Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
1.1.1.1.1Chapter Nine
Foreign Exchange Markets
1.1.1.2 I. Chapter Outline
1. Foreign Exchange Markets and Risk: Chapter Overview
2. Background and History of Foreign Exchange Markets
3. Foreign Exchange Rates and Transactions
a. Foreign Exchange Rates
b. Foreign Exchange Transactions
c. Return and Risk of Foreign Exchange Transactions
d. Role of Financial Institutions in Foreign Exchange Transactions
4. Interaction of Interest Rates, Inflation, and Exchange Rates
a. Purchasing Power Parity
b. Interest Rate Parity
Appendix 9A: Balance of Payments Accounts (available on Connect or from your McGraw-Hill
representative)
Instructor’s Manual Appendix: Factors Affecting Exchange Rates (Not in text)
II. Learning Goals
1. Understand what foreign exchange markets and foreign exchange rates are.
2. Understand the history of and current trends in foreign exchange markets.
3. Identify the world’s largest foreign exchange markets.
4. Distinguish between a spot foreign exchange transaction and forward foreign exchange
transaction.
5. Calculate return and risk on foreign exchange transactions.
6. Describe the role of financial institutions in foreign exchange transactions.
7. Identify the relations among interest rates, inflation, and exchange rates.
1.1.1.3 III. Chapter in Perspective
This is the fifth chapter that covers securities markets. In this chapter, a very brief history of
foreign exchange systems (Bretton Woods, e.g.) is provided. The primary focus of the chapter is
to introduce readers to foreign exchange transactions and market terminology. Transaction
exposure and forward hedging are introduced with the emphasis on FI participation in foreign
exchange markets. The concept of translation exposure is introduced, although translation
details are not presented and FASB 52 is not discussed. Relative purchasing power parity and
interest rate parity are introduced and the approximate equations are presented. The two major
balance of payments accounts are explained and recent data are presented. The discussion omits
changes in official reserves and the statistical discrepancy. The appendix (not covered in the
text) outlines some of the major determinants of foreign exchange rate in a conceptual
framework.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Foreign exchange markets Net long (short) in a currency
Foreign exchange rates Open position
Dollarization Safe haven
Foreign exchange risk Purchasing power parity
Currency appreciation Interest rate parity theorem (IRPT)
Currency depreciation Balance of payment accounts
Spot & forward foreign exchange transactions Net exposure
Currency options Law of one price
International Fisher Effect
1.1.1.5
1.1.1.6 V. Teaching Notes
1. Foreign Exchange Markets and Risk: Chapter Overview
In 2012 the U.S. imported $3.3 trillion in goods and services and exported about $3.0 trillion.
Capital markets, foreign exchange markets and derivatives markets all play a part in facilitating
such large amounts of international transactions.
There are two relevant prices involved in international trade. The first is the price of the good or
service purchased and the second is the price of the currency.1 In many transactions the first
price is fixed but the latter will normally fluctuate with changes in the foreign exchange rate.
Fluctuating exchange rates, like fluctuating prices, cause risk in international business
transactions. The foreign exchange rate is in a sense the ‘entry fee’ to purchase a country’s
financial and real goods and services. It is the link between economies, and the foreign
exchange rate reflects the value of the goods and services produced by a given country relative to
the value of goods and services produced in another country. Depreciating foreign currencies
hurt the home currency value of foreign assets, but also reduce the home currency value of
foreign liabilities. The converse is true for appreciating currencies. The recent drop in the value
of the dollar hurt firms that import goods and services into the U.S., but it helped firms that
exported goods and services overseas and improved the translated value of foreign currency
earnings for U.S. U.S. multinational firms.
1 It does not matter whether the good or service purchased is denominated in dollars or not.
Someone faces currency conversion costs and risk. For instance, from the U.S. perspective if the
good is non-dollar denominated the U.S. buyer faces the currency cost, if it is dollar denominated
the foreign seller bears the cost and risk.
Teaching Tip: In fixed or tightly managed floating systems currencies are said to be either
revalued (upward) or devalued (downward). In free floating systems, the terms are appreciation
and depreciation respectively.
