International_Economics_Tenth_Edition (1)

Case 1:

U.S. importer hedges against a dollar depreciation.

Assume Sears Roebuck and Co. owes 1 million francs to a Swiss watch manufacturer in three month's time. During this period, Sears is in an exposed or uncovered position. Sears bears the risk that the dollar price of the franc might rise in three months (the dollar might depreciate against the franc), say, from $0.60 to $0.70 per franc; if so, purchasing 1 million francs would require an extra $100,000.

To cover itself against this risk, Sears could immediately buy 1 million francs in the spot market, but this would immobilize its funds for three months. Alternatively, Sears could contract to purchase 1 million francs in the forward market, at today's forward rate, for delivery in three months. In three months, Sears would purchase francs with dollars, at the contracted price and use the francs to pay the Swiss exporter. Sears has thus hedged against the possibility that francs will be more expensive than anticipated in three months. Note that hedging in the forward market does not require Sears to tie up its own funds when it purchases the forward contract. However, the contract is an obligation that can affect the company's credit. Sears' bank will want to be sure that it has an adequate balance or credit line so that it will be able to pay the necessary amount in three months.

Case 2:

u.s. exporter hedges against a dollar appreciation.

Assume that Microsoft Corporation anticipates receiving 1 million francs in three months from its exports of computer software to a Swiss retailer. During this period, Microsoft is in an uncovered position. If the dollar price of the franc falls (the dollar appreciates against the franc), say, from $0.50 to $0.40 per franc, Microsoft's receipts will be worth $100,000 less when the 1 million francs are converted into dollars.

To avoid this foreign-exchange risk, Microsoft can contract to sell its expected franc receipts in the forward market at today's forward rate. By locking into a set forward-exchange rate, Microsoft is guaranteed that the value of its franc receipts will be maintained in terms of the dollar, even if the value of the franc should happen to fall.

The forward market thus eliminates the uncertainty of fluctuating spot rates from international transactions. Exporters can hedge against the possibility that the domestic currency will appreciate against the foreign currency, and importers can hedge against the possibility that the domestic currency will depreciate against the foreign currency. Hedging is not limited to exporters and importers. It applies to anyone who is obligated to make a foreign-currency payment or who will enjoy for- eign-currency receipts at a future time. International investors, for example, also make use of the forward market for hedging purposes.

As our examples indicate, importers and exporters participate in the forward market to avoid the risk of fluctuations in foreign-exchange rates. Because they make forward transactions mainly through commercial banks, the foreign-exchange risk is transferred to those banks. Commercial banks can minimizeforeign-exchange risk by matching forward purchases from exporters with forward sales to importers. However, because the supply of and demand for forward currency transactions by exporters and importers usually do not coincide, the banks may assume some of the risk.

Suppose that on a given day, a commercial bank's forward purchases do not match its forward sales for a given currency. The bank may then seek out other banks in the market that have offsetting positions. Thus, if Chase Manhattan Bank has an excess of 50-million euro forward purchases over forward sales during the day, it will attempt to find another bank (or banks) that has an excess of forward sales over purchases. These banks can then enter forward contracts among themselves to eliminate any residual exchange risk that might exist.

How Markel Rides Foreign-

Exchange Fluctuations

To corporate giants such as General Electric and Ford Motor Company, currency fluctuations are a fact of life of global production. But for tiny companies such as Markel Corporation, swings in the world currency market have major implications for its bottom line.'

"Drawn from "Ship Those Boxes: Check the Euro." The Wall Street

Journal. February 7. 2003. p. C I.

360 Foreign Exchange

Markel Corporation is a family-owned tubing maker located in Plymouth Meeting, Pennsylvania. Its tubing and insulated lead wire are used in the appliance, automotive, and water-purification industries. About 40 percent of Markel's $26 million in sales in 2003 were exported, mostly to Europe.

To shield itself from fluctuations in exchange rates, Markel uses a 4-part business model: Charge customers relatively stable prices in their own currencies to establish overseas market share; use forward currency markets to foster revenue stability over the next few months; cut costs and improve efficiency to make it through the times when currency trading turns unprofitable; and roll the dice and hope things turn out favorably.

