CHAPTER 11
FOREIGN EXCHANGE
CHAPTER OVERVIEW
This chapter discusses the nature and operation of the foreign exchange market. The chapter begins by describing
the foreign exchange market and the types of foreign exchange transactions. Emphasis is placed on the interbank
market for foreign exchange.
Next we consider the forward market and futures market and also the market for foreign currency options. The role
of the International Monetary Market of the Chicago Mercantile Exchange is emphasized in this section.
Next we examine the nature and operation of uncovered interest arbitrage and covered interest arbitrage. The
chapter concludes by examining foreign exchange market speculation.
After completing this chapter, the student should be able to:
BRIEF ANSWERS TO STUDY QUESTIONS
1. The foreign exchange market refers to the organizational setting within which individuals, firms, and banks buy
and sell foreign currencies. The two largest foreign exchange markets are located in New York and London.
3. The supply and demand for foreign exchange is derived from the credit (debit) items on the balance of
payments, such as exports or investment flows.
5. Traders and investors often participate in the forward market to protect their expected profits from the risk of
exchange rate fluctuations. Speculators also participate in the forward market.
6. The relation between the spot rate and forward rate is a reflection of the interest rate differential between
8. Stabilizing speculation refers to the purchase of a foreign currency with the domestic currency when there
9. The dollar appreciates against the pound; the pound depreciates against the dollar. The dollar depreciates
against the pound; the pound appreciates against the dollar.
10. Arbitragers will buy pounds in New York, at $1.69 per pound, and sell pounds in London, at $1.71 per pound,
11. a. $1.50 per pound. 30 pounds are purchased at a cost of $45.
12. a. The U.S. importer can cover her foreign exchange risk by purchasing 20,000 pounds for three–
month delivery at today’s three-month forward rate of $1.75 per pound. The importer is willing to
pay 5 cents more per pound (or $1000 more for the 20,000 pounds) than today’s spot rate to
13. a. The U.S. investor would purchase pounds on the spot market at $2 per pound, and use the
14. a. 1.7090, 1.7105, 1.7084, 1.7099, 1.7081, 1.7096, 1.7090, 1.7103.
b. $0.5851 per franc, $1.7090 francs per dollar.
15. a. The U.S. speculator should sell francs today for delivery in 6 months at today’s forward rate of the
$0.40 each and deliver them for the previously contracted rate of $0.50 per franc; the speculator
realizes a profit of $0.10 on each franc which the forward contract specifies. If the franc’s spot