Module 9 FOREIGN EXCHANGE MARKETS

CENTRAL PHILIPPINE UNIVERSITY

College of Business and Accountancy

Acctg 3115 – Financial Markets

First Semester
Module # 9

FOREIGN EXCHANGE MARKETS

Objectives:
At the end of this chapter, the students are expected to:
1. understand the concept of foreign exchange markets and foreign exchange rates;
2. understand the history and current trends in foreign exchange markets;
3. identify the world’s largest foreign exchange markets;
4. differentiate a spot foreign exchange transaction from a forward foreign exchange
transaction;
5. calculate return and risk on foreign exchange transactions;
6. describe the role of financial institutions in foreign exchange transactions; and
7. identify the relations among interest rates, inflation, and exchange rates.

FOREIGN EXCHANGE MARKETS AND RISK

In addition to understanding the operations of domestic financial markets, a financial manager

must also understand the operations of foreign exchange markets and foreign capital markets.
It is essential that financial managers understand how events and movements in financial
markets in other countries affect the profitability and performance of their own companies.
Additionally, as firms and investors increase the volume of transactions in foreign currencies,
hedging foreign exchange risk has become a more important activity. Financial managers
therefore must understand how events in other countries in which they operate affect cash flows
received from or paid to other countries and thus their company’s profitability.

Foreign exchange markets are the markets in which traders of foreign currencies transact most
efficiently and at the lowest cost. As a result, foreign exchange markets facilitate foreign trade,
the raising of capital in foreign markets, the transfer of risk between participants, and
speculation on currency values. 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. The actual amount of U.S. dollars received on a
foreign transaction depends on the (foreign) exchange rate between the U.S. dollar and the
foreign currency when the nondollar cash flow is received (and exchanged for U.S. dollars) at
some future date. If the foreign currency declines (or depreciates) in value relative to the U.S.
dollar over the period between the time a foreign investment is made and the time it is
liquidated, the dollar value of the cash flows received will fall. If the foreign currency rises (or
appreciates) in value relative to the U.S. dollar, the dollar value of the cash flows received on
the foreign investment increases.

BACKGROUND AND HISTORY OF FOREIGN EXCHANGE MARKETS

Foreign exchange markets have existed for some time as international trade and investing have
resulted in the need to exchange currencies. The type of exchange rate system used to
accomplish this exchange, however, has changed over time. During most of the 1800s, foreign

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 1
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

exchange markets operated under a gold standard or system. Under the gold standard, currency
issuers guaranteed to redeem notes, upon demand, in an equivalent amount of gold.
Governments that employed such a fixed system of exchange, and which redeemed their notes
to other governments in gold, shared a fixed-currency relationship. As a result, gold became a
transportable, universal, and stable unit of valuation. Further, the United Kingdom, which at
the time was the dominant international trading country, had a longstanding commitment to the
gold standard. However, during the 1939–1942 period, the United Kingdom depleted much of
its gold stock in purchases of munitions and weaponry from the United States and other nations
to fight the Second World War. This depletion of the United Kingdom’s reserve signaled to
Winston Churchill (the U.K. Prime Minister at the time) that returning to a prewar-style gold
standard was impractical. As a result, from 1944 to 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. The Bretton Woods Agreement,
however, led to a situation in which some currencies (such as the U.S. dollar) became very
overvalued and others (such as the German mark) became very undervalued. The Smithsonian
Agreement of 1971 sought to address this situation. Under this agreement, major countries
allowed the dollar to be devalued and the boundaries between which exchange rates could
fluctuate were increased.

In 1973, under the Smithsonian Agreement II, the exchange rate boundaries were eliminated
altogether. This effectively allowed exchange rates of major currencies to float freely. This
free-floating foreign exchange rate system is still partially in place. However, central
governments may still intervene in the foreign exchange markets directly to change the
direction of exchange rate and currency movements by altering interest rates to affect the value
of their currency relative to others. Moreover, in 1992 twelve major European countries and
the Vatican City pegged their exchange rates together to create a single currency, called the
euro.

