Transcript Foreign Exchange Markets and Exchange Rates Foreign Exchange Markets • A network of systems and mechanisms through which currencies are traded • Market actors: • • • • • • • Banks Brokers.

Foreign Exchange Markets
and Exchange Rates
Foreign Exchange Markets
• A network of systems and mechanisms
through which currencies are traded
• Market actors:
•
•
•
•
•
•
•
Banks
Brokers (Brokerage firms)
Business entities (merchants, corporations, etc.)
Individuals
Governments
Central banks
International organizations
Foreign Exchange Rates
• A foreign exchange rate is the price of (one unit
of) a currency in terms of another currency
• There are nearly 200 currencies of which few
than 50 are commonly traded internationally
• Most currency trades take place in the form of
transfer of bank deposits and clear without
actual currency notes changing hands
Currency Quotes
• Today:
UK pound: $/Pd: 1.83 Pd/$: 0.546
Euro:
$/Er: 1.25 Er/$: 0.80
• A year ago: UK pound: $/Pd: 1.64 Pd/$: 0.609
Euro:
$/Er: 1.08 Er/$: 0.925
• Currency cross rates
FX and Portfolio Management
• An asset portfolio is a set or basket of assets
owned by an individual or a business entity
• An asset has a value if it brings returns either
in the form of incomes (earnings) or pleasure
• A portfolio containing FX denominated assets
could change in value as FX rates change
Types of FX Transactions
• Spot transactions
• Forward and futures transactions
• Transactions in FX derivatives (options)
Forward and futures transactions: Buying or
selling a certain amount of a currency at a
predetermine (agreed upon) price for future
delivery
Currency options: Buying and selling options to
buy or options to sell specific amounts of a
currency at a preset price in the future
The Reasons Behind FX Trading
• Clearing transactions
• Arbitrage transactions: taking advantage of rate
differentials (discrepancies) in different markets
• Hedging transactions: Long and short positions
• Hedging in the spot market
• Other types of hedging
• Speculation: Taking a long or a short position in a
currency in the hope of profiting from a favorable
change in the exchange rate
• A person having a long position in the British pound hopes to
see the pound appreciate.
Hedging
• Hedging: A transaction made for the purpose of
avoiding or reducing a business (FX
fluctuation) risk.
Positions in FX: No position
Long position
Short position
Balanced or closed position
• Hedging could be done in the spot market as
well as in other FX markets
Hedging in the Forward Market
• Suppose an American merchant has purchased
five full container loads of German beer at a
total price of € 150,000. She has agreed to pay
for the merchandise 90 days after the
merchandise is placed aboard the ship; she holds
a short position in the euro.
• To close her position she can purchase €150,000
in the forward market today. That would enable
her to buy the amount of euros she would need
in 90 days at a pre-determined rate. The forward
contract would protect her from FX risk.
FX Markets and FX Rates: How
Are FX Rates Determined?
The Interest Parity Model:
A note: A currency forward rate is an agreed-upon rate
of exchange at which a certain amount of a currency is
traded (bought or sold) on a certain (agreed-upon) day
in the future.
In the forward market a currency could be at a
“premium” or at a “discount”
ef - es
Discount or premium (rate)= p = ----------- (12/n)
es
Discount: p < 0
Premium: p > 0
I. Uncovered Interest Arbitrage
Comparing rates of returns on assets
denominated in different currencies:
Suppose:
US interest rate: 12%
UK interest rate: 16%
One-year CDs in US vs. One-year CDs in UK
Spot rate: 1.80
Expected (future) spot rate in a year: 1.70
Interest differential vs. Currency
Appreciation or Depreciation
Interest differential: (i$ - i £)
%Change in e = (ee – es)/es
• $1000 invested in US, after 12 months:
= $1000 ( 1+ .12) = $1120
$1000 invested in UK, after 12 months:
Assuming
e= 1.80
ee = 1.75
= (1000/e ) (1+ .16) ee = 1128
 Invest in pound-denominated assets
• $1000 invested in US, after 12 months:
= $1000 ( 1+ .12) = $1120
$1000 invested in UK, after 12 months:
Assuming e= 1.80
ee = 1.70
= (1000/e ) (1+ .16) ee = 1095
 Invest in pound-denominated assets
What are we comparing?
• Interest in the US, i$ , and the return on a pounddenominated asset; this return is affected not only
by the UK interest rate, but also the (expected)
change in the exchange rate:
That is:
i£ (ee/e) + (ee –e )/e
If i$ < i£ (ee/e) + (ee –e )/e ,
investors will invest in pound-denominated assets.
If i$ > i£ (ee/e) + (ee –e )/e ,
investors will invest in $-denominated assets.
Alternatively,
• We can compare
(i$ - i£ ) and (ee –e )/e
If (i$ - i£ ) > (ee –e )/e ,
dollar denominated assets will be chosen
At parity : (i$ - i£ ) = (ee –e )/e
Covered Interest Parity
• Investing a dollar in the US at %10:
After 12 months: =$1 (1+ i$) = $1.10
• Investing the same dollar in a pound-denominated asset
(at 16%) and covering in the forward market, assuming
e = 1.80 and ef = 1.75:
= ($1/e) ( 1+ i£ ) ef
= (ef /e) + (ef /e) i£ = 1.127
$1 (1+ i$) < (ef /e) + (ef /e) i£
1.10
<
1.127
Or,
(1+ i$) ? (ef /e) + (ef /e) i£
Subtract 1 from both sides
i$ ? (ef /e) + (ef /e) i£- 1
i$ ? ([ef –e]/e) + (ef /e) i£
Assuming (ef /e)  1, and subtraction i£ from both
sides, we write
(i$ - i£) ? ([ef –e]/e)
If (i$ - i£) < ([ef –e]/e),
funds will..?
If (i$ - i£) > ([ef –e]/e),
funds will..?
At parity: (i$ - i£) = ([ef –e]/e),
Does interest parity hold?
The effects of changes in i$ , i£, ee, and ef on e?
Recall: (i$ - i£ ) = (ee –e )/e
and (i$ - i£ ) = (ef –e )/e
For example, if i£ increases, other things
unchanged, e must rise. ($depreciation)
Or, if ef decreases, other things unchanged, e
must fall. ($appreciation)
FX Markets: Supply of and Demand for FX
• Asset Demand
• Transaction Demand
Asset demand: Recall that the return on a FX
asset:
([ef –e]/e) + (ef /e) i£ or ([ee –e]/e) + (ee /e) i£,
given i$, i£, ee, and ef , is inversely related to FX
rate, e.
• As “e” increases the return on the FX asset
decreases, making it less attractive.
Demand for and Supply of FX
e($/£)
S
D
0
{i$, i£, ee,ef}
£
Shifts in the Demand Curve
• US interest rates : (-)
• UK interest rates: (+)
• The pound forward rate (+)
• The expected future £ spot rate (+)
FX Rate Regimes
• Flexible (floating) rates
» Appreciation
» Depreciation
• Fixed (pegged) rates
» Revaluation
» Devaluation
• Managed floating rates
• Exchange control
The Effective Exchange Rate
• A bilateral exchange rate of a currency may not
reflect the real value of a currency.
• A currency may appreciate against some
currencies while depreciating against others
• The effective exchange rate of a currency is a
weighted index reflecting the value of a
currency relative to a multiple ( basket) of other
currencies. (Often the currencies of the
country’s major trading partners)