Chapter 8: The Foreign Exchange Market
Average global trading volmes at how much per day?
$5.3 trillion per day
A bank's foreign exchange department has 4 major categories of clients, what are they?
1. Commercial Customers 2. Speculators 3. Arbitrageurs 4. Central Banks/Treasury Departments
What are the 6 factors that affect exchange rates?
1. Differentials in inflation 2. Interest Rate Differentials 3. Current Account Deficits 4. Public Debt 5. Terms of Trade 6. Political Stability and economic performance
Why is the Euroloan market superior to traditional loan sources?
1. Not subject to the same govt regulations 2. Transactions must be extremely large which reduces cost of making loans 3. Only credit worthy buyers allowed so reduces risk
What are the 5 major kinds of foreign exchange transactions?
1. Spot Transactions 2. Forward Transactions 3. Foreign Exchange Swaps 4. Currency Future Transactions 5. Currency Options
What are the three kinds of overseas banking operations?
1. Subsidiary Banks (separately incorporated) 2. Branch Banks (not separately incorporated) 3. Affiliated Banks (jointly owned with a local or foreign partner)
What are the three kinds of arbitrage of money?
1. Two-Point Arbitrage 2. Three-Point Arbitrage 3. Covered-Interest Arbitrage
IBFs have to follow several rules..
1. only offer international banking services 2. must be legally separate from the bank's domestic operations 3. must still follow some rules issued by the Fed 4. can only accept deposits or make loans to individuals and companies not in the US
International Banking Facilities (IBFs)
1981, created by the fed. US bank subsidiaries that offer only international banking services and are not subjected to many US banking regulations
LIBOR Scandal
2005-09 Barclays understated the rate at which it lent money, cause the LIBOR to be artificially low. Not just Barclays, it was wide spread and made a significant impact
Currency Options account for ___ of foreign exchange activity.
5%
Why is a swap transaction useful?
Allows a company to use one currency to fund obligations denominated in another currency, without the risk of unfavorable exchange rate fluctuations
What causes a SHIFT of the demand curve?
Any change OTHER than price.of the currency
If the forward rate is greater than the spot rate, the market expects the currency to ___ and the currency is selling at a forward ___.
Appreciate, Premium
What are the two types of arbitrage?
Arbitrage of goods and Arbitrage of money
What causes a movement ALONG the demand curve?
Change IN price of the currency
What are the two types of currencies?
Convertible and Inconvertible
Forward Market
Currencies are bought and sold for delivery in the future, usually 1, 3, or 6 months after the transaction takes place
If a currency is selling at a forward discount, a business would want to ___ its assets and ___ its liabilities denominated in that currency.
Decrease, Increase This is because holdings in that currency will be worth less, a company should sell off assets to get the most money for them and convert their liabilities to that currency because the cost of the debt will decrease as the currency depreciates.
If the forward rate is less than the spot rate, the market expects the currency to __ and the currency is selling at a forward ___.
Depreciate, Discount
Countries with high inflation and trade deficits often have currencies that sell at a forward ___.
Discount
What are the major transaction currencies?
Dollar, Euro, Yen, Pound
What are on each axis of the Foreign Exchange graph?
Exchange rate is on the vertical axis. Quantity of the currency is on the horizontal axis.
If a country's inflation rate is expected to increase, the relative value of its money is expected to ___.
Fall. As a result any forward premium should shrink, forward discount should widen, nominal interest rate should be higher
A currency appreciates when a country's real interest rates are ___ than other countries real interest rates.
Higher
A currency appreciates when the terms of trade ___.
Increase/Improve
A currency depreciates when there is a ____ public debt.
Large
Wholesale Market
Large customers in the foreign exchange market are able to buy currency at lower prices than "ordinary" investors
___ has the world's largest foreign exchange market.
London
A currency appreciates when it has ___ political risk and economic risk.
Low
A currency appreciates when a country's inflation rate is ___ than other countries inflation rates.
Lower
Country Funds
Mutual funds that invest in a specific country's firm
Eurodollars
Originally referred to US dollars in European banks. Now refers to any US dollars in any bank outside of the US
At exchange rates above equilibrium there is an ___
Oversupply or surplus
Countries with low inflation and trade surpluses often have currencies that sell at a forward ___.
Premium
Nominal Interest Rate =
Real Interest Rate + Expected Rate of Inflation
Terms of Trade
Refers to the ratio of its export prices to its import prices
If a country's inflation rate is expected to decrease, the relative value of its money is expected to___.
Rise. As a result any forward premium should widen, forward discount should shrink, nominal interest rate should be lower
The future value of a currency can be predicted with ___ and ___ markets.
Spot and Forward
What are the two types of speculation?
Stabilizing and destabilizing
A currency appreciates when there is a ___ in the current account.
Surplus
Forward Transactions
Takes place in the Forward market, currencies that are expected to get weaker in the future sell at a discount aka forward discount. Currencies that are expected to get stronger in the future sell at a premium aka forward premium.
