Chapter 13 The Foreign-Exchange Market The market for foreign exchange arises for tourism, exports/import, and international

l investment. Usually only tourism requires actual currency, the majority of the market for foreign exchange involves the transfer of bank deposits. For example, if GM needs to purchase 10m to pay for an order of foreign car parts, or needs to sell 10m it received for the sale of car engines, it wont actually use currency, it will use a bank transfer of funds. Most foreign exchange trading is done through an international network of large commercial banks, like JP Morgan Chase, to facilitate international trade for MNCs. Currency trading is virtual - automated and electronic, like NASDAQ, using computer terminals and telephones, with no physical market or trading. SPOT RATES Like many markets (commodities, stock indexes, T-bonds, currency), there is a) the spot (cash) market, where spot (cash) rates are quoted for immediate delivery (two days to clear for currency); and b) the forward or futures market, where forward rates are quoted for future delivery. Spot rates for foreign exchange are quoted in Table 13.1 on p. 337 (Jan. 31, 2003) and in the WSJ handout. Swiss francs are selling for $.7332/SF, and dollars are selling for SF1.3639/$, in amounts of $1m or more. For smaller amounts, the price will be higher. Example, an importer needs to buy $10,000 worth of SF, price might be $.75/SF instead of $.7332. $10,000 / ($.75/SF) = SF13,333.33. Or equivalently, $.75/SF = SF1.3333/$, so $10,000 x 1.3333 = SF13,333.33. General Rule: To convert $10,000 to a foreign currency, DIVIDE by the ex-rate if quoted as $/SF and MULTIPLY by the ex-rate if quoted as SF/$. Point: We want the dollars to cancel. The ex-rates in Table 13.1 are quoted as mid-range rates, which is the average of the bid (buying rate) ask (selling rate) spread. See Table 13.2 on p. 338 for the average spreads. For the SF, the bank will pay SF1.3571 to buy dollars and would sell dollars for SF1.3576, making .0005SF per dollar, or SF500 per $1m, and the midrange quote would be SF1.3574. At the bid quote, SF500 / SF1.3571 $368. Note that the spread represents a commission of only .0368% (or less than 1/25th of 1%), and is even less for the Euro (.0199%). The spread will _________ for currencies that are thinly traded, i.e., currencies with low volume and infrequent trading. Large commercial banks like Citibank stand ready to buy currency at the bid ex-rate and sell currency at the ask ex-rate, and help to make a market for foreign exchange. See currency symbols in Table 13.3 on p. 339. ARBITRAGE Riskless profit opportunities requiring no investment, by exploiting price discrepancies. Since the dollar is homogeneous and fungible, it should sell at the same ex-rate everywhere according to the price equalization principle, or the Law of One Price. Suppose SF is selling at a bank in NY for $0.63 and at a bank in London for $0.64. A currency trader could make arbitrage profits by _____ the SF in ______ and _______ the SF in ___________, to make profit of $0.01 per SF, or $10,000 per SF1m, minus any transaction costs. The buying pressure will increase the value of the SF in ______ and the selling pressure will decrease the value of the SF in ________, restoring a uniform exrate.

