Chapter Nine

Foreign
Exchange
Markets

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 Overview of Foreign Exchange
Markets
 Cash flows from the sale of products, services, or assets
denominated in a foreign currency are transacted in
foreign exchange (FX) markets
 A foreign exchange rate is the price at which one currency
(e.g., the U.S. dollar) can be exchanged for another currency
(e.g., the Swiss franc) in the foreign exchange markets
 These transactions expose U.S. corporations and investors to
foreign exchange risk as the cash flows are converted into
and out of U.S. dollars
 Currency depreciation (appreciation) occurs when a
country’s currency falls (rises) in value relative to other
currencies
© 2022 McGraw-Hill Education. 9-2
 Background and History of
Foreign Exchange Markets
 During most of the 1800s, FX markets operated under a
gold system, where currency issuers guaranteed to redeem
notes, upon demand, in an equivalent amount of gold
 From 1944-1971, the Bretton Woods Agreement called for
the exchange rate of one currency for another to be fixed
within narrow bands around a specified rate with the help of
government intervention
 Smithsonian Agreement of 1971 allowed the dollar to be
devalued and the boundaries between which exchange rates
could fluctuate were increased from 1% to 2.25%
 In 1973, under Smithsonian Agreement II, exchange rate
boundaries were eliminated, creating a free-floating system that
is still partially in place
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 Background and History of
Foreign Exchange Markets
(Continued)
 Though the free-floating FX rate system is still partially in
place, central governments may still intervene in the FX
markets
 In 1992, 12 major European countries and Vatican City pegged
their exchange rates together to create a single currency, called
the euro
 Until 1972, the interbank FX market was the only channel
through which spot and forward FX transactions took
place
 Since 1972, organized markets such as the International Money
Market (IMM) or the Chicago Mercantile Exchange (CME) have
developed derivatives trading in FX currency futures and options
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Largest Global FX Markets

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 The Introduction of the Euro

 Euro is the European Union’s single currency

 Started trading on January 1, 1999
 Creation of the euro had its origins in the creation of the
European Community (EC) a consolidation of three European
communities in 1967:
 European Coal and Steel Community, the European Economic
Market, and the European Atomic Energy Community
 Significant effect throughout Europe, as well as the global
financial system
 Dollar remains the unparalleled medium of exchange because
it is the world’s easiest currency to buy or sell
 In 2019, 88% of all FX transactions were denominated in dollars,
while 32% were denominated in euros
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 Dollarization

 Dollarization is the use of a foreign currency in parallel

to, or instead of, the local currency
 After the gold standard and the Bretton Woods Agreement were
abandoned, many countries achieved currency stabilization by
pegging the local currency to a major convertible currency
 Other countries abandoned their local currency in favor of
exclusive use of the U.S. dollar (or another major international
currency, such as the euro)
 Dollarization may occur unofficially or officially
 Major advantage is the promotion of fiscal discipline and
thus greater financial stability and lower inflation
 Panama, Ecuador, and El Salvador are the biggest economies to
have officially dollarized
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 Free-Floating Yuan

 In 2005, China shifted away from its currency’s (the yuan)

peg to the U.S. dollar
 China stated the value of the yuan would be determined using a
“managed” floating system with reference to an unspecified
basket of foreign currencies
 Partial free-floating of the yuan was in part the result of pressure
from Western countries whose politicians argued that China’s
currency regime gave it an unfair advantage in global markets
 In 2009, China began a pilot program of internationalizing its
currency by allowing Hong Kong banks to trade the yuan
 In 2011, China began to allow Americans to trade in the currency
 In 2015, the IMF designated the Chines yuan an IMF-
accepted reserve currency
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 Foreign Exchange Rates

 Recall, a FX rate is the price at which one currency (e.g.,

the U.S. dollar) can be exchanged for another currency
(e.g., the Swiss franc)

 FX rates are listed in two ways:

1. U.S. dollars received for one unit of the foreign currency
exchanged (IN US$ or USD, also referred to as the direct
quote)
2. Foreign currency received for each U.S. dollar exchanged
(PER US$, also referred to as the indirect quote)

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Foreign Currency Exchange Rates

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 Foreign Exchange Transactions

 Two types of FX rates and FX transactions:

1. Spot FX transactions involve the immediate exchange of
currencies at the current (or spot) exchange rate
2. Forward FX transaction is the exchange of currencies at a
specified exchange rate (or forward exchange rate) at some
specified date in the future
 Example is an agreement today (at time 0) to exchange dollars
for pounds at a given (forward) exchange rate in three months
 Typically written for one-, three-, or six-month periods
 Of the $6.6 trillion in average daily trading volume in the
FX markets in 2019, 30.1% involved spot transactions
while 69.9% involved forward and other transactions
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Spot versus Forward Foreign
Exchange Transaction

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Exchange Rate of the U.S. Dollar
with Various Foreign Currencies

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Measuring Risk and Return on FX
Transactions
 Risk involved with a spot FX transaction is that the
value of the foreign currency may change relative to
the U.S. dollar over a holding period
 FX risk is also introduced by adding foreign currency
assets and liabilities to a firm’s balance sheet

