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33 The Foreign Exchange Market The foreign exchange (ForEx) market is the market in which parties exchange national currencies It is not a public outcry auction market, but rather operates as a computer driven over-the-counter market The volume of activity has escalated dramatically in response to the growth in world trade volume in goods & services.
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Chapter 8
The Foreign Exchange Market
©Thomson/South-Western 2006
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International Trade Foreign Exchange
Nations engage in international trade for the same reason that individuals engage in domestic trade
Comparative Advantage Specialization & Int. Trade Improve productivity More Consumption, Income Increase standard of living
International trade requires the exchange of currencies
Currency exchange is often regulated by government.
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The Foreign Exchange Market
The foreign exchange (ForEx) market is the market in which parties exchange national currencies
It is not a public outcry auction market, but rather operates as a computer driven over-the-counter market
The volume of activity has escalated dramatically in response to the growth in world trade volume in goods & services.
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The Foreign Exchange Market
International capital flows The acquisition of financial & real assets across national borders90% of foreign exchange volume is associated with capital flows (investment markets)
The direct or immediate participants (Dealers) U.S. & foreign commercial banks with international deposits & foreign branches
The ultimate participants import & export firms, tourists & other travelers, & financial entities seeking to invest internationally.
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The Foreign Exchange Rate The price at which one nation’s currency is
exchanged for another’s is the foreign exchange rate
An exchange rate exists between each pair of nations that engage in trade using different currencies
A currency appreciates against other currencies when a single unit of that currency buys more units of these foreign currency
Last month: THB 34.50 / $ This month: THB 32.25 / $
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The Foreign Exchange Rate The price at which one nation’s currency is
exchanged for another’s is the foreign exchange rate
An exchange rate exists between each pair of nations that engage in trade using different currencies
It depreciates against other currencies when when a single unit of that currency buys less units of these foreign currency
Last month: $ 1.54 / £ This month: $ 1.33 / £
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Table 8-1
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Figure 8-1
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Fixed & Floating Exchange Rates
Fixed exchange rates : exchange rates do not change & countries must act to maintain some predetermined level of value
Bretton Woods exchange rate system (adjustable-peg)
required countries get IMF approval to change their exchange ratesThe system collapsed in the early 1970s
Major industrial states’ currencies currently float according to supply & demand for each currency
Floating exchange rates : exchange rates continuously change according to supply & demand in the world marketplace.
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Spot & Forward Exchange Markets
Spot transactions involve the exchange of currencies for immediate or “on the spot” delivery & payment
The exchange rate at which such transactions take place is called the spot exchange rate.
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Spot & Forward Exchange Markets
Forward transactions involve the purchase and sale of foreign currencies for delivery & payment at some specific future date, at a price specified in advance
The exchange rate at which these forward transactions take place is the forward exchange rate
Forward exchange markets provide hedging for investors to avoid possible large losses due to changes in the spot exchange rate.
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Forward TransactionForward Contract
Agreement to exchange Thai Baht
for USDPrice: At 33 Baht/USDTime: In the next 3
monthsAmount: 100,000 BahtSign ______ (today)
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Spot Transaction
U.S. Importer
Swiss Exporte
rPay S Fr 100,000
in 30 days
Watches
Today Spot rate = S Fr 1.25 / USD Expected cost = USD 80,000
If that day’s Spot rate = S Fr 1.20 /USD (next 30 days)Then the Actual cost = USD
83,333
On the delivery day
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Forward Transaction
U.S. Importer
Swiss Exporte
rPay S Fr 100,000
in 30 days
Watches
Today Spot rate = S Fr 1.25 / USD Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver in 30 days
Forward rate = S Fr 1.2489 / USD Actual cost = USD 80,070
On the delivery day
Actual cost = USD 80,070
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The Importance of the Exchange Rate
A country’s exchange rate level is important because, together with domestic prices, the exchange rate determines
the cost of the nation’s products in foreign nations influencing the nation’s exports the cost of foreign products sold in the country influencing imports
Currency Appre products look more expensiveExport lessImport moreTrade Deficit
Currency Depre products look cheaperExport moreImport lessTrade Surplus
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The Importance of the Exchange Rate
Exchange rate influences Trade deficits/surplus
Because of the large influence of currency values upon trade, disputes among nations have arisen over one governments’ decisions to intervene in the foreign exchange market
Managed float system..