2. Background and History of Foreign Exchange Markets
Throughout much of the 1800s countries used a gold standard to back the value of their
currencies. Currency issuers agreed to redeem their notes for a certain amount of gold. Gold
thus became a fungible asset convertible to various currencies. The British pound was at the
center of the global system and the pound was the ‘reserve currency’ for the world. This reserve
currency status adds value to a currency beyond immediate supply demand conditions. The gold
standard with the pound at its center could not be maintained in the late 1930s and early 1940s as
Great Britain depleted its gold stocks to pay for war munitions. After World War II the prior gold
standard was replaced with the gold exchange standard, termed the Bretton Woods System
(1944-1971) after the town in New Hampshire where the agreement was crafted. Under Bretton
Woods, currencies were pegged to the U.S. dollar and the U.S. dollar was backed by gold. This
system worked well until the U.S. began to have higher inflation than other developed
economies, particularly Germany and Japan were willing to maintain. A run on gold ensued in
the early 1970s which led to Nixon closing the ‘gold window’ and led to the Smithsonian
Agreement I (1971). This agreement tried to prop up the system but failed, and the second
Smithsonian Agreement (1973) allowed freely floating exchange rates. The fixed exchange
rate system failed because U.S. inflation was greater than the rest of the developed world. The
system was based on the willingness of foreign countries to hold dollars and backed by the
willingness of the U.S. to exchange dollars for gold. At that time, the dollar’s value was fixed at
$35 per ounce of gold. As more and more market participants doubted that the value of the
dollar could be maintained, fewer participants were willing to hold dollars, preferring gold or
other currencies instead. The Treasury and foreign government authorities were unable to
maintain the value of the dollar as depletion of gold reserves ensued.
Bretton Woods arose because of the need to foster cooperation among countries and promote
trade instead of the competitive devaluations that had occurred during the Depression years. The
instructor should emphasize that all fixed exchange rate systems require cooperation among
member countries; otherwise, fixed exchange rates cannot be maintained because private sector
currency trading can dwarf the size of governments’ currency reserves. However, throughout
much of the Bretton Woods period, private currency market trading was quite low. As the
currency markets grew, governments found it increasingly difficult to maintain a fixed exchange
rate that was inconsistent with relative economic conditions among member countries.
Prior to 1972 all forward foreign exchange trading was over–the–counter trading involving
banks. The International Monetary Market (IMM) began trading foreign currency futures
contracts in 1972 although the OTC forward market still dominates trading activity. Advantages
of trading currency futures on an exchange include:
Anonymity of parties
No credit risk concerns because the exchange’s clearinghouse guarantees performance of
both parties
Standardized known terms of contracts
Liquidity: Most futures contracts do not result in making or taking delivery because
participants who are long (short) in a futures contract can easily go short (long) in the
same contract, netting their position to zero. There is a much lower likelihood of finding
a counterparty to offset a given OTC forward contract.
Disadvantages of using currency futures rather than forwards would include the difficulty in
obtaining the exact contract specifications desired, in particular, currency futures are actively
traded on only the major currencies and long–term contracts may not be available or may be
relatively illiquid. In addition, futures are cash settled daily, gains and losses on forwards are not
recognized until contract maturity, which makes forwards more suitable for hedging in many
cases. Currency options are traded on the Philadelphia Stock Exchange and provide yet another
way to speculate on foreign currency movements or hedge currency transactions.
On January 1, 1999, the euro was introduced to represent the currencies of the eleven
participating European Monetary Union (EMU) countries. The euro was initially used for
payments between nations, for currency speculation and for financial transactions. However, the
euro did not begin to replace domestic currencies in circulation until January 1, 2002 (among 12
European countries at the time, since expanded). The creation of the euro was the next step in
stages for monetary union outlined by the Maastricht Treaty of 1993. The euro declined in
value after its launch, probably partly due to the uncertainty whether the European Central Bank
could successfully manage a common currency for somewhat diverse economies. The
immediate impact of the euro was to reduce foreign currency transactions by consolidating
trading for the original currencies. Nevertheless, the euro was an immediate success in financial
transactions and growth in euro denominated debt instruments has been quite large. The euro
has become the world’s second most important currency (number one is the dollar, number three
is the yen).
