The Foreign Exchange Market
Just as other prices in the economy are determined by the interaction of buyers and sellers,
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.
The Actors
The major participants in the foreign exchange market are commercial banks, corporations
that engage in international trade, nonbank financial institutions such as asset-management
firms and insurance companies, and central banks. Individuals may also participate in the
foreign exchange market—for example, the tourist who buys foreign currency at a hotel’s
front desk—but such cash transactions are an insignificant fraction of total foreign exchange
trading.
We now describe the major actors in the market and their roles.
1. Commercial banks. Commercial banks are at the center of the foreign exchange
market because almost every sizable international transaction involves the debiting
and crediting of accounts at commercial banks in various financial centers. Thus, the
vast majority of foreign exchange transactions involve the exchange of bank deposits
denominated in different currencies.
Let’s look at an example. Suppose ExxonMobil Corporation wishes to pay
to a German supplier. First, ExxonMobil gets an exchange rate quotation
from its own commercial bank, the Third National Bank. Then it instructs Third
National to debit ExxonMobil’s dollar account and pay into the supplier’s
account at a German bank. If the exchange rate quoted to ExxonMobil by Third
National is per euro, is debited from
ExxonMobil’s account. The final result of the transaction is the exchange of a
deposit at Third National Bank (now owned by the German bank that supplied the
euros) for the deposit used by Third National to pay ExxonMobil’s German
supplier.
As the example shows, 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. Foreign currency trading among banks—called interbank
trading—accounts for much of the activity in the foreign exchange market. In fact, the
exchange rates listed in Table 14-1 are interbank rates, the rates banks charge each
other. No amount less than $1 million is traded at those rates. The rates available to
corporate customers, called “retail” rates, are usually less favorable than the “wholesale”
interbank rates. The difference between the retail and the wholesale rates is the
bank’s compensation for doing the business.
Because their international operations are so extensive, large commercial banks are
well suited to bring buyers and sellers of currencies together. A multinational corporation
wishing to convert $100,000 into Swedish kronor might find it difficult and costly
€160,000
$192,000
$1.2 $192,000 (= $1.2 per euro * €160,000)
€160,000
€160,000
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 325
to locate other corporations wishing to sell the right amount of kronor. By serving
many customers simultaneously through a single large purchase of kronor, a bank can
economize on these search costs.
2. Corporations. Corporations with operations in several countries frequently make
or receive payments in currencies other than that of the country in which they are
headquartered. To pay workers at a plant in Mexico, for example, IBM may need
Mexican pesos. If IBM has only dollars earned by selling computers in the United
States, it can acquire the pesos it needs by buying them with its dollars in the foreign
exchange market.
3. Nonbank financial institutions. Over the years, deregulation of financial markets
in the United States, Japan, and other countries has encouraged nonbank financial institutions
such as mutual funds 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. So do insurance companies. Hedge funds, which cater to
very wealthy individuals and are not bound by the government regulations that limit
mutual funds’ trading strategies, trade actively in the foreign exchange market.
4. Central banks. In the previous chapter we learned that 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.
Characteristics of the Market
Foreign exchange trading takes place in many financial centers, with the largest volumes
of trade occurring in such major cities as London (the largest market), New York, Tokyo,
Frankfurt, and Singapore. The worldwide volume of foreign exchange trading is enormous,
and it has ballooned in recent years. In April 1989, the average total value of global
foreign exchange trading was close to billion per day. A total of billion was
traded daily in London, billion in the United States, and billion in Tokyo.
Twenty-one years later, in April 2010, the daily global value of foreign exchange trading
had jumped to around trillion. A total of trillion was traded daily in Britain,
billion in the United States, and billion in Japan.1
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. Foreign exchange traders may deal from their homes when a latenight
communication alerts them to important developments in a financial center on
another continent.
