Chapter Nine

Foreign Exchange
Markets

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Overview of Foreign
Exchange Markets

Todays
TodaysU.S.-based
U.S.-basedcompanies
companiesoperate
operateglobally
globally
Events
Eventsand
andmovements
movementsin
inforeign
foreignfinancial
financialmarkets
marketscan
can
affect
affectthe
theprofitability
profitabilityand
andperformance
performanceof
ofU.S.
U.S.firms
firms
Foreign
Foreigntrade
tradeisispossible
possiblebecause
becauseof
ofthe
theease
easewith
withwhich
which
foreign
foreigncurrencies
currenciescan
canbe
beexchanged
exchanged

U.S.
U.S.imported
imported$2.9
$2.9trillion
trillionworth
worthof
ofgoods
goodsinin2007
2007
U.S.
U.S.exported
exported$2.2
$2.2trillion
trillionworth
worthof
ofgoods
goodsinin2007
2007

Internationally
Internationallyactive
activefirms
firmsoften
oftenseek
seekto
tohedge
hedgetheir
their
foreign
foreigncurrency
currencyexposure
exposure

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Foreign Exchange
Foreign
Foreignexchange
exchangemarkets
marketsare
aremarkets
marketsin
inwhich
whichcash
cash
flows
flowsfrom
fromthe
thesale
saleof
ofproducts
productsor
orassets
assetsdenominated
denominatedin
inaa
foreign
foreigncurrency
currencyare
aretransacted
transacted
Foreign
Foreignexchange
exchangemarkets
markets

facilitate
facilitateforeign
foreigntrade
trade
facilitate
facilitateraising
raisingcapital
capitalininforeign
foreignmarkets
markets
facilitate
facilitatethe
thetransfer
transferof
ofrisk
riskbetween
betweenmarket
marketparticipants
participants
facilitate
facilitatespeculation
speculationinincurrency
currencyvalues
values

AAforeign
foreignexchange
exchangerate
rateisisthe
theprice
priceatatwhich
whichone
one
currency
currencycan
canbe
beexchanged
exchangedfor
foranother
anothercurrency
currency
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Foreign Exchange
Foreign
Foreignexchange
exchangerisk
riskisisthe
therisk
riskthat
thatcash
cashflows
flowswill
will
vary
varyas
asthe
theactual
actualamount
amountof
ofU.S.
U.S.dollars
dollarsreceived
receivedon
onaa
foreign
foreigninvestment
investmentchanges
changesdue
dueto
toaachange
changein
inforeign
foreign
exchange
exchangerates
rates
Currency
Currencydepreciation
depreciationoccurs
occurswhen
whenaacountrys
countryscurrency
currency
falls
fallsin
invalue
valuerelative
relativeto
toother
othercurrencies
currencies

domestic
domesticgoods
goodsbecome
becomecheaper
cheaperfor
forforeign
foreignbuyers
buyers
foreign
foreigngoods
goodsbecome
becomemore
moreexpensive
expensivefor
fordomestic
domesticpurchasers
purchasers

Currency
Currencyappreciation
appreciationoccurs
occurswhen
whenaacountrys
countryscurrency
currency
rises
risesin
invalue
valuerelative
relativeto
toother
othercurrencies
currencies
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Foreign Exchange
Foreign
Foreignexchange
exchangemarkets
marketsoperated
operatedunder
underthe
thegold
gold
standard
standardthrough
throughmost
mostof
ofthe
the1800s
1800s

U.K.
U.K.was
wasthe
thedominant
dominantinternational
internationaltrading
tradingcountry
countryuntil
untilWWII
WWII
forced
forceditittotodeplete
depleteits
itsgold
goldreserves
reservestotopurchase
purchasearms
armsand
and
munitions
munitionsfrom
fromthe
theU.S.
U.S.

