Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 3:Chapter 3:

Foreign Exchange Markets and Foreign Exchange Markets and Exchange RatesExchange Rates

I. OverviewI. Overview

The exchange rate ( also known as the foreign exchange rate, The exchange rate ( also known as the foreign exchange rate, forex rate or FX rate) between two countries specify how forex rate or FX rate) between two countries specify how much one currency is worth in terms of the other .much one currency is worth in terms of the other .

A A fixed exchange rate (pegged exchange rate) is a type of fixed exchange rate (pegged exchange rate) is a type of exchange rate regime wherein a currency’s value is matched exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other to the value of another single currency or to a basket of other currencies, or to another measure of value such as gold.currencies, or to another measure of value such as gold.

A floating exchange rate ( flexible exchange rate) is a type of A floating exchange rate ( flexible exchange rate) is a type of exchange rate regime wherein a currency’s value is allowed exchange rate regime wherein a currency’s value is allowed to fluctuate according to foreign exchange market. to fluctuate according to foreign exchange market.

II. The Foreign Exchange MarketII. The Foreign Exchange Market

The market in which individuals, firms, and banks buy and The market in which individuals, firms, and banks buy and sell foreign currencies (sell foreign currencies (foreign exchangeforeign exchange).).

ExamplesExamples: London, Paris, Zurich, Frankfurt, Singapore, : London, Paris, Zurich, Frankfurt, Singapore, Hong Kong, Tokyo and New York. Hong Kong, Tokyo and New York.

These These centerscenters form a form a single internationalsingle international foreign exchange foreign exchange market. They are connected market. They are connected electronicallyelectronically and are in and are in constantconstant contact with each other contact with each other

What are the major world currencies?.What are the major world currencies?. The world have what is called a The world have what is called a vehiclevehicle currency, i.e., the currency, i.e., the

US Dollar which is used to pay for the transactions that US Dollar which is used to pay for the transactions that do not involve USA. do not involve USA.

Note that the Euro is also growing as a world vehicle Note that the Euro is also growing as a world vehicle currency. China and Russia are asking now for a new currency. China and Russia are asking now for a new vehicle currency.vehicle currency.

Major foreign exchange centers (Major foreign exchange centers (by sizeby size) are:) are:

1.1. London (about 40% of daily transactions)London (about 40% of daily transactions)2.2. New YorkNew York3.3. TokyoTokyo4.4. SingaporeSingapore

III. Functions of the Foreign Exchange Markets:III. Functions of the Foreign Exchange Markets:

1.1. The principle function is to transfer funds or purchasing The principle function is to transfer funds or purchasing power from one nation or currency into another.power from one nation or currency into another.

How it is done:How it is done: If we need foreign exchange we usually go to a bank. A If we need foreign exchange we usually go to a bank. A

domestic bank will instruct its domestic bank will instruct its correspondentcorrespondent in a foreign in a foreign monetary center to pay the specified amount of its local monetary center to pay the specified amount of its local currency (currency (foreign exchangeforeign exchange) to a person, firm or an account.) to a person, firm or an account.

This is usually accomplished by This is usually accomplished by electronicelectronic transfers (the transfers (the internetinternet).).

Foreign Exchange (Demand):Foreign Exchange (Demand):

Source of demand for foreign exchange:Source of demand for foreign exchange:

Imports of goods from abroadImports of goods from abroad

Imports of services, e.g., travel abroadImports of services, e.g., travel abroad

Invest abroadInvest abroad

Note: these items are all recorded in the country’s BOPNote: these items are all recorded in the country’s BOP

Foreign Exchange (Supply):Foreign Exchange (Supply):

Source of Supply for foreign exchange:Source of Supply for foreign exchange:

Exports of goods to abroadExports of goods to abroad

Exports of services, e.g., insuranceExports of services, e.g., insurance

Investments at homeInvestments at home

Note: these items are all recorded in the country’s BOPNote: these items are all recorded in the country’s BOP

Important Notes: Important Notes: All these transactions are mainly made through commercial All these transactions are mainly made through commercial

banks which function as a banks which function as a clearinghouseclearinghouse for the foreign for the foreign exchange.exchange.