Markel's executives believe that their strategy of setting their prices in foreign currencies, mainly the euro, has helped the firm attain 70 percent of the world market in high-performance, Teflon-based cable-control liners, tubes that allow car accelerator or shift mechanisms to move smoothly. But it also implies that Markel signs contracts that result in the delivery of heaps of euros months or even years down the road, when the value of those euros in dollars may be much less than it was at signing.

To reduce the uncertainty over the period of a few months, Markel purchases forward contracts through PNC Financial Services Group in Pittsburgh. Markel promises the bank, say, 50,000 euros in three months, and the bank guarantees a certain number of dollars no matter what happens to the exchange rate. When Markel's chief financial officer thinks the dollar is about to appreciate against the euro, she might hedge her entire expected euro revenue stream with a forward contract. When she thinks the dollar is going to depreciate, she will hedge perhaps half and take a chance that she will make more dollars by remaining exposed to currency fluctuations.

However, she doesn't always guess right. In April 2003, for example, Markel had to provide PNC with 50,000 euros from a contract the company purchased three months earlier. The bank paid $1.05 per euro, or $52,500. Had Markel waited, it could have sold at the going rate, $1.08, and made an additional $1,500.

To make matters worse, Markel reached an export deal with a German manufacturer in 1998 and set the sales price assuming the euro would be at $1.18 by 2003-about the level it was traded at when introduced officially in 1999. But the euro's exchange value sharply declined, bottoming out at 82 cents in 2000. That meant each euro Markel received for its products was worth far less in dollars than the company had anticipated. During 2000-2002, Markel realized more than $650,000 in currency losses, and the company posted overall losses. This resulted in pay cuts for Markel employees and efforts to cut costs by improving efficiency.

Markel rode out its losses and by 2003 good times were beginning to return. Most of Markel's currency deals were written assuming that the euro would be valued between 90 cents and 95 cents. But when the euro soared to $1.08, aided by an imminent war with Iraq, nervous U.S. financial markets, and concerns about the U.S. trade deficit, Markel began to realize currency windfalls. Company executives estimated that if the euro remained between $1.05 and $1.07, and the British pound stayed at about $1.60, Markel would realize $400,000 to $500,000 in currency gains in 2003: not enough to offset the currency losses of the three previous years, but at least a step in the right direction.

However, the risk of currency fluctuations goes both ways. Markel demands multiyear contracts for its imported raw materials that are denominated in dollars. This means that its Japanese supplier bears the risk of swings in exchange rates: It will take home fewer yen as the dollar depreciates.

Does Foreign-Currency

Hedging Pay Off?

As a firm that realizes more than half of its sales in profits in foreign currencies, Minnesota Mining & Manufacturing Co. (3M) is very sensitive to fluctuations in exchange rates. As the dollar appreciates against other currencies, 3M's profits decline; as the dollar depreciates, its profits increase. Indeed, when currency markets go wild, like they did during 1997-1998 when Asian currencies and the Russian ruble crashed relative to the dollar, deciding whether or not to hedge is a crucial business decision. Yet 3M didn't use hedges, such as the for-

Exchange-rate fluctuations can substantially change the returns on assets denominated in a foreign currency. A real-world demonstration follows.

Throughout 1992, short-term interest rates in Germany were significantly higher than those in the United States; however; an American choosing between a dollar-denominated and deutsche mark-denominated certificate of deposit (CD) with similar liquidities and default riskswould not necessarily have earned a higher return on the German CD.

On May 27, 1992, an American saver with $10,000 to invest had the choice between a 3- month CD with an annual interest rate of 3.85 percent from an American bank and a 3-month CD with an annual interest rate of 9.65 percent (approximately 2.4 percent for 3 months) from a German bank. After 3 months, the U.S. CD was worth $10,096 and the German CD was worth $11,900 after exchanging the marks for dollars. As the table shows, the substantially larger value of the German CD was due primarily to a 16.6 percent appreciation of the mark against the dollar from May 27 to August 26.

Now consider the choice facing our investor on September 30, 1992: a 3-month U.S, CDoffering an

ward market or currency options market, to guard against currency fluctuations.'

