ECO365H5 Study Guide - The Delay, Foreign Exchange Option, Call Option
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ECO365 ± Summer 2011 Chapter 14 ± Problem Set
Michael Ho Page 1 of 10
1. Who are the participants in the foreign exchange market? Why buying and selling in the foreign exchange
market are dominated by commercial banks? What are the wholesale and retail rates?
Exchange rates are determined by the interaction of the households, firms, and financial institutions that buy
and sell foreign currencies to make international payments. The market in which international currency trades
take place is called the foreign exchange market.
Individuals may also participate in the foreign exchange market, but such cash transactions are an insignificant
fraction of total foreign exchange trading.
Banks routinely enter the foreign exchange market to meet the needs of their customers ± primarily corporations.
In addition, a bank will also quote to other banks exchange rates at which it is willing to buy currencies from
them and sell currencies to them.
Over the years, deregulation of financial markets in the United States, Japan, and other countries has
encouraged nonbank financial institutions to offer their customers a broader range of services, many of them
indistinguishable from those offered by banks. Among these have been services involving foreign exchange
transactions. Institutional investors, such as pension funds, often trade foreign currencies.
Corporations with operations in several countries frequently make or receive payments in currencies other than
that of the country in which they are headquartered.
Central banks sometimes intervene in foreign exchange markets. While the volume of central bank transactions
is typically not large, the impact of these transactions may be great. The reason for this impact is that
participants in the foreign exchange market watch central bank actions closely for clues about future
macroeconomic policies that may affect exchange rates. Government agencies other than central banks may
also trade in the foreign exchange market, but central banks are the most regular official participants.
Because their international operations are so extensive, large commercial banks are well suited to bring buyers
and sellers of currencies together. A bank can economize on these search costs. Foreign currency trading among
banks is called interbank trading, which accounts for most of the activity in the foreign exchange market.
Interbank rates ± the rates banks charge to each other. No amount less than Ds million is traded at those rates.
interbank rates because it is cheaper to carry out a $1million foreign exchange transaction than sr transactions
with each worth Dsrrárrr7KHGLIIHUHQFHEHWZHHQWKH UHWDLODQGZKROHVDOHUDWHVLV WKHEDQN¶VFRPSHQVDWLRQ
for doing the business.
2. If 'D@Lsäs in New York (which is different from London where 'D@Lsät), then explain how the
difference in exchange rates will be eliminated by investors who seek arbitrage profits by buying the euro in
New York and sell it in London, or buying the dollar in London and sell it in New York. How long does it
take to equalize the exchange rates between these two foreign exchange centers? How can the foreign
exchange market work around the clock?
Comparing 'D@Lsäs (every euro can buy säs dollar) in New York and 'D@Lsät (every euro can buy sät
dollar) in London, dollar is relatively expensive in New York (euro is relatively cheaper in New York) and euro
is relatively more expensive in London (dollar is relatively cheaper in London). According to the principle of
buy low and sell high (aarbitrage ± the process of buying a currency cheap and selling it dear), investors can
ECO365 ± Summer 2011 Chapter 14 ± Problem Set
Michael Ho Page 2 of 10
buy cheap euro in New York (säs dollar per euro) and sell the euro at a high price in London (sät dollar per
euro). Alternatively, investors can buy cheap dollar in London (sät dollar per euro) and sell the dollar at a
higher price in New York (säs dollar per euro).
The increased demand for euro in New York would put upward pressure on the price of euro in New York such
that there is a pressure for the dollar to depreciate ('D@ rises above säs) meanwhile investors buying dollars in
London would raise the demand for dollars there and put upward pressure on the price of dollars relative to euro
such that there is a pressure for the dollar to appreciate ('D@ falls below sät). As long as there is arbitrage profit
to be made, the high demand for euro in New York would push 'D@ towards sät while the high demand for
dollar in London would pull 'D@ back to säs. Very quickly, the difference in exchange rates between New
York and London would disappear. Since foreign exchange traders carefully watch their computer screens for
arbitrage opportunities, the few that arise are small and very short-lived.
Direct telephone, fax, and Internet links among the major foreign exchange trading centers make each a part of
a single world market on which the sun never sets. Economic news released at any time of the day is
immediately transmitted around the world and may set off a flurry of activity by market participants. Even after
trading in New York has finished, New York-based banks and corporations with affiliates in other time zones
can remain active in the market.