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Exchange Rate Determination
The foreign exchange market is highly competitive
many small buyers & small sellers relative to the total market homogenous product--a national currency
In Freely Floating Exchange Rates, governments rarely intervene exchange rates are driven entirely by supply & demand
In a Managed Float (the system in place today), governments sometimes intervene in an effort to prevent exchange rate movements perceived to be excessive or strongly at odds with national interests.
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Figure 8-2
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The Supply & Demand Model Demand
The demand curve for dollars stems from foreign buyers of American goods & services, U.S. financial & real assetsThe demand curve is downward sloping because, ceteris paribus, a decline in the price of $ makes everything from the United States cheaper for foreign buyers.
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The Supply & Demand Model Supply
The supply curve for dollars stems from Americans seeking to purchase foreign goods & services, financial & real assetsThe supply curve slopes upward because, given other factors, an increase in the dollar’s value reduces the price of foreign items in the United States.
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Long-Run Exchange Rate Determinants
1. Relative Price Level Behavior (Inflation)
Non-inflation factors2. preferences & product development
(innovation)3. productivity behavior (growth)4. tariffs & quotas (trade restrictions)
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Long-Run Exchange Rate Determinants
1. Relative Price Level Behavior (Inflation) Nations with chronically high inflation are likely to be weak-currency nations—i.e., they are likely to see their currencies depreciate over the years against currencies of nations that experience lower inflation.
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Figure 8-3 Increase in Japanese Prices
S1$
D1$
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Exc
hang
e R
ate
Q$
D2$
S2$
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Long-Run Exchange Rate Determinants
Non-inflation factors2. preferences & product development
(innovation)3. productivity behavior (growth)4. tariffs & quotas (trade restrictions)
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Long-Run Exchange Rate Determinants
2. Preferences & Product Development Japan produces new bread toaster Foreigners start importing this new product Foreigners demand more YenYen appreciates
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Long-Run Exchange Rate Determinants
3. Productivity improve in productivity production costs fall Thai products have lower prices products look more attractive in world market more demand for THBTHB appreciates
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Long-Run Exchange Rate Determinants
4. Tariffs and Quotas U.S. puts more tariffs more tax on imported products Imported products have higher prices U.S. people import less supply less USD USD appreciates
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Long-Run Exchange Rate Determinants
4. Tariffs and Quotas U.S. puts more quotas less quantity of imported products U.S. people import less supply less USD USD appreciates
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Spot - Forward In your new business venture, you expect a shipment of Swiss
watches in 90 days. Upon delivery 90 days from now, you must pay the Swiss company 142,000 Swiss francs.
What risk are you taking if you wait 90 days and then buy the needed francs in the spot market?
Answer : I will face the foreign exchange rate risk. If Swiss francs is appreciated in next 90 days, I need to use more USD, to buy 142,000 Swiss francs.What is the expected cost in $ if the current spot rate = 6.3 S Fr/$
Answer : Expected Cost = 142,000/6.3 = 22,539.97 Swiss francs
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Spot - ForwardWhat is the actual cost in $ if the future spot rate = 5.8 S Fr/$
Answer : Actual Cost = 142,000 / 5.8 = 24,482.76 USD.If you enter 90 days Forward Contract and lock-in the forward rate at 6.15 S Fr/$, what is the expected cost? What is the actual cost?
Answer : Expected Cost = 142,000 / 6.15 = 23,089.43 USD. Actual Cost = 142,000 / 6.15 = 23,089.43 USD.
What is the benefit you get from entering Forward Contract?Answer : Forward exchange markets provide hedging for me to
avoid possible large losses due to Swiss Francs appreciated in the spot exchange rate
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More ExerciseSuppose you are importer, you expect a shipment of computers from United State of America in 60 days. Upon delivery 60 days from now, you must pay the US. company 200,000 USD.
1. What is the expected cost in THB if the current spot rate = 33.40 THB./$?
Answer: The expected cost = 200,000 * 33.4 = 6,680,000 THB2. What is the actual cost in THB if the future spot rate = 34.30 THB./$
?86Answer : The actual cost = 200,000 * 34.3 = 6,860,000 THB
3. If you enter 60 days Forward Contract and lock-in the forward rate at 33.86 THB./$ what is the expected cost? What is the actual cost?
Answer: The expected cost = 200,000 * 33.86 = 6,772,000 THB
