Chapt 2-Financial Mkt and Instruments (Flash).pptx

Financial markets

1. Chapter Two Financial Markets and Instruments

2. Main Points: Money Markets Debt Markets Equity Markets Derivative Markets Foreign Exchange Markets

3. 1.1. Money Market Money market is a market in which short term instruments are traded. Common characteristics of Money market: mature in one year or less. low default risk. Used to fill short-term financial needs Invested by units that have excess short-term funds An active secondary market. sold in large denominations

4. 1.2. Need of Money Market Banks have an efficiency advantage in gathering information Short-term securities are neither as liquid nor as safe as deposits Banks should be able to offer loans more cheaply Given the advantages that banks have, why do the money markets exist at all? Because: Interest rate ceiling Cost structure of the banking (Banks are subject to regulations and government costs).

5. 1 .3. Purpose of Money Market The purpose of money markets is to facilitate the transfer of short-term funds from agents with excess funds (corporations, financial institutions, individuals, government) to those market participants who lack funds for short-term needs. Why do corporations and governments sometimes need to get their hands on funds quickly? Cash inflows and outflows are rarely synchronized.

6. 1.4. Money Market Participants Government Federal Reserve System (Central Bank) Commercial banks Businesses Investments and securities firms Individuals, and Money market mutual funds, etc.

7. Cont… Government Raise funds until tax revenues are received. Replace maturing issues. Example: T-Bills 2. Federal Reserve System Treasury’s agent for the distribution of all government securities. Sell to reduce money supply. Purchase to expanded money supply.

8. Cont… 3. Commercial Banks Bank buy and sell securities. 4. Businesses Many businesses buy and sell securities in the money markets. 5. Investment and Securities Firms Investment Companies . Trade on behalf of commercial accounts. Finance Companies (commercial leasing Companies). Raise funds in the money markets primarily by selling commercial paper, then lend to consumers for the purchase of durable goods such as cars, boats, or home improvements.

9. Cont… c. Insurance Companies. They buys and sales securities. d. Pension Funds. They buys and sales securities. 6. Individuals They participate through direct or money market mutual.

10. Cont… 7. Money market mutual funds. Money market mutual funds Allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities. Have the characteristics of a mutual fund but also function to some extent as a depository . they sell shares to acquire funds that are then used to buy money market instruments

11. 1.5 Money Market Instrument T-Bill Repurchase Agreement Negociable Certificate of Deposite Commercial Paper Bankers Acceptance

12. 1 .5. Money Market Instruments 1. Treasury Bills Issued by government little or even no risk. As benchmark for default-free interest rates. zero-coupon instruments issued at a discount

13. Cont… How do we calculate the purchase price (Po), discount rate, investment rate of T-bills?

14. Cont… Example 1: Assume investor requires a 5 percent annualized return on a one-year Treasury bill with a Birr 100,000 par value. How much h e will be willing to pay to get this return? Ans. Po = 95,238 Example 2: Assume investor requires a 5 percent annualized return on a 6 month Treasury bill with a Birr 100, 000 par value. The price of the security will be: Ans. 97,560 Example 3: Assume investor requires an 8 percent annualized return on a 91-day Treasury bill with a Birr 100,000 par value. The price of the security will be: Ans. 98,039 Example 4: Assume investor requires to pay 98,000 birr for a 91-day Treasury bill with a Birr 100,000 par value. The annualized yield of the security will be: Ans. 8.17%

15. Cont… 2. Repurchase Agreements A firm can sell Treasury securities in a repurchase agreement whereby the firm agrees to buy back the securities at a specified future date. Government securities dealers frequently engage in repos. A short-term collateralized loan. Used to conduct monetary policy (to control inflation).

16. Cont… 3. Negotiable Certificates of Deposit A negotiable certificate of deposit is a bank-issued security that documents a deposit and specifies the interest rate and the maturity date. It is a term security - A financial instrument that have a fixed maturity date. called a bearer instrument. This means that whoever holds the instrument at maturity receives the principal and interest.

17. Cont… 4. Commercial Paper unsecured promissory notes, (No collateral) issued by large corporations, The interest rate is based on company risk. usually held by investors until maturity ( has no active secondary market), because issues of CPs are heterogeneous in terms of issuers, amounts, maturity dates. most issued on a discounted basis.