Banks may end up having:Banks may end up having:- Oversupply- Oversupply of foreign exchange (will sell it to other banks) of foreign exchange (will sell it to other banks) through a through a brokerbroker..- Excess demand- Excess demand of foreign exchange (will buy it from other of foreign exchange (will buy it from other banks) through a banks) through a brokerbroker..

In general: - A country pays for its imports, investments ..etc. with its foreign - A country pays for its imports, investments ..etc. with its foreign exchange earnings from exports, services..etc.exchange earnings from exports, services..etc.- What happens if the - What happens if the nation’s demandnation’s demand for foreign exchange for foreign exchange exceeds exceeds the supplythe supply, or if the supply of foreign exchange exceeds , or if the supply of foreign exchange exceeds demand?demand?

If exchange rate is flexibleIf exchange rate is flexible; ; the exchange rate will have to the exchange rate will have to changechange to equilibrate supply and demand.to equilibrate supply and demand.

What if changes in exchange rates are What if changes in exchange rates are not allowednot allowed? (exchange ? (exchange rate is fixed), there will either berate is fixed), there will either be::

(1) Excess demand(1) Excess demand - Banks will borrow foreign exchange from the - Banks will borrow foreign exchange from the central bankcentral bank ( (lender of the lender of the

last resortlast resort).). -The central bank will -The central bank will draw down its foreign reservesdraw down its foreign reserves ( (a BOP deficita BOP deficit))

(2) Excess Supply(2) Excess Supply --Banks will sell foreign exchange to the Banks will sell foreign exchange to the central bankcentral bank (exchange the (exchange the surplus surplus into domestic currency)into domestic currency) -Foreign reserves in the CB will -Foreign reserves in the CB will accumulateaccumulate ( (a BOP surplusa BOP surplus).).

There are There are four levelsfour levels of participants in the foreign exchange market that of participants in the foreign exchange market that can be identified:can be identified:

4th level the central bank: seller or buyer of the last resort when the nations earnings and expenditures of foreign exchange are unequal, draw down its foreign reserves or adds to them

3rd level foreign exchange brokers (wholesale market)

2nd level commercial banks (clearing house between users & earners)

1st level traditional users: tourists, importers, exporters (immediate users of foreign exchange)

2. Another function is the credit function. International 2. Another function is the credit function. International transactions involve transactions involve credit facilitiescredit facilities, e.g., , e.g.,

An importer is usually given time to resell his imports and An importer is usually given time to resell his imports and make the payments. make the payments.

What the exporter do is to What the exporter do is to discountdiscount the “importer’s obligations the “importer’s obligations to pay” at his bank, i.e., the exporter receives payments.to pay” at his bank, i.e., the exporter receives payments.

The bank eventually collects the payments from the importer The bank eventually collects the payments from the importer when due.when due.

3. A third function is to provide facilities for 3. A third function is to provide facilities for hedging and hedging and speculationspeculation (explained later)(explained later)

IV. Foreign exchange ratesIV. Foreign exchange rates

Equilibrium foreign exchange ratesEquilibrium foreign exchange rates::

Consider the following caseConsider the following case (the Dollar and the Euro) (the Dollar and the Euro)

Rate Rate $/$/€€ Demand Demand

(daily)(daily)

Supply Supply

(daily)(daily)

NoteNote

0.50.5 350350 5050 The euro is The euro is cheapcheap

11 200200 200200 Equilibrium RateEquilibrium Rate

1.51.5 100100 300300 The euro is The euro is expensiveexpensive

22 5050 350350 The euro is The euro is expensiveexpensive

FIGURE 1: The Equilibrium Exchange Rate

According to the table:According to the table:

Under Flexible Exchange Rate RegimeUnder Flexible Exchange Rate RegimeThe exchange rate is determined just like the price of any other The exchange rate is determined just like the price of any other good.good.

