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McGraw-Hill/Irwin
8-1
Internationally active firms often seek to hedge their foreign currency exposure
McGraw-Hill/Irwin
9-2
Foreign Exchange
Foreign exchange markets are markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange markets
facilitate foreign trade facilitate raising capital in foreign markets facilitate the transfer of risk between market participants facilitate speculation in currency values
A foreign exchange rate is the price at which one currency can be exchanged for another currency
McGraw-Hill/Irwin
9-3
Foreign Exchange
Foreign exchange risk is the risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange rates Currency depreciation occurs when a countrys currency falls in value relative to other currencies
domestic goods become cheaper for foreign buyers foreign goods become more expensive for domestic purchasers
Currency appreciation occurs when a countrys currency rises in value relative to other currencies
McGraw-Hill/Irwin
9-4
Foreign Exchange
Foreign exchange markets operated under the gold standard through most of the 1800s
U.K. was the dominant international trading country until WWII forced it to deplete its gold reserves to purchase arms and munitions from the U.S.
1944: Bretton Woods Agreement fixed exchange rates within 1% bands 1971: Smithsonian Agreement increased bands to 2 % 1973: Smithsonian Agreement II introduced managed free float
McGraw-Hill/Irwin
9-5
Foreign Exchange
Foreign exchange markets are the largest of all financial markets: turnover averaged $3.2 trillion per day in 2007
London accounts for 42.5% New York accounts for 23.8% France accounts for 7.1%
Prior to 1972, the only channel through which foreign exchange occurred was through banks
twenty-four hours a day over-the-counter (OTC) market among major banks electronic trading of spot and forward contracts over 90% of contracts are settled with delivery of currency
McGraw-Hill/Irwin
9-6
Foreign Exchange
Organized markets have existed since 1972
International Money Market (IMM) (a subsidiary of the Chicago Mercantile Exchange (CME)) is based in Chicago derivative trading in foreign currency futures and options less than 1% of contracts are completed with delivery of the underlying currency
In 1982 the Philadelphia Stock Exchange (PHLX) became the first exchange to offer around-the-clock trading of currency options
McGraw-Hill/Irwin
9-7
The Euro ()
The European Community (EC) was formed in 1967 by consolidating three smaller communities
European Coal and Steel Community European Economic Market European Atomic Energy Community
The Maastricht Treaty of 1993 set the stage for the eventual creation of the Euro
created an integrated system of European central banks overseen by a single European Central Bank (ECB)
The Euro (), the currency of the European Union (EU), began trading on January 1, 1999 when eleven European countries fixed their currencies exchange ratios Euro notes and coins began circulating on January 1, 2002
McGraw-Hill/Irwin
9-8
The Euro ()
The U.S. dollar depreciated against the euro in the mid 2000s The Central Bank of Russia has replaced some of their U.S. dollar reserves with euros, as has the Chinese Central Bank In 2007, 39% of foreign exchange transactions are denominated in euros, compared to 32% denominated in U.S. dollars
McGraw-Hill/Irwin
9-9
The Yuan
In the early 2000s the international community pressured China to allow its currency (the yuan) to float freely instead of pegging it to the U.S. dollar
a depreciated U.S. dollar had caused the yuan to become undervalued Chinese exports were relatively cheap, which hurt domestic manufacturing in other countries
On July 21, 2005 the Chinese government began a policy of managed float
global interest rates and oil prices have since risen China has cut back on foreign securities purchases
McGraw-Hill/Irwin
9-10
Foreign Exchange
Foreign exchange rates may be listed two ways
U.S. dollars received per unit of foreign currency (in US$) foreign currency received for each U.S. dollar (per US$)
McGraw-Hill/Irwin
9-11
McGraw-Hill/Irwin
9-12
McGraw-Hill/Irwin
9-13
McGraw-Hill/Irwin
9-14
Foreign Exchange
A financial institutions overall net foreign exchange exposure in any given currency is measured as
Net exposurei = (FX assetsi FX liabilitiesi) + (FX boughti FX soldi) = net foreign assetsi + net FX boughti = net positioni where i = ith countrys currency
A net long (short) position is a position of holding more (fewer) assets than liabilities in a given currency
McGraw-Hill/Irwin
9-15
Foreign Exchange
A financial institutions position in foreign exchange markets generally reflects four trading activities
purchase and sale of foreign currencies for customers international trade transactions purchase and sale of foreign currencies for customers investments purchase and sale of foreign currencies for customers hedging purchase and sale of foreign currencies for speculation (i.e., profiting through forecasting foreign exchange rates)
McGraw-Hill/Irwin
9-16
and
iS IPS RIR S
McGraw-Hill/Irwin
9-17
McGraw-Hill/Irwin
9-18
1 iUSt (1 / St ) (1 iUKt ) Ft
iUSt = the interest rate on a U.S. investment maturing at time t iUKt = the interest rate on a U.K. investment maturing at time t St = $/ spot exchange rate at time t Ft = $/ forward exchange rate at time t
McGraw-Hill/Irwin
9-19
McGraw-Hill/Irwin
9-20