Until 1972, the interbank foreign exchange market was the only channel through which spot
and forward foreign exchange transactions took place. The interbank market involves
electronic trades between major banks (such as between J.P. Morgan Chase and HSBC) around
the world. This market is over the counter (OTC) and thus has no regular trading hours, so that
currencies can be bought or sold somewhere around the world 24 hours a day. Since 1972,
organized markets such as the International Money Market (IMM) of the Chicago Mercantile
Exchange (CME) have developed derivatives trading in foreign currency futures and options.
However, the presence of such a well-developed interbank market for foreign exchange
forward contracts has hampered the development of the futures market for foreign exchange
trading.

The foreign exchange markets have become among the largest of all financial markets. London
continues to be the largest center for trading in foreign exchange; it handles over twice the daily
volume of New York, the second-largest market. Third-ranked Tokyo handles approximately
one-sixth the volume of London. Moreover, the FX market is essentially a 24-hour market,
moving from Tokyo, London, and New York throughout the day. Therefore, fluctuations in
exchange rates and thus FX trading risk exposure continues into the night even when some FI
operations are closed.

The Introduction of the Euro. The euro is the name of the European Union’s (EU’s) single
currency. It started trading on January 1, 1999, when exchange rates among the currencies of
the original 11 participating countries were fixed, although domestic currencies (e.g., the Italian
lira and French franc) continued to circulate and be used for transactions within each country.
By January 1, 2002, domestic currencies started to be phased out and euro notes and coins
began circulating within 12 EU countries (increased to 16 EU countries by 2010) and the
Vatican City. The eventual creation of the euro had its origins in the creation of the European
Community (EC): a consolidation of three European communities in 1967 (the European Coal
and Steel Community, the European Economic Market, and the European Atomic Energy
Community). The emphasis of the EC was both political and economic. Its aim was to break

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 2
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

down trade barriers within a common market and create a political union among the people of
Europe. The Maastricht Treaty of 1993 set out stages for transition to an integrated monetary
union among the EC participating countries, referred to as the European Monetary Union
(EMU). Some of the main stipulations of the Maastricht Treaty included the eventual creation
of a single currency (the euro), the creation of an integrated European system of central banks,
and the establishment of a single European Central Bank (ECB).

While the creation of the euro has had a significant effect throughout Europe, it has also had a
notable impact on the global financial system. For example, in the first decade of the 2000s, as
the U.S. experienced an increasing national debt, rapid consumer spending, and a current
account deficit big enough to bankrupt most other countries, the euro increased in value by 35
percent against the U.S. dollar. Indeed, in the mid-2000s, as the dollar depreciated in value
against the euro, Russia’s Central Bank said it was considering replacing some of the U.S.
dollars in its reserves with euros. Asian central banks hinted that they would soon do the same.
The Chinese Central Bank had already substituted some of its dollars for euros. As a result of
these actions, the euro is now the world’s second most important currency for international
transactions behind the dollar and some predict, given the combined size of the “euro-
economies” (particularly if the United Kingdom eventually replaces the pound sterling with
the euro), may even compete against the dollar as the premier international currency.

Dollarization. Following the abandonment of the gold standard and the Bretton Woods
Agreement, some countries sought ways to promote global economic stability and hence their
own prosperity. For many of these countries, currency stabilization was achieved by pegging
the local currency to a major convertible currency. Other countries simply abandoned their
local currency in favor of exclusive use of the U.S. dollar (or another major international
currency, such as the euro). The use of a foreign currency in parallel to, or instead of, the local
currency is referred to as dollarization. Dollarization can occur unofficially (when private
agents prefer the foreign currency over the domestic currency) or officially (when a country
adopts the foreign currency as legal tender and ceases to issue the domestic currency). For
example, if the U.S. dollar is the currency adopted, Federal Reserve notes become legal tender
and the only form of paper money recognized by the government. There is nothing to prevent
a country from unilaterally moving to an official dollarized currency. However, if the U.S.
dollar is to be used as another country’s official currency, the Fed has recommended that it
receive advance notification of the extra notes that it would have to make available.

