I. Exchange Rate definintion:

The price of one currency against another currency is called an exchange rate.
If for instance, today, in order to buy one Euro you have to pay 40¢, then the dollar exchange rate against Euro is .40 dollar per Euro.

II. The importance of exchange rates in international transaction and exchange rate quotation:

Exchange rates play a central role in international transactions. Let's assume you, as a customer, want to buy a car. You are considering buying a Ford Escort for $7000 and a Toyota for which the price is 10,000,000 Japanese Yen. 10,000,000 Yen!! Should you spend 10,000,000 Yen on a car? You do not know until you find out what
the $/Yen exchange rate is.
What if you find out that for every $ you can buy 2000 Yen. So, in fact, buying the Toyota is to your advantage, because it will only cost you $5000 to buy the Toyota. 10,000,000/2000 = 5000

III. How one can get information about exchange rates?

In the U.S., major newspapers report the exchange rates in their financial sections daily.
The handout shows exchange rate quotation by the Wall Street Journal.
Notice that each price is stated in two ways:

1. As the price of a foreign currency in terms of dollars (ie. with one British Pound, one can buy $1.17 dollars).
2. As the price of dollars in terms of the foreign currency (ie. with $1, you can get .85 British Pound).

Throughout this course, to avoid confusion, we will use the first method.

As it is explained at the top of the table, the rates generally quoted refer to the trading among the banks (for the amount of $1million and more), which are the major actors in the foreign exchange market.

The next question is then what is the foreign exhange market.

EXCHANGE RATE TABLE

IV. Foreign Exchange Market:

Foreign exchange market is where the exchange rate is determined. This market is not a single gathering place where traders shout buy and sell orders at each other. Traders work at their desk dealing with each other by computer and by phone.
Who are these traders?

Who are the major participants in the foreign exchange markets?

V. The Major Participants in the Foreign Exchange Market:

The major participants in the foreign exchange markets are commercial banks, and to a smaller degree central banks, non-financial institutions and corporations and brokers (intermediaries between banks). (Sometimes banks would like to keep their rate confidential and they deal with brokers.)
Because the major role is played by the commercial banks, we concentrate on their operations in the foreign exchange market.

Every major bank around the world posts the exchange rate ranges at which it is willing to trade currencies. A bank shopping for its customers or itself first consult the exchange rate ranges. It does that through its computer.

The bank obviously is going to buy British £ from Citibank. This way will save its customers $100.

To buy £1,000,000 from Bank of America, Scott Paper would pay $1,174,000
To buy £1,000,000 from Citibank in N Y, Scott Paper would pay $1,173,900

Difference $100.00

VI. Services provided by the Foreign Exchange Market:

The two most important services provided by the foreign exchange market are:
1. CLEARING
2. HEDGING

1. Clearing: The foreign exchange market provides clearing services to many businesses and individuals.
Clearing services mean that foreign exchange market helps each party in transaction to end up holding the kind of currency which it prefers. If you want British Pounds or Deutsche Marks, you can get them through the foreign exchange market.

Why may you need British Pounds £?

American demand £ for either travelling to England or sending gift to a friend or relative who lives in England. The Americans, however, primarily demand British £ when they are importing goods from England. (Also, they may want to keep their wealth in form of £ as we will see shortly).

If someone in the U.S. imports, say, a million dollars of British automobiles, then it is very likely that they should
pay the British auto company the equivalent in British £. So the American firm is going to buy equivalent of $1 million in £.

In general, US IMPORTS of goods and services will create a DEMAND for foreign currency and a SUPPLY
of $.**

In contrast, if a British firm wants to buy $1 million worth of American aircraft, it has to pay it in $ (American firm accepts $). So it has to give British £ in order to buy $1 million.

In general, US EXPORTS of goods and services will create a SUPPLY of foreign currency and a DEMAND for $.

** (Only if US Exporter is content to hold £ and/or the British Importers have large reserves of $ to spend, can US exports keep from generating a supply of £ and a demand for $.)

