ENC 500 SEU Economics Brazils Balance of Payments Discussion

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Select a country of your choice (other than Saudi Arabia) and observe the last balance of payments issued by that country. Does the country run a current account deficit or surplus? What are the driving factors for the deficit or surplus? What policies should the government implement to improve the external position of the country?

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INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 11:
Foreign
Exchange
© 2019 Cengage. All rights reserved.
2
Chapter Outline (1 of 2)
Foreign Exchange Market
Foreign Currency Trading Becomes Automated
Types of Foreign Exchange Transactions
Interbank Trading
Reading Foreign Exchange Quotations
Forward and Futures Markets
Foreign Currency Options
Exchange Rate Determination
© 2019 Cengage. All rights reserved.
3 3
Chapter Outline (2 of 2)
Indexes of the Foreign-Exchange Value of the
Dollar: Nominal & Real Exchange Rates
The Forward Market
Interest Arbitrage, Currency Risk, and Hedging
Foreign Exchange Market Speculation
Foreign Exchange Trading as a Career
© 2019 Cengage. All rights reserved.
4 4
Foreign Exchange Market (1 of 2)
Foreign exchange market
• Organizational setting in which individuals,
businesses, governments, and banks buy and
sell foreign currencies and other debt
instruments
• Largest and most liquid market in world
• Dominated by four currencies
• U.S. dollar, Euro, Japanese yen, British pound
© 2019 Cengage. All rights reserved.
5
Foreign Exchange Market (2 of 2)
• Foreign exchange market (cont.)
• Three of largest markets located in London,
New York, and Tokyo
• Foreign Exchange Market functions at 3
levels:
• Transactions between commercial banks and
commercial customers
• Domestic interbank market conducted through
brokers
• Active trading in foreign exchange with banks
overseas
© 2019 Cengage. All rights reserved.
6
Types of Foreign Exchange
Transactions (1 of 4)
Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, and swap
• Spot market
• Foreign exchange bought and sold for delivery
immediately
• Spot transaction
• Outright purchase or sale of currency now, as in “on the
spot”
• Spot dealing simplest way to meet currency
requirements but carries high risk of exchange rate
fluctuations because there’s no certainty of rate until
transaction complete
© 2019 Cengage. All rights reserved.
7
Types of Foreign Exchange
Transactions (2 of 4)
• Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, swap (cont.)
• Forward transactions
• Receiving or paying an amount of foreign currency on a
specific date in future, months to years from now
• Fixed exchange rate
• Protect against unfavorable movements in exchange
rate but will not allow gains to be made, should
exchange rate move in one’s favor
• Forward market
• Foreign exchange bought/sold for delivery at future
date?exists mainly for widely traded currencies
© 2019 Cengage. All rights reserved.
8
Types of Foreign Exchange
Transactions (3 of 4)
• Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, swap (cont.)
• Currency swaps
• Conversion of one currency to another currency at
one point in time
• Agreement to reconvert it back to original
currency at specified time in future
• Rates of both exchanges agreed to in advance
• Involves single transaction in which traders
agree to pay/receive stipulated amounts of
currencies at specified rates
© 2019 Cengage. All rights reserved.
9
Types of Foreign Exchange
Transactions (4 of 4)
TABLE 11.1 Global Distribution of Foreign Exchange Transactions, 2016
AVERAGE DAILY VOLUME (BILLIONS OF DOLLARS)
Foreign Exchange Instrument
Foreign exchange/currency swaps
Amount
Percentage
$2,460
48.6
1,652
32.6
Forward transactions
700
13.8
Foreign exchange options
254
5.0
5,066
100.0
Spot transactions
Total
Source: From Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market, 2016. See also Federal Reserve Bank of New York, 2016, Triennial Central Bank Survey of
Foreign Exchange and Derivatives Market, available at http://www.newyorkfed.org/.
© 2019 Cengage. All rights reserved.
10
Interbank Trading
(1 of 3)
Retail transactions
• Bank purchases from and sales to customers
• Less than 1 million currency units
Wholesale transactions
• More than 1 million currency units
• Between banks or with large corporate
customers
© 2019 Cengage. All rights reserved.