$904 $312
$4.0 $1.85
$115 $111
$600 $184
1April 1989 figures come from surveys carried out simultaneously by the Federal Reserve Bank of New York,
the Bank of England, the Bank of Japan, the Bank of Canada, and monetary authorities from France, Italy, the
Netherlands, Singapore, Hong Kong, and Australia. The April 2010 survey was carried out by 53 central banks.
Revised figures are reported in “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market
Activity in April 2010: Preliminary Global Results,” Bank for International Settlements, Basel, Switzerland,
September 2010. Daily U.S. foreign currency trading in 1980 averaged only around $18 billion.
326 PART THREE Exchange Rates and Open-Economy Macroeconomics
The integration of financial centers implies that there can be no significant difference
between the dollar/euro exchange rate quoted in New York at 9 A.M. and the dollar/euro
exchange rate quoted in London at the same time (which corresponds to 2 P.M. London
time). If the euro were selling for in New York and in London, profits could be
made through arbitrage, the process of buying a currency cheap and selling it dear. At the
prices listed above, a trader could, for instance, purchase million in New York for
million and immediately sell the euros in London for million, making a pure profit of
. If all traders tried to cash in on the opportunity, however, their demand for
euros in New York would drive up the dollar price of euros there, and their supply of euros
in London would drive down the dollar price of euros there. Very quickly, the difference
between the New York and London exchange rates would disappear. Since foreign
exchange traders carefully watch their computer screens for arbitrage opportunities, the
few that arise are small and very short-lived.
While a foreign exchange transaction can match any two currencies, most transactions
(roughly 85 percent in April 2010) are exchanges of foreign currencies for U.S. dollars.
This is true even when a bank’s goal is to sell one nondollar currency and buy another!
A bank wishing to sell Swiss francs and buy Israeli shekels, for example, will usually sell
its francs for dollars and then use the dollars to buy shekels. While this procedure may
appear roundabout, it is actually cheaper for the bank than the alternative of trying to find
a holder of shekels who wishes to buy Swiss francs. The advantage of trading through the
dollar is a result of the United States’ importance in 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 against Swiss francs or shekels. In contrast, relatively few
transactions require direct exchanges of Swiss francs for shekels.2
Because of its pivotal role in so many foreign exchange deals, the U.S. 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 2010, about
39 percent of foreign exchange trades were against euros—less than half the share of the
dollar, albeit above the figure of 37 percent clocked three years earlier. Japan’s yen is the
third most important currency, with a market share of 19 percent (out of 200). The pound
sterling, once second only to the dollar as a key international currency, has declined
greatly in importance.3
Spot Rates and Forward Rates
The foreign exchange transactions we have been discussing take place on the spot: Two
parties agree to an exchange of bank deposits and execute the deal immediately. Exchange
rates governing such “on-the-spot” trading are called spot exchange rates, and the deal is
called a spot transaction.
$100,000
$1.2
€1 $1.1
$1.1 $1.2
2The Swiss franc/shekel exchange rate can be calculated from the dollar/franc and dollar/shekel exchange rates
as the dollar/shekel rate divided by the dollar/franc rate. If the dollar/franc rate is $0.80 per franc and the
dollar/shekel rate is $0.20 per shekel, then the Swiss franc/shekel rate is
swiss franc/shekel. Exchange rates between nondollar currencies are called “cross rates” by foreign exchange traders.
3For a more detailed discussion of vehicle currencies, see Richard Portes and Hélène Rey, “The Emergence of
the Euro as an International Currency,” Economic Policy 26 (April 1998), pp. 307–343. Data on currency shares
come from Bank for International Settlements, op. cit., table 3. For a recent assessment of the future roles of the
dollar and the euro, see the essays in Jean Pisani-Ferry and Adam S. Posen, eds., The Euro at Ten: The Next
Global Currency? (Washington, D.C.: Peterson Institute for International Economics, 2009).