If the rate of the Euro is $ 0.5, the quantity of euros demanded If the rate of the Euro is $ 0.5, the quantity of euros demanded will exceed the quantity supplied will exceed the quantity supplied the rate will bid up towards the rate will bid up towards the equilibrium ratethe equilibrium rate

If the rate of the Euro is $ 1.5, the quantity of euros supplied will If the rate of the Euro is $ 1.5, the quantity of euros supplied will exceed the quantity demanded exceed the quantity demanded the rate will fall towards the the rate will fall towards the equilibrium rateequilibrium rate

FIGURE 2: The Exchange Rate Under a Flexible Exchange Rate System.

According to the table:According to the table:

Under Fixed Exchange Rate RegimeUnder Fixed Exchange Rate Regime

What if the rate is fixed (fixed exchange rate system). What if the rate is fixed (fixed exchange rate system). (1)(1)In case of In case of excess demandexcess demand the central bank (Fed) will either: the central bank (Fed) will either:

- fill the gap between demand and supply out of its international - fill the gap between demand and supply out of its international reserves, orreserves, or

- set restrictions on the demand for euro- set restrictions on the demand for euro

(2) In case of (2) In case of excess supply excess supply the central bank (Fed) will either:the central bank (Fed) will either: individuals are not willing to hold the existing supply of euro. In such case Central Bank must absorb the excess supply of euro.

FIGURE 3 The Exchange Rate Under a Fixed Exchange Rate System.

According to the graphs:According to the graphs:

Why the demand is negatively slopped? Why the demand is negatively slopped?

(note that the demand for foreign exchange is a (note that the demand for foreign exchange is a derived demandderived demand))

- - At lower rates the demand for the euro increases: why?At lower rates the demand for the euro increases: why?

The lower the rate, the lower is the quantity of dollars required to buy one The lower the rate, the lower is the quantity of dollars required to buy one euro euro the cheaper it is for Americans to import and to invest in Europe the cheaper it is for Americans to import and to invest in Europe the greater is the demand for eurosthe greater is the demand for euros..

Why the supply is positively slopped?Why the supply is positively slopped?

- At higher rates, European residents will receive more dollar for each euro At higher rates, European residents will receive more dollar for each euro they will find American goods and investments cheaper and more they will find American goods and investments cheaper and more attractive attractive they will spend more in USA and the supply of euro will they will spend more in USA and the supply of euro will increase increase

Changes in demand and supply of foreign exchangeChanges in demand and supply of foreign exchange

(1) Demand Changes ( shifting up)(1) Demand Changes ( shifting up)

If the American demand for euros shifted up, e.g., as a result of If the American demand for euros shifted up, e.g., as a result of increased US increased US tastestastes for European goods and the US quantity for European goods and the US quantity supplied for euros increased at point supplied for euros increased at point G in figure 4G in figure 4, the euro , the euro rate will be 1.5 and the equilibrium daily quantity will be € 300 rate will be 1.5 and the equilibrium daily quantity will be € 300 mn. mn.

It requires now $ 1.5 (instead of $ 1) to buy one euro. This is a It requires now $ 1.5 (instead of $ 1) to buy one euro. This is a depreciationdepreciation of the US $, which is an of the US $, which is an increaseincrease in the in the domesticdomestic priceprice (US) of the foreign currency (euro). (US) of the foreign currency (euro).

FIGURE 4 FIGURE 4

D€1

depreciationdepreciation

(2) Demand Changes ( shifting down)(2) Demand Changes ( shifting down)

If the American demand for euros shifted down to so as to If the American demand for euros shifted down to so as to intersect the US supply at point H intersect the US supply at point H in figure 5, in figure 5, the equilibrium the equilibrium exchange rate of the euro would fall to $ 0.5 and the daily exchange rate of the euro would fall to $ 0.5 and the daily equilibrium quantity would be € 50 mn. equilibrium quantity would be € 50 mn.

It requires now fewer dollars to buy one euro, It requires now fewer dollars to buy one euro, this is an this is an appreciationappreciation of the $ US, which is a of the $ US, which is a declinedecline in the in the domestic domestic priceprice (US) of the euro. (US) of the euro.