11
Interbank Trading
(2 of 3)
TABLE 11.2 Top Ten Banks by Share of Foreign Exchange Market, 2016
Bank
Share of Foreign Exchange Market
Citi (United States)
12.91
JP Morgan (United States)
8.77
UBS (Switzerland)
8.76
Deutsche Bank (Germany)
7.86
Bank of America Merrill Lynch (United States)
6.40
Barclays (United Kingdom)
5.67
Goldman Sachs (United States)
4.65
HSBC (Hong Kong)
4.56
XTX Markets (United Kingdom)
3.87
Morgan Stanley (United States)
3.19
Source: From “Foreign Exchange Survey,” Euromoney, 2016, available at www.euromoney.com.
© 2019 Cengage. All rights reserved.
12
Interbank Trading
(3 of 3)
• Earning profits in foreign-exchange
transactions (24-hour basis)
• Bid rate – price that bank is willing to pay for
unit of foreign currency
• Offer rate – price at which bank is willing to
sell unit of foreign currency
• Spread – difference between bid and offer
rate
• A bank’s bid quote < its offer quote to make a profit © 2019 Cengage. All rights reserved. 13 Reading Foreign Exchange Quotations (1 of 2) Exchange rate • Price of one currency in terms of another • Number of units of foreign currency required to purchase one unit of domestic currency Exchange rate reported • Midrange between bid and offer prices © 2019 Cengage. All rights reserved. 14 Reading Foreign Exchange Quotations (2 of 2) • Currency depreciation • More units of a nation’s currency required to purchase a unit of foreign currency • Currency appreciation • Fewer units of a nation’s currency required to purchase a unit of foreign currency • Cross-exchange rate • Exchange rate between any two currencies (such as Swiss franc and British pound) © 2019 Cengage. All rights reserved. 15 Forward and Futures Markets (1 of 6) Foreign exchange can be bought & sold for delivery immediately (spot market) or in future (forward market) Foreign exchange can also be traded in futures market • Parties agree to future exchanges of currencies and set applicable exchange rates in advance • Only some leading currencies traded • Trading takes place in standardized contract amounts and in specific geographic location © 2019 Cengage. All rights reserved. 16 Forward and Futures Markets (2 of 6) TABLE 11.4 Forward Contract versus Futures Contract Forward Contract Futures Contract Issuer Commercial bank International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange Trading “Over the counter” by telephone On the IMM’s market floor Contract size Tailored to the needs of the exporter/importer/investor; no set size Standardized in round lots Date of delivery Negotiable Only on particular dates Contract costs Based on the bid/offer spread Brokerage fees for sell- and buy-orders Settlement On expiration date only, at prearranged price Profits or losses paid daily at close of trading © 2019 Cengage. All rights reserved. 17 Forward and Futures Markets (3 of 6) • International Monetary Market (IMM) • Chicago Mercantile Exchange, 1972 • Extension of commodity futures market • Size of each contract • On the same line as the currency’s name and country • First column • Maturity months © 2019 Cengage. All rights reserved. 18 Forward and Futures Markets (4 of 6) TABLE 11.5 Foreign Currency Futures, April 24, 2017 Open High Low Settle Change Open Interest JAPAN YEN (CME)—12.5 million yen; $ per 100 yen May .9084 .9126 .9070 .9118 ?.0046 487 June .9090 .9139 .9075 .9130 ?.0046 202,972 Source: From Chicago Mercantile Exchange, International Monetary Market, available at http://www.cme.com/trading. © 2019 Cengage. All rights reserved. 19 Forward and Futures Markets (5 of 6) • Open • Price at which currency first sells when IMM opens in morning • High • Contract’s highest price for day • Low • Contract’s lowest price for day • Settle • Contract’s closing price for day © 2019 Cengage. All rights reserved. 20 Forward and Futures Markets (6 of 6) • Change • Compares today’s closing price with closing price as listed in previous day’s paper • (+) means prices ended higher • (?) means prices ended lower • Open interest • Total number of contracts outstanding © 2019 Cengage. All rights reserved. 21 Foreign Currency Options (1 of 3) Option • Agreement between holder (buyer) and writer (seller) • Holder has right, but not obligation, to buy or sell financial instruments at any time through specified date • Writer (seller) has obligation to fulfill a transaction • Used by firms seeking to hedge against rate risk; also used by speculators seeking profit © 2019 Cengage. All rights reserved. 