18. Cont… 5. Banker’s Acceptances A banker’s acceptance is an order to pay a specified amount of money to the bearer on a given date. Foreign exporters prefer that banks act as payment guarantors before sending goods to importers . Payable to the bearer ( salable in secondary markets). discounted basis like commercial paper and T-bills.

19. Summary Treasury bill returns are the lowest because they are virtually devoid of default risk. Banker’s acceptances and negotiable certificates of deposit are next lowest because they are backed by the creditworthiness of large money center banks.

20. Questions What characteristics define the money markets? Is a Treasury bond issued 29 years ago with six months remaining before it matures a money market instrument? Why do banks not eliminate the need for money markets? Distinguish between a term security and a demand security. What was the purpose motivating regulators to impose interest ceilings on bank savings accounts? Why do businesses use the money markets? What purpose initially motivated to offer money market mutual funds to its customers? Which of the money market securities is the most liquid and considered the most risk-free? Why? Who issues federal funds, and what is the usual purpose of these funds? Does the Federal Reserve directly set the federal funds interest rate? How does the Fed influence this rate? Who issues commercial paper and for what purpose? Why are banker’s acceptances so popular for international transactions? What would be your annualized discount rate % and your annualized investment rate % on the purchase of a 182-day Treasury bill for $4,925 that pays $5,000 at maturity? What is the annualized discount rate % and your annualized investment rate % on a Treasury bill that you purchase for $9,940 that will mature in 91 days for $10,000? If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91-day Treasury bill that pays $5,000 at maturity? What is the annualized discount and investment rate % on a Treasury bill that you purchase for $9,900 that will mature in 91 days for $10,000? The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%, what will the paper pay at maturity? How much would you pay for a Treasury bill that matures in 182 days and pays $10,000 if you require a 1.8% discount rate? The price of $8,000 face value commercial paper is $7,930. If the annualized discount rate is 4%, when will the paper mature? If the annualized investment rate % is 4%, when will the paper mature? How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you require a 3% discount rate? The annualized discount rate on a particular money market instrument, is 3.75%. The face value is $200,000, and it matures in 51 days. What is its price? What would be the price if it had 71 days to maturity?

21. 2.1. Bond Market What is Bond? A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond\ What is Bond market? A market in which bond is traded. Firms and individuals use the capital markets for longterm investments. Who are Capital Market Participants? The federal, State and municipal governments issues long-term notes and bonds to fund the national debt, to finance capital projects, such as school. Usually, governments never issue stock because they cannot sell ownership claims. Corporations issue both bonds and stock.

22. Cont’d Figure 2.1.1: Hamilton/BP Corporate Bond

23. 2 .2. Types of Bonds Treasury bonds (T-bond) Corporate Bond Municipal Bond Foreign Bond 1. Treasury Bond (T-Bond) Government bonds Issued by the federal government. No default risk.

24. Cont’d 2. Corporate bonds Issued by corporations Exposed to default risk (“credit risk”) 3. Municipal bonds Issued by state and local governments Default risk. Exempt from federal taxes and also from state taxes if the holder is a resident. Consequently, municipal bonds carry interest rates that are considerably lower than those on corporate bonds.

25. Cont’d 4. Foreign bonds Issued by foreign governments or foreign corporations. Exposed to default risk It has an additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency.

26. 2.3. Key Characteristics of Bonds Long-term debt instrument or security. Can be secured or unsecured. Interest Rate or coupon rate is fixed. Face Value or par value Maturity is fixed (maturity date). Redemption value ( Call Provision) Market Value Convertible. bonds that are convertible into shares of common stock, at the option of the bondholder. Index . Indexed, or purchasing power, bond.

27. Is simply the present value of the cash flows the asset is expected to produce. For a “regular” bond with a fixed coupon rate, here is the situation: 2.4. Bond Valuation

28. Cont’d

29. Bond and Bond Valuation The Bond-Pricing Equation PV(Annuity) PV(lump sum) C = Coupon payment; F = Face value

30. Cont’d Example: Suppose an investor is considering the purchase of a 5 year, Rs . 1,000 par value bond, bearing a nominal rate of interest of 7 % annum. The investor’s required rate of return is 8%. What should he be willing to pay now to purchase the bond if it matures at par? Ans. Rs.960.07 since Cr < Mr the bond is sold at discount.