The major advantage of dollarization is the promotion of fiscal discipline and thus greater
financial stability and lower inflation. The biggest economies to have officially dollarized are
Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). The U.S. dollar, the
euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar are
the only currencies used by other countries for official dollarization.

Dollarization was highly unsuccessful at helping Argentina address its financial crisis in the
early 2000s and was abandoned. Prior to its economic crisis from 1999–2002, Argentina
operated under a currency board system that maintained a 1:1 exchange rate between the dollar
and the peso. Dollarization required holding sufficient dollar reserves to fully back the pesos
in circulation. With the appreciation of the dollar in the late 1990s, the Argentine currency
board experienced overvaluation. Argentina’s exports became less competitive on the world
market. In addition, Argentina had been running massive fiscal budget deficits for some years.
The climbing deficit led to an increase in devaluation concerns.

The Free-Floating Yuan. On July 21, 2005, the Chinese government shifted away from its
currency’s (the yuan) peg to the U.S. dollar, stating that the value of the yuan would be
determined using a “managed” floating system with reference to an unspecified basket of
foreign currencies. The 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 due to the relative underpricing of the yuan with respect to the
dollar and other currencies. The undervalued yuan resulted in Chinese exports being relatively

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 3
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

cheap, which hurt domestic manufacturing in other countries, especially the United States.
Indeed, lawmakers in the U.S. Congress, worried about the loss of U.S. jobs, threatened to
impose steep tariffs on Chinese goods unless China changed its foreign exchange policy.
Finance ministers from the world’s leading economies unanimously argued that China should
let the yuan float.

At the time some argued that letting the yuan rise in value could have some negative
consequences: world interest rates would likely (and did) rise along with oil prices as the yuan
rose in value. Additionally, the Chinese cut back on their foreign securities purchases, driving
up yields on U.S. Treasury bonds and mortgage-backed securities. However, many economists
argued that China would still have a significant cost advantage over U.S. companies, even with
a stronger yuan, since many of its government-sponsored companies could afford a period of
lower profits so as not to lose U.S. sales.

Despite the 2005 move to let its currency float, China continued to keep the yuan weak
throughout the 2000s. U.S. officials worried that, by keeping its currency artificially weak and
thus its goods more competitive on world markets, China’s failure to let the yuan float freely
would slow down the U.S. and worldwide recovery from the financial crisis and the recession
of 2008–2009. Beijing promised a more flexible exchange rate in June 2010, but the yuan rose
by only about 2 percent against the dollar in the following three months. Its appreciation sped
up slightly after the U.S. House of Representatives passed a bill in September 2010 that would
allow Washington to sanction countries that manipulate their currency for trade gain.

FOREIGN EXCHANGE RATES AND TRANSACTIONS

Foreign Exchange Rates

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). Foreign exchange rates are listed in
two ways: U.S. dollars received for one unit of the foreign currency exchanged (IN US$, also
referred to as the direct quote) and foreign currency received for each U.S. dollar exchanged
(PER US$, also referred to as the indirect quote). For example, the exchange rate of U.S. dollars
for Canadian dollars on August 19, 2010, was $0.9622 (US$/C$), or U.S. $0.9622 could be
received for each Canadian dollar exchanged. Conversely, the exchange rate of Canadian
dollars for U.S. dollars was 1.0393 (C$/US$), or 1.0393 Canadian dollars could be received
for each U.S. dollar exchanged.