22 Foreign Currency Options (2 of 3) • Foreign currency options • Options holder has right to buy or sell fixed amount of foreign currency at prearranged price within specified period • Can choose which exchange rate to guarantee and length of contract • Call option • Gives holder right to buy foreign currency at specified price © 2019 Cengage. All rights reserved. 23 Foreign Currency Options (3 of 3) • Put option • Gives holder right to sell foreign currency at specified price • Strike price • Price at which option can be exercised • Premium • Fee received by writer of options contract © 2019 Cengage. All rights reserved. 24 Exchange Rate Determination (1 of 6) Demand for Foreign Exchange • Exchange rates in free market determined by supply and demand • Demand for foreign exchange • Is derived demand • Is driven by foreigners’ demand for domestic goods and assets • Corresponds to debit items in a country’s balance of payments • Varies inversely with price © 2019 Cengage. All rights reserved. 25 Exchange Rate Determination (2 of 6) • Supply of Foreign Exchange • Amount of foreign exchange offered in market • Increases at various exchange rates, all other factors equal © 2019 Cengage. All rights reserved. 26 Exchange Rate Determination (3 of 6) © 2019 Cengage. All rights reserved. 27 Exchange Rate Determination (4 of 6) • Equilibrium Rate of Exchange • Determined by market forces of supply and demand • Increase in demand for pounds (rightward shift of demand curve) • Dollar depreciates against pound • Decrease in demand for pounds (leftward shift of demand curve) • Dollar appreciates against pound © 2019 Cengage. All rights reserved. 28 Exchange Rate Determination (5 of 6) • Increase in supply of pounds (rightward shift) • Dollar appreciates against pound • Decrease in supply of pounds (leftward shift) • Dollar depreciates against pound © 2019 Cengage. All rights reserved. 29 Exchange Rate Determination (6 of 6) TABLE 11.6 Advantages and Disadvantages of a Strengthening and Weakening Dollar Strengthening (appreciating) dollar Advantages Disadvantages 1. U.S. consumers see lower prices on foreign goods. 1. U.S. exporting firms find it harder to compete in foreign markets. 2. Lower prices on foreign goods help keep U.S. inflation low. 2. U.S. firms in import-competing markets find it harder to compete with lower-priced foreign goods. 3. U.S. consumers benefit when they travel to foreign countries. 3. Foreign tourists find it more expensive to visit the United States. Weakening (depreciating) dollar Advantages Disadvantages 1. U.S. exporting firms find it easier to sell goods to foreign markets. 1. U.S. consumers face higher prices on foreign goods. 2. Firms in the United States have less competitive pressure to keep prices low. 2. Higher prices on foreign goods contribute to higher inflation in the United States. 3. More foreign tourists can afford to visit the United States. 3. U.S. consumers find traveling abroad more costly. © 2019 Cengage. All rights reserved. 30 Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (1 of 4) Exchange-rate index • Effective exchange rate or trade-weighted dollar • Weighted average of exchange rates between domestic currency and those of nation’s most important trading partners • Weights determined by relative importance of nation’s trade with each of its trading partners © 2019 Cengage. All rights reserved. 31 Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (2 of 4) • Nominal exchange-rate index • Average value of dollar • Not adjusted for changes in price levels in U.S. and trading partners • An increase means the dollar appreciates relative to other currencies in index • Loss of U.S. competitiveness • A decrease means the dollar depreciates relative to other currencies in index • Improves U.S. competitiveness © 2019 Cengage. All rights reserved. 32 Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (3 of 4) TABLE 11.7 Exchange-Rate Indexes of the U.S. Dollar (March1973 = 100)* Year 1973 (March) 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 (December) Nominal Exchange-Rate Index Real Exchange-Rate Index 100.0 87.4 138.3 92.7 86.6 87.4 98.3 85.4 80.7 73.6 95.8 100.0 91.3 117.7 83.5 81.8 85.3 103.1 90.6 88.5 82.8 109.0 *The “major currency index” includes the currencies of the United States, Canada, Euro area, Japan, United Kingdom, Switzerland, Australia, and Sweden. Source: From Federal Reserve, Foreign Exchange Rates, available at http://www.federalreserve.gov/releases/H10/Summary/. © 2019 Cengage. All rights reserved. 