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