Chapter 10: Foreign Exchange Market

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What affects supply and demand of currency?

- Exports (more exports = appreciation) - Imports (more imports = depreciation) - Capital inflows and outflows (inflows = depreciation; outflows = appreciation) - Inflation (depreciation) - Real (and nominal) interest rates (high = appreciation) - Political and Economic Risk (depreciation with more uncertainty) - Expectations regarding the future

Who are key actors?

- Interbank Market - Brokers - Central Banks

Economic Theories of Exchange Rate Determination

- Law of One Price - Purchasing Power Parity - Fisher Effect - International Fisher Effect

Major types of FX transactions:

- Spot Market - Forward Market

Managerial Implications

- Transaction Exposure - Translation Exposure - Economic Exposure

International trade involves essentially two transactions:

- Transfer of merchandise, services, and portfolio products - The exchange of currencies

Foreign exchange market is open:

24 hours a day (trading concentrated in UK, US & Japan)

Maturities of:

30, 60, 90, 120, 180, and 360 days

US dollar involved in:

89% of transactions

Cross Rate

An exchange rate computed from two other exchange rates

The Central Question:

At what rate should one currency be exchanged for another currency?

Interbank Market

Banks dealing with other banks in large volumes, usually involving transactions exceeding $1M

International Fisher Effect

Combines interest rates, inflation, exchange rates - The currency of the country with the lower nominal interest rate is expected to strengthen in the future

Spot Market

Exchange rates quotes for transactions that require immediate delivery or within two days

Arbitrage

Firms target country where price is greatest until prices even out because of increase/decrease of supply

Forward Market Transactions

Forward contracts allow firms to lock in a rate of exchange on funds required in the future

Purchasing Power Parity

Inflation differential across countries reflected in prices and ultimately the exchange rate

Arbitrage

Interest rates become even because of increase/decrease supply

Fisher Effect

Interest rates reflect expectations about future inflation rates

Depreciation

Less demand leads to a weakening of that currency against others

Appreciation

More demand leads to a strengthening of a currency against others

Soft Currency

Mostly not convertible; comparatively weak and unstable in value

Central Banks

National banks that implement government policies regarding currency values

Direct Quote

Number of units of the domestic currency needed to acquire one unit of the foreign currency (ex. in US, $/foreign currency)

Indirect Quote

Number of units of the foreign currency needed to acquire one unit of the domestic currency (ex. in US, foreign currency/$)

Exchange Rate $/Foreign = (PPP)

P $/P foreign

Brokers

Professionals who assist in the transfer of funds between banks and find most favorable currency prices

Forward Rate

Rate quoted for transactions that call for delivery at some future date

Interest Rate Parity

Real interest rates become equal through arbitrage

Lead vs. Lag Strategy

Strategies to speed up or delay the receipt or payment of FX

Central Question Answer:

Supply and demand for a currency relative to that of other currencies

Economic Exposure

The extent to which a firm's future international earning power is affected by changes in FX

Transaction Exposure

The extent to which income from an individual transaction is affected by fluctuations in FX

Translation Exposure

The extent to which the reported financial statements of a corporation are effected by fluctuations in foreign exchange values

Exchange Rate

The number of units of one currency needed to acquire one unit of another currency

Law of One Price

Under completely free trade, prices of comparable goods should be equivalent across countries

Hard (Vehicle) Currency

Usually fully convertible; strong and/or stable in value in comparison with other currencies

Growth in FX transactions has been:

astronomical

The spread in the spot market is the:

difference between the bid and offer rates

Not all currencies are:

fully convertible

The structure of the foreign exchange market is:

informal (no central place or floor where trading takes place)

In countries where inflation is expected to be high:

interest rates will also be high (higher interest rates mean more people want to invest)

Relationship between the 3:

low nominal interest rate = low inflation rate --> appreciation

Thousands of:

telecommunications links between financial institutions around the globe

When buying a good from one country, you have to pay for it in:

that country's currency (must exchange your currency for an equal value of the other country's currency)

Two quotes given by the FX trader:

the bid (buy) and the asking (sell) rates

If the nominal interest rate in one country is lower than that in another:

the first country's inflation rate is expected to be lower so that real interest rates are equal

A premium exists when:

the forward rate exceeds the spot rate

A discount exists when:

the forward rate is less than the spot rate


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