Fall Semester 09-10 Akila Weerapana

Lecture 3: The Foreign Exchange Market

I. INTRODUCTION
In the last lecture, we looked at some exchange rate basics, including denitions, the distinction between real and nominal exchange rates, the concepts of appreciation and depreciation and how they would aect exports and imports. We also discussed the possibilities and limitations of using a simple supply/demand framework to model the determination of the exchange rate. We concluded by discussing the major players in the f/x market and some of the dierent reasons that bring buyers and sellers to the foreign exchange market In todays lecture, we will take a closer look at how the various needs of major players have driven the creation of various types of markets in which domestic and foreign currency are exchanged. Within the umbrella of the trading system we term the foreign exchange market, there are two broad types of markets. The rst type known as spot markets, is similar to most markets in that buyers and sellers meet to agree on a price for an immediate transaction. The second type of market is where buyers and sellers meet to agree on a price today for a transaction to take place in the future. We will look at three dierent incarnations of this type of market - forward markets, futures markets and options markets. In the forward market, buyers and sellers agree on prices today for future delivery of currency; in the futures market, buyers and sellers place bets on what the future value of a currency is; and in the options market, buyers and sellers can (for a price) obtain the ability to trade currency in the future at a rate agreed on today

II. THE SPOT MARKET

The spot market for foreign exchange is the market for currency delivered immediately or, at the most, within a couple of days. These exchange rates are typically for large blocs of currency, typically $1 million or more. Individuals who trade smaller amounts are likely to get much more unfavorable exchange rates and larger spreads. The actions of people engaging in arbitrage brings about some striking features of the spot market, which are worth a closer look. It is important to keep in mind that, unlike speculation, arbitrage is a risk-free prot making opportunity. In a world where currency trading has no restrictions, the actions of arbitrageurs will quickly take advantage of, and eliminate, arbitrage opportunities. Some of these regularities are as follows: 1. Arbitrage ensures that we can talk about a single exchange rate for a pair of currencies even though they may be transacted at various locations all over the world. Think about the arbitrage opportunity aorded by an exchange rate of 1.20 $/e in London and 1.199

$/e in New York. Traders rush to make a prot by exchanging dollars for euros in New York and re-exchanging euros for dollars in London. In the process, the demand for euros rises in New York causing the dollar to depreciate (the $/e exchange rate in NY rises above 1.199 $/e) while the demand for dollars rises in London causing the dollar to appreciate there (the $/e rate in London falls below 1.2 $/e). As a result, we are very likely to see a quick move towards a single exchange rate somewhere in between the two values, say 1.19975 $/e. 2. The existence of arbitrage ensures cross-rate consistency among currencies. So the = = $/Y rate should be equivalent to the $/erate multiplied by the e/Y exchange rate, otherwise arbitragers can make money by trading through the euro. For example, suppose you see the following exchange rates: 1.2 $/e, 0.8 $/C$ being oered by a bank in New York and an exchange rate of 1.49 C$/e being oered by a bank in Toronto. Then you can make a prot because the implicit exchange rate in New York is 1.2$/e =1.5 C$/e.
0.8$/C$

So you should buy Euros in Canada, sell them for U.S. dollars in New York, and then use those dollars to buy Canadian $ in New York. Illustrative example: If you had C$ 149, you could buy e100 in Canada, exchange them for $ 120 in New York, and then use that to buy C$ 150 in New York leaving you with C$ 1 dollar in prot for every C$ 149 you put in. So if you can move 14.9 million Canadian dollars in and out, you can make a prot of 100,000 Canadian dollars, not bad for a few seconds of work. 3. Arbitrage also establishes exchange rates for rarely traded pairs of currency. The Polish Zloty/Nigerian Naira exchange rate would seem to be be very dicult to establish since supply and demand will both be so thin. However, this rate will be equivalent to the Zloty/$ rate multiplied by the $/Naira rate. So as long as buyers and sellers exist for the Zloty-Dollar and the Naira-Dollar markets, the Naira-Zloty market exchange rate stays well established.