1944:
1944:Bretton
BrettonWoods
WoodsAgreement
Agreementfixed
fixedexchange
exchangerates
rates
within
within1%
1%bands
bands
1971:
1971:Smithsonian
SmithsonianAgreement
Agreementincreased
increasedbands
bandsto
to22%
%
1973:
1973:Smithsonian
SmithsonianAgreement
AgreementII
IIintroduced
introducedmanaged
managed
free
freefloat
float
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Foreign Exchange
Foreign
Foreignexchange
exchangemarkets
marketsare
arethe
thelargest
largestof
ofall
allfinancial
financial
markets:
markets:turnover
turnoveraveraged
averaged$3.2
$3.2trillion
trillionper
perday
dayin
in2007
2007

London
Londonaccounts
accountsfor
for42.5%
42.5%
New
NewYork
Yorkaccounts
accountsfor
for23.8%
23.8%
France
Franceaccounts
accountsfor
for7.1%
7.1%

Prior
Priorto
to1972,
1972,the
theonly
onlychannel
channelthrough
throughwhich
whichforeign
foreign
exchange
exchangeoccurred
occurredwas
wasthrough
throughbanks
banks

twenty-four
twenty-fourhours
hoursaaday
dayover-the-counter
over-the-counter(OTC)
(OTC)market
marketamong
among
major
majorbanks
banks
electronic
electronictrading
tradingof
ofspot
spotand
andforward
forwardcontracts
contracts
over
over90%
90%of
ofcontracts
contractsare
aresettled
settledwith
withdelivery
deliveryof
ofcurrency
currency

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Foreign Exchange
Organized
Organizedmarkets
marketshave
haveexisted
existedsince
since1972
1972

International
InternationalMoney
MoneyMarket
Market(IMM)
(IMM)(a(asubsidiary
subsidiaryof
ofthe
the
Chicago
ChicagoMercantile
MercantileExchange
Exchange(CME))
(CME))isisbased
basedininChicago
Chicago
derivative
derivativetrading
tradingininforeign
foreigncurrency
currencyfutures
futuresand
andoptions
options
less
lessthan
than1%
1%of
ofcontracts
contractsare
arecompleted
completedwith
withdelivery
deliveryof
ofthe
the
underlying
underlyingcurrency
currency

In
In1982
1982the
thePhiladelphia
PhiladelphiaStock
StockExchange
Exchange(PHLX)
(PHLX)
became
becamethe
thefirst
firstexchange
exchangeto
tooffer
offeraround-the-clock
around-the-clock
trading
tradingof
ofcurrency
currencyoptions
options

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The Euro ()
The
TheEuropean
EuropeanCommunity
Community(EC)
(EC)was
wasformed
formedin
in1967
1967by
by
consolidating
consolidatingthree
threesmaller
smallercommunities
communities

European
EuropeanCoal
Coaland
andSteel
SteelCommunity
Community
European
EuropeanEconomic
EconomicMarket
Market
European
EuropeanAtomic
AtomicEnergy
EnergyCommunity
Community

The
TheMaastricht
MaastrichtTreaty
Treatyof
of1993
1993set
setthe
thestage
stagefor
forthe
theeventual
eventual
creation
of
the
Euro
creation of the Euro

created
createdan
anintegrated
integratedsystem
systemof
ofEuropean
Europeancentral
centralbanks
banksoverseen
overseen
by
a
single
European
Central
Bank
(ECB)
by a single European Central Bank (ECB)