 FIs, and particularly commercial banks, are the main

participants in the FX markets

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FX Risk: Example

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 FX Risk: Example (Continued)

 To hedge, the U.S. firm could have entered into a forward:

 If the U.S. firm had entered into a one-month forward contract
selling the Swiss franc on March 13, 2020, at the same time it
purchase the spot francs, the U.S. firm would have been
guaranteed an exchange rate of 1.0502 U.S. dollars per Swiss
franc, or 0.9522 Swiss francs per U.S. dollar, on delivering the
francs to the buyer in one month’s time
 If the U.S. firm had sold francs one month forward at 1.0502 on
March 13, 2020, it would have largely avoided the $43,800 loss
 By selling 3 million francs forward, it would have received
1.0502 x Sf 3 million = $3,150,600 at the end of the month,
suggesting a small net loss of $3,150,600 - $3,156,300 =
$5,700 on the combined spot and forward transactions
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 Hedging Foreign Exchange Risk

 Managers hedge to manage their exposure to currency

risks, not to eliminate it
 While it reduces possible losses, it also reduces possible gains
 An FI can better control the scale of its FX exposure in
either of two major ways:
1. On-balance-sheet hedging involves making changes in the on-
balance-sheet assets and liabilities to protect the FI’s profits
from FX risk
2. Off-balance-sheet hedging involves no on-balance-sheet
changes, but rather involves taking a position in forward or
other derivative securities to hedge FX risk

© 2022 McGraw-Hill Education. 9-17

 On-Balance-Sheet Hedging

 By directly matching its foreign asset and liability book, an

FI can lock in a positive return or profit spread whichever
direction exchange rates change over the investment
period
 Sources of FX risk exposure include the following:
 International differentials in real prices
 Cross-country differences in the real rate of interest
 Regulatory and government intervention
 Restrictions on capital movements
 Trade barriers
 Tariffs

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Hedging with Forwards

 Securities that may be used to hedge foreign exchange

risk includes the following:
 Forwards
 Futures and options foreign exchange contracts
 Foreign exchange swaps

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 Role of Financial Institutions in FX
Transactions

 FX market transactions are conducted among dealers

mainly OTC using telecommunication and computer
networks
 A major structural change in FX trading has been the growing
share of electronic brokerage in the interbank markets at the
expense of direct dealing (and telecommunication)

 Since 1982, when Singapore opened its FX market, FX

markets have operated 24 hours a day

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Financial Institutions in FX
Transactions

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 Role of Financial Institutions in FX
Transactions (Continued)
 An FI’s net exposure is the overall FX exposure in any
given currency, measured by its net book or position
exposure, where i = ith country’s currency:

 A positive net exposure position implies an FI is overall net

long in a currency (i.e., the FI has purchased more foreign
currency than it has sold)
 A negative net exposure position implies the FI is net short
(i.e., the FI has sold more foreign currency than it has
purchased) in a foreign currency
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 Role of Financial Institutions in FX
Transactions (Concluded)
 A financial institution’s position in the FX markets generally
reflects four trading activities:
1. Purchase and sale of foreign currencies to allow customers to
partake in and complete international commercial trade
transactions
2. Purchase and sale of foreign currencies to allow customers
(or the FI itself) to take positions in foreign real and financial
investments
3. Purchase and sale of foreign currencies for hedging purposes
to offset customer (or FI) exposure in any given currency
4. Purchase and sale of foreign currencies for speculative
purposes through forecasting or anticipating future
movements in FX rates
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 Interaction of Interest Rates,
Inflation, and Exchange Rates
 Recall the relationship among nominal interest rates, real
interest rates, and expected inflation is the Fisher effect

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 Interaction of Interest Rates,
Inflation, and Exchange Rates
(Continued)
 The international Fisher effect incorporated FX rates into
the relationship; the expected spot rate is the current spot
rate multiplied by the ratio of the foreign nominal interest
rate to the domestic nominal interest rate:

 Suppose the spot exchange rate of U.S. dollars for

Canadian dollars is 0.7709, the current nominal interest
rate in the U.S. is 4%, and the nominal interest rate in
Canada is 5%. The international Fisher effect predicts:

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 Purchasing Power Parity (PPP)

 Purchasing power parity (PPP) is the theory explaining

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

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 Purchasing Power Parity (PPP)
(Continued)
 Assuming real rates of interest (or rates of time
preference) are equal across countries:

 Then, the following is true:

 PPP theorem states the change in the exchange rate
between two countries’ currencies is proportional to the
difference in their inflation rates:

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Purchasing Power Parity (PPP)
(Concluded)
 The law of one price is an economic rule which states
that, in an efficient market, identical goods and services
produced in different countries should have a single
price
 This is the theory behind purchasing power parity
 An example of this line of thinking is demonstrated in
The Economist’s “Big Mac” index

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 Interest Rate Parity

 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
 IRPT can be expressed as the following:

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Interest Rate Parity: Example

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