(0.20 $/shekel)/(0.80 $/franc) = 0.25
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 327
Foreign exchange deals sometimes specify a future transaction date—one that may be
30 days, 90 days, 180 days, or even several years away. The exchange rates quoted in
such transactions are called forward exchange rates. In a 30-day forward transaction,
for example, two parties may commit themselves on April 1 to a spot exchange of
for on May 1. The 30-day forward exchange rate is therefore
per pound, and it is generally different from the spot rate and from the forward rates
applied to different future dates. When you agree to sell pounds for dollars on a future
date at a forward rate agreed on today, you have “sold pounds forward” and “bought dollars
forward.” The future date on which the currencies are actually exchanged is called
the value date.4 Table 14-1 shows forward exchange rates for some major currencies.
Forward and spot exchange rates, while not necessarily equal, do move closely together,
as illustrated for monthly data on dollar/pound rates in Figure 14-1. The appendix to this
chapter, which discusses how forward exchange rates are determined, explains this close
relationship between movements in spot and forward rates.
An example shows why parties may wish to engage in forward exchange transactions.
Suppose Radio Shack knows that in 30 days it must pay yen to a Japanese supplier for a
shipment of radios arriving then. Radio Shack can sell each radio for and must pay
its supplier per radio; its profit depends on the dollar/yen exchange rate. At the current
spot exchange rate of per yen, Radio Shack would pay
and would therefore make $5.50 on each radio
imported. But Radio Shack will not have the funds to pay the supplier until the radios arrive
and are sold. If over the next 30 days the dollar unexpectedly depreciates to
per yen, Radio Shack will have to pay
per radio and so will take a loss on each.
To avoid this risk, Radio Shack can make a 30-day forward exchange deal with Bank of
America. If Bank of America agrees to sell yen to Radio Shack in 30 days at a rate of
Radio Shack is assured of paying exactly
per radio to the supplier. By buying yen and selling dollars forward, Radio Shack is guaranteed
($0.0107 per yen) * (¥9,000 per radio) = $96.30
$0.0107,
$3.50
($0.0115 per yen) * (¥9,000 per radio) = $103.50
$0.0115
(¥9,000 per radio) = $94.50 per radio
$0.0105 ($0.0105 per yen) *
¥9,000
$100
£100,000 $155,000 $1.55
Spot rate
Forward rate
Exchange rates ($/£)
1.0
1.5
2.0
2.5
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Figure 14-1
Dollar/Pound Spot and Forward Exchange Rates, 1983–2011
Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.
4In days past, it would take up to two days to settle even spot foreign exchange transactions. In other words, the
value date for a spot transaction was actually two days after the deal was struck. Nowadays, most spot trades of
major currencies settle on the same day.
328 PART THREE Exchange Rates and Open-Economy Macroeconomics
a profit of per radio and is insured against the possibility that a sudden exchange rate
change will turn a profitable importing deal into a loss. In the jargon of the foreign exchange
market, we would say that Radio Shack has hedged its foreign currency risk.
From now on, when we mention an exchange rate but don’t specify whether it is a spot
rate or a forward rate, we will always be referring to the spot rate.
Foreign Exchange Swaps
A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of
that currency. For example, suppose the Toyota auto company has just received million
from American sales and knows it will have to pay those dollars to a California supplier in
three months. Toyota’s asset-management department would meanwhile like to invest the
million in euro bonds. A three-month swap of dollars into euros may result in lower brokers’
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.
Futures and Options
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. Only 25 years ago, some of these instruments
were not traded on organized exchanges.
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. Such a sale might
appear advantageous, for example, if your views about the future spot exchange rate
were to change.
A foreign exchange option gives its owner the right to buy or sell a specified amount of
foreign currency at a specified price at any time up to a specified expiration date. The other
party to the deal, the option’s seller, is required to sell or buy the foreign currency at the
discretion of the option’s owner, who is under no obligation to 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. Forwards,
swaps, futures, and options are all examples of financial derivatives, which we encountered
in Chapter 13.