In 1998, the producer of Scotch Tape and Post-it notes announced that the appreciating dol-

"Perils of the Hedge Highwire." Business Week, October 26, 1998, pp. 74--76.

annual interest rate of 3.09 percent, and a comparable German investment offering an annual interest rate of 9.1 percent (approximately 2.3 percent for 3 months). After 3 months. the U.S. CD was worth $10,077. If the investor purchased the German CD, however, she would have had only $8,964 at the end of the 3 months-$1,036 less than the purchase price. This loss resulted from the 12.5 percent appreciation of the dollar against

the mark between September and December 1992. With hindsight, the American saver would have preferred the U.S. CDto the German CD, even though the German interest rate was higher.

These examples provide a clear message. Even though interest rates playa key role in determining the relative attractiveness of assets denominated in domestic and foreign currencies, the effects of exchange-rate changes can swamp the effects of interest-rate differentials. Such large differences in returns illustrate why many investors choose to hedge against exchange-rate changes.

Source: Patricia 5. Pollard, "Exchange-Rate Risk: The Hazard of Investing Abroad," InternationalEconomic Conditions, Federal Reserve Bank of 51. Louis, Februarv 1993, p. 1.

lar had cost the firm $330 million in profits and $1.8 billion in revenue during the previous three years. Indeed, 3M's no-hedging policy had investors nervous. Was 3M unwise in not hedging its currency risk? Not according to many analysts and other big firms that chose to hedge very little, if at all. Firms ranging from ExxonMobil to Deere

362 Foreign Exchange

to Kodak have maintained that currency fluctuations improve profits as often as they hurt them. In other words, although an appreciation of the dollar would detract from their profits, a dollar depreciation would add to them. As a result, hedging isn't necessary, as the ups and down of currencies even out over the long run.

The standard argument for hedging is increased stability of cash flows and earnings. Surveys of corporate America's largest companies have found that one-third of them do some kind of foreign-currency hedging. For example, drug giant Merck and Co. hedges some of its foreign cash flows using the currency options market to sell the currencies for dollars at fixed rates. Merck maintains that it can protect against adverse currency moves by exercising its options, or enjoy favorable moves by not exercising them. Either way, the firm aims to guarantee that cash flow from foreign sales remains stable so that it can sustain research spending in years when a strong dollar trims foreign earnings. According to Merck's chief financial officer, the firm pays money for insurance to dampen volatility from unknown events.

Yet many well-established companies see no need to pay for protection against currency risk. Instead, they often choose to cover the risks out of their own deep pockets. According to 3M officials, if you consider the cost of hedging over the entire cycle, the drain on your earnings is very high for purchasing that insurance. Indeed, foreign-cur- rency hedging eats into profits. A simple forward contract that locks in an exchange rate costs up to half a percentage point per year of the revenue being hedged. Other techniques such as currency options are more costly. What's more, fluctuations in a firm's business can detract from the effectiveness of foreign-currency hedging.

Indeed, many companies have decided hedging is not worth the trouble. For example, in late 1993 Eastman Kodak concluded that the benefits of extensive use of foreign-currency hedging did not justify the costs because the ups and downs of currencies would even out over the long run. As a result, the firm switched from hedging its overall receipts and payments to hedging only a few specific contracts. Moreover, IB}..;[ had reduced the

impact of currency fluctuations without hedging by locating plants in many countries where it does business, so its costs are in the same currency as its revenues.

IInterest Arbitrage

Investors make their financial decisions by comparing the rates of return of foreign investment with those of domestic investment. If rates of return from foreign investment are larger, they will desire to shift their funds abroad. Interest arbitrage refers to the process of moving funds into foreign currencies to take advantage of higher investment yields abroad. But investors assume a risk when they have foreign investments: When the investment's proceeds are converted back into the home currency, their value may fall because of a change in the exchange rate. Investors can eliminate this exchange risk by obtaining "cover" in the forward market.

Uncovered Interest Arbitrage

Uncovered interest arbitrage occurs when an investor does not obtain exchange-market cover to protect investment proceeds from foreign-currency fluctuations. Although this practice is rarely used, it is a good pedagogical starting point.

Suppose the interest rate on 3-month Treasury bills is 6 percent (per annum) in New York and 10 percent (per annum) in London, and that the current spot rate is $2 per pound. A U.S. investor would seek to profit from this opportunity by exchanging dollars for pounds at the rate of $2 per pound and using these pounds to purchase 3- month British Treasury bills in London. The investor would earn 4 percent more per year, or 1 percent more for the 3 months, than if the same dollars had been used to buy 3-month Treasury bills in New York. These results are summarized in Table 11.9.