33 Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (4 of 4) • Real exchange-rate index • Embodies changes in price levels in different countries; indicates average value of dollar based on real exchange rates • Real exchange rate - nominal exchange rate adjusted for relative price levels • Increase in index indicates appreciation of dollar Real Exchange Rate = Nominal Exchange Rate ? © 2019 Cengage. All rights reserved. Foreign Country's Price Level ( Home Country's Price Level ) 34 Arbitrage (1 of 2) Exchange arbitrage • Simultaneous purchase and sale of currency in different foreign-exchange markets • Goal is to profit from exchange-rate differentials in the two locations • Eventually leads to identical price for same currency in different locations • Results in one market © 2019 Cengage. All rights reserved. 35 Arbitrage (2 of 2) • Two-point arbitrage • Two currencies traded between two financial centers • Three-point arbitrage • Triangular arbitrage • Three currencies and three financial centers • Switching funds among three currencies to profit from exchange-rate inconsistencies © 2019 Cengage. All rights reserved. 36 The Forward Market (1 of 8) Forward market • Currencies bought and sold now for future delivery – typically 1, 3, or 6 months • Exchange rate agreed to at time of contract • Payment made when future delivery takes place • Banks provide this service to earn profits © 2019 Cengage. All rights reserved. 37 The Forward Market (2 of 8) • Forward rate • Rate of exchange used in settlement of forward transactions • At a premium • When a foreign currency is worth more in forward market than in spot market • At a discount • When a foreign currency is worth less in forward market than in spot market © 2019 Cengage. All rights reserved. 38 The Forward Market (3 of 8) Forward rate Premium (discount ) = Forward Rate ? Spot Rate 12 ? Spot Rate No. of Months Forward $1.0944 ? $1.0904 12 Premium = ? = 0.044, or 4.4 percent $1.0904 1 © 2019 Cengage. All rights reserved. 39 The Forward Market (4 of 8) • Relative gains from interest-rate differentials tend to be offset by losses on foreign-exchange conversions, reducing or eliminating the incentive to invest in U.K. Treasury bills © 2019 Cengage. All rights reserved. 40 The Forward Market (5 of 8) Managing Your Foreign Exchange Risk: Forward Foreign Exchange Contract • Interest rates play key role in determining relative attractiveness of assets denominated in domestic and foreign currencies • Exchange-rate fluctuations • Can substantially change returns on assets denominated in foreign currency • Can swamp effects of interest-rate differentials © 2019 Cengage. All rights reserved. 41 The Forward Market (6 of 8) • Managing Your Foreign Exchange Risk: Forward Foreign Exchange Contract (cont’d) • Firms and individuals can insulate themselves from volatile currency values by hedging— i.e., avoiding or covering a foreign exchange risk—in forward market • Some firms do not hedge • Rationalize that currency fluctuations even out over the long term–no need to hedge © 2019 Cengage. All rights reserved. 42 The Forward Market (7 of 8) • How Markel, Volkswagen, and Nintendo Manage Foreign Exchange Risk • Many hedge and convert cash when exchange rates most favorable • Smaller companies (e.g., Markel) can purchase forward contracts that guarantee bottom-line exchange rate regardless of actuals © 2019 Cengage. All rights reserved. 43 The Forward Market (8 of 8) • Does Foreign Currency Hedging Pay Off? • When currencies fluctuate dramatically, hedging may be too expensive • Some companies (e.g., 3M) do not hedge, believing market evens out over time © 2019 Cengage. All rights reserved. 44 Interest Arbitrage, Currency Risk, and Hedging (1 of 4) Interest arbitrage • Process of moving funds into foreign currencies to take advantage of higher investment yields abroad Currency risk • Unpredictable losses or gains returns from foreign investments converted from foreign to domestic currency © 2019 Cengage. All rights reserved. 45 Interest Arbitrage, Currency Risk, and Hedging (2 of 4) Uncovered interest arbitrage • When investor does not obtain exchange-market cover to protect investment proceeds from foreign-currency fluctuations TABLE 11.9 Uncovered Interest Arbitrage: An Example Rate per Year Rate per 3 Months U.K. 3-month Treasury bill interest rate 10% 2.5% U.S. 3-month Treasury bill interest rate 6% 1.5% Uncovered interest differential favoring the U.K. 4% 1.0% © 2019 Cengage. All rights reserved. 