Foreign Exchange Transactions

There are two types of foreign exchange rates and foreign exchange transactions: spot and
forward. Spot foreign exchange transactions involve the immediate exchange of currencies
at the current (or spot) exchange rate. Spot transactions can be conducted through the foreign
exchange division of commercial banks or a nonbank foreign currency dealer. For example, a
U.S. investor wanting to buy British pounds through a local bank on August 19, 2010,
essentially has the dollars transferred from his or her bank account to the dollar account of a
pound seller at a rate of $1 per 0.6413 pound (or $1.5594 per pound). Simultaneously, pounds
are transferred from the seller’s account into an account designated by the U.S. investor. If the
dollar depreciates in value relative to the pound (e.g., $1 per 0.6372 pound or $1.5694 per
pound), the value of the pound investment, if converted back into U.S. dollars, increases. If the
dollar appreciates in value relative to the pound (e.g., $1 per 0.6432 pound or $1.5547 per
pound), the value of the pound investment, if converted back into U.S. dollars, decreases.

Historically, the exchange of a sum of money into a different currency required a trader to first
convert the money into U.S. dollars and then convert it into the desired currency. More recently,
cross-currency trades allow currency traders to bypass this step of initially converting into U.S.
dollars. Crosscurrency trades are a pair of currencies traded in foreign exchange markets that
do not involve the United States dollar. For example, GBP/JPY cross-exchange trading was
created to allow individuals in the U.K. and Japan who wanted to convert their money into the

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 4
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

other currency to do so without having to bear the cost of having to first convert into U.S.
dollars. Cross-currency exchange rates for eight major countries are listed at Bloomberg’s

The appreciation of a country’s currency (or a rise in its value relative to other currencies)
means that the country’s goods are more expensive for foreign buyers and foreign goods are
cheaper for foreign sellers (all else constant). Thus, when a country’s currency appreciates,
domestic manufacturers find it harder to sell their goods abroad and foreign manufacturers find
it easier to sell their goods to domestic purchasers. Conversely, depreciation of a country’s
currency (or a fall in its value relative to other currencies) means the country’s goods become
cheaper for foreign buyers and foreign goods become more expensive for foreign sellers.

A forward foreign exchange transaction is the exchange of currencies at a specified

exchange rate (or forward exchange rate) at some specified date in the future. An example is
an agreement today (at time 0) to exchange dollars for pounds at a given (forward) exchange
rate three months into the future. Forward contracts are typically written for one-, three-, or
six-month periods, but in practice they can be written over any given length of time.

Spot versus Forward Foreign Exchange Transaction

The Decline and Rise of the U.S. Dollar. The U.S. dollar depreciated relative to the euro and
a number of other floating currencies between 2003 and 2007. A main factor affecting
exchange rate movements was interest rate differentials across major economies. The euro’s
rise in value against the U.S. dollar was due, at least in part, to the fact that the euro area had
the highest interest rates and thus attracted yield-driven investment capital. In the summer of
2007, the Federal Reserve decreased interest rates to boost a weakening economy that was
particularly hard hit as a result of a crumbling subprime mortgage market and a record
slowdown in the overall housing market. Relatively high interest rates in the United Kingdom
contributed to the appreciation of the pound against the dollar (and the yen) as well.

A second factor affecting the exchange rates was a high volume of central bank intervention
relative to past practice, especially in Asian countries. These actions kept upward pressure on
the local currencies but helped to devalue the U.S. dollar. For example, the Japanese Ministry
of Finance purchased $316 billion of U.S. assets between January 2003 and March 2004 (many
times the purchases in earlier years). Chinese monetary authorities bought dollar reserves while
trying to preserve the yuan’s fixed exchange rate with the U.S. dollar. In India, Korea, and
Taiwan, dollar reserves also rose substantially as monetary authorities tried to limit the
appreciation of their currencies against the U.S. dollar. Official foreign exchange reserves held
by monetary authorities worldwide increased another $850 billion in 2006 (twice the amount
held in 2005). China had the largest accumulation of foreign exchange reserves, despite moving
to a more flexible exchange rate regime in 2005. Russia had the second largest increase,
followed by Brazil and India. By 2007 there was talk of a possible dollar crisis.