Some countries have dollarized their economies, meaning they now use the U.S. dollar as their
currency. A strong stable currency attracts foreign capital, which some emerging markets need to
generate growth. If a country dollarizes they give up the ability to engage in independent
domestic monetary policy in a countercyclical fashion. A dollarized economy is also at risk of a
dollar appreciation, which may make the country’s good and services overpriced or a declining
dollar may generate inflation in the dollarized economy. Dollarization removes the temptation to
monetize public debt and thus may require fiscal discipline. Dollarization may make sense for
countries that can’t provide fiscal discipline any other way.
In 2013 the foreign exchange markets were the largest markets in the world with $5.34 trillion of
daily trading activity in essentially a 24-hour market.
Teaching Tip:
Selected foreign currency reserves 1/2013:
Country Foreign Currency Reserves
(all in $ in billions)
China $3,317
Saudi Arabia 643
Russia 538
Taiwan 398
S. Korea 327
(all U.S. $ value but only an estimated 60% are in U.S. $)
Sources: Economist, ECB and IMF
These reserves are built up when foreign central banks intervene in the currency markets to
acquire dollars or require local firms to exchange foreign currency earnings for the local
currency. Foreign central banks may engage in these operations to suppress or peg the value of
their local currency in order to help stimulate their export sector. Without these interventions the
local currency should rise as local firms that export to the U.S. acquire too many dollars and
begin to sell their dollar holdings in the currency markets. The dropping dollar may them make
the imports too expensive in the U.S or erode foreign profit margins. China in particular has
accumulated huge dollar holdings. China maintains capital controls that regulate private capital
flows in and out of the country. The currency reserves are typically invested in U.S. Treasuries,
keeping U.S. interest rates lower than they would be otherwise and probably allowing the U.S.
government and U.S. private borrowers to accumulate more debt than they could otherwise.
However, accumulation of foreign currency reserves can be inflationary as the process involves
creating extra local currency. Eventually China will have to allow the yuan to float to limit
inflationary pressures in China.
China is now allowing limited fluctuation in the value of the Chinese currency, the yuan, against
the dollar. The yuan is officially valued against a basket of currencies and allowed to fluctuate in
a narrow range although in reality the yuan is managed relative to the euro and the dollar. The
yuan was mostly pegged from 2001-2005 and from 2008-2010. In September 2010 the U.S.
House of Representatives passed a bill allowing the U.S. to institute tariffs or other sanctions
against countries determined to be ‘currency manipulators’ to bolster their export sectors. The
U.S. has considered naming China as a currency manipulator. Note that the U.S.’ QE program
could be considered to be a currency manipulation designed in part to stimulate growth in the
U.S. export sector. In June 2010 China promised to allow the yuan to float more freely.
In 2009 Hong Kong was allowed to begin trading the yuan offshore and offshore deposits grew
from 100 billion yuan in 2010 to 600 billion in 2013. In January 2011 Chinese based companies
use the yuan off the mainland and America was allowed to begin yuan trading. As of October
2011 foreign companies can settle direct investment accounts on the mainland in yuan. China
widened the trading band against the dollar and in February 2013 the CME Group initiated
trading in yuan or renminbi futures.
Will the U.S. dollar remain the world’s reserve currency?
No one know for sure but notice that in the chart below that uses data from the Economist the
disproportionate size of the foreign currency dollar reserves in relation to the proportion of U.S.
financial assets, trade and GDP. The point the Economist Magazine is making is that dollar
currency reserves are too high for the relative size of the U.S. economy, and this may not be
sustainable if foreign investors lose faith in the value of the U.S. economy and its currency. If
other alternatives emerge, such as a more stable European economy and a maturing China, it is
possible and maybe even likely that the reserve currency status of the U.S. dollar will be slowly
eroded over time. This may make it more difficult for the U.S. government to finance its large
deficits and debt levels but the timing of such changes is highly uncertain.
