The Foreign Exchange Market Exchange Rates 1/12/01 German Mark: Japanese Yen: British Pound: EMU Euro:

DM2.0554 per US dollar ¥118.53 per US dollar $1.4778 per £ $0.95222 per €

__________ terms: the foreign currency prices of a dollar __________ terms: the dollar price of a unit of foreign exchange

Appreciation and Depreciation E$/¥ = the price of the yen in terms of dollars A rise in E$/¥ ⇒_______________ of the yen against the dollar; _______________ of the dollar against the yen A fall in E$/¥ ⇒_______________ of the yen against the dollar; _______________ of the dollar against the yen

Example In Munich, a bratwurst costs €2 = PB€ In Boston, a hot dog costs $1 = PH$ If E$/€ =1.5, then PB$ = E$/€ PB€ = 1.5 x 2 = $3.0. So PB$/ PH$ =3.0/1.0 = 3.0 hot dog per bratwurst If E$/€ =1.25, then PB$/ PH$ = per bratwurst

= _____hot dog

A hot dog becomes more expensive relative to a bratwurst.

Euro € Jan. 1999 ~ EU: Austria, Belgium, Germany, Finland, France, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain. Not participate: __________, __________, __________ 2002: euro completely replaces national currencies.

Appreciation and Depreciation (cont’d) An appreciation of a country’s currency makes its goods -______ expensive for foreigners, and makes foreigners’ goods ______ expensive for the country’s residents.

An appreciation of a country’s currency ________ the relative price of domestic goods and ________ the relative price of foreign goods.

Foreign Exchange (FX) Market The FX market is an ____________________ market. i.e. there is ___ physical location where traders get together to exchange currencies. Rather traders are located in the offices of major commercial banks around the world and communicate using computer terminals, telephones, telexes, and other information channels.

FX market (cont’d) The FX market is almost a 24 hour market. The major foreign exchange trading centers are in ________, New York, and Tokyo --- 60% Zurich, __________, and Hong Kong --- 20%

FX market (cont’d) Participants Importers and exporters, ____________ managers Commercial banks Foreign currency brokers Central banks Size: $

trillion per day in 1998.

Market-makers Traders in the major money center banks around the world who deal in two-way prices. They announce ______ and ______ prices at which they will exchange two currencies. The difference between the two prices is referred to as the ____________________, which is traders’ profits. Bid (ask or offer) price = a price at which a trader is willing to _____ (_____).

Brokers Individuals who match up buy and sell orders from two different parties. About 85% of all FX trading is between _______________. Less than 15% is commercial business (by companies engaged in trade, by tourists etc.)

FX trading ____________ traders are major players in FX market. 90% of trading takes place with respect to the ____________.

The reasons for quoting most exchange rates against a common currency (a “_________ currency”) Avoid informational complexity Avoid the possibility of ______________ arbitrage

Three types of transactions __________ __________ __________

Spot transaction An agreement on ________ today, with ____________ usually two business days later. Settlement = actual __________ of currency for currency In the case of the US dollar for the Canadian dollar (or the Mexican peso), settlement is on the ______ day of the transaction.

Forward transaction An agreement on price today for settlement at some date (called the “_______ date”) in the future (one or two weeks, or 1 ~ 12 months). Example Exxon has a scheduled payment of £25 million in 8 months and buys that amount of British pounds ________ today. No ________ will change hands now.

Swap A sale (purchase) of a foreign currency with a simultaneous agreement to ______________ (________) it at some date in the future. Usually in the ____________ market Example Citibank buys DM 2.5 million from Deutsch Bank for $1 million, with a simultaneous agreement to ______ the DM back in 6 months for $1.05 million. $50,000 = swap rate.

FX transaction 65% of transactions: ______ 33% of transactions : ______ 2%

: (outright) ________

Spot against forward Tomorrow next Forward-forward

Forward Premium and Discount If the value of a foreign currency is greater (less) forward than it is spot, the foreign currency is said to be at a _________ (___________). Example The spot DM is DM2.0554 = $1 in Jan. 12, 2001, and the one-month forward DM is DM2.0536 = $1. So the onemonth forward DM is at a __________. It takes less DM to buy $1 forward than it takes to buy $1 spot.

Futures Contract A bet on the __________ of price (exchange rate) movement of the underlying currency. If you buy (sell) a futures contract or go ________ (go ________), and the futures price goes ______ (______), you make money. If you stop an FX futures bet prior to the end of trading on the last trade date, you do not have to ______ or _________ currency. Profits and losses are paid over ____________ at the end of trading.

Futures Contract Example Suppose a £62,500 futures contract is opened during Day1 at a negotiated price of $1.4500/£ and the settlement prices are Opening price: $1.4500/£ Settlement price, Day 1: $1.4460 Settlement price, Day 2: $1.4510 then the cash flows for long and short positions are _________Long Short Day1: ( )x62,500 = -$ +$ Day2: (

-

)x62,500 = +$312.50

-$

The brokerage firm requires a certain amount of cash deposited with it as a security bond (this is called ________). The brokerage firm will in turn post margin with a __________________, which will then guarantee both sides of the futures contract against default by the other party. International Monetary Market (IMM) of Chicago Mercantile Exchange (CME) Trading on a floor for standardized contracts 4 value dates: the 3rd Wednesday of March, June, September, and December. Example: 125,000 marks, 100,000 Can dollars, 62,500 pounds, 12,500,000 yen. Quotes are always in ____________terms. Prices not allowed to vary more than a certain amount in a given day (______________). London International Financial Futures Exchange (LIFFE) Differences between Forward contracts and Futures contracts The daily cash flows take place on a futures contract. In a forward contract, ____________ will change hands until the contract expires. Because the time pattern of cash flow is different, your opportunity cost is different.

To read futures price quotation: Hedging with futures Suppose you have accounts receivable denominated in British pounds. There is an ________________: The dollar value of the account receivable will drop if the British pound loses value with respect to the dollar. To hedge this risk, you go ________ pound futures. If the pound loses value in dollar terms, you will make money, which will offset the loss in the value of your account receivable.

Foreign Currency Options Option: The ______ (but not obligation) to buy or sell something at a specified price (________________). You want to use the contract if you want to. Potential loss is limited. Option to ______: Call Option to ______: Put At a specified date: __________ option At any time prior to a specified date (expiration date, maturity): __________ option

Foreign Currency Options (cont’d) Example An importer has to make a 31,250 Br. pounds payment in 90 days. He buys a call option at $.0422 per pounds in FILX. The strike price is $1.975. Thus, the importer pays $1,318.75 for the right to buy pounds any time within 90 days at $________ per Br. Pound. Suppose that at the end of 90 days the pound is at $2.05. Then the importer saves 2.05 x 31,250 – 1,318.75 – 1.975 x 31,250 = $1,025 He makes a windfall profit.

Foreign Currency Options (cont’d) A Call (Put) on Futures The call (put) buyers pays the __________ to the writer in order to acquire the right (but not obligation) to go long (short) an exchange —traded FX futures at the strike price. Foreign currency options on spot and futures can be considered types of ____________ against adverse exchange rate movements.

What else? Central-Bank Intervention To drive the value of their currencies to certain desirable levels, the ________________ sometimes buy or sell currencies in the FX market. CBs often use ______ arrangements for this purpose, which are facilitated by the ______ in many cases. In developing countries, governments often restrict foreign exchange transactions. ⇒ ________ market The government allows a free market to coexist with the official market. ⇒ ____________ market