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Foreign Exchange Markets and Exchange Rates Foreign Exchange Markets and Exchange Rates

Foreign Exchange Markets • A network of systems and mechanisms through which currencies are Foreign Exchange Markets • A network of systems and mechanisms through which currencies are traded • Market actors: • • Banks Brokers (Brokerage firms) Business entities (merchants, corporations, etc. ) Individuals Governments Central banks International organizations

Foreign Exchange Rates • A foreign exchange rate is the price of (one unit Foreign Exchange Rates • A foreign exchange rate is the price of (one unit of) a currency in terms of another currency • There are nearly 200 currencies of which few than 50 are commonly traded internationally • Most currency trades take place in the form of transfer of bank deposits and clear without actual currency notes changing hands

Currency Quotes • Today: UK pound: $/Pd: 1. 83 Pd/$: 0. 546 Euro: $/Er: Currency Quotes • Today: UK pound: $/Pd: 1. 83 Pd/$: 0. 546 Euro: $/Er: 1. 25 Er/$: 0. 80 • A year ago: UK pound: $/Pd: 1. 64 Pd/$: 0. 609 Euro: $/Er: 1. 08 Er/$: 0. 925 • Currency cross rates

FX and Portfolio Management • An asset portfolio is a set or basket of FX and Portfolio Management • An asset portfolio is a set or basket of assets owned by an individual or a business entity • An asset has a value if it brings returns either in the form of incomes (earnings) or pleasure • A portfolio containing FX denominated assets could change in value as FX rates change

Types of FX Transactions • Spot transactions • Forward and futures transactions • Transactions Types of FX Transactions • Spot transactions • Forward and futures transactions • Transactions in FX derivatives (options) Forward and futures transactions: Buying or selling a certain amount of a currency at a predetermine (agreed upon) price for future delivery Currency options: Buying and selling options to buy or options to sell specific amounts of a currency at a preset price in the future

The Reasons Behind FX Trading • Clearing transactions • Arbitrage transactions: taking advantage of The Reasons Behind FX Trading • Clearing transactions • Arbitrage transactions: taking advantage of rate differentials (discrepancies) in different markets • Hedging transactions: Long and short positions • Hedging in the spot market • Other types of hedging • Speculation: Taking a long or a short position in a currency in the hope of profiting from a favorable change in the exchange rate • A person having a long position in the British pound hopes to see the pound appreciate.

Hedging • Hedging: A transaction made for the purpose of avoiding or reducing a Hedging • Hedging: A transaction made for the purpose of avoiding or reducing a business (FX fluctuation) risk. Positions in FX: No position Long position Short position Balanced or closed position • Hedging could be done in the spot market as well as in other FX markets

Hedging in the Forward Market • Suppose an American merchant has purchased five full Hedging in the Forward Market • Suppose an American merchant has purchased five full container loads of German beer at a total price of € 150, 000. She has agreed to pay for the merchandise 90 days after the merchandise is placed aboard the ship; she holds a short position in the euro. • To close her position she can purchase € 150, 000 in the forward market today. That would enable her to buy the amount of euros she would need in 90 days at a pre-determined rate. The forward contract would protect her from FX risk.

FX Markets and FX Rates: How Are FX Rates Determined? The Interest Parity Model: FX Markets and FX Rates: How Are FX Rates Determined? The Interest Parity Model: A note: A currency forward rate is an agreed-upon rate of exchange at which a certain amount of a currency is traded (bought or sold) on a certain (agreed-upon) day in the future. In the forward market a currency could be at a “premium” or at a “discount” ef - es Discount or premium (rate)= p = ------ (12/n) es Discount: p < 0 Premium: p > 0

I. Uncovered Interest Arbitrage Comparing rates of returns on assets denominated in different currencies: I. Uncovered Interest Arbitrage Comparing rates of returns on assets denominated in different currencies: Suppose: US interest rate: 12% UK interest rate: 16% One-year CDs in US vs. One-year CDs in UK Spot rate: 1. 80 Expected (future) spot rate in a year: 1. 70

Interest differential vs. Currency Appreciation or Depreciation Interest differential: (i$ - i £) %Change Interest differential vs. Currency Appreciation or Depreciation Interest differential: (i$ - i £) %Change in e = (ee – es)/es