Note that changes in supply of euros would similarly affect the Note that changes in supply of euros would similarly affect the equilibrium exchange rate and quantity of euros.equilibrium exchange rate and quantity of euros.

FIGURE 5FIGURE 5

D€2

appreciationappreciation

Another Definitions of the Exchange RatesAnother Definitions of the Exchange Rates

(1) Foreign Currency Price The exchange rate can be defined as the foreign currency price The exchange rate can be defined as the foreign currency price

of a unit of domestic currency. If the Dollar price of the euro is of a unit of domestic currency. If the Dollar price of the euro is $1.5 = $1.5 = € € 1 then the euro price of the dollar is (1/1.5) = .667, i.e., 1 then the euro price of the dollar is (1/1.5) = .667, i.e., it takes 0.667 euros to buy one dollar.it takes 0.667 euros to buy one dollar.

note: the conventional definition (number of domestic currency note: the conventional definition (number of domestic currency units to buy one unit of foreign currency) is (R), hence the units to buy one unit of foreign currency) is (R), hence the other definition is (1/R)).other definition is (1/R)).

Another Definitions of the Exchange RatesAnother Definitions of the Exchange Rates

(2) Cross Exchange rates:

There are rates between the dollar and other currencies, i.e., There are rates between the dollar and other currencies, i.e., between the dollar and the euro, the dollar and the Sterling…between the dollar and the euro, the dollar and the Sterling…etc. once the rate between the dollar and other two currencies etc. once the rate between the dollar and other two currencies is determined, the exchange rate between them (is determined, the exchange rate between them (crosscross) can ) can easily be calculated. easily be calculated.

ExampleExample:: if the rate between the dollar and the Sterling is $ 2 = £ 1 and if the rate between the dollar and the Sterling is $ 2 = £ 1 and the rate between the dollar and the euro is $ 1.25 = € 1, then the the rate between the dollar and the euro is $ 1.25 = € 1, then the cross exchange rate between the sterling and the euro is 1.60.cross exchange rate between the sterling and the euro is 1.60.R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6

i.e., it takes € 1.6 to purchase £ 1.i.e., it takes € 1.6 to purchase £ 1.

Another Definitions of the Exchange RatesAnother Definitions of the Exchange Rates

(3) Effective Exchange Rate:

A weighted average of the rate between the domestic currency A weighted average of the rate between the domestic currency and the nations most and the nations most important trade partnersimportant trade partners, with weights , with weights given by the relative importance of the given by the relative importance of the nation’s trade nation’s trade with each with each of these partners.of these partners.

(4) Nominal and Real Exchange Rates: Nominal exchange rate is the domestic price of the foreign Nominal exchange rate is the domestic price of the foreign

currency (direct or indirect rate). currency (direct or indirect rate). The The realreal exchange rate is the nominal exchange rate divided by exchange rate is the nominal exchange rate divided by

the ratio of the the ratio of the consumer price indicesconsumer price indices in the two countries. in the two countries. e.g., the real exchange rate between the dollar and the Sterling is:e.g., the real exchange rate between the dollar and the Sterling is:

($/£)/(P($/£)/(PUSAUSA/P/PUKUK) = ( $/£ )( P) = ( $/£ )( PUK UK / P/ PUSAUSA ) )

ArbitrageArbitrage The purchase of a currency from the monetary center where it The purchase of a currency from the monetary center where it

is cheaper for immediate resale in the monetary center where it is cheaper for immediate resale in the monetary center where it is more expensive in order to make a profit. is more expensive in order to make a profit.

Arbitrage keeps the exchange rate between two currencies the Arbitrage keeps the exchange rate between two currencies the same in different monetary centers. same in different monetary centers.

