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Chapter 16
Foreign Exchange
Derivative Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline

Background on foreign exchange markets

Factors affecting exchange rates

Movements in exchange rates

Forecasting exchange rates

Forecasting exchange rate volatility

Speculation in foreign exchange markets

Foreign exchange derivatives

International arbitrage

Explaining price movements of foreign exchange
derivatives
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Background on Foreign Exchange
Markets

in some currencies and short positions in others

Provide forward contracts to customers

Offer currency options to customers, which can be tailored to a
customer’s specific needs
International
mutual funds

Use foreign exchange markets to exchange currencies when
reconstructing their portfolios

Use foreign exchange derivatives to hedge a portion of their
exposure
Brokerage firms
and investment
banking firms

Engage in foreign security transactions for their customers or for
their own accounts
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Background on Foreign Exchange
Markets (cont’d)
Financial
Institution
Participation in Swap Market
Insurance
companies

Use foreign exchange markets when exchanging currencies for their

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Computing A Cross-Exchange
Rate
The euro is worth $1.15, and the Canadian dollar
is worth $0.60. What is the value of the euro in
Canadian dollars?
92.1$C60.0$/15.1$C$ in euro of Value ==
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Background on Foreign Exchange
Markets (cont’d)

Types of exchange rate systems

1944 to 1971: the exchange rate at which one currency
could be exchanged for another was maintained within
1 percent of a specified rate (the Bretton Woods era)

1971: an agreement among major countries
(Smithsonian Agreement) allowed for devaluation of
the dollar and a widening of the boundaries to 2.25%

1973: boundaries were eliminated and exchange rates
of major countries were allowed to float

Dirty float

Freely floating system
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Background on Foreign Exchange
Markets (cont’d)

controls to prevent their exchange rate from
fluctuating

When controls are removed, the exchange rate abruptly
adjust to a new market-determined level
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Factors Affecting Exchange Rates

The value of a currency adjusts to changes in
demand and supply

In equilibrium, there is no excess or deficiency of that
currency

If a currency increases in value, it appreciates

If a currency decreases in value, it depreciates

Exchange rates are influenced by:

Differential inflation rates

Differential interest rates

Government intervention
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Factors Affecting Exchange Rates
(cont’d)

Differential inflation rates


The central bank increased interest rates to discourage foreign
investors from withdrawing their investments in Mexico’s debt
securities

Indirect intervention during the Asian Crisis

Some Asian countries increased their interest rates to encourage
investors to leave their funds in Asia

Indirect intervention during the Russian crisis

The Russian central bank attempted to prevent outflows by tripling
interest rates
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Factors Affecting Exchange Rates
(cont’d)

Foreign exchange controls

Controls, such as restrictions on the exchange
of a currency, can be used as a form of
indirect intervention

e.g., Venezuela imposed foreign exchange controls
in the mid-1990s

Under severe pressure, governments tend to
let the currency float temporarily toward its
market-determined level