However, it is not necessarily true that our U.S. investor realizes an extra 1 percent rate of return (per 3 months) by moving funds to London. This amount will be realized only if the exchange value of the pound remains constant over the investment period. If the pound depreci-

Uncovered Interest Arbitrage: An Example

ates against the dollar, the investor makes less; if the pound appreciates against the dollar, the investor makes more!

Suppose our investor earns an extra 1 percent by purchasing 3-month British Treasury bills rather than U.S. Treasury bills. Over the same period, suppose the dollar price of the pound falls from $2.00 to $1.99 (the pound depreciates against the dollar). When the proceeds are converted back into dollars, the investor loses 0.5 percent-($2 - $1.99)/$2 =

.005. The investor thus earns only 0.5 percent more (1 percent - 0.5 percent) than if the funds had been placed in U'S. Treasury bills. The reader can verify that if the dollar price of the pound fell from $2 to $1.98 over the investment period, the U.S. investor would earn nothing extra by investing in British Treasury bills.

Alternatively, suppose that over the 3-month period the pound rises from $2 to $2.02, a 1 percent appreciation against the dollar. This time, in addition to the extra 1 percent return on British Treasury bills, our investor realizes a return of 1 percent from the appreciation of the pound. The reason? When she bought pounds to finance her purchase of British Treasury bills, she paid $2 per pound; when she converted her investment proceeds back into dollars, she received $2.02 per pound-($2.02 - $2)/$2 = .01. Because the pound's appreciation adds to her investment's profitability, she earns 2 percent more than if she had purchased U.S. Treasury bills.

In summary, a U.S. investor's extra rate of return on an investment in the United Kingdom, as

compared to the United States, equals the interestrate differential adjusted for any change in the value of the pound, as follows:

Extra return = (U.K. interest rate - U.S. interest rate) - % depreciation of the pound

or

Extra return =(U.K. interest rate - U.S. interest rate) + % appreciation of the pound

Covered Interest Arbitrage

Investing funds in a foreign financial center involves an exchange-rate risk. Because investors typically desire to avoid this risk, interest arbitrage is usually covered.

Covered interest arbitrage involves two basic steps. First, an investor exchanges domestic currency for foreign currency, at the current spot rate, and uses the foreign currency to finance a foreign investment. At the same time, the investor contracts in the forward market to sell the amount of the foreign currency that will be received as the proceeds from the investment, with a delivery date to coincide with the maturity of the investment. It pays for the investor to make the foreign investment if the positive interest-rate differential in favor of the foreign investment more than offsets the cost of obtaining the forward cover.

Suppose the interest rate on 3-month Treasury bills is 12 percent (per annum) in London and 8 percent (per annum) in New York; the interest differential in favor of London is 4 percent per annum, or 1 percent for the 3 months. Suppose also that the current spot rate for the pound is $2, while the 3-month forward pound sells for $1.99. This means that the 3-month forward pound is at a 0.5 percent discQunt-($1.99 - $2)/$2 = -.005.

By purchasing 3-month Treasury bills in London, a U.S. investor could earn 1 percent more for the 3 months than if he bought 3-monrh Treasury bills in New York. To eliminate the uncertainty over how many dollars will be received when the pounds are reconverted into dollars, the investor sells enough pounds on the 3-month forward market to coincide with the anticipated proceeds of the investment. The cost of the forward cover equals the difference between the spot rate

364 Foreign Exchange

and the contracted 3-month forward rate; this difference is the discount on the forward pound, or 0.5 percent. Subtracting this 0.5 percent from the interest-rate differential of 1 percent, the investor is able to realize a net rate of return that is 0.5 percent higher than if he had bought U.S. Treasury bills. These results are summarized in Table 11.10.

This investment opportunity will not last long, because the net profit margin will soon disappear. As U.S. investors purchase spot pounds, the spot rate will rise. Concurrently, the sale of forward pounds will push the forward rate downward. The result is a widening of the discount on the forward pounds, which means that the cost of covering the exchange-rate risk increases. This arbitraging process will continue until the forward discount on the pound widens to 1 percent, at which point the extra profitability of the foreign investment vanishes. The discount on the pound now equals the interest-rate differential between New York and London:

Pound forward discount = U.K. interest rate - U.S. interest rate

In short, the theory of foreign exchange suggests that the forward discount or premium on one currency against another reflects the difference in the short-term interest rates between the two nations. The currency of the higher-interest-rate nation should be at a forward discount while the currency of the lower-interest-rate nation should be at a forward premium.