U.S. percentage of the world total in the given category:
Data Source: www.economist.com, China's Currency, The Rise of the Redback, Jan 20, 2011
3. Foreign Exchange Rates and Transactions
a. Foreign Exchange Rates
Currency quotes are often very confusing to students. Rates can be quoted two ways:
1. Dollar value of one unit of foreign currency: £1 = $1.60
2. Foreign currency value of the dollar: $1 = £0.625
These two quotes are inverses.
Teaching Tip: When discussing percentage changes in the value of a currency one must pay
careful attention to the form of the quote. For example if in the above quote we say the pound
appreciated 10%, how is the new value of the pound calculated?
£1 = $1.60 initially so the new value of the pound is $1.60 1.1 = $1.76. The value of the dollar
did not drop 10% however. The inverse of $1.76 is 0.5682 so the $1 = £0.5682, a 9.09% drop.
Teaching Tip: If the dollar appreciates, the foreign currency value of the dollar rises but the
dollar value of the foreign currency falls.
b. Foreign Exchange Transactions
Spot or immediate transactions are normally settled within two to three business days, but
currencies may be bought or sold forward for one or more months (transaction dates beyond 1
year are less common). As a country’s exchange rate increases, its exports may become more
expensive and imports may be relatively cheaper. A strong currency can contribute to a current
account deficit. Conversely, a weaker currency may improve the current account deficit. The
dollar has gone through wide swings in value in recent years. The dollar fell 33% against the
euro from 2002 to 2004, regained much of the loss in 2005 but fell again in 2007 and 2008
reaching record lows.
The dollar regained much of its losses in 2005. The resounding ‘no’ vote on the European
constitution by the French and Dutch constituencies dampened prospects for continuing reforms
needed to stimulate European growth (the so called “Lisbon Reforms”). Concerns about the
expansion of the EU coupled with the no vote raised doubts about the long term viability of the
euro and of the move toward political and economic convergence that some economists feel are
needed to promote European growth.
The dollar’s drop continued in 2007 and in early 2008, hitting record lows against the euro and
declining against the yen. In February 2008 the dollar stood at its weakest in 12 years on a trade
weighted basis. The dollar weakness was due to labor market prospects, the housing problems
and poorer U.S. growth prospects.2
From September 2008 to March 2009 the dollar increased in value against the major currencies
as investor sought safety in U.S. Treasury investments. From March to November 2009 the
dollar began to fall as investors again sought out higher yields as fears of economic collapse
subsided. Subsequent to this time period the dollar strengthened against the euro because of the
European sovereign debt problems in Portugal, Ireland, Iceland, Greece and Spain. About 42%
of all foreign exchange trading involves the dollar and the second largest currency traded is the
euro involved in about 20% of trading. The euro strengthened against the dollar in 2010 and
through August 2011, but in September of 2011 fears of more European problems caused the
dollar to strengthen despite a downgrade of the U.S. credit rating by S&P, particularly after the
U.S. passed a debt ceiling increase.
What lies in store for the dollar in the future? No one knows for sure but the long term trend in
the value of the dollar on a trade weighted basis is down and is likely to continue downward for
the following reasons.
The size of the U.S. current account deficit which was reaching record levels in absolute
terms and as a percent of GDP before the crisis remains large. This deficit may not be
ultimately sustainable because it requires foreigners to be willing to hold large quantities
of dollars (dollar assets).
Europe has had higher interest rates than the U.S, although the European Central Bank
recently dropped its benchmark interest rate and began charging negative deposit rates on
bank reserves. Nevertheless, higher interest rates in Europe puts pressure on the dollar to
fall against the euro through carry trades.3
Asian central banks continue to acquire dollars to keep their currencies from rising.
Europe did not follow suit and the result has been a stronger euro, ceteris paribus.
Continuing problems with Europe’s economies and growing disillusionment with the
2 “Dollar’s Dive Deepens as Oil Soars: Power of Greenback Faces Severe Test, But No Rivals
Loom, by Craig Karmin and Joanna Slater, The Wall Street Journal Online, February 29, 2008,
Page A1.