III. THE FORWARD MARKET

Earlier we discussed how certain groups of people who know that they need access to a particular quantity of a foreign currency at some point in the future, would like to protect themselves against unexpected exchange rate movements. Examples of such groups could include an importer who needs to pay her foreign supplier once her 90-day trade credit runs out, or a family who is sending their daughter to study in another country next year. These groups can hedge against uctuations by buying the foreign currency on the spot market, but this can be costly for two reasons. First, you have to have money upfront to acquire the foreign currency now, even though the payment is not due for a while. This is particularly onerous for importers who may want to sell the goods they import so that they have enough money to pay for the goods they bought. Second, hedging on the spot market means that you tie up your money now in foreign currency, foregoing the opportunity to leave your money in the bank earning interest. As a result, many would be hedgers have a keen interest in nding a hedging mechanism that does not require them to have money upfront or tie up their money in foreign currency upfront, yet protects them against uctuations. The forward market provides them with just that ability.

 In the forward market, an exchange rate is agreed on now for delivery of the foreign currency at some point in the future, typically 30, 90 or 180 days. So the 30-day forward rate for the Euro is the price agreed on NOW for delivery of the Euro 30 days from now. This type of market emerges because there are many importers in the United States who know they will be needing pounds or euros to pay bills in 30, 90 or 180 days time (they will drive demand in the forward market) AND there are importers in England or Germany who know they will be needing dollars to pay their bills in 30, 90 or 180 days time (they will drive supply in the forward market). The forward exchange rate is simply the rate that equilibrates supply and demand in the forward market. We will denote the 30-day forward rate by f 30 , the 90-day forward rate by f 90 and the 180day forward rate by f 180 respectively. If the forward rate for the Euro exceeds the spot rate for the Euro, then the Euro is said to be trading at a forward premium; the Euro is more valuable in the forward market. If the spot rate for the Euro exceeds the forward rate for the Euro, the Euro is said to trade at a forward discount, the Euro is less valuable in the forward market. Since the spot rate on any given day is the exchange rate at which currency is exchanged immediately whereas the forward rate on that day is the rate at which currency will be exchanged in the future, there is no reason for the two rates to be equal. There is also no reason why the spot rate should be systematically higher or lower than the forward rate either. So if the 90 day forward rate on January 1st is 1.25 $/e, the spot rate on January 1st could be higher or lower than 1.25 $/e. What the forward rate reects, however, is the spot rate that is expected to prevail in the future. This is because of the actions of speculators. If the forward rate on January 1st is 1.25 $/e and the consensus among speculators is that the spot rate on April 1st will be 1.5 $/e they will all rush to buy euros on the forward market, causing the euro to rise in value (the dollar to depreciate) on the forward market to 1.5 $/e. On the other hand, if the consensus among speculators is that the spot rate on April 1st will be 1 $/e they will all rush to sell euros on the forward market, causing the euro to fall in value (the dollar to appreciate) on the forward market to 1 $/e. Either way, the forward rate will represent the consensus expectation in the market about what the spot rate will be in the future.

IV. THE FUTURES MARKET

The futures market is similar in spirit to the forward market; on any given day you can lock in an exchange rate for a pre-specied future date. Futures markets are widely used in commodities trading - wheat, pork bellies, corn etc. An agreement to buy or sell a commodity on a futures market is known as a futures contract. In practice, there are important dierences between the futures market and the forward market.