The
TheEuro
Euro(),
(),the
thecurrency
currencyof
ofthe
theEuropean
EuropeanUnion
Union(EU),
(EU),
began
trading
on
January
1,
1999
when
eleven
European
began trading on January 1, 1999 when eleven European
countries
countriesfixed
fixedtheir
theircurrencies
currenciesexchange
exchangeratios
ratios
Euro
Euronotes
notesand
andcoins
coinsbegan
begancirculating
circulatingon
onJanuary
January1,1,2002
2002
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The Euro ()
The
TheU.S.
U.S.dollar
dollardepreciated
depreciatedagainst
againstthe
theeuro
euroin
inthe
themid
mid
2000s
2000s
The
TheCentral
CentralBank
Bankof
ofRussia
Russiahas
hasreplaced
replacedsome
someof
oftheir
their
U.S.
U.S.dollar
dollarreserves
reserveswith
witheuros,
euros,as
ashas
hasthe
theChinese
ChineseCentral
Central
Bank
Bank
In
In2007,
2007,39%
39%of
offoreign
foreignexchange
exchangetransactions
transactionsare
are
denominated
denominatedin
ineuros,
euros,compared
comparedto
to32%
32%denominated
denominatedin
in
U.S.
U.S.dollars
dollars

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The Yuan
In
Inthe
theearly
early2000s
2000sthe
theinternational
internationalcommunity
communitypressured
pressured
China
Chinato
toallow
allowits
itscurrency
currency(the
(theyuan)
yuan)to
tofloat
floatfreely
freely
instead
insteadof
ofpegging
peggingititto
tothe
theU.S.
U.S.dollar
dollar
aadepreciated
depreciatedU.S.
U.S.dollar
dollarhad
hadcaused
causedthe
theyuan
yuantotobecome
become
undervalued
undervalued
Chinese
Chineseexports
exportswere
wererelatively
relativelycheap,
cheap,which
whichhurt
hurtdomestic
domestic
manufacturing
manufacturingininother
othercountries
countries

On
OnJuly
July21,
21,2005
2005the
theChinese
Chinesegovernment
governmentbegan
beganaapolicy
policy
of
ofmanaged
managedfloat
float

global
globalinterest
interestrates
ratesand
andoil
oilprices
priceshave
havesince
sincerisen
risen
China
Chinahas
hascut
cutback
backon
onforeign
foreignsecurities
securitiespurchases
purchases

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2009, The McGraw-Hill Companies, All Rights

Foreign Exchange
Foreign
Foreignexchange
exchangerates
ratesmay
maybe
belisted
listedtwo
twoways
ways

U.S.
U.S.dollars
dollarsreceived
receivedper
perunit
unitof
offoreign
foreigncurrency
currency(in
(inUS$)
US$)
foreign
foreigncurrency
currencyreceived
receivedfor
foreach
eachU.S.
U.S.dollar
dollar(per
(perUS$)
US$)

Foreign
Foreignexchange
exchangecan
caninvolve
involveboth
bothspot
spotand
andforward
forward
transactions
transactions

spot
spotforeign
foreignexchange
exchangetransactions
transactionsinvolve
involvethe
theimmediate
immediate
exchange
exchangeof
ofcurrencies
currenciesatatcurrent
currentexchange
exchangerates
rates
forward
forwardforeign
foreignexchange
exchangetransactions
transactionsinvolve
involvethe
theexchange
exchangeof
of
currencies
currenciesatataaspecified
specifiedexchange
exchangerate
rateatataaspecific
specificdate
dateininthe
the
future
future

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The U.S. Dollar ($)

The
Thelargest
largestforeign
foreignholders
holdersof
ofU.S.
U.S.dollars
dollarsare
areChina,
China,Russia,
Russia,
Brazil,
Brazil,and
andIndia
India
The
TheU.S.
U.S.dollar
dollardepreciated
depreciatedbetween
between2002
2002and
and2007
2007as,
as,among
among
other
otherthings,
things,relatively
relativelyhigh
highinterest
interestrates
ratesin
inthe
theeuro
euroarea
area
attracted
attractedinvestment
investmentcapital
capitalaway
awayfrom
fromthe
theU.S.
U.S.
There
Therehas
hasalso
alsobeen
beenaahigh
highvolume
volumeof
ofAsian
Asiancentral
centralbank
bank
intervention
intervention