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Triangular arbitrage is also possible involving three currencies, e.g., selling $1m for BPs, selling BPs for SF, selling SF for USD, and ending up with more than $1m. For example, suppose we have these three ex-rates: $/ = $1.90 /SF = 0.20 $/SF = $0.40 Start with $1.9m and buy 1m ($1.9m / $1.9/ = 1m), and then buy SF5m (1m / .20/SF = SF5m), and then buy $2m (SF5m x $0.40 = $2m), for an arbitrage profit of $100,000, ignoring transaction costs. Arbitrage trading would quickly eliminate the ex-rate discrepancies, and eliminate arbitrage opportunities. In equilibrium, there should be no arbitrage opportunities in efficient markets. Cross-rates are displayed in Table 13.4, p. 341. Most currency trading and quotations involve the dollar, from which cross rates can be determined: If $1.6472/ and $1.0765/, then we can calculate the cross rate: 1.5301/ (1.6472 / 1.0765). See Figure 13.1 on p. 342 for the global currency trading cycle. Trading is 24/7, but is most active during overlap between US and European markets (our markets open before London market closes), and Europe and Asia (late in the trading day for Asia, early part of the day in Europe). FORWARD RATES The largest part of the foreign exchange market is for forward currency contracts at the forward rate in the forward market, to avoid currency risk. Forward rates are typically quoted for 1 month, 3 months and 6 months, see Table 31.1, but are available for other maturities. Example: U.S. importer places an order for Swiss watches for delivery in 3 months, the contract is invoiced for SF100,000, payable in 3 months. Importer could just wait and buy SF in the spot market in 3 months, but would be exposed to currency risk of ___________. At the current spot rate of $0.7332/SF, SF100,000 would cost $73,320, but what if the SF appreciated and the dollar depreciated, and the future spot rate ended up being $0.75? The watches now cost $75,000, or $1,680 more, a 2.29% increase. If the SF depreciated and the dollar appreciated, to $0.72/SF, then the order would cost only $72,000, a 1.8% decrease in price. POINTS: 1. Exchange rates change daily, exposing exporters and importers to significant currency risk, when future payments or future revenues are invoiced in a foreign currency. 2. Currency risk can be either: a) positive and beneficial or b) negative and detrimental. The importer could consider using a forward contract for SF to eliminate currency risk, by locking in at the F 90 = $0.7346, and buying the SF forward for 90 days. Now the importer locks in a price to buy SF in 3 months, and locks in a price of $73,460 for the watches, and doesnt a) have to worry about currency risk and b) doesnt have to bother with buying SF today and investing for three months in Switzerland (another option). Forward markets are really insurance markets for hedging or eliminating currency risk. Note: By observing and comparing the spot rates and the forward rates, we can determine whether the dollar or SF is expected to appreciate or depreciate by observing whether the dollar or SF is selling at a forward premium
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(expected to appreciate), or a forward discount (expected to depreciate). Forward discounts/premiums are expressed as a percentage (%). Spot Rate: Forward Rate: S($/SF) = F180($/SF) = $0.7332/SF $0.7360/SF

The SF _________ and the USD ____________. The SF is selling at a forward __________ and the USD is selling at a forward ___________ . The percentage change is calculated as: [(F S) / S ] x 100 [(.7360 - .7332) / .7332] x 100 = .38% Therefore, the SF is selling a 6-month forward __________ of .38% and the USD is selling at a 6-month forward ____________ of .38%. To annualize, we would multiply by 2x, and would get a one-year discount or premium of .76%. CURRENCY FUTURES MARKET Futures contracts for currency are similar in principle to forward contracts, except for these differences: 1. Forward contracts are completely flexible in terms of amount ($1m and over) and settlement date, whereas futures contracts are standardized amounts on fixed expiration dates. For example, currency futures contracts are for 12.5m (about $115,000), C$100,000, (about $80,000) 62,500 (about $112,500), SF125,000 (about $102,000), for settlement dates in March, June, September and December. A forward contract can be customized, allowing a client to buy/sell SF20m in November on any day, which is not possible with a futures contract. 2. Forward contracts are usually private, customized contracts between a bank and a client, with no secondary market. Standardized futures contacts are traded on the secondary market, e.g., Chicago Mercantile Exchange, Chicago Board of Trade and the NY Board of Trade. 3. Forward contracts are settled in the actual currency, futures contracts are usually settled in cash. 4. Forward contracts are usually used for hedging only, futures contracts are used for hedging currency risk and speculating (pure investment) on currency. 5. Forward contracts are offered as part of commercial, wholesale banking activity for large MNCs with large minimums ($1m), whereas currency futures are part of the larger derivatives market, and offer smaller contracts for smaller firms. Example of a speculative position in December currency futures for the at $1.80/:

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Long

Profit

F90 = $1.80

Spot Rate at Expiration

Loss

Short Currency contracts are available to buy (go long at $1.80/) the BP, or sell (go short at $1.80/) the BP. If a speculator thinks that the BP will actually be trading in the spot market at $1.82/ in December, he/she will take a _________ position and ________ the BP at $1.80/. One contract is for 62,500. If the BP is trading at $1.82/ in December, the speculator has made a profit of ($1.82/ - $1.80/) x 62,500 = $1,250. If the BP is trading at $1.77/, the speculator has lost $1,875 ($1.77/ $1.80/) x 62,500. If the speculator goes short on December BP futures contracts, the payoffs would be the opposite of the long position. At $1.82/, the short position would gain/lose ________ and at $1.77/ the short position would gain/lose_________. Currency Futures for Hedging GM has to pay 10m in three months for a delivery of parts from Germany invoiced in euros. Worried? Over the next three months: $______ and ______ . For example, suppose the spot ex-rate is $1.25/ and remains constant for 3 months, the parts will cost $12,500,000 ($1.25/ x 10m). If the euro appreciates by 4% over the next three months, the ex-rate will be ____ and the parts will now cost _________, an increase of _________. Suppose that 3-month euro futures contracts are priced at $1.2550/. Euro contracts are for 125,000, so GM would need 80 contracts to cover the 10m. GM would take a _________ position to hedge against the euro __________. Settlement will be in cash, not euros.