a) Futures contracts are standardized - they are for specic amounts of foreign exchange to be transacted on a specic date (typically the end or the beginning of a quarter) unlike forward contracts which can be for any amount of money to be transacted on any day that the two parties agree to beforehand. b) Each futures contract, like a forward contract has a buyer and a seller of a particular currency. However, futures contracts are typically traded through a clearinghouse - an exchange that acts as a buyer to all sellers and a seller to all buyers. The Chicago Mercantile Exchange (CME) is one of the leading clearing houses for foreign exchange futures in the United States. So you end up dealing with the CME and not with another individual party. c) Because the clearing house agrees to clear all trades, they take steps to protect themselves by ensuring that the parties are creditworthy. Therefore, futures contracts require a small upfront deposit, known as a margin. These can range from 2% to 20% of the value of the contract. Suppose that the margin was 10%. Then an importer who wants to acquire $10 million worth of foreign currency would have to put up 10% of $10 million or $1 million as a margin deposit. In contrast, forward contracts require no money up front but that is because they are typically restricted to large, stable institutions. d) Unlike a forward contract, which is fullled on the designated date, a futures contract can be closed, or extinguished at any time by the contract holder. In other words, the holder of a futures contract can close out their position at any time before the pre-specied date of maturity of the contract and take their gains or pay o their losses. e) Unlike with a forward contract, you do not actually engage in actual buying or selling of the currency. The owner of the futures contract settles her gains/losses with the clearinghouse at the time that the contract is extinguished, and uses the spot market to acquire the needed currency. The simplest way to understand a futures contract is as a bet between two parties on the price at which a specic quantity of a good (whether it be wheat, corn or foreign currency) will trade at a specied date in the future. For example, you could enter it into a futures contract to buy 1 million Euros at $1.25 per euro in 90 days, or you could enter into a contract to buy 10 million gallons of frozen concentrated orange juice at 35 cents per gallon in 365 days. Once the two parties have agreed on the futures contract, if the price of the commodity rises above the price at which the contract was purchased, then the person buying the contract benets at the expense of the seller. If the price of the commodity falls below the price at which the contract was purchased, then the person selling the contract benets at the expense of the buyer. Lets illustrate how this works with an example. Suppose that on January 1st, an importer entered into a futures contract to buy 5 million at an exchange rate of 2 $/ in 90 days time (90 days from January 1st will be April 1st). Also keep in mind that, as with the forward rate, there is no reason for the futures rate to equal the current spot rate - it could be higher or lower because the futures rate is a bet about a spot rate that will prevail in the future. However, the futures rate will be closely related to both the forward rate and to the expected future spot rate, for the same reasons laid out in the discussion of the forward rate.

 The value of this futures contract on January 1st is $10 million (5 million * April 1st futures exchange rate on January 1st (which was 2 $/), as shown below. Col(1) Date 1-Jan Col(2) Spot Rate 1.90 Col(3) Apr 1st Futures Rate 2.00 Col(4) Value of Contract $10 million Col(5) Gain/(Loss) -

From this point on, the value of the futures contract will uctuate every day as the futures exchange rate for April 1st uctuates daily. What is the futures exchange rate for April 1st on, say January 8th? It is simply the rate that two parties are willing to bet on January 8th as being the exchange rate that is likely to prevail on April 1st. On any given day, the value of the futures contract will be 5 million * April 1st futures exchange rate on that day. Any increase in value will be credited to the buyer, any decreases in value will be debited from the buyers account. For instance, if on January 8th the April 1 futures exchange rate changed to 2.10 $/ then the value of the futures contract will be 5 million * 2.10 $/= $10.5 million. So the holder is up $500,000 (0.10 $/ * 5 million). This $500,000 will be credited to the holders account. Suppose instead that on January 2nd the April 1 futures exchange rate had changed to 1.80 $/ then the value of the futures contract will be 5 million * 1.80 $/= $9 million. So the importer is down $1,000,000 (-0.20 $/ * 5 million). This $1,000,000 will be debited from her account. Note that the spot rate will also uctuate daily, but I am not putting any particular values in for it since that is irrelevant for the value of the futures contract. Col(1) Date 1-Jan 8-Jan 15-Jan Col(2) Spot Rate eJan1 eJan8 eJan15 Col(3) Apr 1st Futures Rate 2.00 2.1 1.8 Col(4) Value of Contract $10 million $10.5 million $9 million Col(5) Gain/(Loss) $500,000 -$1 million

The margin account ensures that the losses can be covered. If the losses exceed the margin account balance, then the holder of the futures contract may be asked to put up more money into the margin account to ensure that future losses can be covered. Continuing on, as market conditions change, the April 1st futures exchange rate will uctuate each day between January 1st and April 1st. This is intuitive if we think of the April 1st futures rate that prevails on day x as being the rate that two parties are willing to bet, on the information available as of day x, as to what the exchange rate will be on April 1st. Since new information about market conditions arrives every day, the bets that people are willing to make change from day to day. Since the April 1st futures rate uctuates each day, the futures account will also either increase or decrease in value every day.

