C. Foreign Exchange
1. Foreign-exchange market
- Foreign currencies and debt instruments bought
and sold by individuals, businesses, governments and banks
- Main currencies - U.S. dollar, Euro, Japanese yen,
British pound
- Largest markets are in London, New York, and
Tokyo
- Levels of market transactions
a. Commercial banks and customers
- Importers, exporters, investors, tourists
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b. Interbank market
- Use foreign-exchange brokers
- Buy and sell foreign currencies to maintain
desired balance
c. Trading with foreign banks
- Allow supply and demand of foreign exchange
to be matched
2. Types of transactions
a. Spot transactions (40.9%)
- Foreign exchange bought and sold for delivery
immediately ("on the spot")
- Cash settlement within two business days
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b. Forward transactions (13.6%)
- Agreement to exchange currency at a certain
rate some time in the future
- Use if it is known the foreign currency will
be received or needed at a specific date in the future
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c. Currency swaps (45.6%)
- Exchange one currency for another with
agreement to convert back at a specific date in the future
- Use if there is a temporary excess of one
currency and a need for another
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3. Interbank trading
a. Transaction classification
- Retail transactions - less than 1 million
currency units involved
- Wholesale transactions - more than 1 million
currency units involved
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b. Profitability
(1) Transactions
- Bid rate - price bank is willing
to pay for a foreign currency
- Offer rate - price at which bank
is willing sell a foreign currency
- Spread - offer rate - bid rate
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(2) Speculation
- Depreciation - takes more of a currency
to get another
- Sell currency and buy back later if
depreciation is expected
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- Appreciation - takes less of a currency
to get another
- Buy currency and sell later if
appreciation is expected
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- Exchange rate between any two currencies
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Pacific Exchange Rate Service
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4. Futures and options
a. Futures
- Can buy a fixed bundle of currency at a fixed
exchange rate some time in the future
- Traded on International Monetary Market in
Chicago Mercantile Exchange
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b. Options
- Gives holder the right to buy or sell foreign
currency at a fixed rate at some time in the future
- Call option - right to buy at a certain rate
(strike price)
- Put option - right to sell at a certain rate
(strike price)
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5. Exchange rate determination
a. Demand for foreign exchange
- Depends on debit items in balance of payments
- Imports
- Investments in a foreign country
- Transfer payments to a foreign country
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b. Supply of foreign exchange
- Depends on credit items in balance of
payments
- Exports
- Investments domestically by foreigners
- Transfer payments by a foreign country
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c. Equilibrium
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d. Impact of changes
(1) Changes in demand
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(2) Changes in supply
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e. Impact of appreciation and depreciation
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(1) Appreciation
(a) Advantages
- Lower prices for domestic consumers
of foreign goods
- Less expensive to travel overseas
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(b) Disadvantages
- Harder for exporters to compete
overseas
- Harder for import-competing
industries to deal with foreign products
- More expensive for foreign tourists
to visit
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(2) Depreciation
(a) Advantages
- Easier for exporters to compete
overseas
- Easier for import-competing
industries to deal with foreign products
- Less expensive for foreign tourists
to visit
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(b) Disadvantages
- Higher prices for domestic consumers
of foreign goods
- More expensive to travel overseas
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6. Exchange rate indexes
- Exchange-rate index (effective exchange rate)
- weighted average of bilateral exchange rates
- U.S. - trade-weighted dollar, major
currency index (Fed)
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- Nominal exchange rates - not adjusted for
inflation
- Real exchange rates - takes inflation into
account
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7. Arbitrage
- Simultaneous purchase and sale of a currency in
different foreign exchange markets
- Want to profit from discrepancies in values
- Leads to a single exchange rate
a. Two-point arbitrage
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b. Three-point arbitrage
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8. Forward market
a. Forward rate
- Exchange rate used to settle forward
transactions
- Premium - foreign currency worth more in the
forward market than in the spot market
- Discount - foreign currency
worth less in the forward market than in the spot market
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b. Hedging
- Avoid or cover foreign-exchange risk
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