that the spread represents a commission of only .0368% (or less than 1/25 th of 1%), and is even less for the Euro (.0199%). The spread will _________ for currencies that are thinly traded, i.e., currencies with low volume and infrequent trading. Large commercial banks like Citibank stand ready to buy currency at the bid ex-rate and sell currency at the ask ex-rate, and help to “make a market” for foreign exchange. See currency symbols in Table 13.3 on p. 339. ARBITRAGE January 23, 2012 1
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Riskless profit opportunities requiring no investment, by exploiting price discrepancies. Since the dollar is homogeneous and “fungible,” it should sell at the same ex-rate everywhere according to the price equalization principle, or the Law of One Price. Suppose SF is selling at a bank in NY for $0.63 and at a bank in London for $0.64.
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This note was uploaded on 01/23/2012 for the course ECON 360 taught by Professor Staff during the Spring '11 term at University of Michigan.

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360-13 - Chapter 13 The Foreign-Exchange Market The market...

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