Chapter 10: Foreign Exchange Market
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