Chapter 31 – Foreign Exchange

Every Government Issues Currency The purchasing power of currencies vary

across countries The exchange rate is the rate at which one

currency can buy another currency such that the buying or purchasing power is not changed

The relative value of currencies change over time, some rather rapidly

Currency Risk is the exposure to these changes

Chapter 31 – Foreign Exchange

Exchange Rates Direct Rate is the home or domestic currency needed

to purchase one unit of the foreign currency $0.008006 can buy one Yen (American)

Indirect Rate is the amount of home currency that can be purchase with a single foreign currency (reciprocal of direct)

124 Yen can buy $1 (European) Cross-Rate is the exchange rate of two foreign

currencies Triangular Arbitrage of Exchange Rates or the

relationship of cross-rates, direct and indirect rates

Chapter 31 – Foreign Exchange

Forward Rates Making the international real rate the same The Spot or Cash Exchange rate is for buying

or selling a foreign currency today The forward rate is the expected spot rate a

specific future date Forward Direct RateT = Spot Rate x (1+ inflation

in foreign country over 1 + inflation rate in US ])T

Example…purchasing power the same through investment alternative

Chapter 31 – Foreign Exchange

Currency Futures and Options Locking in Forward Exchange Rates Based on the expected inflations rates

Currency Swaps Hedging Long-term Exchange Risk exposure Arbitrage based motives

And Now a new multi-country Currency, the Euro