46 Interest Arbitrage, Currency Risk, and Hedging (3 of 4) • Covered interest arbitrage (Reducing currency risk) • Investor exchanges domestic currency for foreign currency at current spot rate • Uses foreign currency to finance foreign investment • Investor contracts in forward market to sell amount of foreign currency that will be received as proceeds from investment © 2019 Cengage. All rights reserved. 47 Interest Arbitrage, Currency Risk, and Hedging (4 of 4) TABLE 11.10 Covered Interest Arbitrage: An Example Rate per Year Rate per 3 Months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest-rate differential favoring the U.K. 4% 1% Forward discount on the 3-month pound Covered interest-rate differential favoring the U.K. © 2019 Cengage. All rights reserved. ?0.5% 0.5% 48 Foreign Exchange Market Speculation (1 of 2) • Speculation • • Attempt to profit by trading on expectations about prices in future Deliberate assumption of exchange-rate risk • Long position • Attempt to realize gains from an expected appreciation of a currency • Short position • “sell high and buy low” © 2019 Cengage. All rights reserved. 49 Foreign Exchange Market Speculation (2 of 2) • Stabilizing speculation • Works against market forces by moderating or reversing rise/fall in currency’s exchange rate • Useful function for bankers and businesses that seek stable exchange rates • Destabilizing speculation • Can amplify and reinforce fluctuations in currency’s exchange rate • Can disrupt international transaction by impeding trade and disrupting investment © 2019 Cengage. All rights reserved. 50 Foreign Exchange Trading as a Career • Foreign exchange traders hired by commercial banks, companies, central banks • Study factors that affect local economies and rates of exchange, then take advantage of misvaluations of currencies by buying and selling in different foreign exchange markets • Do you really want to trade currencies? • Only 15% of day traders realize profits © 2019 Cengage. All rights reserved. 51 INTERNATIONAL ECONOMICS SEVENTEENTH EDITION ROBERT J. CARBAUGH © 2019 Cengage. All rights reserved. 1 Chapter 11: Foreign Exchange © 2019 Cengage. All rights reserved. 2 Chapter Outline (1 of 2) Foreign Exchange Market Foreign Currency Trading Becomes Automated Types of Foreign Exchange Transactions Interbank Trading Reading Foreign Exchange Quotations Forward and Futures Markets Foreign Currency Options Exchange Rate Determination © 2019 Cengage. All rights reserved. 3 3 Chapter Outline (2 of 2) Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates The Forward Market Interest Arbitrage, Currency Risk, and Hedging Foreign Exchange Market Speculation Foreign Exchange Trading as a Career © 2019 Cengage. All rights reserved. 4 4 Foreign Exchange Market (1 of 2) Foreign exchange market • Organizational setting in which individuals, businesses, governments, and banks buy and sell foreign currencies and other debt instruments • Largest and most liquid market in world • Dominated by four currencies • U.S. dollar, Euro, Japanese yen, British pound © 2019 Cengage. All rights reserved. 5 Foreign Exchange Market (2 of 2) • Foreign exchange market (cont.) • Three of largest markets located in London, New York, and Tokyo • Foreign Exchange Market functions at 3 levels: • Transactions between commercial banks and commercial customers • Domestic interbank market conducted through brokers • Active trading in foreign exchange with banks overseas © 2019 Cengage. All rights reserved. 6 Types of Foreign Exchange Transactions (1 of 4) Banks typically engage in 3 types of foreign exchange transactions: spot, forward, and swap • Spot market • Foreign exchange bought and sold for delivery immediately • Spot transaction • Outright purchase or sale of currency now, as in “on the spot” • Spot dealing simplest way to meet currency requirements but carries high risk of exchange rate fluctuations because there’s no certainty of rate until transaction complete © 2019 Cengage. All rights reserved. 7 Types of Foreign Exchange Transactions (2 of 4) • Banks typically engage in 3 types of foreign exchange transactions: spot, forward, swap (cont.) • Forward transactions • Receiving or paying an amount of foreign currency on a specific date in future, months to years from now • Fixed exchange rate • Protect against unfavorable movements in exchange rate but will not allow gains to be made, should exchange rate move in one’s favor • Forward market • Foreign exchange bought/sold for delivery at future date?exists mainly for widely traded currencies © 2019 Cengage. All rights reserved. 