Two point arbitrageTwo point arbitrage

New YorkNew York LondonLondon$ 1.99 = £ 1$ 1.99 = £ 1 $ 2.01 = £ 1$ 2.01 = £ 1

* Buy here* Buy here * sell here* sell here

Therefore, Arbitrageur profit = 2.01-1.99 = $ .02 per £ 1 Therefore, Arbitrageur profit = 2.01-1.99 = $ .02 per £ 1 (minus (minus transactions cost)transactions cost)

Note: As arbitrage continues, the exchange rate between the two currencies Note: As arbitrage continues, the exchange rate between the two currencies equalizes. e.g.,equalizes. e.g.,

$ 2.00 = £ 1$ 2.00 = £ 1 $ 2.00 = £ 1$ 2.00 = £ 1

Eliminating thus the profitability of further arbitrage.Eliminating thus the profitability of further arbitrage.

V. Exchange rates and the BOPV. Exchange rates and the BOP

Figure 6: Disequilibrium under a fixed and flexible exchange rate

According to the graph 6:According to the graph 6:

DD€ € is reached by imports of goods and services from and is reached by imports of goods and services from and investment in Europe.investment in Europe.

SS€ € is reached by exports of goods and services to Europe and is reached by exports of goods and services to Europe and European investments in USEuropean investments in US

Both are autonomous (BOP = 0)Both are autonomous (BOP = 0) Equilibrium exchange rate is $1 = €1. and the equilibrium Equilibrium exchange rate is $1 = €1. and the equilibrium

quantity is 200 million. quantity is 200 million.

If demand for € increases to DIf demand for € increases to D€’ €’ the effect will depend on the the effect will depend on the exchange rate systemexchange rate system

According to the graph 6:According to the graph 6:

Under Fixed Exchange Rate RegimeUnder Fixed Exchange Rate Regime If US wants to keep the euro rate at $1, it would have to satisfy the If US wants to keep the euro rate at $1, it would have to satisfy the

excess demand TE (€ 250), out of official reserves, i.e. purchase $ and excess demand TE (€ 250), out of official reserves, i.e. purchase $ and sell €. sell €.

Under Flexible Exchange Rate RegimeUnder Flexible Exchange Rate Regime The rate would rise to $1.5 to equilibrate demand and supply for €. The rate would rise to $1.5 to equilibrate demand and supply for €. Use of reserves is unnecessary because the depreciation of the $ Use of reserves is unnecessary because the depreciation of the $

would eliminate excess demand for €.would eliminate excess demand for €.

Under Managed – Floating Exchange Rate RegimeUnder Managed – Floating Exchange Rate Regime Monetary authorities intervene in the market to moderate Monetary authorities intervene in the market to moderate

depreciation of the $ to only $1.25 = €1. This can be done by depreciation of the $ to only $1.25 = €1. This can be done by supplying the market by WZsupplying the market by WZ

Part of the deficit is financed by loss of official reserves, Part of the deficit is financed by loss of official reserves, The other part is eliminated by the depreciation of the $.The other part is eliminated by the depreciation of the $. Loss of reserves indicates the degree of interventionLoss of reserves indicates the degree of intervention

VI. Spot, Forward, Future, and Option RatesVI. Spot, Forward, Future, and Option Rates

Spot Exchange Rate:Spot Exchange Rate:A spot transactionA spot transaction involves the payment and receipt of foreign involves the payment and receipt of foreign exchange within two days after the day of transaction is exchange within two days after the day of transaction is

agreed agreed upon. The rate is called spot rate. upon. The rate is called spot rate.

Forward Exchange Rate:Forward Exchange Rate:

- A forward transaction- A forward transaction involves an agreement to buy or sell a involves an agreement to buy or sell a specified amount of foreign exchange at a specified future date, at a specified amount of foreign exchange at a specified future date, at a rate agreed upon today (rate agreed upon today (forward rateforward rate). ).

- The contract is for one, three or six months. - The contract is for one, three or six months. Three months is the Three months is the most commonmost common..

-Equilibrium Forward rate-Equilibrium Forward rate is determined at the intersection of the is determined at the intersection of the market demand and supply of foreign exchange for future delivery.market demand and supply of foreign exchange for future delivery.

-This demand is derived in the course of hedging from foreign -This demand is derived in the course of hedging from foreign exchange speculation and from covered interest arbitrage (will exchange speculation and from covered interest arbitrage (will explained later).explained later).