3. Why there is a need for a vehicle currency? What are the major currencies in the foreign exchange market?
While a foreign exchange transaction can match any two currencies, most transactions between banks (nearly
zw¨ in 2010DUHH[FKDQJHVRIIRUHLJQFXUUHQFLHVIRU86GROODUV7KLVLVWUXHHYHQZKHQDEDQN¶VJRDOLVWR
sell one nondollar currency and buy another! While this procedure may appear roundabout, it is actually
the world economy. Because the volume of international transactions involving dollars is so great, it is not hard
to find parties willing to trade dollars.
Because of its pivotal role in so many foreign exchange deals, the dollar is sometimes called a vehicle currency.
A vehicle currency is one that is widely used to denominate international contracts made by parties who do not
reside in the country that issues the vehicle currency. It has been suggested that the euro, which was introduced
at the start of 1999, will evolve into a vehicle currency on a par with the dollar. By April 2004, however, only
about uy¨ of foreign exchange trades were against euros. The pound sterling once second only to the dollar as
a key international currency, has declined in importance.
4. What are spot rates, forward rates, swaps, futures contracts, options contracts in the foreign exchange
The foreign exchange transactions we have been discussing take place on the spot: two parties agree to an
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trading are called spot exchange rates, and the deal is called a spot transaction. The term spot is a bit misleading
because even spot exchanges usually become effective only two days after a deal is struck. The delay occurs
because in most cases it takes two days for payment instructions to be cleared through the banking system. In
the jargon of the foreign exchange market, the value date for a spot transaction ± the date on which the parties
actually receive the funds they have purchased ± occurs two business days after the deal is made.
ECO365 ± Summer 2011 Chapter 14 ± Problem Set
Michael Ho Page 3 of 10
Foreign exchange deals sometimes specify a value date farther away than two days. The exchange rates quoted
in such transactions are called forward exchange rates, which are generally different from the spot rates and
from the forward rates applied to different value dates. When you agree to sell pounds for dollars on a future
Forward and spot exchange rates, while not necessarily equal, do move closely together. Why parties may wish
to engage in forward exchange transactions? To avoid exchange rate risk. By buying yen and selling dollars
forward, a firm is guaranteed a profit and is insured against the possibility that a sudden exchange rate change
will turn a profitable importing deal into a loss.
A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of the currency. A
three-PRQWKVZDSRIGROODUVLQWRHXURVPD\UHVXOWLQORZHUEURNHUV¶fees than the two separate transactions of
selling dollars for spot euros and selling the euros for dollars on the forward market. Swaps make up a
significant proportion of all foreign exchange trading.
Several other financial instruments traded in the foreign exchange market, like forward contracts, involve future
exchanges of currencies. The timing and terms of the exchanges can differ, however, from those specified in
forward contracts, giving traders additional flexibility in avoiding foreign exchange risk.
When you buy a futures contract, you buy a promise that a specified amount of foreign currency will be
delivered on a specified date in the future. A forward contract between you and some other private party is an
alternative way to ensure that you receive the same amount of foreign currency on the date in question. But
while you have no choice about fulfilling your end of a forward deal, you can sell your futures contract on an
organized futures exchange, realizing a profit or loss right away.
A foreign exchange option gives its owner the right to buy or sell a specified amount of foreign currency at a
required to sell or buy the foreiJQFXUUHQF\DWWKHGLVFUHWLRQRIWKHRSWLRQ¶VRZQHUZKRLVXQGHUQRREOLJDWLRQWR
exercise his right.
Imagine that you are uncertain about when in the next month a foreign currency payment will arrive. To avoid
the risk of a loss, you may wish to buy a put option giving you the right to sell the foreign currency at a known
exchange rate at any time during the month. If instead you expect to make a payment abroad sometime in the
month, a call option, which gives you the right to buy foreign currency to make the payment at a known price,
might be attractive. Options can be written on many underlying assets (including foreign exchange futures), and,
like futures, they are freely bought and sold.
5. Discuss how expected real return, risk, and liquidity affect the demand for currency deposits.
Currency deposits are assets in the form of saving. People can hold wealth in many forms. The object of
acquiring wealth ± of saving ± is to transfer purchasing power into the future. Because the object of saving is to
provide for future consumption, we judge the desirability of an asset largely on the basis of its rate of return,
that is, the percentage increase in value it offers over some time period. The return on stock, it pays you a
You often cannot know with certainty the return that an asset win actually pay after you buy it. Both the
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decision therefore must be based on an expected rate of return. To calculate an expected rate of return over