Just as other prices in the economy are determined by the interaction of buyers and sellers,
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.
The Actors
The major participants in the foreign exchange market are commercial banks, corporations
that engage in international trade, nonbank financial institutions such as asset-management
firms and insurance companies, and central banks. Individuals may also participate in the
foreign exchange market—for example, the tourist who buys foreign currency at a hotel’s
front desk—but such cash transactions are an insignificant fraction of total foreign exchange
trading.
We now describe the major actors in the market and their roles.
1. Commercial banks. Commercial banks are at the center of the foreign exchange
market because almost every sizable international transaction involves the debiting
and crediting of accounts at commercial banks in various financial centers. Thus, the
vast majority of foreign exchange transactions involve the exchange of bank deposits
denominated in different currencies.
Let’s look at an example. Suppose ExxonMobil Corporation wishes to pay
to a German supplier. First, ExxonMobil gets an exchange rate quotation
from its own commercial bank, the Third National Bank. Then it instructs Third
National to debit ExxonMobil’s dollar account and pay into the supplier’s
account at a German bank. If the exchange rate quoted to ExxonMobil by Third
National is per euro, is debited from
ExxonMobil’s account. The final result of the transaction is the exchange of a
deposit at Third National Bank (now owned by the German bank that supplied the
euros) for the deposit used by Third National to pay ExxonMobil’s German
supplier.
As the example shows, 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. Foreign currency trading among banks—called interbank
trading—accounts for much of the activity in the foreign exchange market. In fact, the
exchange rates listed in Table 14-1 are interbank rates, the rates banks charge each
other. No amount less than $1 million is traded at those rates. The rates available to
corporate customers, called “retail” rates, are usually less favorable than the “wholesale”
interbank rates. The difference between the retail and the wholesale rates is the
bank’s compensation for doing the business.
Because their international operations are so extensive, large commercial banks are
well suited to bring buyers and sellers of currencies together. A multinational corporation
wishing to convert $100,000 into Swedish kronor might find it difficult and costly
€160,000
$192,000
$1.2 $192,000 (= $1.2 per euro * €160,000)
€160,000
€160,000
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 325
to locate other corporations wishing to sell the right amount of kronor. By serving
many customers simultaneously through a single large purchase of kronor, a bank can
economize on these search costs.
2. Corporations. Corporations with operations in several countries frequently make
or receive payments in currencies other than that of the country in which they are
headquartered. To pay workers at a plant in Mexico, for example, IBM may need
Mexican pesos. If IBM has only dollars earned by selling computers in the United
States, it can acquire the pesos it needs by buying them with its dollars in the foreign
exchange market.
3. Nonbank financial institutions. Over the years, deregulation of financial markets
in the United States, Japan, and other countries has encouraged nonbank financial institutions
such as mutual funds 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. So do insurance companies. Hedge funds, which cater to
very wealthy individuals and are not bound by the government regulations that limit
mutual funds’ trading strategies, trade actively in the foreign exchange market.
4. Central banks. In the previous chapter we learned that 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.
Characteristics of the Market
Foreign exchange trading takes place in many financial centers, with the largest volumes
of trade occurring in such major cities as London (the largest market), New York, Tokyo,
Frankfurt, and Singapore. The worldwide volume of foreign exchange trading is enormous,
and it has ballooned in recent years. In April 1989, the average total value of global
foreign exchange trading was close to billion per day. A total of billion was
traded daily in London, billion in the United States, and billion in Tokyo.
Twenty-one years later, in April 2010, the daily global value of foreign exchange trading
had jumped to around trillion. A total of trillion was traded daily in Britain,
billion in the United States, and billion in Japan.1
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. Foreign exchange traders may deal from their homes when a latenight
communication alerts them to important developments in a financial center on
another continent.