31. Cont’d Changes in Bond Values Over Time The value of the bond has inverse r/n ship with market interest rate.

32. Cont’d Example 2: Suppose an investor is considering the purchase of a 3 year, $1,000 par value bond, bearing a nominal rate of interest of 10% annum. The investor’s required rate of return is 10%. What should he be willing to pay now to purchase the bond if it matures at par? At the time a coupon bond is issued, market price = Par value. A lower coupon, investors willing to pay below $1,000 for the bond, A higher coupon, investors would willing to pay over $1,000.

33. Cont’d Example 3 : Now suppose interest rates in the economy fell after (one year after issued) the bonds were issued, and, as a result, kd fell below the coupon rate , decreasing from 10 to 5 percent. Both the coupon interest payments and the maturity value remain constant. What is the value of the bond at the end of the first year? If the Kd < CIR ( i ) = Value bond > par value, Premium or above the par

34. Cont’d An outstanding bonds would be bid up in price to $1,092.95 at which point they would provide the same rate of return to a potential investor as the new bonds, 5 percent. Notice that if you purchased the bond at a price of $1,092.95 and then sold it one year later with kd still at 5 percent, What would be the total rate of return or yield? Percentage rate of return = Interest yield (current yield ) + a capital gains yield,

35. Cont’d Example 4: Had interest rates risen from 10 to 15 percent during the first year after issue rather than fallen from 10 to 5 percent. What is the value of the bond at the end of the first year ? Notice that if you purchased the bond at a price of $918.7 and then sold it one year later with kd still at 15 percent, What would be the total rate of return or yield? b. If the Kd > CIR ( i ) = Value bond < par value, Discount or below the par

36. Cont’d Generally, to do the above conclusion, assuming that interest rates in the economy: Remain constant at 10 percent Fall to 5 percent and then remain constant at that level, or Rise to 15 percent and remain constant at that level.

37. 3.1. Equity Market A share of stock in a firm represents ownership . Stock does not mature. Most stockholders have the right to vote for: Directors amendments to the corporate charter new shares should be issued Investors a return on stock = Price Rises + Dividends .

38. 3.2. Common Stock vs. Preferred Stock Common Stock receive a vary dividend Hope that the price of their stock will rise. stockholders usually vote a claim on assets after preferred shareholders Preferred Stock receive a fixed dividend the price of preferred stock is relatively stable. stockholders do not usually vote unless the firm has failed to pay the promised dividend. a claim on assets priority over the claims of common shareholders

39. 3. 3. How Stocks Are Sold Literally billions of shares of stock are sold each business day in the United States. T raditionally stocks are trading on either an Organized exchange or over-the-counter . The traditional definition of an organized exchange is that there is a specified location where buyers and sellers meet on a regular basis to trade securities. 2. Recently , electronic trading grows

40. How Stocks Are Sold: Cont’d Organized Securities Exchanges Historically, the New York Stock Exchange (NYSE ) has been the best known of the organized exchanges. The NYSE first began trading in 1792, when 24 brokers began trading a few stocks on Wall Street. The NYSE is still the world’s largest and most liquid equities exchange.

41. How Stocks Are Sold: Cont’d The NYSE currently advertises itself as a hybrid market (combines both electronic trading and traditional auction market trading). How the firms register in a Stock exchange? To have a stock listed for trading on one of the organized exchanges, a firm must file an application and meet certain criteria set by the exchange designed . There are also major organized stock exchanges around the world. For example, Nikkei in Tokyo, London Stock Exchange in England, DAX in Germany, and the Toronto Stock Exchange in Canada.

42. How Stocks Are Sold: Cont’d 2. Over-the-counter (OTC) securities that are not listed on a major exchange are traded via a broker-dealer network. usually small companies that are not meet the requirements to be listed on a national exchange are participated. This market is not organized in the sense of having a building where trading takes place. Instead , trading occurs over sophisticated telecommunications networks.

43. How Stocks Are Sold: Cont’d 3. Electronic Communications Networks ( ECNs ) ECNs have been challenging both Over-the-Counter and the organized exchanges for business in recent years. An ECN is an electronic network that brings together major brokerages and traders so that they can trade between themselves and bypass the middleman . Advantages: Transparency All unfilled orders are available for review by ECN traders . Provides valuable information about supply and demand that traders can use to set their strategy.