 On April 1st itself, the April 1st futures exchange rate is identical to the spot exchange rate. Why? By denition, on April 1st, the rate that two parties are willing to bet on as being the rate at which they can exchange currencies on April 1st, is the spot rate. So how does the futures market lock in an exchange rate, like the forward market does? Well, think about it this way. If the dollar depreciates to $2.50 per pound by April 1st, the futures contract will rise in value by $0.50 per pound, as shown below giving a prot of 2.5 million dollars. The importer has to get the foreign currency on the spot market for 5 million*2.5 $/=$12.5 million. But there will be a prot of $2.5 million on the futures account osetting that, which results in a total cost of $10 million, or $2 per pound. Col(1) Date 1-Jan 8-Jan 15-Jan . . . 1-Apr Col(2) Spot Rate 1.90 eJan8 eJan15 . . . 2.5 Col(3) Apr 1st Futures Rate 2.00 2.1 1.8 . . . 2.5 Col(4) Value of Contract $10 million $10.5 million $9 million . . . $12.5 million Col(5) Gain/(Loss) $500,000 -$1 million . . . $2.5 million

On the other hand suppose the dollar had appreciated to $1.50 per pound, the futures contract will fall in value by $0.50 per pound, as shown below giving a loss of 2.5 million dollars. The importer now get the foreign currency on the spot market for 5 million*1.5 $/=$7.5 million. But there will be a loss of $2.5 million on the futures account osetting that, which results in a total cost of $10 million, or $2 per pound. Col(1) Date 1-Jan 8-Jan 15-Jan . . . 1-Apr Col(2) Spot Rate 1.90 eJan8 eJan15 . . . 1.5 Col(3) Apr 1st Futures Rate 2.00 2.1 1.8 . . . 1.5 Col(4) Value of Contract $10 million $10.5 million $9 million . . . $7.5 million Col(5) Gain/(Loss) $500,000 -$1 million . . . -$2.5 million

Of course if all a futures contract did was protect you against depreciation it would not be of much use - a forward contract would be a much simpler way of doing the same thing. The real advantage of a futures contract is that on any given day t if the SPOT rate appreciates, you can decide whether the cost of buying the foreign currency you need on the spot market, when combined with the gain or loss from your futures account would be better for you than holding on to the futures contract till the end. In addition you know that you are always protected against spot rate depreciation by the futures contract held until the end.

V. THE OPTIONS MARKET

An options contract provides its owner the right, but not the obligation, to buy or sell a specied amount of foreign currency at a specied price up to a specied date. If the contract is a right to buy it is known as a call option while if it is a right to sell it is known as a put option.

 The phrase right but not the obligation is the critical one. The owner of an options contract can choose to transact at the specied price but does not have to do so, unlike with a forward contract which has to be honored. Suppose that an importer bought a call option for pounds 30 days from now, and that the exchange rate specied in the option is 2 $/. She has locked in the dollar price at $10 million. If by April 1st the dollar depreciates to 2.25 $/ on the spot market, she is not aected because she owns the right to buy pounds at 2 $/. So her cost will at most be $10 million Thus far it seems similar to a forward contract. However, suppose instead that the dollar appreciated to 1.8 $/ on the spot market on April 1st. Because the option represents a right, and not an obligation, she can ignore her options contract and pay $9 million to buy 5 million on the spot market. This is what diers an options contract from a forward contract. If she had a forward contract for 2 $/, she would have to buy pounds at that price, even though the spot rate was much less. This makes an option much more desirable to her. Since the option has the desirable property of conferring a right but not the obligation on the person holding the option, it is to be expected that the person buying the option is charged a price upfront for acquiring the option. This price is typically a specic amount per unit of currency traded (or equivalently a percentage of the value of the potential eventual transaction). Note that this option price is paid upfront regardless of whether or not the option is eventually exercised. For example, suppose that our importer had to pay an option price of $0.20 / . Then her 5 million option would carry a cost of $ 1 million payable at the time the option was acquired. This would NOT be refunded if she decided not to buy the 5 million at the specied option price of 2 $/ in the future. Finally, keep in mind that, as with the forward rate and the futures rate, there is no reason for the options rate to equal the current spot rate - it could be higher or lower because the options rate deals with a transaction that will prevail in the future. The options rate will be closely related to the forward rate, the futures rate, and to the expected future spot rate, for the same reasons laid out in the discussion of the forward rate.