CHAPTER 12 FOREIGN EXCHANGE - Wright State University

194 CHAPTER 12 CHAPTER 12 FOREIGN EXCHANGE CHAPTER OVERVIEW This chapter discusses the nature and operation of the foreign exchange market. The chapter begins by describing the foreign exchange market and the types of foreign exchange transactions. Emphasis is placed on the interbank market for foreign exchange. Next we consider the forward market and futures market and also the market for foreign currency options. The role of the International Monetary Market of the Chicago Mercantile Exchange is emphasized in this section. The chapter introduces the determination of the equilibrium rate of exchange in a free market. The sources of the demand for foreign exchange and the supply of foreign exchange are identified. A distinction is made between the exchange rate

of one currency in terms of another currency and the trade-weighted value (effective exchange rate) of a currency. Next we examine the nature and operation of uncovered interest arbitrage and covered interest arbitrage. The chapter concludes by examining foreign exchange market speculation. After completing this chapter, the student should be able to: • Discuss the operation of the foreign exchange market. • Understand the foreign exchange quotations of The Wall Street Journal. • Explain how traders benefit from the forward exchange market. • Describe how exchange rates are determined in a free market. • Discuss the nature and operation of currency arbitrage. • Explain the strategy of exchange-rate speculation. BRIEF ANSWERS TO STUDY QUESTIONS 1. The foreign exchange market refers to the organizational setting within which individuals, firms, and banks buy and sell foreign currencies. The two largest foreign exchange markets are located in New York and London. 2. The spot market permits the buying and selling of foreign exchange for immediate delivery. Future contracts are made by those who will make or receive foreign exchange payments in the weeks or months ahead. 3. The supply and demand for foreign exchange is derived from the credit (debit) items on the balance of payments, such as exports or investment flows. Chapter 12: Foreign Exchange 195 4. Exchange-rate quotations throughout the world are brought into harmony via exchange arbitrage. 5. Traders and investors often participate in the forward market to protect their expected profits from the risk of exchange rate fluctuations. Speculators also participate in the forward market. 6. The relation between the spot rate and the forward rate is maintained via the process of covered interest arbitrage. 7. Exchange market speculators deliberately assume foreign exchange risk with the hope of profiting from exchange rate fluctuations over time. Most speculation is conducted in the forward market. 8. Stabilizing speculation refers to the purchase of a foreign currency with the domestic currency when there occurs a fall in the foreign exchange rate. The anticipation is that the exchange rate will soon rise and thus generate a profit. Stabilizing speculation moderates a fall (rise) in the exchange rate. Destabilizing speculation reinforces fluctuations in exchange rates. 9. The dollar appreciates against the pound; the pound depreciates against the dollar. The dollar depreciates against the pound; the pound appreciates against the dollar. 10. Arbitragers will buy pounds in New York, at $1.69 per pound, and sell...

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