Financial Markets and Institutions Week 6: Lecture 2 - Introduction to Foreign Exchange Markets Flashcards
◼ Introduction to the module ◼ Understand the meaning and functions of the foreign exchange market ◼ Describe the exchange rate systems used by various governments. ◼ To Understand the spot, forward, cross, and effective exchange rates. ◼ Understand the meaning of foreign exchange risks, hedging and speculation (32 cards)
Why Study Financial Markets?
Financial markets:
Channel funds from savers to investors.
Affect personal wealth, business performance, and economic growth.
Financial institutions:
Include banks, insurance companies, mutual funds, pension funds.
Help manage risk, monetary policy, and capital flows.
Institutions like the IMF play a role in global financial stability.
Introduction to the Foreign Exchange Market
The Foreign Exchange Market (FEM) is where individuals, firms, and banks buy and sell foreign currencies.
It is the largest financial market in the world, with a daily volume of ~$5 trillion.
It determines exchange rates, which affect:
- The cost of imports/exports.
- The value of foreign investments.
- The purchasing power of tourists.
Example: A weakening dollar makes European vacations more expensive for Americans; a stronger dollar reduces foreign demand for US goods.
Functions of the Foreign Exchange Market
- Transfer of Purchasing Power:
Demand arises from tourism, imports, and foreign investment.
Supply arises from foreign tourist spending, exports, and foreign investment inflows. - Provision of Credit:
Credit is needed for goods in transit and delayed payments. - Hedging and Speculation:
90% of forex trading is speculative/financial.
Only 10% is trade-related.
Participants in the Foreign Exchange Market
Tourists, importers, exporters, investors: Demand/supply currency for transactions.
Commercial banks: Act as clearinghouses for currency exchange.
Foreign exchange brokers: Match buyers and sellers between banks.
Central banks: Act as buyers/sellers of last resort to stabilize currency.
Open Economy Macroeconomics and Exchange Rates
Open economy macroeconomics studies the interaction between a home country and the rest of the world (ROW).
Key variables:
P: Home price level (e.g., in £).
P^star: Foreign price level (e.g., in $, €, ¥).
S: Exchange rate converting P to P*.
Exchange rates affect relative prices and competitiveness in global trade.
Understanding Exchange Rate Movements
Exchange rate (S): Number of domestic currency units per unit of foreign currency.
Depreciation: Domestic currency loses value.
E.g., $/€ rises from $1 to $1.50 → dollar depreciates.
Appreciation: Domestic currency gains value.
E.g., $/€ falls from $1 to $0.50 → dollar appreciates.
Determined by supply and demand in a flexible exchange rate system.
What are the different types of exchange rate systems?
Fixed: Rates held constant or within narrow bands.
Examples: Bretton Woods (1944–1971), Smithsonian Agreement (1971).
Freely Floating: Determined by market forces.
No government intervention.
Managed Float: Rates move freely but governments may intervene.
Pegged: Currency tied to another (e.g., USD).
Currency Board: Domestic currency fully backed by foreign currency.
Dollarization: Replacing local currency with USD. E.g. Ecuador in 2000
Pros & cons of Fixed Exchange Rate system
✅ Pros:
Future exchange rates are known → reduces uncertainty.
Encourages trade and investment.
❌ Cons:
Countries are vulnerable to economic conditions in other countries.
Requires large reserves to maintain the peg.
Limits monetary policy flexibility.
Pros & cons of Freely Floating Exchange Rate System
✅ Pros:
Countries are more insulated from foreign economic problems.
No need for central bank intervention.
Governments have more freedom in domestic policy-making.
Fewer capital flow restrictions → enhances market efficiency.
❌ Cons:
High volatility → firms may need to spend more on managing exchange rate risk.
Economic problems (e.g., inflation, unemployment) may worsen if the currency depreciates.
Pros & cons of Managed Float Exchange Rate system
✅ Pros:
Flexibility with some stability.
❌ Cons:
Risk of manipulation: governments may adjust rates to benefit their own economy at the expense of others.
Pros & cons of Pegged Exchange Rate system
✅ Pros:
Provides stability in exchange rates.
❌ Cons:
Requires constant monitoring and intervention.
Vulnerable to speculative attacks.
Pros & cons of Currency Board as an Exchange Rate system
✅ Pros:
Strong commitment to stability.
Reduces inflation (e.g., Argentina: 800% → <5%).
❌ Cons:
Loss of independent monetary policy.
Cannot act as lender of last resort.
Vulnerable to external shocks (e.g., Argentina’s collapse in 2002).
