INTERNATIONAL ECONOMICS

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

• Round-the-clock trading

• 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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• Cross exchange rate

- Exchange rate between any two currencies

- 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

• Lower inflation

• 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

• Higher inflation

• 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

• Currencies bought and sold now for future delivery

• Done by banks to earn profits

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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