International differences in interest rates do exert a major influence on the relationship between the spot and forward rates. But on any particular day, one would hardly expect the spread on short-term interest rates between financial centers to precisely equal the discount or premium on foreign exchange, for several reasons. First, changes in interest-rate differentials do not always induce an immediate investor response necessary to eliminate the investment profits. Second, investors sometimes transfer funds on an uncovered basis; such transfers do not have an effect on the forward rate. Third, factors such as governmental exchange controls and speculation may weaken the connection betweenthe interestrate differential and the spot and forward rates.

Foreign-Exchange Market

Speculation c;"{/\'f

Besides being used for the financing of commercial transactions and investments, the foreignexchange market is also used for exchange-rate speculation. Speculation is the attempt to profit by trading on expectations about prices in the future. Some speculators are traders acting for financial institutions or firms; others are individuals. In either case, speculators buy currencies that they expect to go up in value and sell currencies that they expect to go down in value.

Note the difference between arbitrage and speculation. With arbitrage, a currency trader

When the dollar is expected to depreciate, u.s. investors may look to foreign markets for big returns. Why? A declining dollar makes foreigndenominated financial instruments valued at more in dollar terms. However, those in the business emphasize that trading currency is "speculation," not investing. If the dollar rebounds, any foreigndenominated investment would provide lower returns. Simply put, big losses can easily occur if your bet is wrong.

The most direct way to play an anticipated drop in the dollar would be to stroll down to Bank of America and purchase $10,000 of euros, put the bills in your safe deposit box, and reconvert the currency to dollars in, say, six months. However, it'snot an especially efficient way to do the job because of transaction costs.

Another way is to purchase bonds denominated in a foreign currency. A U.S. investor who anticipates that the yen's exchange valuewill significantly appreciate in the near future might purchase bonds issuedby the Japanesegovernment or corporations and expressed in yen. These bonds can be purchased from brokerage firms such as Charles Schwab and J.P. Morgan Chase &Co. The bonds are paid for in yen, which are purchased by converting dollars into yen at the prevailing spot rate. If the yen goes up, the speculator gets not only the accrued interest from the bond but also its appreciated value in dollars. The catch is that, in all likelihood, others have the same expectations. The overall demand for the bonds may be sufficient to force up the bond price, resulting in a lower interest rate. For the investor to win, the yen'sappreciation must exceed the lossof interest income. In many cases, the exchange-rate changes are not large enough to make such investments worthwhile. Besides investing in a particular foreign bond, one can invest in a foreign-bond mutual fund, provided by brokerage firms like Merrill Lynch. Although you can own a foreign-bond fund

with as little as $2,500,you generally must pony up $100,000 or more to own bonds directly.

Rather than investing in foreign bonds, some investors choose to purchase stocks of foreign corporations, denominated in foreign currencies. The investor in this case is trying to predict the trend of not only the foreign currency but also its stock market. The investor must be highly knowledgeable about both financial and economic affairs in the foreign country. Instead of purchasing individual stocks, an investor could put money in a foreignstock mutual fund.

For investors who expect that the spot rate of a foreign currency will soon rise, the answer lies in a savings account denominated in a foreign currency. For example, a U.s. investor may contact a major Citibank or a U.S. branch of a foreign bank and take out an interest-bearing certificate of deposit expressed in a foreign currency. An advantage of such a savings account isthat the investor is guaranteed a fixed interest rate. An investor who has guessedcorrectly also enjoys the gains stemming from the foreign currency's appreciation. However, the investor must be aware of the possibility that governments might tax or shut off such deposits or interfere with the investor's freedom to hold another nation'scurrency.

