BA 543Foreign Currency MarketsExchange RatesDirect QuotesIndirect QuotesBid – Ask SpreadCurrency RiskExchange Rate RegimesPurchasing Power ParitySlide 10CPISlide 12Slide 13Slide 14Cross RatesTriangular ArbitrageTriangular Arbitrage ExampleTriangular Arbitrage Example Cont.Slide 19Slide 20Slide 21Slide 22BA 543BA 543The Market for Foreign The Market for Foreign Exchange Rate Risk Control Exchange Rate Risk Control InstrumentsInstrumentsBy: Gurjot DhaliwalBy: Gurjot DhaliwalForeign Currency MarketsForeign Currency Markets►Largest Trading Market in the WorldLargest Trading Market in the World►$1.2 Trillion average daily trading $1.2 Trillion average daily trading volumevolume►Open 24/7Open 24/7Exchange RatesExchange Rates►The amount of US dollars necessary to The amount of US dollars necessary to acquire one unit of foreign currency, acquire one unit of foreign currency, and this is the dollar price of one unit and this is the dollar price of one unit of foreign currency; orof foreign currency; or►The number of units of foreign The number of units of foreign currency necessary to acquire one US currency necessary to acquire one US dollar, or the foreign currency price of dollar, or the foreign currency price of one dollar.one dollar.Direct QuotesDirect Quotes►The number of units of a local currency The number of units of a local currency exchangeable for one unit of a foreign exchangeable for one unit of a foreign currency.currency.►$1/.8152 Euro$1/.8152 EuroIndirect QuotesIndirect Quotes►The number of units of a foreign The number of units of a foreign currency that can be exchanged for currency that can be exchanged for one unit of a local currency. one unit of a local currency. ►1 Euro / $1.22681 Euro / $1.2268Bid – Ask SpreadBid – Ask Spread►In the floating market currencies are In the floating market currencies are traded just as in the open market with a traded just as in the open market with a bid price and an ask price. The bid price and an ask price. The difference between the two is the bid difference between the two is the bid ask spread. The bid is always given ask spread. The bid is always given first. first. ►An example of a bid ask spread is 1 Euro An example of a bid ask spread is 1 Euro = $1.33-42. This means that there is a = $1.33-42. This means that there is a bid price of $1.33 and the sellers are bid price of $1.33 and the sellers are asking $1.42 per Euro.asking $1.42 per Euro.Currency RiskCurrency Risk►Is the risk that a currency’s value may Is the risk that a currency’s value may change adverselychange adversely►Also termed foreign exchange riskAlso termed foreign exchange riskExchange Rate RegimesExchange Rate Regimes►Fixed Rates – A country establishes a fixed Fixed Rates – A country establishes a fixed band in which a currency is allowed to trade band in which a currency is allowed to trade relative to another countries currency.relative to another countries currency.►Floating Rates – A country allows its currency Floating Rates – A country allows its currency to move according to market conditions.to move according to market conditions.►Managed Floating Rates – A country allows its Managed Floating Rates – A country allows its currency limited movement according to the currency limited movement according to the market but actively purchases currency to market but actively purchases currency to control where its currency moves.control where its currency moves.Purchasing Power ParityPurchasing Power Parity►Consumer Price IndexConsumer Price IndexBrief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices over Brief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs for two time of goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs for two population groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers population groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers households of wage earners and clerical workers that comprise approximately 32 percent of the total households of wage earners and clerical workers that comprise approximately 32 percent of the total population and (2) the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-population and (2) the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-CPI- U), which cover approximately 87 percent of the total population and include in addition to wage CPI- U), which cover approximately 87 percent of the total population and include in addition to wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the earners and clerical worker households, groups such as professional, managerial, and technical workers, the self- employed, short-term workers, the unemployed, and retirees and others not in the labor force. The self- employed, short-term workers, the unemployed, and retirees and others not in the labor force. The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors' and CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living. Prices are dentists' services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 retail establishments- department stores, supermarkets, hospitals, filling stations, and other types of stores retail establishments- department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments. All taxes directly associated with the purchase and use of items are included in and service establishments. All taxes directly associated with the purchase and use of items are included in the index. Prices of fuels and a few other items are obtained every month in all 87 locations. Prices of most the index. Prices of fuels and a few other