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 5
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

The financial crisis, however, brought a halt to such discussions. During the crisis, the dollar
appreciated sharply against most foreign currencies, in fact, such a sharp appreciation of the
dollar had not been seen since 1973, when the generalized floating of currency exchange rates
began. Many explanations have been given for the sharp appreciation of the dollar during the
financial crisis. One explanation is that U.S. and foreign investors led a flight to quality, selling
corporate bonds and mortgage-backed securities and investing in U.S. Treasury securities. Seen
as a safe haven, U.S. Treasuries gained in value as equities plunged and credit spreads widened
to record levels. This demand for U.S. Treasuries resulted in a dollar shortage and resulted in
high dollar interest rates that supported the U.S. dollar. Following the crisis, however, the dollar
depreciated in value almost as quickly as it had appreciated in value during the crisis.

RETURN AND RISK OF FOREIGN EXCHANGE TRANSACTIONS

Measuring Risk and Return on Foreign Exchange Transactions. 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 over a holding period. Further, foreign exchange risk is introduced by adding
foreign currency assets and liabilities to a firm’s balance sheet. Like domestic assets and
liabilities, returns result from the contractual income from or costs paid on a security. With
foreign assets and liabilities, returns are also affected by changes in foreign exchange rates.

Foreign Exchange Risk

Suppose that on August 19, 2010, a U.S. firm plans to purchase 3 million Swiss francs’ (Sf) worth of
Swiss bonds from a Swiss FI in one month’s time. The Swiss FI wants payment in Swiss francs.
Believing that the exchange rate of U.S. dollars for Swiss francs will move against it in the next
month, the U.S. firm will convert dollars into Swiss francs today. The spot exchange rate for August
19, 2010 of U.S. dollars for Swiss francs is 0.9691, or one franc costs 0.9691 in dollars. Consequently,
the U.S. firm must convert:
U.S.$/Sf exchange rate X Sf 3 million =
0.9691 X Sf 3m = $2,907,300
into Swiss francs today.
One month after the conversion of dollars to Swiss francs, the Swiss bond purchase deal falls through
and the U.S. firm no longer needs the Swiss francs it purchased at $0.9691 per franc. The spot
exchange rate of the Swiss franc to the dollar has fallen or depreciated over the month so that the
value of a franc is worth only $0.9566, or the exchange rate is $0.9566 per franc. The U.S. dollar
value of 3 million Swiss francs is now only:
0.9566 X Sf 3 million = $2,869,800
The depreciation of the Swiss franc relative to the dollar over the month has caused the U.S. firm to
suffer a $37,500 ($2,869,800 - $2,907,300) loss due to exchange rate fluctuations.

To avoid such a loss in the spot markets, the U.S. firm could have entered into a forward
transaction, which is the exchange of currencies at a specified future date and a specified
exchange rate (or forward exchange rate). Forward contracts are typically written for a one-,
three-, or six-month period from the date the contract is written, although they can be written
for any time period from a few days to many years. For example, if the U.S. firm had entered
into a one-month forward contract selling the Swiss franc on August 19, 2010, at the same time
it purchased the spot francs, the U.S. firm would have been guaranteed an exchange rate of
0.9694 U.S. dollars per Swiss franc, or 1.0316 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
0.9694 on August 19, 2010, it would have largely avoided the loss of $37,500. Specifically, by
selling 3 million francs forward, it would have received:

at the end of the month, suggesting a small net profit of $2,908,200 - $2,907,300 = $900 on the
combined spot and forward transactions. Essentially, by using the one-month forward contract,
the U.S. firm hedges (or insures itself) against foreign currency risk in the spot market.

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 6
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

Financial institutions, and particularly commercial banks, are the main participants in the
foreign exchange markets. When issuing a foreign-currency-denominated liability or buying a
foreign-currency-denominated asset an FI will do so only if the expected return is positive.

