Foreign Exchange Markets

8-1McGraw-Hill/IrwinChapter NineForeign Exchange Markets9-2McGraw-Hill/IrwinOverview of ForeignExchange MarketsToday’s U.S.-based companies operate globallyEvents and movements in foreign financial markets can affect the profitability and performance of U.S. firmsForeign trade is possible because of the ease with which foreign currencies can be exchangedU.S. imported $2.9 trillion worth of goods in 2007U.S. exported $2.2 trillion worth of goods in 2007Internationally active firms often seek to hedge their foreign currency exposure9-3McGraw-Hill/IrwinForeign ExchangeForeign exchange markets are markets in which cash flows from the sale of products or assets denominated in a foreign currency are transactedForeign exchange marketsfacilitate foreign tradefacilitate raising capital in foreign marketsfacilitate the transfer of risk between market participantsfacilitate speculation in currency valuesA foreign exchange rate is the price at which one currency can be exchanged for another currency9-4McGraw-Hill/IrwinForeign ExchangeForeign exchange risk is the risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange ratesCurrency depreciation occurs when a country’s currency falls in value relative to other currenciesdomestic goods become cheaper for foreign buyersforeign goods become more expensive for domestic purchasersCurrency appreciation occurs when a country’s currency rises in value relative to other currencies9-5McGraw-Hill/IrwinForeign ExchangeForeign exchange markets operated under the gold standard through most of the 1800sU.K. was the dominant international trading country until WWII forced it to deplete its gold reserves to purchase arms and munitions from the U.S.1944: Bretton Woods Agreement fixed exchange rates within 1% bands1971: Smithsonian Agreement increased bands to 2 ¼%1973: Smithsonian Agreement II introduced “managed” free float9-6McGraw-Hill/IrwinForeign ExchangeForeign exchange markets are the largest of all financial markets: turnover averaged $3.2 trillion per day in 2007London accounts for 42.5%New York accounts for 23.8%France accounts for 7.1%Prior to 1972, the only channel through which foreign exchange occurred was through bankstwenty-four hours a day over-the-counter (OTC) market among major bankselectronic trading of spot and forward contracts over 90% of contracts are settled with delivery of currency9-7McGraw-Hill/IrwinForeign ExchangeOrganized markets have existed since 1972International Money Market (IMM) (a subsidiary of the Chicago Mercantile Exchange (CME)) is based in Chicagoderivative trading in foreign currency futures and optionsless than 1% of contracts are completed with delivery of the underlying currencyIn 1982 the Philadelphia Stock Exchange (PHLX) became the first exchange to offer around-the-clock trading of currency options9-8McGraw-Hill/IrwinThe Euro (€)The European Community (EC) was formed in 1967 by consolidating three smaller communitiesEuropean Coal and Steel CommunityEuropean Economic MarketEuropean Atomic Energy CommunityThe Maastricht Treaty of 1993 set the stage for the eventual creation of the Eurocreated an integrated system of European central banks overseen by a single European Central Bank (ECB)The Euro (€), the currency of the European Union (EU), began trading on January 1, 1999 when eleven European countries fixed their currencies’ exchange ratiosEuro notes and coins began circulating on January 1, 20029-9McGraw-Hill/IrwinThe Euro (€)The U.S. dollar depreciated against the euro in the mid 2000sThe Central Bank of Russia has replaced some of their U.S. dollar reserves with euros, as has the Chinese Central BankIn 2007, 39% of foreign exchange transactions are denominated in euros, compared to 32% denominated in U.S. dollars9-10McGraw-Hill/IrwinThe YuanIn the early 2000s the international community pressured China to allow its currency (the yuan) to float freely instead of pegging it to the U.S. dollara depreciated U.S. dollar had caused the yuan to become undervaluedChinese exports were relatively cheap, which hurt domestic manufacturing in other countriesOn July 21, 2005 the Chinese government began a policy of “managed” floatglobal interest rates and oil prices have since risenChina has cut back on foreign securities purchases9-11McGraw-Hill/IrwinForeign ExchangeForeign exchange