Pros & cons of Dollarization as exchange rate system
✅ Pros:
Eliminates currency risk and speculative attacks.
❌ Cons:
Total loss of monetary policy control.
Cannot print money or act as lender of last resort.
Increased exposure to US economic conditions.
What are currency boards and dollarization, and how do they differ?
Currency Board:
Fixed exchange rate backed 100% by foreign currency.
Example: HK$7.80 = US$1 since 1983.
Argentina: Inflation fell from 800% (1990) to <5% (1994), but collapsed in 2002.
Dollarization:
Country adopts USD as official currency.
Example: Ecuador (2000).
Eliminates speculative attacks but sacrifices monetary policy control
Exchange Rate Arrangements Around the World
Pegged to USD: Bahamas, Bermuda, Hong Kong, Barbados, Saudi Arabia.
Floating: UK, US, Japan, Canada, Australia, India, Brazil, etc.
China: Pegged to a weighted basket of currencies.
Interpreting Foreign Exchange Quotations
Direct quote: Value of foreign currency in home currency.
E.g., £0.625:$1.
Indirect quote: Units of foreign currency per unit of home currency.
E.g., $1.6:£1.
Bid/Ask Spread:
Bid = buy rate; Ask = sell rate.
Spread = (Ask - Bid) / Ask.
Example: Bid = $1.52, Ask = $1.60 → Spread = 5%.
Note (Slide 16):
‘Devaluation’ and ‘revaluation’ are deliberate government actions. Depreciation/appreciation are market-driven.
What are cross and effective exchange rates, and how are they calculated?
Cross Exchange Rate:
The implied exchange rate between two currencies derived from their exchange rates with a third currency (usually the USD).
Formula:
Cross Rate= USD/£ / USD/€
Example:
$/€ = 1.25, $/£ = 2 → €/£ = 2 / 1.25 = 1.60.
Effective Exchange Rate:
A weighted average of a country’s exchange rates with its major trading partners.
Reflects the overall strength or weakness of a currency in international trade.
What is arbitrage and how does it affect exchange rates?
Arbitrage: Buying a currency in one market and selling it in another to profit from price differences.
Purpose: Ensures consistency in exchange rates across markets.
Mechanism:
Buying in the low-price market reduces supply → price rises.
Selling in the high-price market increases supply → price falls.
Result: Exchange rates converge across markets.
3-point arbitrage: Involves three currencies and three markets to exploit discrepancies.
What are spot and forward exchange rates and what are forward premiums/discounts and how are they calculated?
Spot Rate: Exchange rate for immediate delivery (within 2 business days).
Forward Rate: Agreed rate for a future transaction (1, 3, 6, 12, or 24 months).
Forward Premium/Discount:
Measures how much the forward rate differs from the spot rate.
Formula:
Currency Swaps
A currency swap is a combined spot and forward transaction:
Sell a currency now (spot).
Agree to buy it back later (forward).
Purpose: Reduce transaction costs and manage currency exposure.
Common in interbank trading.
Example:
Regions Bank receives €5 million but prefers to hold USD for 3 months.
It sells euros now and simultaneously agrees to repurchase them in 3 months.
Currency Futures
Standardized contracts traded on organized exchanges (e.g., IMM).
Used to buy/sell currencies at a future date at a predetermined rate.
Traded Currencies:
Yen, CAD, GBP, CHF, AUD, MXN, EUR.
Key Features:
Standard contract sizes.
Limited delivery dates.
Daily price limits.
Traded in cities like Chicago, NY, Frankfurt, Singapore.
Differences from Forwards:
Futures are standardized and exchange-traded.
Forwards are customizable and OTC.
Note (Slide 43):
Futures contracts are only traded on 4 dates/year: 3rd Wednesday of March, June, Sept, Dec.
What are the key similarities between currency forwards and futures contracts?
Both are agreements to exchange currencies at a future date.
Both are used for hedging and speculation.
Both derive their value from the underlying spot exchange rate.
How can currency futures be used to hedge against exchange rate risk?
Scenario: A UK exporter expects to receive $1.35 million in 6 months.
Concern: GBP may appreciate, reducing the value of USD receipts in GBP.
Solution: Use currency futures to lock in a favorable exchange rate.
Futures rate: $1.35/£1.
Exporter buys 16 contracts (each for £62,500) to guarantee £1 million.
Outcome:
If spot rate becomes $1.50/£1, the exporter would only get £900,000.
But futures contract allows them to sell at $1.50/£1 → profit = $150,000.
Total: £900,000 (converted) + £100,000 (from futures profit) = £1 million guaranteed.