** The US firm selling aircrafts to British importer in exchange for payment in £ would take the British importer's promise to pay (IOU) and sell it to a bank in return for $. This US bank can sell this IOU in £ to another bank which wants to buy £ with $. In financial jargon, the US exporter "draws a bill on London" and "discounts" it with a US bank, which "rediscounts" it.

2. Hedging: The fact that exchange rate fluctuates makes some people hesitant in holding any foreign exchange. These people want to hold only their home currency. This act is called hedging.
Hedging means protect yourself against the risk, making sure you have neither net asset or a net liablity in a foreign currency.

Example 1: You are managing the financial assets of an American Rock group and that group just received £100,000 in check from London as a result of selling its records in London. (The interest rate in England is higher than in the US.) The exchange rate is now $1.74 per £, but it may drop or rise in the next 3 months. Let's suppose that the group does not want to take a risk and wants to take advantage of higher rate of interest, and consequently use the foreign exchange market and sell its £100,000 for $117,400. Whether or not the group ends up making more money or not is irrelevant, since it does not want to have the value of its wealth depend on the future exchange rate.

Example 2: An American who will have to pay £100,000 in 3 months does not have to wait to buy £ sterling in future at uncertain exchange rate. He can hedge against the sterling liablity by buying £ now and holding enough money in Britain to be able to repay £100,000 after 3 months. (He buys it now, pays $174,000 and will pay it in 3 months.)

What if in the future exchange rate for £ increased to $2.00? In order to pay his debt, he must pay $200,000.

VII. Spot and Forward Exchange Rates:

SPOT: Most of foreign exchange transactions take place on spot, meaning thats when the buying and selling currencies take place immediately. The exchange rates governing such transactions are called spot exchange rate.

Using spot or immediately is somehow misleading, because even under a spot transaction, the parties actually receive the funds (currencies) which they have purchased within 2 working days.

FORWARD: You can, however, buy a foreign currency not on spot, but for a future delivery. You can buy a foreign currency for a month from today, or for two months from today.
The exchange rate negotiated now for later delivery is called forward exchange rate.

British £

Spot rate £1 = $2

3 mon forward rate £1 = $2.025

3 mon forward rate £1 = $1.975

A foreign currency is said to be at premium when it buys more $ in the forward market than in the spot
market. (FR>SR)

For instance: when spot rate is $2 and 180 day forward rate is $2.025, then we say £ is selling at Forward Premium.

The difference between the spot and forward rate are usually expressed in % form on a per annum basis: (like interest rate).

For Instance: spot rate

Functions of the forward / future exchange rate:

The primary function/purpose of the forward market is to protect international traders and investors from the risks involved in fluctuations of the spot rate. As we discussed previously, the process of avoiding or covering a foreign exchange risk is known as hedging. The people who expect to make or receive payments in terms of a foreign currency at future dates are concerned that if the spot rate changes, they must make a greater payment, or receive less in terms of the domestic currency, than expected. This would wipe out anticipated profit level.

Consider the situation of a US importer who must pay £10,000 in three months. Today spot rate 1 £ = $1 (This will not remain the same.) Should the dollar price of £ rise? ($ depreciates), the purchase of £10,000 requires more dollar than expected. To cover himself against this risk, the importer might buy £ immediately, but then he is going to have the opportunity cost associated with immobilizing his funds for 3 months. Alternatively, the importer could cover himself in forward market and buy £ at today's forward rate. Then he knows the exact rate he has to negotiate in 3 months, but he does not have to pay for it immediately. The importer has hedged his exchange risk.

Forward contracts must be honored by both parties on the delivery date. Though forward contract can be reversed (eg. a party can sell a currency forward in order to neutralize a previous purchase.)

Hedgers always use forward market if they have to receive or pay something in the future.