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Long

Profit

F90 = $1.2550/

Spot Rate at Expiration

Loss

Short Suppose the euro is trading at $1.30/ in 3 months. GM will separately: a) settle the futures contracts and b) buy the euros in the spot market. a. Gain on futures ($1.30/ $1.255/) x 10m = +$450,000 profit. b. Purchase 10m @ $1.30 = ($13,000,000) Net cost of buying the euros: -$13m (spot) + $.45m (futures) = $12.55m (or $1.255/) Suppose the euro is $1.20 in 3 months. GM will separately: a) settle the futures contracts and b) buy the euros in the spot market. a. Loss on futures ($1.20 $1.255) x 10m = -$550,000 loss. b. Purchase 10m @ $1.20 = ($12,000,000) Net cost of buying the euros: -$12m (spot) - $.55m (futures) = $12.55m (or $1.255/) CONCLUSION: With futures contracts at $1.255/, GM guarantees an ex-rate of $1.255/ and a total cost of $12.55m, regardless of what happens to the euro. Even though GM locks in an ex-rate of $1.255/, it doesnt actually buy euros at that rate. It will buy the 10m in the spot market in three months, and at the same time, settle the futures contract in CASH. If GM entered into a forward contract at $1.255/, then it would actually buy the euros at $1.255/. Forward contracts: Lock in a rate, settlement in currency (buy or sell foreign exchange) Futures contracts: Lock in a rate, settlement in cash FOREIGN CURRENCY OPTIONS Currency options are another hedging tool, to protect against currency risk. Suppose that a U.S. importer is buying SF1m of Swiss watches, payable in three months. Current spot rate is $0.6371/SF, and the importer is worried that the $ will __________ and the SF will ____________ over the next 3 months. At the current spot rate, the cost in USD will be $637,100. Suppose that SF call options are available at a price (premium) of $0.0092/SF for a 3-month option contract of SF62,500, with an exercise (strike) price of $0.65/SF. To cover the entire SF1m, the importer would need to buy 16 call options @ $575 (premium) each, or $9,200 in total premium costs. The call option gives the buyer,
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the right, but not the obligation, to buy SF at the exercise price of $0.65/SF in three months. For this right, the call buyer (importer) is paying a premium of $0.0092 NOW to have the option to buy SF1m at $0.65, as insurance against an appreciation of the SF above $0.65. Cost of insurance = $9,200 ($0.0092 x SF1m). Suppose that in 90 days, the spot rate is $0.68/SF. The importer exercises the option and buys SF1m at $0.65/SF, for a total cost of $650,000. With the premium of $9,200, the total cost of buying the SF1m is $659,200 using the call option vs. $680,000 without the call option, for a savings of $20,800. If the spot rate in 90 days is $0.63/SF, then the importer will let the option expire, and will use the spot market and buy SF @ $0.63 instead of exercising the call option and buying at $0.65. In this case, the total cost will be $630,000 (spot) + $9,200 (premium) = $639,200, vs. $659,200 using the option, so it is cheaper to let the option expire and use the spot market. Strategy with Call Option: Paying a premium of $9,200 in advance guarantees that the maximum price in dollars for the importers order will be $659,200 ($0.65/SF exercise price + $0.0092/SF premium = $0.6592/SF x SF1m = $659,200). Sets an upper limit on the cost of the order in dollars for protection, but also allows for potential cost savings if SF depreciates. With a forward contract, the ex-rate is fixed in advance. With a call option, a ceiling or limit is set ($659,200), with the possibility of cost savings if the SF drops and dollar appreciates. PAYOFF DIAGRAM OF SF CALL OPTION
PROFIT