-If the forward rate < the present spot rate, the foreign currency is said If the forward rate < the present spot rate, the foreign currency is said to be at a to be at a forward discountforward discount..

- If the forward rate > the present spot rate, foreign currency is said - If the forward rate > the present spot rate, foreign currency is said to be at a to be at a forward premiumforward premium. .

For Example:For Example:

If R is $2 = £1, and the If R is $2 = £1, and the threethree monthmonth forward rate $1.98 = £1, forward rate $1.98 = £1,

The £ is at a forward The £ is at a forward discountdiscount of 2 cents (or 1% (2/200), or the of 2 cents (or 1% (2/200), or the annual forward discount is 4% (8/200)). Same forward annual forward discount is 4% (8/200)). Same forward premiumpremium if the if the three month forward rate is $ 2.02. three month forward rate is $ 2.02.

Hence, the forward discount or premium is calculated (Hence, the forward discount or premium is calculated (for a for a three month contractthree month contract) as) as::

FD or FP = ((FR – SR)/SR)FD or FP = ((FR – SR)/SR)××44 (quarters within one year)(quarters within one year) ××100100 ( to express percentage)( to express percentage)

FD = ((1.98-2)/2) FD = ((1.98-2)/2) ×× 4 4 ×× 100 = -4% 100 = -4%FP = ((2.02-2)/2) FP = ((2.02-2)/2) ×× 4 4 ×× 100 = 4% 100 = 4%

Currency Swaps (combination of spot and forward)Currency Swaps (combination of spot and forward)

-A currency swap refers to the -A currency swap refers to the spot salespot sale of a currency combined of a currency combined with a with a forward purchaseforward purchase of the same currency - as part of a of the same currency - as part of a singlesingle transaction. transaction.

--The swap rateThe swap rate is the difference between the is the difference between the spotspot and and forward rate forward rate in the currency swap.in the currency swap.

-The foreign exchange market is currently dominated by swaps, -The foreign exchange market is currently dominated by swaps, about 50% of foreignabout 50% of foreign exchange contractsexchange contracts. .

OptionsOptions-A foreign exchange option is a contract giving the purchaser the -A foreign exchange option is a contract giving the purchaser the right, but not the obligation, to buy (a right, but not the obligation, to buy (a callcall option) or to sell (a option) or to sell (a putput option) a standard amount of traded currency on a stated date (option) a standard amount of traded currency on a stated date (the the European optionEuropean option) or at any time () or at any time (the American optionthe American option), and at a ), and at a stated price (stated price (the strike or exercise pricethe strike or exercise price). ).

-Restricted -Restricted standard sizesstandard sizes for amount traded. for amount traded.

-The buyer of the option has the -The buyer of the option has the right to purchase or foregoright to purchase or forego the the purchase if it turns out to be purchase if it turns out to be unprofitableunprofitable. .

-The -The sellerseller of the option, however, of the option, however, must fulfillmust fulfill the contract if the the contract if the buyer desires so. buyer desires so.

-For this privilege, the -For this privilege, the buyer must pay the seller a premium (option buyer must pay the seller a premium (option priceprice) ranging from 1 to 5% of the value of the contract. ) ranging from 1 to 5% of the value of the contract.

VII. Foreign Exchange Risk, Hedging and SpeculationVII. Foreign Exchange Risk, Hedging and Speculation

(1) Foreign Exchange Risk(1) Foreign Exchange RiskOver time demand and supply for foreign exchange shifts due Over time demand and supply for foreign exchange shifts due

to changes in tastes, differences in inflation, changes in relative to changes in tastes, differences in inflation, changes in relative interest rates, changing expectations ..etcinterest rates, changing expectations ..etc

•Increasing demandIncreasing demand (tastes) by Kuwaitis for American goods raises (tastes) by Kuwaitis for American goods raises the US $ rate (depreciation of KD)the US $ rate (depreciation of KD)•If domestic inflationIf domestic inflation in Kuwait decreases relative to US inflation the in Kuwait decreases relative to US inflation the US $ depreciates relative to the KD. US $ depreciates relative to the KD. •If interest ratesIf interest rates on domestic currency (KD) deposits are greater than on domestic currency (KD) deposits are greater than the rate on US $ deposits, the KD will appreciate.the rate on US $ deposits, the KD will appreciate.•If expectationsIf expectations of a stronger KD increases, the KD appreciates of a stronger KD increases, the KD appreciates relative to US $.relative to US $.