Japanese
JapaneseMinistry
Ministryof
ofFinance
Financeincreased
increasedU.S.
U.S.asset
assetpurchases
purchases
Chinese
ChineseMonetary
MonetaryAuthority
Authoritybought
boughtU.S.
U.S.dollar
dollarreserves,
reserves,but
but
maintained
a
pegged
currency
maintained a pegged currency
India,
India,Korea,
Korea,and
andTaiwan
Taiwanhave
haveall
allattempted
attemptedtotolimit
limittheir
theircurrencies
currencies
appreciation
appreciationrelative
relativetotothe
theU.S.
U.S.dollar
dollar

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Foreign Exchange Risk

The
Therisk
riskinvolved
involvedwith
withaaspot
spotforeign
foreignexchange
exchange
transaction
transactionisisthat
thatthe
thevalue
valueof
ofthe
theforeign
foreigncurrency
currencymay
may
change
changerelative
relativeto
tothe
theU.S.
U.S.dollar
dollar
Foreign
Foreignexchange
exchangerisk
riskcan
cancome
comefrom
fromholding
holdingforeign
foreign
assets
assetsand/or
and/orliabilities
liabilities
Suppose
Supposeaafirm
firmmakes
makesan
aninvestment
investmentin
inaaforeign
foreigncountry:
country:

convert
convertdomestic
domesticcurrency
currencytotoforeign
foreigncurrency
currencyatatspot
spotrates
rates
invest
investininforeign
foreigncountry
countrysecurity
security
repatriate
repatriateforeign
foreigninvestment
investmentand
andinvestment
investmentearnings
earningsatat
prevailing
prevailingspot
spotrates
ratesininthe
thefuture
future

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Foreign Exchange Risk

Firms
Firmscan
canhedge
hedgetheir
theirforeign
foreignexchange
exchangeexposure
exposureeither
eitheron
on
or
oroff
offthe
thebalance
balancesheet
sheet
On-balance-sheet
On-balance-sheethedging
hedginginvolves
involvesmatching
matchingforeign
foreign
assets
assetsand
andliabilities
liabilities
as
asforeign
foreignexchange
exchangerates
ratesmove
moveany
anydecreases
decreasesininforeign
foreignasset
asset
values
valuesare
areoffset
offsetby
bydecreases
decreasesininforeign
foreignliability
liabilityvalues
values(and
(andvice
vice
versa)
versa)

Off-balance-sheet
Off-balance-sheethedging
hedginginvolves
involvesthe
theuse
useof
offorward
forward
contracts
contracts

forward
forwardcontracts
contractsare
areentered
enteredinto
into(at
(attt==0)
0)that
thatspecify
specifyexchange
exchange
rates
ratestotobe
beused
usedininthe
thefuture
future(i.e.,
(i.e.,no
nomatter
matterwhat
whatthe
theprevailing
prevailing
spot
spotexchange
exchangerates
ratesare
areatattt==1)
1)

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Foreign Exchange
AAfinancial
financialinstitutions
institutionsoverall
overallnet
netforeign
foreignexchange
exchange
exposure
exposurein
inany
anygiven
givencurrency
currencyisismeasured
measuredas
as
Net
Netexposure
exposurei i==(FX
(FXassets
assetsi iFX
FXliabilities
liabilitiesi)i)++(FX
(FXbought
boughti iFX
FXsold
soldi)i)
==net
netforeign
foreignassets
assetsi i++net
netFX
FXbought
boughti i
==net
netposition
positioni i
where
where
ii==ith
ithcountrys
countryscurrency
currency