rates may be listed two waysU.S. dollars received per unit of foreign currency (in US$)foreign currency received for each U.S. dollar (per US$)Foreign exchange can involve both spot and forward transactionsspot foreign exchange transactions involve the immediate exchange of currencies at current exchange ratesforward foreign exchange transactions involve the exchange of currencies at a specified exchange rate at a specific date in the future9-12McGraw-Hill/IrwinThe U.S. Dollar ($)The largest foreign holders of U.S. dollars are China, Russia, Brazil, and IndiaThe U.S. dollar depreciated between 2002 and 2007 as, among other things, relatively high interest rates in the euro area attracted investment capital away from the U.S.There has also been a high volume of Asian central bank interventionJapanese Ministry of Finance increased U.S. asset purchasesChinese Monetary Authority bought U.S. dollar reserves, but maintained a pegged currencyIndia, Korea, and Taiwan have all attempted to limit their currencies’ appreciation relative to the U.S. dollar9-13McGraw-Hill/IrwinForeign Exchange RiskThe risk involved with a spot foreign exchange transaction is that the value of the foreign currency may change relative to the U.S. dollarForeign exchange risk can come from holding foreign assets and/or liabilitiesSuppose a firm makes an investment in a foreign country:convert domestic currency to foreign currency at spot ratesinvest in foreign country securityrepatriate foreign investment and investment earnings at prevailing spot rates in the future 9-14McGraw-Hill/IrwinForeign Exchange RiskFirms can hedge their foreign exchange exposure either on or off the balance sheetOn-balance-sheet hedging involves matching foreign assets and liabilitiesas foreign exchange rates move any decreases in foreign asset values are offset by decreases in foreign liability values (and vice versa)Off-balance-sheet hedging involves the use of forward contractsforward contracts are entered into (at t = 0) that specify exchange rates to be used in the future (i.e., no matter what the prevailing spot exchange rates are at t = 1)9-15McGraw-Hill/IrwinForeign ExchangeA financial institution’s overall net foreign exchange exposure in any given currency is measured asNet exposurei = (FX assetsi – FX liabilitiesi) + (FX boughti – FX soldi) = net foreign assetsi + net FX boughti = net positioni where i = ith country’s currencyA net long (short) position is a position of holding more (fewer) assets than liabilities in a given currency9-16McGraw-Hill/IrwinForeign ExchangeA financial institution’s position in foreign exchange markets generally reflects four trading activitiespurchase and sale of foreign currencies for customers’ international trade transactionspurchase and sale of foreign currencies for customers’ investmentspurchase and sale of foreign currencies for customers’ hedgingpurchase and sale of foreign currencies for speculation (i.e., profiting through forecasting foreign exchange rates)9-17McGraw-Hill/IrwinPurchasing Power ParityPurchasing power parity (PPP) is the theory explaining the change in foreign currency exchange rates as inflation rates in the countries changei = interest rateIP = inflation rateRIR = real rate of interestUS = the United StatesS = foreign country9-18McGraw-Hill/IrwinPurchasing Power ParityAssuming real rates of interest are equal across countriesFinally, the PPP theorem states that the change in the exchange rate between two countries’ currencies is proportional to the difference in the inflation rates in the countries SUS/S = the spot exchange rate of U.S. dollars per unit of foreign currency9-19McGraw-Hill/IrwinInterest Rate ParityThe interest rate parity theorem (IRPT) is the theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency iUSt = the interest rate on a U.S. investment maturing at time t iUKt = the interest rate on a U.K. investment maturing at time t St = $/£ spot exchange rate at time t Ft = $/£ forward exchange rate at time t9-20McGraw-Hill/IrwinBalance of Payments AccountsBalance of payments accounts summarize all transactions between citizens of two countriescurrent accounts summarize foreign trade in goods and services, net investment income, and gifts, grants, and aid given to other countriescapital accounts summarize capital flows into and out of a country