$904 $312
$4.0 $1.85
$115 $111
$600 $184
1April 1989 figures come from surveys carried out simultaneously by the Federal Reserve Bank of New York,
the Bank of England, the Bank of Japan, the Bank of Canada, and monetary authorities from France, Italy, the
Netherlands, Singapore, Hong Kong, and Australia. The April 2010 survey was carried out by 53 central banks.
Revised figures are reported in “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market
Activity in April 2010: Preliminary Global Results,” Bank for International Settlements, Basel, Switzerland,
September 2010. Daily U.S. foreign currency trading in 1980 averaged only around $18 billion.
326 PART THREE Exchange Rates and Open-Economy Macroeconomics
The integration of financial centers implies that there can be no significant difference
between the dollar/euro exchange rate quoted in New York at 9 A.M. and the dollar/euro
exchange rate quoted in London at the same time (which corresponds to 2 P.M. London
time). If the euro were selling for in New York and in London, profits could be
made through arbitrage, the process of buying a currency cheap and selling it dear. At the
prices listed above, a trader could, for instance, purchase million in New York for
million and immediately sell the euros in London for million, making a pure profit of
. If all traders tried to cash in on the opportunity, however, their demand for
euros in New York would drive up the dollar price of euros there, and their supply of euros
in London would drive down the dollar price of euros there. Very quickly, the difference
between the New York and London exchange rates would disappear. Since foreign
exchange traders carefully watch their computer screens for arbitrage opportunities, the
few that arise are small and very short-lived.
While a foreign exchange transaction can match any two currencies, most transactions
(roughly 85 percent in April 2010) are exchanges of foreign currencies for U.S. dollars.
This is true even when a bank’s goal is to sell one nondollar currency and buy another!
A bank wishing to sell Swiss francs and buy Israeli shekels, for example, will usually sell
its francs for dollars and then use the dollars to buy shekels. While this procedure may
appear roundabout, it is actually cheaper for the bank than the alternative of trying to find
a holder of shekels who wishes to buy Swiss francs. The advantage of trading through the
dollar is a result of the United States’ importance in 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 against Swiss francs or shekels. In contrast, relatively few
transactions require direct exchanges of Swiss francs for shekels.2
Because of its pivotal role in so many foreign exchange deals, the U.S. 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 2010, about
39 percent of foreign exchange trades were against euros—less than half the share of the
dollar, albeit above the figure of 37 percent clocked three years earlier. Japan’s yen is the
third most important currency, with a market share of 19 percent (out of 200). The pound
sterling, once second only to the dollar as a key international currency, has declined
greatly in importance.3
Spot Rates and Forward Rates
The foreign exchange transactions we have been discussing take place on the spot: Two
parties agree to an exchange of bank deposits and execute the deal immediately. Exchange
rates governing such “on-the-spot” trading are called spot exchange rates, and the deal is
called a spot transaction.
$100,000
$1.2
€1 $1.1
$1.1 $1.2
2The Swiss franc/shekel exchange rate can be calculated from the dollar/franc and dollar/shekel exchange rates
as the dollar/shekel rate divided by the dollar/franc rate. If the dollar/franc rate is $0.80 per franc and the
dollar/shekel rate is $0.20 per shekel, then the Swiss franc/shekel rate is
swiss franc/shekel. Exchange rates between nondollar currencies are called “cross rates” by foreign exchange traders.
3For a more detailed discussion of vehicle currencies, see Richard Portes and Hélène Rey, “The Emergence of
the Euro as an International Currency,” Economic Policy 26 (April 1998), pp. 307–343. Data on currency shares
come from Bank for International Settlements, op. cit., table 3. For a recent assessment of the future roles of the
dollar and the euro, see the essays in Jean Pisani-Ferry and Adam S. Posen, eds., The Euro at Ten: The Next
Global Currency? (Washington, D.C.: Peterson Institute for International Economics, 2009).
