Introduction to Foreign Exchange

230-758 Advanced International Economics

Dr. Jeffery Heinrich

Agenda
Define and interpret exchange rates. Describe foreign exchange market actors and characteristics. Consider foreign exchange risk. Describe the instruments of foreign exchange trading meant to manage this risk. Briefly discuss hedging and speculation as strategies to manage and exploit risk.

Exchange Rates

Exchange Rate = Relative Price of Currencies

Direct or Natural or Right Quote/American Terms

dollar price of 1 unit foreign currency; $/FX1 = dollars per unit foreign exchange used in futures market

Indirect or Reverse or Left Quote/European Terms

foreign currency price of $; FX/$1 used in Cash market. Most currencies quoted this way, except

Indirect Quote is inverse of Direct Quote Here, E = exchange rate in American Terms; is inverse of exchange rate used in text (R = 1/E) .

Using Exchange Rates

Comparing Prices in Different Currencies

P = E P*, where P = price (* = foreign), E = exchange rate E = $ depreciation (lower value of $)

$ price of foreign goods higher; FX price of U.S. goods lower U.S. Net Exports (Exports less Imports in dollar terms) increase; foreign net exports (in foreign currency terms) fall

E = $ appreciation
$ price foreign goods lower; FX price of U.S. goods higher. U.S. Net Exports fall; foreign net exports increase

Example

US made computer, $ price = $2000 E1 = .5162 $/DM; E2 = .6 $/DM DM price P* = P/E P1* = DM 3874.47; P2* = DM 3333.33 $ has depreciated; $ costed good has lower DM price! DM price of $: 1/E1 = 1.937 DM/$; 1/E2 = 1.667 DM/$

Actors in the Foreign Exchange Market

Commercial & Investment Banks (Inter-bank market)

amounts > $1m, typically $10m liquid market (vis--vis loans) with limited credit exposure for clients and themselves allows bit players to economize on transactions costs

Central Banks

non-commercial motives relatively small portion of trading volume may intervene to address perceived economic/financial imbalances partnership of high net-worth individuals highly leveraged global investing add liquidity, flexibility, and sometimes instability to FX markets

Hedge Funds

Actors, cont.

Corporations

mostly act through intermediaries tourists ~ insignificant volume

Individuals

Intermediaries Brokers

mostly service commercial banks and trading houses anonymous connected to many banks ~ shop for best price (exchange rate)

Direct Dealing

through dealing system ~ e.g., Reuters, Quotron quotes valid for 20 sec.

Physical Market

Daily Turnover in excess of $1.5 trillion

more than 50 times U.S. daily GDP; more than 30 times global goods and services trade FX market activity far in excess of that necessary to purchase global output!

Major Markets: London, New York, Tokyo

trading around the clock

more than half of all trades against US$ lower transactions costs when trading indirectly against US$, even if $ not actually needed. , also function as lesser vehicle currencies

US$ as vehicle currency

Spot Market for Foreign Exchange

Spot Market value date = 2 days (to clear)

WSJ gives Ask/Offer Rate ~ selling price Any published rate is for a specific time may change 15,000 times a day or more. BID (buying) rate and ASK rate
e.g., monitor might show CAD 1.5223-28 (per US$). BID = 1.5223, ASK = 1.5228. Spread is 5 pips, where pip is last decimal.

Spreads

Spread is a transaction cost Spread is larger for more thinly traded (lower liquidity) currencies Central Bank intervention influences supply and/or demand

Rate Determination ~ supply of and demand for currencies.

Arbitrage: Buy Low, Sell High

Exchange Rates will be equalized across markets/actors Example: let $/DM = .5 in NY, and = .55 in Frankfurt

profitable to buy DM in NY, sell DM in Frankfurt

$1000 DM2000 in NY $1100 in Frank. profit $100

Demand for DM in NY, ENY Supply DM in Frankfurt, EFrank. : Exchange rates converge! Highest ASK no lower than lowest BID ~ Difference in Exchange Rates no larger than transaction cost! Cross-rates must correspond to pairs of direct rates
$/DM in NY = .5; DM/ in Frank. = 3; then /$ in London must be 0.667

Triangular Arbitrage

Foreign Exchange Risk

Spot Rates may change in a way that makes a transaction less (or more) profitable.

You are uncovered if you depend on spot market

e.g., 10m account payable due in 90d. If you wait 90d to buy yen and $ depreciates, the 10m costs you more.

Types of Risk Exposure

Translation Exposure Economic Exposure Transaction Exposure

domestic currency value of future transactions.

Managing XR Risk: Forward, Futures, and Option Markets

Forward Markets

Buying & Selling currency for future delivery ~ 30, 90, or 180 days Contract stipulates amount traded, the price, and value date

price = forward rate = F ($/unit foreign currency) F may be quoted outright (actual quote), or by forward spread (from spot rate; used by dealing systems). F < E ~ fewer $ to buy FX in future than now; $ trading at forward premium F > E ~ forward discount signs reversed if use indirect quote
e.g., CAD 1.5228 (per US$) spot, 1.5244 180d fwd CAD at forward discount, $ at forward premium

Forward Premiums and Discounts

Forward Markets, cont.

Forward rates reflect relative rates of return and expectations of future exchange rates. Actors using forward contracts are covered or hedged. Problems with Forwards

Default Risk Illiquidity ~ contracts customized, limited transferability Solutions: short maturity; margins; limited clientele. Combine two transactions into one Foreign Exchange Swap: spot trade with opposing forward trade Currency Swap: firms borrow domestic currency, swap principal w/ foreign firm ~ cheaper foreign currency borrowing.

Swaps

Futures
Like Forward, except

active secondary market standardized contracts ~ fewer currencies, standardized value and expiry date smaller than forwards ~ more accessible to smaller businesses a clearing house guarantees contract against default, requires margin against unprofitable positions.

day-to-day losses & gains posted against margin deposit; defaulting only saves last days losses, not cumulative losses. if margin account falls too low, have to top it off

Options

Underlying Asset = future or spot cash Right, but not obligation, to buy or sell at strike price

CALL ~ right to buy PUT ~ right to sell Premium ~ up-front cost of obtaining right American vs. European options

Protects against unfavorable spot XR changes, while not limiting ability to exploit favorable spot XR changes

In the money ~ can profitably exercise option CALL in the money when currency appreciates; hedge accounts payable in foreign currencies PUT in the money when currency depreciates; hedge accounts receivable in foreign currencies STRADDLE: CALL and PUT ~ in the money for any large swing in exchange rates ~ useful for highly volatile currencies

Hedging and Speculation

Distinction can be fuzzy, but

hedge = reduced risk; speculation = increased risk Speculation

long position ~ buy FX (any contract) to sell at higher-than-expected future spot XR (future spot higher than expected by market) short position ~ sell FX you dont have for future delivery at what you think is higher than expected future spot price; buy spot in future, close your position at a profit (future spot less than expected)

Example

C$5m account payable due 90d. E (spot) = .69$/CAD, F = .67$/CAD. Call option strike = .68$/CAD. Expect $ depreciation. Future spot = .72 exercise option, save .03/CAD or $150,000 over previous spot, though F @ .67 was better. Future spot = .65 just buy spot; save .02/CAD over fwd