 • $1000 invested in US, after 12 months: = $1000 ( 1+. 12) • $1000 invested in US, after 12 months: = $1000 ( 1+. 12) = $1120 $1000 invested in UK, after 12 months: Assuming e= 1. 80 ee = 1. 75 = (1000/e ) (1+. 16) ee = 1128 Invest in pound-denominated assets

 • $1000 invested in US, after 12 months: = $1000 ( 1+. 12) • $1000 invested in US, after 12 months: = $1000 ( 1+. 12) = $1120 $1000 invested in UK, after 12 months: Assuming e= 1. 80 ee = 1. 70 = (1000/e ) (1+. 16) ee = 1095 Invest in pound-denominated assets

What are we comparing? • Interest in the US, i$ , and the return What are we comparing? • Interest in the US, i$ , and the return on a pounddenominated asset; this return is affected not only by the UK interest rate, but also the (expected) change in the exchange rate: That is: i£ (ee/e) + (ee –e )/e If i$ < i£ (ee/e) + (ee –e )/e , investors will invest in pound-denominated assets. If i$ > i£ (ee/e) + (ee –e )/e , investors will invest in $-denominated assets.

Alternatively, • We can compare (i$ - i£ ) and (ee –e )/e If Alternatively, • We can compare (i$ - i£ ) and (ee –e )/e If (i$ - i£ ) > (ee –e )/e , dollar denominated assets will be chosen At parity : (i$ - i£ ) = (ee –e )/e

Covered Interest Parity • Investing a dollar in the US at %10: After 12 Covered Interest Parity • Investing a dollar in the US at %10: After 12 months: =$1 (1+ i$) = $1. 10 • Investing the same dollar in a pound-denominated asset (at 16%) and covering in the forward market, assuming e = 1. 80 and ef = 1. 75: = ($1/e) ( 1+ i£ ) ef = (ef /e) + (ef /e) i£ = 1. 127 $1 (1+ i$) < (ef /e) + (ef /e) i£ 1. 10 < 1. 127

Or, (1+ i$) ? (ef /e) + (ef /e) i£ Subtract 1 from both Or, (1+ i$) ? (ef /e) + (ef /e) i£ Subtract 1 from both sides i$ ? (ef /e) + (ef /e) i£- 1 i$ ? ([ef –e]/e) + (ef /e) i£ Assuming (ef /e) 1, and subtraction i£ from both sides, we write (i$ - i£) ? ([ef –e]/e) If (i$ - i£) < ([ef –e]/e), funds will. . ? If (i$ - i£) > ([ef –e]/e), funds will. . ? At parity: (i$ - i£) = ([ef –e]/e),

Does interest parity hold? The effects of changes in i$ , i£, ee, and Does interest parity hold? The effects of changes in i$ , i£, ee, and ef on e? Recall: (i$ - i£ ) = (ee –e )/e and (i$ - i£ ) = (ef –e )/e For example, if i£ increases, other things unchanged, e must rise. ($depreciation) Or, if ef decreases, other things unchanged, e must fall. ($appreciation)

FX Markets: Supply of and Demand for FX • Asset Demand • Transaction Demand FX Markets: Supply of and Demand for FX • Asset Demand • Transaction Demand Asset demand: Recall that the return on a FX asset: ([ef –e]/e) + (ef /e) i£ or ([ee –e]/e) + (ee /e) i£, given i$, i£, ee, and ef , is inversely related to FX rate, e. • As “e” increases the return on the FX asset decreases, making it less attractive.

e($/£) Demand for and Supply of FX S D 0 {i$, i£, ee, ef} e($/£) Demand for and Supply of FX S D 0 {i$, i£, ee, ef} £

Shifts in the Demand Curve • US interest rates : (-) • UK interest Shifts in the Demand Curve • US interest rates : (-) • UK interest rates: (+) • The pound forward rate (+) • The expected future £ spot rate (+)

FX Rate Regimes • Flexible (floating) rates » Appreciation » Depreciation • Fixed (pegged) FX Rate Regimes • Flexible (floating) rates » Appreciation » Depreciation • Fixed (pegged) rates » Revaluation » Devaluation • Managed floating rates • Exchange control

The Effective Exchange Rate • A bilateral exchange rate of a currency may not The Effective Exchange Rate • A bilateral exchange rate of a currency may not reflect the real value of a currency. • A currency may appreciate against some currencies while depreciating against others • The effective exchange rate of a currency is a weighted index reflecting the value of a currency relative to a multiple ( basket) of other currencies. (Often the currencies of the country’s major trading partners)