Role of Financial Institutions in Foreign Exchange Transactions

Foreign exchange market transactions, like corporate bond and money market transactions, are
conducted among dealers mainly over the counter (OTC) using telecommunication and
computer networks. Foreign exchange traders are generally located in one large trading room
at a bank or other FI where they have access to foreign exchange data and telecommunications
equipment. Traders generally specialize in just a few currencies.

A major structural change in foreign exchange trading has been the growing share of electronic
brokerage in the interbank markets at the expense of direct dealing (and telecommunication).
Online foreign exchange trading is increasing and the transnational nature of the electronic
exchange of funds makes secure, Internet-based trading an ideal platform. Online trading
portals—terminals where currency transactions are being executed—are a low-cost way of
conducting spot and forward foreign exchange transactions.

Two companies, Reuters and EBS, currently dominate the market for the provision of
electronic trading platforms, software, and FX quotation systems. Electronic brokers
automatically provide traders with the best prices available to them. Traders using traditional
methods typically needed to contact several dealers to obtain market price information. Since
1982, when Singapore opened its FX market, foreign exchange markets have operated 24 hours
a day. When the New York market closes, trading operations in San Francisco are still open;
when trading in San Francisco closes, the Hong Kong and Singapore markets open; when
Tokyo and Singapore close, the Frankfurt market opens; an hour later, the London market
opens; and before these markets close, the New York market reopens. The nation’s largest
commercial banks are major players in foreign currency trading and dealing, with large money
center banks such as Citigroup and J.P. Morgan Chase also taking significant positions in
foreign currency assets and liabilities. Smaller banks maintain lines of credit with these large
banks for foreign exchange transactions.

While the growth of liabilities to and asset claims on foreigners slowed during the financial
crisis, levels remained stable as U.S. FIs were seen as some of the safest FIs during the crisis.
Further, except for 2004 and 2010, U.S. banks had more liabilities to than claims (assets) on
foreigners. Thus, if the dollar depreciated relative to foreign currencies, more dollars
(converted into foreign currencies) would be needed to pay off the liabilities and U.S. banks
would experience a loss due to foreign exchange risk. However, the reverse was true in 2004
and 2010, i.e., the dollar appreciated relative to foreign currencies and U.S. banks experienced
a gain from their foreign exchange exposures.

Foreign currency trading dominates direct portfolio investments. Even though the aggregate
trading positions appear very large—for example, U.S. banks bought 1,094.8 trillion Swiss
francs—their overall or net exposure positions can be relatively small (e.g., the net position in
Swiss francs was 7.185 billion Swiss francs).

A financial institution’s overall net foreign exchange (FX) exposure in any given currency
can be measured by its net book or position exposure, which is measured as:

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 7
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

Clearly, a financial institution could match its foreign currency assets to its liabilities in a given
currency and match buys and sells in its trading book in that foreign currency to reduce its
foreign exchange net exposure to zero and thus avoid foreign exchange risk. It could also offset
an imbalance in its foreign asset–liability portfolio by an opposing imbalance in its trading
book so that its net exposure position in that currency would also be zero.

A positive net exposure position implies that a U.S. financial institution is overall net long in a
currency (i.e., the financial institution has purchased more foreign currency than it has sold).
The institution will profit if the foreign currency appreciates in value against the U.S. dollar,
but it also faces the risk that the foreign currency will fall in value against the U.S. dollar, the
domestic currency. A negative net exposure position implies that a U.S. financial institution is
net short (i.e., the financial institution has sold more foreign currency than it has purchased) in
a foreign currency. The institution will profit if the foreign currency depreciates in value against
the U.S. dollar, but it faces the risk that the foreign currency will rise in value against the dollar.
Thus, failure to maintain a fully balanced position in any given currency exposes a U.S.
financial institution to fluctuations in the exchange rate of that currency against the dollar.
Indeed, the greater the volatility of foreign exchange rates given any net exposure position, the
greater the fluctuations in value of a financial institution’s foreign exchange portfolio. An FI’s
net position in a currency may not be completely under its own control. Thus, it is important
that the FI manager recognize the potential for future foreign exchange losses and undertake
hedging or risk management strategies like those described above when making medium- and
long-term decisions in nondomestic currencies.

