Chapter Nine

Foreign Exchange
Markets

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 Overview of Foreign
Exchange Markets
• Today’s U.S.-based companies operate globally
• Events and movements in foreign financial markets can
affect the profitability and performance of U.S. firms
• Foreign trade is possible because of the ease with which
foreign currencies can be exchanged
• Internationally active firms often seek to hedge their
foreign currency exposure

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 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
• A foreign exchange rate is the price at which one
currency can be exchanged for another currency

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 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 country’s 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 country’s currency
rises in value relative to other currencies

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 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

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 Foreign Exchange

• Foreign exchange rates may be listed two ways

– U.S. dollars received per unit of foreign currency (in US$)
– foreign currency received for each U.S. dollar (per US$)
• Foreign exchange can involve both spot and forward
transactions
– spot foreign exchange transactions involve the immediate
exchange of currencies at current exchange rates
– forward foreign exchange transactions involve the exchange of
currencies at a specified exchange rate at a specific date in the
future

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 Foreign Exchange Risk

• The risk involved with a spot foreign exchange transaction

is that the value of the foreign currency may change
relative to the U.S. dollar
• Foreign exchange risk can come from holding foreign
assets and/or liabilities
• Suppose a firm makes an investment in a foreign country:
– convert domestic currency to foreign currency at spot rates
– invest in foreign country security
– repatriate foreign investment and investment earnings at
prevailing spot rates in the future

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 Foreign Exchange Risk

• Firms can hedge their foreign exchange exposure either on

or off the balance sheet
• On-balance-sheet hedging involves matching foreign
assets and liabilities
– as foreign exchange rates move any decreases in foreign asset
values are offset by decreases in foreign liability values (and vice
versa)
• Off-balance-sheet hedging involves the use of forward
contracts
– forward contracts are entered into (at t = 0) that specify exchange
rates to be used in the future (i.e., no matter what the prevailing
spot exchange rates are at t = 1)

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 Foreign Exchange

• A financial institution’s 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 country’s currency

• A net long (short) position is a position of holding more

(fewer) assets than liabilities in a given currency

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 Foreign Exchange

• A financial institution’s 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)

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 Purchasing Power Parity

• Purchasing power parity (PPP) is the theory explaining

the change in foreign currency exchange rates as inflation
rates in the countries change

i = interest rate
IP = inflation rate
RIR = real rate of interest
US = the United States
S = foreign country

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 Purchasing Power Parity

• Assuming real rates of interest are equal across countries

• Finally, the PPP theorem states that the change in the

exchange rate between two countries’ currencies is
proportional to the difference in the inflation rates in the
countries

SUS/S = the spot exchange rate of U.S. dollars per unit of foreign
currency

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 Interest Rate Parity

• The interest rate parity theorem (IRPT) is the theory

that the domestic interest rate should equal the foreign
interest rate minus the expected appreciation of the
domestic currency

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

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 Balance of Payments Accounts

• Balance of payments accounts summarize all

transactions between citizens of two countries
– current accounts summarize foreign trade in goods
and services, net investment income, and gifts, grants,
and aid given to other countries
– capital accounts summarize capital flows into and out
of a country

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