Finally, you can play the falling dollar by putting your money into a variety of currency derivatives, all of which are risky. For example, you can trade futures contracts at the Chicago Mercantile Exchange. Or trade currency directly by opening an account at a firm that specializes in that businesses, such as Saxo Bank (Danish) or CMC (British). The minimum lot is often $10,000, and you can leverage up to 95 percent. Thus, for a $100,000 trade, the typical size, you'dhave to put only $5,000 down. Additional information on the techniques of currency speculation is found in "Exploring Further 11.1."

simultaneously buys a currency at a low price and sells that currency at a high price, thus making a riskless profit. A speculator's goal is to buy a currency at one moment (such as today) and sell that

currency at a higher price in the future (such as tomorrow). Speculation thus implies the deliberate assumption of exchange risk: If the price of the currency falls between today and tomorrow,

the speculator loses money. An exchange-market speculator deliberately assumes foreign-exchange risk on the expectation of profiting from future changes in the spot exchange rate. Such activity can exert either a stabilizing or a destabilizing influence on the foreign-exchange market.

Stabilizing speculation goes against market forces by moderating or reuersing a rise or fall in a currency's exchange rate. For example, it would occur when a speculator buys foreign currency with domestic currency when the domestic price of the foreign currency falls, or depreciates. The hope is that the domestic price of the foreign currency will soon increase, leading to a profit. Such purchases increase the demand for the foreign currency, which moderates its depreciation. Stabilizing speculation performs a useful function for bankers and businesspeople, who desire stable exchange rates.

Destabilizing speculation goes with market forces by reinforcing fluctuations in a currency's exchange rate. For example, it would occur when a speculator sells a foreign currency when it depreciates, on the expectation that it will depreciate further in the future. Such sales depress the foreign currency's value. Destabilizing speculation

can disrupt international transactions in several ways. Because of the uncertainty of financing exports and imports, the cost of hedging may become so high that international trade is impeded. What is more, unstable exchange rates may disrupt international investment activity. This is because the cost of obtaining forward cover for international capital transactions may rise significantly as foreign-exchange risk intensifies.

To lessen the amount of destabilizing speculation, some government officials propose government regulation of foreign-currency markets. If foreign-currency markets are to be regulated by government, however, will such intervention be superior to the outcome that occurs in an unregulated market? Will government be able to identify better than markets what the "correct" exchange rate is? Many analysts contend that government would make even bigger mistakes. Moreover, markets are better than government in admitting their mistakes and reversing out of them. That is because, unlike governments, markets have no pride. Destabilizing speculation will be further discussed in Chapter 15.

1.The foreign-exchange market provides the institutional framework within which individuals, businesses, and financial institutions purchase and sell foreign exchange. Two of the world's largest foreign-exchange markets are located in New York and London.

2.The exchange rate is the price of one unit of foreign currency in terms of the domestic currency. From a U.S. viewpoint, the exchange rate might refer to the number of dollars necessary to buy a Swiss franc. A dollar depreciation (appreciation) is an increase (decrease) in the number of dollars required to buy a unit of foreign exchange.

3.In the foreign-exchange market, currencies are traded around the clock and throughout the world. Most foreign-exchange trading is in the interbank market. Banks typically

engage in three types of foreign-exchange transactions: spot, forward, and swap.

4.The Wall Street]ournal's foreign-exchange quotations include those of the New York foreignexchange market and the International Monetary Market located in Chicago. Both spot quotations and forward quotations are provided.

5.The equilibrium rate of exchange in a free market is determined by the intersection of the supply and demand schedules of foreign exchange. These schedules are derived from the credit and debit items in a nation's balance of payments.

6.Exchange arbitrage permits the rates of exchange in different parts of the world to be kept the same. This is achieved by selling a currency when its price is high and purchasing when the price is low.

7.Foreign traders and investors often deal in the forward market for protection from possible exchange-rate fluctuations. However, speculators also buy and sell currencies in the futures markets in anticipation of sizable profits. In general, interest arbitrage deter-

mines the relationship between the spot rate and the forward rate.

8.Speculation in the foreign-exchange markets may be either stabilizing or destabilizing in nature.

•Appreciation (page 345)

•Bid rate (page 344)

•Call option (page 349)

•Covered interest arbitrage

(page 363)

•Cross exchange rate

(page 346)

•Currency swap (page 342)

•Depreciation (page 345)

•Destabilizing speculation

(page 366)

•Discount (page 357)

•Effective exchange rate

(page 354)

•Exchange arbitrage

(page 356)

•Exchange rate (page 345)

•Exchange-rate index

(page 354)

•Foreign-currency options

(page 349)

•Foreign-exchange market

(page 340)

•Forward market (page 347)

•Forward rate (page 357)

•Forward transaction

(page 342)

•Futures market (page 347)