3 In carry trades the investor borrows in the low interest rate currency, sells the currency and
invests in the high interest rate currency. This puts pressure on the dollar to fall if our rates are
lower than in Europe.
euro may limit the extent of euro appreciation against the dollar. Weaker Chinese growth
may limit dollar appreciation against the yuan.
The administration has not seemed to mind having the dollar drop. A falling dollar can
help the export sector of the U.S. economy. It seems likely that the U.S. will pursue an
easy monetary policy for some time to come and this will continue to put pressure on the
dollar to fall and stress the world’s willingness to absorb dollars.
As a result of the subprime crisis, high government debt levels and the credit crunch the
U.S. continues on a slower growth path than many other countries potential growth. This
may imply poorer investment opportunities and returns than can be found elsewhere but
the safe haven status of the dollar continues to outweigh the desire for higher returns that
should be available elsewhere.
Teaching Tip: The classical economic treatment of a dropping dollar improving the current
account deficit is true but the effects of devaluation are more complex than may first be realized.
As explained in Determinants of the Balance of Trade and Payments, 1997: Published in
International Money and Finance, by Michael Melvin, the elasticity of demand for U.S. goods
and services and the elasticity of supply of U.S. imports are crucial factors in how quickly a
devaluation leads to an improvement in the current account. For instance, if a depreciation leads
to import price increases to maintain foreign profit margins, more money may be spent on
imports, not less, at least in the short run. This is the basis for the so called “J” curve where a
current account deficit first gets worse with devaluation (the downward part of the J) and
eventually improves (the upward movement along the J).
Teaching Tip: As indicated above the Fed (U.S. Treasury) has had to allow the dollar to drop in
order to stimulate the economy with lower interest rates due to the ongoing anemic U.S. job
growth. Not all economists agreed on this policy, worrying that the dollar’s slide could become
precipitous and difficult to stop although this fear is probably overblown. The drop in value of
the dollar also exacerbates recessionary and inflationary pressures on the U.S. economy. Many
commodities are dollar priced, including oil and gold. If the dollar drops in value, eventually
oil prices may increase, because foreign oil sellers want to maintain their home currency profit
margins and because demand increases for buyers whose currency has appreciated against the
dollar, reducing the effective cost of the higher dollar price. The increased supply from fracking
has dampened these price pressures however.
All this adds to longer term inflationary risk which, if it occurs, will likely result in less
consumer spending on other items. Consumer spending has been a major driver of U.S. growth.
Subsidies for alternative biofuels have also created inflation in food prices. People forget how
regressive inflation actually is, hurting poorer people far more than those in higher income
brackets. The Fed has a difficult task managing the multiple risks now facing the U.S. economy.
Not all currencies declined against the dollar. Some countries that also had current account
deficits saw their currencies decline against the dollar, including South Korea, South Africa,
Indonesia, India and Turkey. These countries have had difficulties financing their deficits,
leading to drops in currency values. See the appendix for further discussion or see the cites
below:4
c. Return and Risk of Foreign Exchange Transactions
For a U.S. firm, transaction exposure (exposure to a change in the value of a foreign currency for
a given transaction) arises whenever foreign currency assets or liabilities are acquired, or when
commitments to buy or sell in a foreign currency are made. Commitments to purchase goods or
services in a foreign currency are at risk from rising foreign exchange rates (falling dollar) and
may be hedged by buying the foreign currency forward. Commitments to sell in a foreign
currency are at risk from falling foreign currency values and may be hedged by selling the
currency forward.
Teaching Tip: Any event that will lead to the receipt of foreign currency may be hedged by
selling the currency forward. Any event that requires payment of foreign currency in the future
may be hedged by buying the currency forward. Hedgers may have difficulty hedging beyond
one year with forwards; this is one reason for the creation of longer term swaps.
4 “Weak Dollar Feels New Stress,” by Joanna Slater, The Wall Street Journal Online, March 11,
2008, Page A1, and “The Yen and Euro May Grab the Headlines, But Not All Currencies Are
Beating the Buck,” by Evan Ramstad, The Wall Street Journal Online, March 18, 2008, Page C2.