Speculation in the foreign exchange market:

Speculation is the opposite of hedging. Whereas a hedger seeks to cover a risk, a speculator accepts risk in the hope of making a profit. Speculation can take place in the spot and forward markets - more likely the forward market.
i. Speculation in spot market: If a speculator believes that the spot rate of a particular foreign currency will rise ( you will need more $ per foreign currency), he could purchase the currency now and hold it or deposit in a bank for resale. If he is correct and the spot rate does indeed rise, he earns a profit. EX. Today's spot rate (£1=$1), purchase £10,000 and if tomorrow exchange rate changes to (£1=$2), sell £10,000 and receive $20,000 & in the process makes $10,000 profit.

On the other hand, if today's rate is (£1 = $1) and he believes the spot rate will fall to (£1=$.50) tomorrow, he could borrow £10,000 from a British bank and immediately sell it for $ (at present spot rate of £1=$1). He will obtain $10,000 and assuming he is correct and the rate falls the next day, he could profit by paying $5000 in order to buy £10,000 and pay his debt to the bank.

In both of the above examples, the speculator either has to tie up his own funds or had to borrow to speculate, which has serious shortcomings and involves certain cost in addition to the exchange market risk. (In one case, opportunity cost is another interest which he has to pay on borrowed money)

ii. Speculation in Forward market: The most widely used method of profiting from speculation is operation in a forward exchange market. In such operation, speculator does not have to immobilize his funds immediately.

Short position: when one sells £ in forward, that is when speculator expects spot rate in 3 months will be less than 3 month forward.
Ex. Suppose that the 3 month forward rate on the £ is FR $2.02=£1 and the speculator believes that the spot rate of the £ in 3 months will be SR $1.98=£1. Let's say he sells £10,000 forward for delivery in 3 months. (He does not have to pay any money now.) After 3 months, if he is correct, the he buys 10,000 on the spot rate (10,000 * $1.98 = $19,800) and immediately sells this £10,000 at the pre-agreed upon forward rate of $2.02 and receives $20,200 (£10,000 * $2.02 = $20,200) and makes a profit of $400 (20,200 - 19,800).

Speculator who does such an operation is said to have taken a short position. Meaning he sells £ at foward exchange rate today.

Long position: when one buys in forward, happens when one expects 3 month spot rate > 3 month forward rate.
Ex. An alternative to the above speculator is the one who believes that the spot rate of £ in 3 months will exceed the forward rate of (FR $2.02 = £1). For instance, s/he believes that that spot rate of £ in 3 months will be
(SR $2.22 = £1). In this case s/he will buy, let's say, £10,000 in the forward market. So, in 3 months he has to pay $2.02 * £10,000 = $20,200 to buy £. If his prediction is correct and spot rate of £ will be $2.22=£1, then he immediately sell £10,000 and receives $2.22 * £10,000 = $22,200 and makes a profit of $2000.
Such a speculator is said to have taken a long position. Meaning, he buys £ at forward rate today.

In practice, most speculators are wealthy individuals or firms rather than banks. They conduct their transactions at the International Monetary Market, established in 1972 by the Chicago Mercantile Exchange. At this market, an established speculator for a mere $5000 (let's say deposit) can trade up to $100,000 worth of foreign currency.

Speculation and Exchange Market Stability:

An exchange market speculator's activities can exert either stabilizing or destabilizing influence on the exchange market.
Stabilizing: An speculator can have a stabilizing effect on the market and that happens when he buys foreign currency when the $ price ($1=£1) of that foreign currency will soon increase. Such purchase increases the demand for the foreign currency, which moderates $ appreciation (foreign currency depreciation).

Destabilizing: occurs when a speculator sells a foreign currency when it depreciates (was $1=£1, now 50¢=£1), the expectation is that it will further depreciate in the future (10¢=£1). Such sales depress the foreign currencies value.

So destabilizing occurs when speculation goes along with market forces by reinforcing the fluctuation in an exchange rate. Stabilizing speculation, on the other hand, goes against the market forces by moderating or reversing a rise or fall in a currency's exchange rate.