Ex-Price

0
$0.0092

$0.65/SF

$0.6592

LOSS

Where Premium = $0.0092/SF, Strike Price/Exercise Price = $0.65/SF. Note: Usually the options are settled in cash, not the currency. For example, calculate the cost to the importer under four spot rates for S($/SF) in 3 months: $0.62/SF, $0.64/SF, $0.68/SF and $.70/SF, assume that option contract is settled in cash and the company buys SF at spot ex-rate:
S($0.62/SF): 1m SF x $.62 = $620,000 + __________ = _____________ Total Cost Exercise or Not? S($0.64/SF): 1m SF x $.64 = $640,000 + __________ = _____________ Total Cost Exercise or Not? S($0.68/SF): 1m SF x $0.68 = $680,000 ___________ = _____________ Total Cost
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($.68/SF - $.6592/SF) SF1m = ____________ S($0.70/SF): 1m SF x $0.70 = $700,000 ___________ = _____________ Total Cost ($.70/SF - $.6592/SF) SF1m = ____________

CENTRAL BANK INTERVENTION Central banks intervene in the foreign exchange markets to influence the value of their currency and other currencies. For example, see Figure 13.2 on p. 349, market for USD and BP, ex-rate = $/. Suppose ex-rate is initially $1.60/, and then there is an increase in demand for British goods, services and/or assets, which increases the demand for BP to D, and appreciates the BP to $1.70/, which now makes British goods _________ expensive to Americans. A 100 good in England will now increase in price in the U.S. from _____ to _____. To make U.K. goods competitive in the U.S. market, and maintain or increase exports, the Bank of England may decide to intervene in the foreign exchange market, with [expansionary or contractionary?] monetary policy, to [increase or decrease?] the supply of BPs and [appreciate or depreciate?] the BP. The central bank will [buy or sell?] USDs and [buy or sell?] BPs, to [appreciate or depreciate?] the USD and [appreciate or depreciate?] the BP. The supply curve for BP will shift to S and the BP will go back to $1.60/. Movement: A to C to B. If the BP was depreciating to $1.50/, and the Bank of England wanted to help stimulate the British [export or import?] sector of the economy, it would decrease the supply of BPs by [buying or selling?] BPs and [buying or selling] USDs, to [appreciate or depreciate?] the BP back to $1.60/. Case Study: The Chinese central bank has pursued an interventionist policy for the last ten years to peg the value of the Chinese currency (Yuan) at about Y8.2765/$, see graph:
8.8 8.7 8.6 YUAN/$ 8.5 8.4 8.3 8.2 94 95 96 97 98 99 00 01 02 03 04 CHINESE YUAN PER DOLLAR, 1994-2004

Notice that in 1994, the dollar started to [depreciate or appreciate?] and the Yuan started to [depreciate or appreciate?] which would have made Chinese exports to the U.S. [more or less?] expensive. Because of our ongoing trade deficit with China (M > X), the Yuan would naturally start to [appreciate or depreciate?], which would make their products [more or less?] expensive in the U.S., and U.S. products [more or less?] expensive in
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China. Therefore, Exports to China would go [down or up?] and Imports from China would go [down or up?], which would lead to a [smaller or larger?] trade deficit, or a trade balance or trade surplus. To prevent the Yuan from appreciating and the dollar from depreciating, the Chinese central bank has been [buying or selling?] Yuan and [buying or selling?] dollars to maintain the pegged ex-rate at Y8.2765 for two purposes: 1. Prevent ex-rate ________________ 2. Maintain or enhance the competitiveness of Chinas products. BLACK MARKETS AND PARALLEL MARKETS In developed economies, foreign exchange is openly sold and traded, and market ex-rates prevail and are generally universal, and there is no black market for foreign currency. For example, if you go to U.K. with dollars, you will get about 0.56 for every dollar, whether you go to a bank or hotel or currency exchange, etc. You wont be about to go out on the street and find currency dealers willing to give you .60 or more per dollar. But in developing economies, there are often restrictions on foreign currency trading and foreign currency holdings, and the government often imposes an artificial official ex-rate, which deviates significantly from the true market rate. As a consequence, black markets for foreign currency develop, either illegally, or often as a parallel market, where more of a true, market ex-rate is determined. For example, suppose that in the Soviet Union, the official ex-rate is 30 Rubles to the dollar, R30/$, indicating that the Soviet government will buy dollars for R30. Perhaps the true market rate is closer to R50, so there is a black market or parallel market for dollars, where you can get the official rate of R30 at a bank, but you can get R50 on the street, or at a hotel, restaurant or store. Why would Russians or foreigners in other countries be willing to pay a premium for dollars, over the official ex-rate?

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