AAnet
netlong
long(short)
(short)position
positionisisaaposition
positionof
ofholding
holdingmore
more
(fewer)
(fewer)assets
assetsthan
thanliabilities
liabilitiesin
inaagiven
givencurrency
currency
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Foreign Exchange
AAfinancial
financialinstitutions
institutionsposition
positionin
inforeign
foreignexchange
exchange
markets
marketsgenerally
generally reflects
reflectsfour
fourtrading
tradingactivities
activities
purchase
purchaseand
andsale
saleof
offoreign
foreigncurrencies
currenciesfor
forcustomers
customers
international
internationaltrade
tradetransactions
transactions
purchase
purchaseand
andsale
saleof
offoreign
foreigncurrencies
currenciesfor
forcustomers
customers
investments
investments
purchase
purchaseand
andsale
saleof
offoreign
foreigncurrencies
currenciesfor
forcustomers
customers
hedging
hedging
purchase
purchaseand
andsale
saleof
offoreign
foreigncurrencies
currenciesfor
forspeculation
speculation(i.e.,
(i.e.,
profiting
profitingthrough
throughforecasting
forecastingforeign
foreignexchange
exchangerates)
rates)

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Purchasing Power Parity

Purchasing
Purchasingpower
powerparity
parity(PPP)
(PPP)isisthe
thetheory
theoryexplaining
explaining
the
thechange
changein
inforeign
foreigncurrency
currencyexchange
exchangerates
ratesas
asinflation
inflation
rates
ratesin
inthe
thecountries
countrieschange
change

iUS IPUS RIRUS

and

iS IPS RIRS

ii==interest
interestrate
rate
IP
IP==inflation
inflationrate
rate
RIR
RIR==real
realrate
rateof
ofinterest
interest
US
US==the
theUnited
UnitedStates
States
SS==foreign
foreigncountry
country
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Purchasing Power Parity

Assuming
Assumingreal
realrates
ratesof
ofinterest
interestare
areequal
equalacross
acrosscountries
countries

iUS iS IPUS IPS

Finally,
Finally,the
thePPP
PPPtheorem
theoremstates
statesthat
thatthe
thechange
changein
inthe
the
exchange
exchangerate
ratebetween
betweentwo
twocountries
countriescurrencies
currenciesisis
proportional
proportionalto
tothe
thedifference
differencein
inthe
theinflation
inflationrates
ratesin
inthe
the
countries
countries

IPUS IPS SUS / S / SUS / S

SSUS/S
= the spot exchange rate of U.S. dollars per unit of foreign
US/S = the spot exchange rate of U.S. dollars per unit of foreign
currency
currency
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2009, The McGraw-Hill Companies, All Rights

Interest Rate Parity

The
Theinterest
interestrate
rateparity
paritytheorem
theorem(IRPT)
(IRPT)isisthe
thetheory
theory
that
thatthe
thedomestic
domesticinterest
interestrate
rateshould
shouldequal
equalthe
theforeign
foreign
interest
interestrate
rateminus
minusthe
theexpected
expectedappreciation
appreciationof
ofthe
the
domestic
domesticcurrency
currency

1 iUSt (1 / St ) (1 iUKt ) Ft
iUSt
iUSt==the
theinterest
interestrate
rateon
onaaU.S.
U.S.investment
investmentmaturing
maturingatattime
timett
iUKt
iUKt==the
theinterest
interestrate
rateon
onaaU.K.
U.K.investment
investmentmaturing
maturingatattime
timett
SSt t==$/
$/spot
spotexchange
exchangerate
rateatattime
timett
FFt t==$/
$/forward
forwardexchange
exchangerate
rateatattime
timett

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Balance of Payments Accounts

Balance
Balanceof
ofpayments
paymentsaccounts
accountssummarize
summarizeall
all
transactions
transactionsbetween
betweencitizens
citizensof
oftwo
twocountries
countries
current
currentaccounts
accountssummarize
summarizeforeign
foreigntrade
tradein
ingoods
goods
and
andservices,
services,net
netinvestment
investmentincome,
income,and
andgifts,
gifts,grants,
grants,
and
andaid
aidgiven
givento
toother
othercountries
countries
capital
capitalaccounts
accountssummarize
summarizecapital
capitalflows
flowsinto
intoand
andout
out
of
ofaacountry
country

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