foreign exchange markets

International Economics International Economics An Overview An Overview Foreign Exchange___ SN (edited) 2 Foreign exchange Foreign exchange market  Largest and most liquid market in the world __ total world turnover in a single day in 2006 was USD 1400 billion (approx).  No central market - key markets in several cities around the world  Participating banks and brokers are in constant contact via phone and computer  Three general types of transaction  Between banks and their customers  Domestic interbank market conducted through brokers  Trading with overseas banks____ Foreign Exchange___ SN (edited) 3 The Major Players  The major players are____  Individuals: tourists, migrants  Firms: importers and exporters  Banks: short position, long position, square position  Governments/ monetary authorities: market intervention  International agencies: lending  Two tier market: First tier: ultimate customer and banker  Second tier: between banks  Classifications of participants__  Non-banking entities: business transactions and hedging  Banks: foreign exchange dealers  Arbitrageurs: profit seeking from variations in rates in different markets  Speculators: profit seeking from movements in exchange rates Foreign Exchange___ SN (edited) 4 Foreign exchange Types of FX transactions  Spot transactions - executed nearly immediately  Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance  Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning Foreign Exchange___ SN (edited) 5 Foreign exchange Foreign exchange quotations  Exchange rate is the price of one currency in terms of another  One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) [ direct quote like $ 1 = Rs. 39.75]  A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency)  Two –way quote: $ 1 = INR 39.72 / 77  With a spread of .05 Foreign Exchange___ SN (edited) 6 Foreign exchange Foreign exchange quotations  Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar  Since USD is the anchor currency, any INR / CAD rate will be given by dealer in India with the help of cross rates___ through INR / USD and CAD / USD rates Foreign Exchange___ SN (edited) 7 Foreign exchange markets Forward markets, futures & options  Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date_ margin money deposited with the seller bank  Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement Foreign Exchange___ SN (edited) 8 Some concepts  Appreciation  Depreciation  Cross rates  Anchor currency  Arbitrage  Speculation  Open position  Close position Foreign Exchange___ SN (edited) 9 Foreign exchange markets Forward markets, futures & options  Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date  Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates Foreign Exchange___ SN (edited) 10 Foreign exchange markets Forward markets, futures & options  Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option  Options to buy are called call options, and those to sell are called put options  Options are frequently used to reduce risk from exchange rate changes  Other concepts__ Option : In-the-money: Out-of-the money: At –the- money  Asset price, strike price [...]... rates Foreign Exchange _ 22 Foreign exchange Impact of an appreciating Indian Rupee  Pros  Lower prices on foreign goods  Keeps inflation down  Foreign travel is cheaper  Less expensive to invest abroad  Cons  Exporters’ products become more expensive abroad  Imports-competing firms face price competition  Travel more expensive for foreign tourists  Slows inflow of foreign investment Foreign Exchange. .. 23 Foreign exchange Impact of a depreciating Indian Rupee  Pros  Exporters can sell abroad more easily  Less competition for Indian firms from imports  Foreign tourism is encouraged  Indian capital markets more attractive  Cons  Higher prices on imports  Upward pressure on inflation  Travel abroad more expensive  Harder for Indian firms to expand into foreign markets Foreign Exchange _ 24 Foreign. . .Foreign exchange markets Exchange rate determination Foreign Exchange _ 11 Theory #1: Purchasing power parity [ Cassel, 1927] Law of One Price Versions of Versions of PURCHASING PURCHASING POWER POWER PARITY PARITY Absolute PPP Relative PPP Foreign Exchange _ 12 The Law of One Price  A commodity will have the same price in... Subject to exchange rate risk Foreign Exchange _ 25 Foreign exchange markets Arbitrage and hedging  Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions  Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate... sudden exchange rate swings Foreign Exchange _ 26 Foreign exchange markets Speculation  Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future basically a position is created in the expectation of positive gain  Speculation can either reduce or increase volatility in foreign exchange rates   If speculators... rates to continue, their transactions can accelerate the rise or fall of the target currency Foreign Exchange _ 27 What about Indian rupee ?  How rupee’s exchange rate is determined ?  Present scenario _ INR has appreciated about 12 % in the last one year… Foreign Exchange _ 28 Big Mac Index  Index Foreign Exchange _ 29 ... Travel abroad more expensive  Harder for Indian firms to expand into foreign markets Foreign Exchange _ 24 Foreign exchange markets Arbitrage and hedging  Exchange arbitrage involves taking advantage of exchange rate differences in different markets to make a profit  Helps equalize exchange rates globally  Three point Arbitrage Pound, Dollar and Euro example  Three point arbitrage _ let GBP 1... bushel): P$ S€/$ = spot exchange rate P€ = s€/$ • P$ Foreign Exchange _ 13 Absolute PPP  Extension of law of one price to a basket of goods  Absolute PPP examines price levels  Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket): where P€ = Σi (wFR,i • p€,i ) PUS = Σi (wUS,i • pUS,i ) S€/$ = P€ / PUS Foreign Exchange _ 14 Relative PPP... (1 + i$) Using absolute PPP to cancel terms and rearranging: 1 + i€ = E(s€/$) 1 + i$ s€/$ Relative PPP: Foreign Exchange _ 15 Relative PPP  Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates: 1 + i€ = E(s€/$) 1 + i$ s€/$ Foreign Exchange _ 16 Interest Rate Parity START (today) year) END (in one r$=2.24% $117,228 (Invest in $) s€/$=0.83215... interest rates: (1 + rNominal) = (1 + rReal)(1 + i ) (1 + rReal) = (1 + rNominal) / (1 + i ) Foreign Exchange _ 19 Theory #4: Expectations theory of forward rates  Main idea:  The forward rate equals expected spot exchange rate f€/$ = E(s€/$) Expectations theory of forward rates: f€/$ = E(s€/$ ) s€/$ s€/$ Foreign Exchange _ 20 Important Relations  1 i = R + п [ nominal interest = real interest + inflation