Fluctuations in exchange rates impose Fluctuations in exchange rates impose risksrisks on individuals, on individuals, firms, and banks that have to make or receive payments in the future firms, and banks that have to make or receive payments in the future denominated in foreign exchange.denominated in foreign exchange.

Examples: Examples:

• A local importer A local importer purchases $ 100,000 of goods to be paid in 3 month time. If the KD/$ rate is 0.300, He will have to pay KD 30,000 in three month time.

-In 3 month time the rate could be 0.330, He will pay 33,000 (extra KD 3000).-In 3 month time the rate could be 0.330, He will pay 33,000 (extra KD 3000).

-The rate could also be 0.270 , then he will only pay KD 27,000 (KD 3000 less)-The rate could also be 0.270 , then he will only pay KD 27,000 (KD 3000 less)

• The exporter and investor The exporter and investor may face the same situationmay face the same situation

Therefore; Therefore;

Both the importer and exporter will have to Both the importer and exporter will have to insureinsure against the against the increase in the rates in 3 months. increase in the rates in 3 months.

In general, whenever a future payment must be made in a foreign In general, whenever a future payment must be made in a foreign currency, a foreign currency risk, or the so called currency, a foreign currency risk, or the so called open positionopen position, , occurs because the spot rate changes overtime. Most business occurs because the spot rate changes overtime. Most business people are people are risk averserisk averse..

(2) Hedging (2) Hedging

Avoidance of “Avoidance of “foreign exchange riskforeign exchange risk” or the covering of an “open ” or the covering of an “open position”. position”.

How it is done? How it is done?

In the spot marketIn the spot market

An importerAn importer purchases $100,000 goods. purchases $100,000 goods. The importer The importer could borrow could borrow domestic currency equals to the $100,000 ( loan with paying interest) and domestic currency equals to the $100,000 ( loan with paying interest) and exchange it at the present spot rate, and leave the sum on deposit in a bank exchange it at the present spot rate, and leave the sum on deposit in a bank for 3 months and earn interest, when the payment is due. This way the for 3 months and earn interest, when the payment is due. This way the importer avoids the risk.importer avoids the risk.

The cost of insuring against the foreign exchange risk is the positive The cost of insuring against the foreign exchange risk is the positive difference between the interest rate he pays on the loan and the interest rate difference between the interest rate he pays on the loan and the interest rate he earns on his deposithe earns on his deposit. .

An exporter An exporter exports $100,000 goods. exports $100,000 goods. The exporterThe exporter who expects the who expects the rate to go down could also borrow the $100,000 in foreign exchange ( rate to go down could also borrow the $100,000 in foreign exchange ( loan with paying interest) he expects to receive, exchange them into loan with paying interest) he expects to receive, exchange them into KDs, and deposit the sum in a bank for 3 month with interest. After 3 KDs, and deposit the sum in a bank for 3 month with interest. After 3 months, he will repay the loan using the payment he receives. months, he will repay the loan using the payment he receives.

The cost of avoiding the risk is the difference between the borrowing The cost of avoiding the risk is the difference between the borrowing and deposit interest rate. and deposit interest rate.

The problem with coverage of exchange risk in the spot market is The problem with coverage of exchange risk in the spot market is that the exporter (importer)that the exporter (importer) has to tie his funds for three months.has to tie his funds for three months.

(3) Speculation(3) Speculation

Opposite of hedging. Opposite of hedging. A speculator accepts and even seeks out a A speculator accepts and even seeks out a foreign exchange risk,foreign exchange risk, or an open position in the hope of making a or an open position in the hope of making a profit. profit.

A speculator can make profit or incurs a loss. A speculator can make profit or incurs a loss.