(0.20 $/shekel)/(0.80 $/franc) = 0.25
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 327
Foreign exchange deals sometimes specify a future transaction date—one that may be
30 days, 90 days, 180 days, or even several years away. The exchange rates quoted in
such transactions are called forward exchange rates. In a 30-day forward transaction,
for example, two parties may commit themselves on April 1 to a spot exchange of
for on May 1. The 30-day forward exchange rate is therefore
per pound, and it is generally different from the spot rate and from the forward rates
applied to different future dates. When you agree to sell pounds for dollars on a future
date at a forward rate agreed on today, you have “sold pounds forward” and “bought dollars
forward.” The future date on which the currencies are actually exchanged is called
the value date.4 Table 14-1 shows forward exchange rates for some major currencies.
Forward and spot exchange rates, while not necessarily equal, do move closely together,
as illustrated for monthly data on dollar/pound rates in Figure 14-1. The appendix to this
chapter, which discusses how forward exchange rates are determined, explains this close
relationship between movements in spot and forward rates.
An example shows why parties may wish to engage in forward exchange transactions.
Suppose Radio Shack knows that in 30 days it must pay yen to a Japanese supplier for a
shipment of radios arriving then. Radio Shack can sell each radio for and must pay
its supplier per radio; its profit depends on the dollar/yen exchange rate. At the current
spot exchange rate of per yen, Radio Shack would pay
and would therefore make $5.50 on each radio
imported. But Radio Shack will not have the funds to pay the supplier until the radios arrive
and are sold. If over the next 30 days the dollar unexpectedly depreciates to
per yen, Radio Shack will have to pay
per radio and so will take a loss on each.
To avoid this risk, Radio Shack can make a 30-day forward exchange deal with Bank of
America. If Bank of America agrees to sell yen to Radio Shack in 30 days at a rate of
Radio Shack is assured of paying exactly
per radio to the supplier. By buying yen and selling dollars forward, Radio Shack is guaranteed
($0.0107 per yen) * (¥9,000 per radio) = $96.30
$0.0107,
$3.50
($0.0115 per yen) * (¥9,000 per radio) = $103.50
$0.0115
(¥9,000 per radio) = $94.50 per radio
$0.0105 ($0.0105 per yen) *
¥9,000
$100
£100,000 $155,000 $1.55
Spot rate
Forward rate
Exchange rates ($/£)
1.0
1.5
2.0
2.5
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Figure 14-1
Dollar/Pound Spot and Forward Exchange Rates, 1983–2011
Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.
4In days past, it would take up to two days to settle even spot foreign exchange transactions. In other words, the
value date for a spot transaction was actually two days after the deal was struck. Nowadays, most spot trades of
major currencies settle on the same day.
328 PART THREE Exchange Rates and Open-Economy Macroeconomics
a profit of per radio and is insured against the possibility that a sudden exchange rate
change will turn a profitable importing deal into a loss. In the jargon of the foreign exchange
market, we would say that Radio Shack has hedged its foreign currency risk.
From now on, when we mention an exchange rate but don’t specify whether it is a spot
rate or a forward rate, we will always be referring to the spot rate.
Foreign Exchange Swaps
A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of
that currency. For example, suppose the Toyota auto company has just received million
from American sales and knows it will have to pay those dollars to a California supplier in
three months. Toyota’s asset-management department would meanwhile like to invest the
million in euro bonds. A three-month swap of dollars into euros may result in lower brokers’
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.
Futures and Options
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. Only 25 years ago, some of these instruments
were not traded on organized exchanges.
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. Such a sale might
appear advantageous, for example, if your views about the future spot exchange rate
were to change.
A foreign exchange option gives its owner the right to buy or sell a specified amount of
foreign currency at a specified price at any time up to a specified expiration date. The other
party to the deal, the option’s seller, is required to sell or buy the foreign currency at the
discretion of the option’s owner, who is under no obligation to 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. Forwards,
swaps, futures, and options are all examples of financial derivatives, which we encountered
in Chapter 13.
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