8 Types of Foreign Exchange Transactions (3 of 4) • Banks typically engage in 3 types of foreign exchange transactions: spot, forward, swap (cont.) • Currency swaps • Conversion of one currency to another currency at one point in time • Agreement to reconvert it back to original currency at specified time in future • Rates of both exchanges agreed to in advance • Involves single transaction in which traders agree to pay/receive stipulated amounts of currencies at specified rates © 2019 Cengage. All rights reserved. 9 Types of Foreign Exchange Transactions (4 of 4) TABLE 11.1 Global Distribution of Foreign Exchange Transactions, 2016 AVERAGE DAILY VOLUME (BILLIONS OF DOLLARS) Foreign Exchange Instrument Foreign exchange/currency swaps Amount Percentage $2,460 48.6 1,652 32.6 Forward transactions 700 13.8 Foreign exchange options 254 5.0 5,066 100.0 Spot transactions Total Source: From Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market, 2016. See also Federal Reserve Bank of New York, 2016, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market, available at http://www.newyorkfed.org/. © 2019 Cengage. All rights reserved. 10 Interbank Trading (1 of 3) Retail transactions • Bank purchases from and sales to customers • Less than 1 million currency units Wholesale transactions • More than 1 million currency units • Between banks or with large corporate customers © 2019 Cengage. All rights reserved. 11 Interbank Trading (2 of 3) TABLE 11.2 Top Ten Banks by Share of Foreign Exchange Market, 2016 Bank Share of Foreign Exchange Market Citi (United States) 12.91 JP Morgan (United States) 8.77 UBS (Switzerland) 8.76 Deutsche Bank (Germany) 7.86 Bank of America Merrill Lynch (United States) 6.40 Barclays (United Kingdom) 5.67 Goldman Sachs (United States) 4.65 HSBC (Hong Kong) 4.56 XTX Markets (United Kingdom) 3.87 Morgan Stanley (United States) 3.19 Source: From “Foreign Exchange Survey,” Euromoney, 2016, available at www.euromoney.com. © 2019 Cengage. All rights reserved. 12 Interbank Trading (3 of 3) • Earning profits in foreign-exchange transactions (24-hour basis) • Bid rate - price that bank is willing to pay for unit of foreign currency • Offer rate - price at which bank is willing to sell unit of foreign currency • Spread - difference between bid and offer rate • A bank’s bid quote < its offer quote to make a profit © 2019 Cengage. All rights reserved. 13 Reading Foreign Exchange Quotations (1 of 2) Exchange rate • Price of one currency in terms of another • Number of units of foreign currency required to purchase one unit of domestic currency Exchange rate reported • Midrange between bid and offer prices © 2019 Cengage. All rights reserved. 14 Reading Foreign Exchange Quotations (2 of 2) • Currency depreciation • More units of a nation’s currency required to purchase a unit of foreign currency • Currency appreciation • Fewer units of a nation’s currency required to purchase a unit of foreign currency • Cross-exchange rate • Exchange rate between any two currencies (such as Swiss franc and British pound) © 2019 Cengage. All rights reserved. 15 Forward and Futures Markets (1 of 6) Foreign exchange can be bought & sold for delivery immediately (spot market) or in future (forward market) Foreign exchange can also be traded in futures market • Parties agree to future exchanges of currencies and set applicable exchange rates in advance • Only some leading currencies traded • Trading takes place in standardized contract amounts and in specific geographic location © 2019 Cengage. All rights reserved. 16 Forward and Futures Markets (2 of 6) TABLE 11.4 Forward Contract versus Futures Contract Forward Contract Futures Contract Issuer Commercial bank International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange Trading “Over the counter” by telephone On the IMM’s market floor Contract size Tailored to the needs of the exporter/importer/investor; no set size Standardized in round lots Date of delivery Negotiable Only on particular dates Contract costs Based on the bid/offer spread Brokerage fees for sell- and buy-orders Settlement On expiration date only, at prearranged price Profits or losses paid daily at close of trading © 2019 Cengage. All rights reserved. 17 Forward and Futures Markets (3 of 6) • International Monetary Market (IMM) • Chicago Mercantile Exchange, 1972 • Extension of commodity futures market • Size of each contract • On the same line as the currency’s name and country • First column • Maturity months © 2019 Cengage. All rights reserved. 18 Forward and Futures Markets (4 of 6) TABLE 11.5 Foreign Currency Futures, April 24, 2017 Open High Low Settle Change Open Interest JAPAN YEN (CME)—12.5 million yen; $ per 100 yen May .9084 .9126 .9070 .9118 ?.0046 487 June .9090 .9139 .9075 .9130 ?.0046 202,972 Source: From Chicago Mercantile Exchange, International Monetary Market, available at http://www.cme.com/trading. © 2019 Cengage. All rights reserved. 