Speculation can take place in spot, forward, futures and option Speculation can take place in spot, forward, futures and option markets. markets.

How it is done? How it is done?

In the spot marketIn the spot market

If a currency is believed to If a currency is believed to rise in three monthsrise in three months, the speculator will :, the speculator will :

buybuy the currency at the spot rate now. the currency at the spot rate now. deposit the currency in a bank deposit the currency in a bank In the future if the rate is higher, he will sell it at the spot rate and earns In the future if the rate is higher, he will sell it at the spot rate and earns profit.profit.

If a currency is believed to If a currency is believed to fall in three monthsfall in three months, the speculator will:, the speculator will:

borrowborrow the currency and exchange it for domestic currency at the spot rate, the currency and exchange it for domestic currency at the spot rate, deposit the domestic currency in a bank for three months. deposit the domestic currency in a bank for three months. After three months, if the rate is lower, he will purchase the currency at the After three months, if the rate is lower, he will purchase the currency at the sport rate and repay the loan.sport rate and repay the loan.

Note: For a speculation to be profitable, the difference between the two spot Note: For a speculation to be profitable, the difference between the two spot rates should be higher than the rates should be higher than the difference between the interest rates on the difference between the interest rates on the domestic and foreign currencydomestic and foreign currency

VIII. Interest Arbitrage and Efficiency in the Foreign Exchange VIII. Interest Arbitrage and Efficiency in the Foreign Exchange MarketMarket

(1) Uncovered interest arbitrage(1) Uncovered interest arbitrage

Suppose that interest rate on 3 month T.B is 6% in New York and 8% Suppose that interest rate on 3 month T.B is 6% in New York and 8% in Frankfurt.in Frankfurt.

The American investor may want to exchange $ for € and purchase The American investor may want to exchange $ for € and purchase EMU TBs, to earn an extra 2%. When the TBs matures the investor EMU TBs, to earn an extra 2%. When the TBs matures the investor exchange back his euros plus interest into dollars. By that time the exchange back his euros plus interest into dollars. By that time the euro may have depreciated so that he would get fewer dollars than he euro may have depreciated so that he would get fewer dollars than he paid. If the euro depreciates by more than 2% the investor loses. (if paid. If the euro depreciates by more than 2% the investor loses. (if the euro appreciates he would get an extra gain from the appreciation the euro appreciates he would get an extra gain from the appreciation of the euro) (of the euro) (this is an uncovered interest arbitragethis is an uncovered interest arbitrage) )

(2) Covered interest arbitrage(2) Covered interest arbitrage

Investors of short term funds abroad generally want to avoid the foreign Investors of short term funds abroad generally want to avoid the foreign exchange risk by exchange risk by covering interest arbitragecovering interest arbitrage. .

To do this the investor To do this the investor sells forwardsells forward the amount of foreign exchange he the amount of foreign exchange he invested plus interest with the maturity of the investment.invested plus interest with the maturity of the investment.

Covered interest arbitrage:Covered interest arbitrage: refers to the spot purchase of the foreign currency refers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of it to make the investment and the offsetting simultaneous forward sale of it ((swapswap) to cover the risk. ) to cover the risk.

Since the currency with the higher interest rate is Since the currency with the higher interest rate is usually at a forward usually at a forward discount (why?),discount (why?), the the net return on investment is roughly the interest net return on investment is roughly the interest differential minus the differential minus the forward discountforward discount..

(3) Efficiency of foreign exchange markets(3) Efficiency of foreign exchange markets

In general a market is efficient if it reflects all available information.In general a market is efficient if it reflects all available information.

A foreign exchange market is efficient if forward rates accurately predict A foreign exchange market is efficient if forward rates accurately predict the future spot rates. the future spot rates.

If forward rates reflect all available information and quickly adjust to any If forward rates reflect all available information and quickly adjust to any new information so that investors can not earn consistent and unusual new information so that investors can not earn consistent and unusual profits by utilizing any available information, then the market is efficient. profits by utilizing any available information, then the market is efficient.

Tests of efficiency are difficult to formulate and interpret. Tests of efficiency are difficult to formulate and interpret.