A financial institution’s position in the foreign exchange markets generally reflects four trading
activities:
1. The purchase and sale of foreign currencies to allow customers to partake in and
complete international commercial trade transactions.
2. The purchase and sale of foreign currencies to allow customers (or the financial
institution itself) to take positions in foreign real and financial investments.
3. The purchase and sale of foreign currencies for hedging purposes to offset customer
(or financial institution) exposure in any given currency.
4. The purchase and sale of foreign currencies for speculative purposes through
forecasting or anticipating future movements in foreign exchange rates.

INTERACTION OF INTEREST RATES, INFLATION, AND EXCHANGE RATES

As global financial markets and financial institutions and their customers have become
increasingly interlinked, so have interest rates, inflation, and foreign exchange rates. For
example, higher domestic interest rates may attract foreign financial investment and impact the
value of the domestic currency.

The relationship among nominal interest rates, real interest rates, and expected inflation is often
referred to as the Fisher effect, named for the economist Irving Fisher, who identified these
relationships early in the last century. The Fisher effect theorizes that nominal interest rates
observed in financial markets must (1) compensate investors for any reduced purchasing power
due to inflationary price changes and (2) provide an additional premium above the expected
rate of inflation for forgoing present consumption due to the time value of money (which
reflects the real interest rate), such that

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 8
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall
Module 9 FOREIGN EXCHANGE MARKETS

Purchasing Power Parity

One factor affecting a country’s foreign currency exchange rate with another country is the
relative inflation rate in each country (which, as shown below, is directly related to the relative
interest rates in these countries).

Assuming real rates of interest (or rates of time preference) are equal across countries:

The (nominal) interest rate spread between the United States and Switzerland reflects the
difference in inflation rates between the two countries.

As relative inflation rates (and interest rates) change, foreign currency exchange rates that are
not constrained by government regulation should also adjust to account for relative differences
in the price levels (inflation rates) between the two countries. One theory that explains how this
adjustment takes place is the theory of purchasing power parity (PPP). According to PPP,
foreign currency exchange rates between two countries adjust to reflect changes in each
country’s price levels (or inflation rates and, implicitly, interest rates) as consumers and
importers switch their demands for goods from relatively high inflation (interest) rate countries
to low inflation (interest) rate countries. Specifically, 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 two countries. That is:

Thus, according to PPP, the most important factor determining exchange rates is the fact that
in open economies, differences in prices (and by implication, price level changes with inflation)
drive trade flows and thus demand for and supplies of currencies.

The theory behind purchasing power parity is that in the long run exchange rates should
move toward rates that would equalize the prices of an identical basket of goods and services
in any two countries. This is also known as the law of one price, an economic concept which
states that in an efficient market, if countries produce a good or service that is identical to that
in other countries, that good or service must have a single price, no matter where it is purchased.

Interest Rate Parity

The relationship that links spot exchange rates, interest rates, and forward exchange rates is
described as the interest rate parity theorem (IRPT). Given that investors have an opportunity
to invest in domestic or foreign markets, the IRPT implies that, by hedging in the forward
exchange rate market, an investor should realize the same returns, whether investing
domestically or in a foreign country—that is, the hedged dollar return on foreign investments
just equals the return on domestic investments. This is consistent with the assumption of PPP
that real rates of interest are equal across countries.

* Saunders and Cornett, Financial Markets and Institutions, 2019, 7th Ed, New York: McGraw Hill Education
** Madura, Financial Markets and Institutions, 2015, 11th Ed, Australia: Cengage Learning 9
***Mishkin and Eakins, Financial Markets and Institutions, 2012, 7th Ed, Boston: Prentice Hall