Foreign ExchangeForeign Exchange Market

•Exchange Rate

Appreciation/Depreciation

•Effective Exchange Rate

Trade Weighted Dollar

Real Exchange Rate

Interbank Market: Dealers / Brokers

Spot Market

•Bid Rate / Ask Rate / Spread

•Cross Exchange Rates

•Exchange Arbitrage: 2 point / 3 point

Forward Market/Swaps

•Discount / Premium

•Covered Interest Arbitrage

•Uncovered Interest Arbitrage

Futures Market

•IMM

Options Market•Call Option / Put Option•Strike Price / DurationHedgingSpeculation: Long position / Short position•Stabilizing Speculation•Destabilizing Speculation

Foreign Exchange MarketsMajor players:

1. Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies

… banks hold inventories of foreign currencies to meet customer demands

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 conduct foreign currency transactions to buy/sell goods, services and assets.

4. Central banks: conduct official international reserves transactions.

• Daily volumes of foreign exchange transactions• $600 billion in 1989/$1.9 trillion in 2004/$3.2 trillion in 2007.

Major “markets”: London/New York/Tokyo Other “markets”: Chicago/Frankfurt/Hong Kong/Singapore About 90% of transactions involve US dollars.

Spot Market: (Wholesale Prices)

Foreign Exchange Markets: Interbank Market Players

http://www.bloomberg.com/markets/currencies/fxc.html

Forward Market

o currency worth more in forward market than spot market => premium

o currency worth less in forward market than spot market => discount

Forward Months No. Rate Spot12

Rate SpotRate SpotRate Forward

premium

Uncovered Interest Arbitrageo moving funds into

foreign currency to take advantage of higher rate of return without forward contract

o Extra return:

UK U.S. Percentage= Interest - Interest ± Appreciation/Depreciation Rate Rate of Pound

Covered Interest Arbitrage1) purchase foreign currency at spot rate and use it to

finance purchase of foreign assets (bonds)2) contract in the forward market to sell amount of

foreign currency that will be received

because of activity in the forward market such investment opportunities quickly disappear

Flavors of exchange rates and contracts• Spot rates: for currency exchanges “on the spot”

• Forward rates: for currency exchanges that will occur at a future (“forward”) date.

– Forward contracts can be customized.• 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.

• Foreign exchange swaps: a combination of a spot sale with a forward repurchase.

• Futures contracts: designed by a third party for a standard amount of foreign currency delivered/received on a standard date. – Contracts can be bought and sold in markets– Only the current owner is obliged to fulfill the contract.

• Options contracts: designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date.

– Pay a premium for the option, but not obligation, to buy (call option) or sell a currency (put option) at a strike price before the option’s expiration date.

Nominal and Real Exchange Rates

Real Exchange Rate Index = Nominal Index x (Our CPI/Their CPI)

If our prices are rising faster than foreign prices yet our nominalexchange rate hasn’t depreciated, we’re really getting a better deal