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Introduction

• Purchases of an international transaction:


– Buying foreign currency
– Foreign currency used to facilitate
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international transaction
• Institutional arrangements required
– Settling monetary claims with minimum
inconvenience to parties
• Foreign-exchange markets
International Monetary System
Unit
• IMF
• Salient features
• Collapse of the IMF system
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• Floating Exchange rates


• Debt Crisis of developing countries
• Washington Consensus
• LPG Strategy
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Foreign-Exchange Market
• Organizational setting involving
transaction of buying and selling foreign
currencies and other debt instruments
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– Transaction conducted by individuals,


businesses, governments, and banks
– Not all currencies are traded for reasons
ranging from political instability to economic
uncertainty
Foreign-Exchange MarketContinued
• Functions at three levels:
– Transactions between commercial banks and
their commercial customers
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– Domestic interbank market conducted through


brokers
– Transactions between trading banks and their
overseas branches or foreign correspondents
Types of Foreign-Exchange
Transactions
• Spot transaction
– Outright purchase and sale of foreign currency for
cash settlement; immediate delivery
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• Forward transaction
– Based on contracts, for future payment receipts
• Currency swap
– Conversion of one currency to another currency
• Distribution of foreign-exchange transactions (
Table 11.1)
Interbank Trading
• Bank transactions with each other
– Retail transactions
– Wholesale transactions
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• Foreign-exchange departments of major


commercial banks serve as profit centers
– Leading banks trading in the foreign-
exchange market (Table 11.2)
Interbank Trading Continued

• Earning profits in foreign-exchange


transactions:
– Bid rate: Price bank is willing to pay for a unit
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of foreign currency
– Offer rate: Price at which the bank is willing to
sell a unit of foreign currency
– Difference between bid and offer rate:
• Size of the transaction
• Liquidity of the currencies being traded
Forward and Futures Markets
• Forward contracts:
– Made by those who will receive or make payment in
foreign exchange in the weeks or months ahead
– The New York foreign-exchange market is a spot
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market for most currencies of the world (Table 11.3)


• Futures market:
– Contracting parties agree to future exchanges of
currencies; set applicable exchange rates in advance
– Example: International Monetary Market (IMM)
• Major differences between forward and futures
market (Table 11.4)
Future Market: International
Monetary Market (IMM)
• Foreign-exchange trading limited to major
currencies
– IMM’s futures prices (Table 11.5)
• Size of contract on same line as currency’s name and
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country
– First column shows the maturity months of the contract
• Open: Price at which yen was first sold
• High, low, and settle columns indication of contract’s closing
prices for the day
• Change compares closing prices
• Lifetime high and low
• Open interest: Total number of contracts outstanding
Foreign-Currency Options
• Provide options holder the right to buy or
sell a fixed amount of foreign currency at a
prearranged price
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– Two types of foreign-currency options:


• Call option
• Put option
– Strike price: Price at which the option can be
exercised
Exchange-Rate Determination
• Demand for foreign exchange
– Derived from the debit items on its balance of
payments
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• Supply of foreign exchange


– All factors held constant, amount of foreign
exchange offered to the market at various
exchange rates
• Relationship between demand and supply
(Figure 11.1)
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Exchange-Rate Determination
Continued

• Equilibrium rate of exchange


– Determined by the market forces of supply
and demand
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– Exchange-market equilibrium occurs at point


E (Figure 11.1)
Is a Strong Dollar Always Good and
a Weak Dollar Always Bad?
• Parties affected by strengthening or
weakening dollar:
– Consumers
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– Tourists
– Investors
– Exporters
– Importers
• Effects of strengthening and weakening (
Table 11.6)
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Is a Strong Dollar Always Good and
a Weak Dollar Always Bad?
• Cases for discussion
– High Sierra Sport Co., a leather-goods
manufacturer in Illinois
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– Trek Bicycle Inc., a bike manufacturer in


Wisconsin
– Computer Network Technology Inc., a
producer of network systems in Minnesota
– Sony Computer Entertainment, Inc., a U.S.-
based unit of Sony Corp.
Arbitrage
• Factor underlying consistency of the exchange
rates
– Exchange arbitrage
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– Two-point arbitrage
– Three-point (triangular) arbitrage
• Result of this activity:
– Currency exchange rates consistent throughout the
world
– Only minimal deviations due to transaction costs
Forward Market
• Currencies bought and sold now for future
delivery
– Period range from date of transaction
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– Exchange rate agreed on at the time of the


contract
– Payment made only when actual delivery
takes place
– Banks provide this service to earn profits
Forward Rate
• Rate of exchange used in the settlement
of forward transactions
– Premium: Foreign currency worth more in the
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forward market than in the spot market


– Discount: Currency is worth less in the
forward market than in the spot market

– Examples of forward rates (Table 11.8)


Forward Rate Differs from the Spot
Rate
• What determines the forward rate?
– Interest-rate differentials between countries
• Why might it be at a premium or discount
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compared to the spot rate?


– One country’s interest rates higher than
another’s, currency is a forward discount
– One country’s interest rates lower than
another country’s, currency is a forward
premium
Forward Market Functions
• Hedging: Protects international
traders and investors from risks
involved in fluctuations of spot rate
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– Case 1: U.S. importer hedges against a


dollar depreciation
– Case 2: U.S. exporter hedges against a
dollar appreciation
How Markel Rides Foreign-
Exchange Fluctuations
• Business model to shield itself from
exchange rates fluctuations:
– Charge customers relatively stable prices in
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their own currencies


– Use forward currency markets to foster
revenue stability
– Cut costs and improve efficiency
– Roll the dice and hope things turn out
favorably
Does Foreign-Currency Hedging
Pay Off?
• Beneficial for firms that realize more than half of
its sales in profits in foreign currencies
• Standard argument for hedging:
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– Increased stability of cash flows and earnings


• Reasons companies may not view hedging as a
benefit:
– Locks in an exchange rate costs up to half a
percentage point per year of the revenue being
hedged
– Fluctuations in a firm’s business can detract from the
effectiveness of foreign-currency hedging
Foreign-Exchange Market
Speculation
• Speculation: Attempt to profit by trading on
expectations about prices in the future
• Stabilizing speculation: Goes against
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market forces by moderating or reversing


a rise or fall in a currency’s exchange rate
• Destabilizing speculation: Goes with
market forces by reinforcing fluctuations in
a currency’s exchange rate
Currency Markets Draw Day
Traders
• Foreign-exchange market has become a
speculative arena for individual traders
• Professional traders caution against
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amateurs speculating in foreign currencies