19 Forward and Futures Markets (5 of 6) • Open • Price at which currency first sells when IMM opens in morning • High • Contract’s highest price for day • Low • Contract’s lowest price for day • Settle • Contract’s closing price for day © 2019 Cengage. All rights reserved. 20 Forward and Futures Markets (6 of 6) • Change • Compares today’s closing price with closing price as listed in previous day’s paper • (+) means prices ended higher • (?) means prices ended lower • Open interest • Total number of contracts outstanding © 2019 Cengage. All rights reserved. 21 Foreign Currency Options (1 of 3) Option • Agreement between holder (buyer) and writer (seller) • Holder has right, but not obligation, to buy or sell financial instruments at any time through specified date • Writer (seller) has obligation to fulfill a transaction • Used by firms seeking to hedge against rate risk; also used by speculators seeking profit © 2019 Cengage. All rights reserved. 22 Foreign Currency Options (2 of 3) • Foreign currency options • Options holder has right to buy or sell fixed amount of foreign currency at prearranged price within specified period • Can choose which exchange rate to guarantee and length of contract • Call option • Gives holder right to buy foreign currency at specified price © 2019 Cengage. All rights reserved. 23 Foreign Currency Options (3 of 3) • Put option • Gives holder right to sell foreign currency at specified price • Strike price • Price at which option can be exercised • Premium • Fee received by writer of options contract © 2019 Cengage. All rights reserved. 24 Exchange Rate Determination (1 of 6) Demand for Foreign Exchange • Exchange rates in free market determined by supply and demand • Demand for foreign exchange • Is derived demand • Is driven by foreigners’ demand for domestic goods and assets • Corresponds to debit items in a country’s balance of payments • Varies inversely with price © 2019 Cengage. All rights reserved. 25 Exchange Rate Determination (2 of 6) • Supply of Foreign Exchange • Amount of foreign exchange offered in market • Increases at various exchange rates, all other factors equal © 2019 Cengage. All rights reserved. 26 Exchange Rate Determination (3 of 6) © 2019 Cengage. All rights reserved. 27 Exchange Rate Determination (4 of 6) • Equilibrium Rate of Exchange • Determined by market forces of supply and demand • Increase in demand for pounds (rightward shift of demand curve) • Dollar depreciates against pound • Decrease in demand for pounds (leftward shift of demand curve) • Dollar appreciates against pound © 2019 Cengage. All rights reserved. 28 Exchange Rate Determination (5 of 6) • Increase in supply of pounds (rightward shift) • Dollar appreciates against pound • Decrease in supply of pounds (leftward shift) • Dollar depreciates against pound © 2019 Cengage. All rights reserved. 29 Exchange Rate Determination (6 of 6) TABLE 11.6 Advantages and Disadvantages of a Strengthening and Weakening Dollar Strengthening (appreciating) dollar Advantages Disadvantages 1. U.S. consumers see lower prices on foreign goods. 1. U.S. exporting firms find it harder to compete in foreign markets. 2. Lower prices on foreign goods help keep U.S. inflation low. 2. U.S. firms in import-competing markets find it harder to compete with lower-priced foreign goods. 3. U.S. consumers benefit when they travel to foreign countries. 3. Foreign tourists find it more expensive to visit the United States. Weakening (depreciating) dollar Advantages Disadvantages 1. U.S. exporting firms find it easier to sell goods to foreign markets. 1. U.S. consumers face higher prices on foreign goods. 2. Firms in the United States have less competitive pressure to keep prices low. 2. Higher prices on foreign goods contribute to higher inflation in the United States. 3. More foreign tourists can afford to visit the United States. 3. U.S. consumers find traveling abroad more costly. © 2019 Cengage. All rights reserved. 30 Indexes of the Foreign-Exchange Value of the Dollar: Nominal & Real Exchange Rates (1 of 4) Exchange-rate index • Effective exchange rate or trade-weighted dollar • Weighted average of exchange rates between domestic currency and those of nation’s most important trading partners • Weights determined by relative importance of nation’s trade with each of its trading partners © 2019 Cengage. All rights reserved. 31 Inde