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Chapter Eight. Foreign Exchange Markets. Chapter Outline. Overview Foreign Exchange Transactions Role of FIs in Foreign Exchange Interest Rate Parity. 1. Foreign Exchange Markets Overview. - PowerPoint PPT Presentation
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McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-1
Chapter EightForeign Exchange Markets
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-2
Chapter Outline
1. Overview
2. Foreign Exchange Transactions
3. Role of FIs in Foreign Exchange
4. Interest Rate Parity
1. Overview
2. Foreign Exchange Transactions
3. Role of FIs in Foreign Exchange
4. Interest Rate Parity
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-3
1. Foreign Exchange Markets Overview
• Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted
• Foreign exchange rate - the price at which one currency can be exchanged for another currency
• Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates
• Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies
• Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted
• Foreign exchange rate - the price at which one currency can be exchanged for another currency
• Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in FX rates
• Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-4
Background and History of Foreign Exchange Markets
• Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued
• Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate
• Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate
• Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued
• Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate
• Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-5
2. Foreign Exchange Transactions
Spot foreign exchange transaction: 0 1 2 3 mo
Exchange Rate Agreed/Paid + Currency Delivered bybetween Buyer and Seller Seller to Buyer
Forward exchange transaction 0 1 2 3 mo
Exchange Rate Agreed Buyer Pays Forward Pricebetween Buyer and Seller Seller delivers currency
Spot foreign exchange transaction: 0 1 2 3 mo
Exchange Rate Agreed/Paid + Currency Delivered bybetween Buyer and Seller Seller to Buyer
Forward exchange transaction 0 1 2 3 mo
Exchange Rate Agreed Buyer Pays Forward Pricebetween Buyer and Seller Seller delivers currency
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-6
Foreign Exchange Market Trading (in billions of U.S. dollars)
0
200
400
600
800
1000
1200
1400
1989 1992 1995 1998 2000 2004
Spot transactionsForward transactions
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-7
Hedging with Forwards
• Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market– 1. U.S.bank sells $100 M for pounds at spot exchange rate
today and receives $100 M/1.6 = L62.5 M
– 2. Bank then lends the L62.5 M to British customer at 15% for one year
– 3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year
– 4. British borrower repays P & I in L71.875 M
– 5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M
• Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market– 1. U.S.bank sells $100 M for pounds at spot exchange rate
today and receives $100 M/1.6 = L62.5 M
– 2. Bank then lends the L62.5 M to British customer at 15% for one year
– 3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year
– 4. British borrower repays P & I in L71.875 M
– 5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-8
3. Role of FIs in Foreign Exchange Transactions
• Net exposure - a FIs overall foreign exchange exposure in any given currency
• Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given currency
• Four trading activities– purchase/sale of foreign currencies for trade transactions
– purchase/sale of foreign currencies for investment
– purchase/sale of foreign currencies for hedging
– purchase/sale of foreign currencies for speculating
• Net exposure - a FIs overall foreign exchange exposure in any given currency
• Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given currency
• Four trading activities– purchase/sale of foreign currencies for trade transactions
– purchase/sale of foreign currencies for investment
– purchase/sale of foreign currencies for hedging
– purchase/sale of foreign currencies for speculating
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-9
Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)
0
20000
40000
60000
80000
100000
120000
1993 1996 1999 2002 2004
Banks' liabilitiesBanks' claimsClaims of banks' domestic customers
0
20000
40000
60000
80000
100000
120000
1993 1996 1999 2002 2004
Banks' liabilitiesBanks' claimsClaims of banks' domestic customers
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-10
FI’s overall net foreign exchange (FX) exposure
Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought
= Net position
Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought
= Net position
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-11
Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004
-500,000
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
Assets Liab FXBought
FX Sold NetPosition
Canada dollar (mns)
Japanese yen (bns)
Swiss francs (mns)
British pounds (mns)
Euro (mns)
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-12
4. Purchasing Power Parity
The theory explaining the change in foreign currencyexchange rates as inflation rates in the countries change
iUS = IPUS + RIRUS
and: iS = IPS + RIRS
where: iUS = Interest rate in the United States iS = Interest rate in Switzerland
then: iUS - iS = IPUS - IPS
The theory explaining the change in foreign currencyexchange rates as inflation rates in the countries change
iUS = IPUS + RIRUS
and: iS = IPS + RIRS
where: iUS = Interest rate in the United States iS = Interest rate in Switzerland
then: iUS - iS = IPUS - IPS
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9-13
Interest Rate Parity
The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciationof the domestic currency
1 + iUSt = (1/St) (1 + iUKt) Ft
where: 1 + iUSt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + iUKt = 1 plus the interest rate on a U.K. investment maturing at time t St = S/L spot exchange rate at time t Ft = S/L forward exchange rate at time t
The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciationof the domestic currency
1 + iUSt = (1/St) (1 + iUKt) Ft
where: 1 + iUSt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + iUKt = 1 plus the interest rate on a U.K. investment maturing at time t St = S/L spot exchange rate at time t Ft = S/L forward exchange rate at time t