•Hedging (page 358)

•Interbank market (page 343)

•Interest arbitrage (page 362)

•International Monetary Market (IMM) (page 347)

•Long position (page 371)

•Maturity months (page 347)

•Nominal exchange rate

(page 354)

•Nominal exchange-rate index (page 354)

•Offer rate (page 344)

•Option (page 349)

•Premium (page 357)

•Put option (page 349)

•Real exchange rate

(page 355)

•Real exchange-rate index

(page 356)

•Short position (page 371)

•Speculation (page 364)

•Spot market (page 347)

•Spot transaction (page 342)

•Spread (page 344)

•Stabilizing speculation

(page 366)

• Strike price (page 349)

•Three-point arbitrage

(page 356)

•Trade-weighted dollar

(page 354)

•Two-point arbitrage

(page 356)

•Uncovered interest arbitrage (page 362)

1.What is meant by the foreign-exchange market? Where is it located?

2.What is meant by the forward market? How does this differ from the spot market?

3.The supply and demand for foreign exchange are considered to be derived schedules. Explain.

4.Explain why exchange-rate quotations stated in different financial centers tend to be consistent with one another.

5.Who are the participants in the forwardexchange market? What advantages does this market afford these participants?

6.What explains the relationship between the spot rate and the forward rate?

7.What is the strategy of speculating in the forward market? In what other ways can one speculate on exchange-rate changes?

8.Distinguish between stabilizing speculation and destabilizing speculation.

368Foreign Exchange

9.If the exchange rate changes from $1.70 = £1 to $1.68 = £1, what does this mean for the dollar? For the pound? What if the exchange rate changes from $1.70 =£1 to $1.72 =£1?

10.Suppose $1.69 = £1 in New York and $1.71 = £1 in London. How can foreign-exchange arbitragers profit from these exchange rates? Explain how foreign-exchange arbitrage results in the same dollar/pound exchange rate in New York and London.

11.Xtra: For a tutorial of this question, go to

~http://carbaughxtra.swlearning.com

Table 11.11 shows supply and demand schedules for the British pound. Assume that exchange rates are flexible.

a.The equilibrium exchange rate equals __ . At this exchange rate, how many pounds will be purchased, and at what cost in terms of dollars?

b.Suppose the exchange rate is $2 per pound. At this exchange rate, there is an excess (supply/demand) of pounds. This imbalance causes (an increase/a decrease) in the dollar price of the pound, which leads to (a/an) __ in the quantity of pounds supplied and (alan) __ in the quantity of pounds demanded.

c.Suppose the exchange rate is $1 per pound. At this exchange rate, there is an excess (supply/demand) for pounds. This imbalance causes (an increase/ a decrease) in the price of the pound, which leads to

Supply and Demand of British Pounds

(a/an) in the quantity of pounds supplied and (a/an) __ in the quantity of pounds demanded.

12.Suppose the spot rate of the pound today is $1.70 and the 3-month forward rate is $1. 75.

a.How can a U.S. importer who has to pay 20,000 pounds in 3 months hedge her foreign-exchange risk?

b.What occurs if the U.S. importer does not hedge and the spot rate of the pound in 3 months is $1.80?

13.Suppose the interest rate (on an annual basis) on 3-month Treasury bills is 10 percent in London and 6 percent in New York, and the spot rate of the pound is $2.

a.How can a U.S. investor profit from uncovered interest arbitrage?

b.If the price of the 3-month forward pound is $1.99, will a U.S. investor benefit from covered interest arbitrage? If so, by how much?

14.Table 11.12 gives hypothetical dollar/franc exchange values for Wednesday, May 5, 2003.

a.Fill in the last two columns of the table with the reciprocal price of the dollar in terms of the franc.

b.On Wednesday, the spot price of the two

currencies was dollars per franc, or __ francs per dollar.

c.From Tuesday to Wednesday, in the spot market the dollar (appreciated!depreciated) against the franc; the franc (appreciated! depreciated) against the dollar.

d.In Wednesday's spot market, the cost of

e.On Wednesday, the 30-day forward franc was at a (premium/discount) of __

dollars, which equaled percent on an annual basis. What about the 90-day forward franc?

15.Assume a speculator anticipates that the spot rate of the franc in three months will be lower than today's 3-month forward rate of the franc, $0.50 = 1 franc.