How do major banks make money on the foreign exchange market?
They earn a profit on the spread between the "bid" and "ask" prices for foreign exchange. Can also earn profit by speculating on future exchange rate movements through arbitrage.
Retail Market
This consists of individual customers who buy and sell small quantities of currency on the foreign exchange market
Direct Exchange Rate
This expresses the price of a foreign currency in terms of the home currency
Indirect Exchange Rates
This expresses the price of the home currency in terms of the foreign currency
Foreign Exchange
This is a commodity consisting of currencies issued by countries other than one's own
Demand for Foreign Exchange
This is downward sloping, indicating that firms and individuals will demand less foreign exchange at higher prices. This is a derived demand.
Equilibrium Exchange Rate
This is the point where there is neither a surplus nor a shortage of foreign exchange. Aka Market-Clearing Price
Supply of Foreign Exchange
This is upward sloping, indicating that firms and individuals will supply more foreign exchange at a higher price. This is a derived supply.
Foreign Exchange (forex) Market
This promotes efficient cross-border trade by facilitating currency conversion. Also facilitates international investment and capital flows
Commercial Banking Services
This type of banking service exchanges currency, provides advice, facilitates short-term financing, electronic fund transfers, forward purchases
Investment Banking Services
This type of banking service locates debt and equity funding, arranges mergers and acquisitions. Commissioned for large corporations or wealthy individuals
What is the primary transactional currency?
US Dollar
At exchange rates below equilibrium there is an ___
Undersupply or shortage
Speculation occurs when..
When banks bet on the direction they believe the exchange rate will move by buying or selling currencies accordingly
What two categories can the foreign exchange market be split into?
Wholesale Market and Retail Market
Annualized Forward Premium or Discount=
[(forward price - spot price) / spot price] x [number of periods in a year]
Global Bond
a large, highly liquid financial asset that can be traded anywhere, at any time
Currency futures make up __ of the volume of trades on the foreign exchange market.
about 1%
Law of One Price
activity of buying and selling to amke a profit will eventually cuse the prices in these markets to converge
Convertible Currency
aka Hard Currency. They are freely tradable, you are allowed to trade them.
Inconvertible Currency
aka Soft Currency. They are not freely tradable. This is because foreigners do not want to hold them or the government places limitations on their purchase/sale.
Swap Transaction
aka Spot Against Forward. Currency is bought and sold at the same time, but delivery of the currencies is made at different times
Eurocurrency
currency deposited in a country other than in which it was issued
Call Option
gives the holder the right to buy foreign currency
Put Option
gives the holder the right to sell foreign currency
The Theory of Purchasing Power Parity(PPP)
if there is free trade, the exchange-rate-adjusted prices of goods should eventually equalize across countries
Majority of foreign exchange transactions involve ___ that amount to $1 million or more.
interbank exchange
Stabilizing Speculation
involves buying foreign currency at a low price with the expectation that the price will rise in the future. Or selling a foreign currency at a high price with the expectation that the price will fall in the future.
Destabilizing Speculation
involves buying foreign currency when the exchange rate is high, with the expectation that it will rise even higher in the future. Or selling currency when the exchange rate is low, with the expectation that it will fall even lower in the future
Arbitrage
involves the riskless buying and selling of assets to profit from a price discrepancy
Currency Option
is an agreement that gives its holder the right(but not the obligation) to buy or sell a certain amount of foreign currency at a future date and at a specified exchange rate
Currency Future
is an exchange-agreement to buy or sell currency at a specific price on a particular future date, based on a standardized, exchange-traded contract
Eurobonds
issued in one country and denominated in that country's currency, but sold to people in other countries
Foreign Bonds
issued in one country to the resident of another country and is denominated in the currency of the buyer's country
Euroloan Market provides..
large loans at low cost to credit-worthy buyers
Spot Transactions
one currency is exchanged for another within a period of two days(considered immediate). 33% of all foreign exchange transactions are this.
International Fisher Effect
refers to the fact that differences in nominal interest rates between countries are ultimately determined by differences in expected inflation rates between countries. It connects foreign exchange rates with interest rates and with inflation.
Forward Rate (aka forward price)
reflects the market's aggregate prediction about how the spot price will change
Transactional Currency
this is the currency used to make foreign exchange transactions
London Interbank Offered Rate (LIBOR)
this is the interest rate London banks charge other London banks for short-term (overnight) Eurocurrency loans
Three-Point Arbitrage
this type of arbitrage involves buying and selling three different currencies. If the cross rate is different from the direct rate, an opportunity for this kind of arbitrage exists.
Covered-Interest Arbitrage
this type of arbitrage involves opportunities that exist when interest rates do not fully account for the forward premium or discount on a currency.
Two-Point Arbitrage (aka geographic arbitrage)
this type of arbitrage overcomes geographical differences in exchange rates. Very rare because the get corrected so quickly
Terms of trade improve when...
when the prices of a country's exports increase more than the price of its imports increase
Correspondent Relationship
where one bank would act as another agents in another country