44. How Stocks Are Sold: Cont’d 2. Cost reduction No middleman and the commission or lower transaction costs. 3. Faster execution Since ECNs are fully automated, trades are matched and confirmed faster than can be done when there is human involvement. 4. After-hours trading Since ECNs never close, trading can continue around the clock.

45. How Stocks Are Sold: Cont’d 4. Exchange Traded Funds ( ETFs ) the latest market innovation to capture investor interest. ETFs are formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange. ETFs share the following features: They are listed and traded as individual stocks on a stock exchange. They are indexed rather than actively managed. Indexed such as the S&P 500 or the Dow Jones Industrial Average . 3 . Their value is based on the underlying net asset value of the stocks held in the index basket.

46. 3.4. Computing The Price of Common Stock 1. Cost of common stock, K e Is Equity Capital Free of Cost? No, it has an opportunity cost. Companies can raise common equity in two ways: Directly by issuing new shares and Indirectly by retaining earnings. If new shares are issued, what rate of return must the company earn to satisfy the new stockholders? Which is the investors require a return of K e .  

47. Computing The Price of Common Stock : Cont’d Few mature firms issue new shares of common stock. In fact, less than 2 percent of all new corporate funds come from the external equity market. There are three reasons for this: Flotation costs can be quite high . Investors believe that managers have superior knowledge about companies’ future prospects, and that managers are most likely to issue new stock when they think the current stock price is higher than the true value.

48. Computing The Price of Common Stock: Cont’d Whereas debt and preferred stock are contractual obligations that have easily determined costs, it is more difficult to estimate K e . However, we can employ the following principles or methods to produce reasonably good cost of equity estimates: Dividend Growth model or Discounted cash flow ( DCF ) method, and Capital Asset Pricing Model ( CAPM ) These methods are not mutually exclusive— no method dominates the others, and all are subject to error when used in practice. then choose among them on the basis of our confidence in the data used for each in the specific case at hand.

49. Computing The Price of Common Stock: Cont’d Dividend Growth model

50. Computing The Price of Common Stock: Cont’d Example 1, Example 2, A firm is currently earning Rs 100,000 and its share is selling at a market price of Rs 80. The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has a payout ratio of 100 per cent. What is the cost of equity? We can use expected earnings-price ratio to compute the cost of equity. Thus: Ans. K e =EPS/P = 10/80 = 12.5%   Ans. i. 10.75, ii. 11%

51. Computing The Price of Common Stock: Cont’d   2. Capital Asset Pricing Model ( CAPM ) As per the CAPM , the required rate of return on equity is given by the following relationship: Equation requires the following three parameters to estimate a firm’s cost of equity: The risk-free rate ( R f ) The market risk premium ( R m – R f ) The beta of the firm’s share (  ) , systematic risk

52. Computing The Price of Common Stock: Cont’d   Example: Suppose in the year 2002 the risk-free rate in USA is 6 per cent, the market risk premium is 9 per cent and beta of SS company’s share is 1.54. The cost of equity for SS company is: Ans. K e = 19.86%

53. 3.5. Regulation of the Stock Market   Properly functioning capital markets are a hallmark of an economically advanced economy . Investors must be able to trust the information that is released about the firms that are using them. Most notable example of this in the United States was the Great Depression . During the 1920s , about $50 billion in new securities were offered for sale. By 1932, half had become worthless. The public’s confidence in the capital markets justifiably plummeted, and lawmakers agreed that for the economy to recover, public faith had to be restored .

54. Regulation of the Stock Market: Cont’d   To develop the confidence(trust) of the investor or to solve these types of problems, the congress passed the following laws: Require firms to tell the public the truth about their businesses, and Require brokers, dealers, and exchanges to treat investors fairly. The Congress established the Securities and Exchange Commission (SEC) to enforce these laws ..

55. Regulation of the Stock Market: Cont’d   Primary mission of the U.S. Securities and Exchange Commission are: to protect investors and maintain the integrity of the securities markets. Assuring a constant, timely, and accurate flow of information to investors . Reducing asymmetric information . For example, SEC collects the many documents that public companies are required to file. These include annual reports , registration statements, quarterly filings, and many others.

56. 4.1. Derivative Markets   A derivative security is a financial instrument whose value depends on, or is derived (hence “derivative”) from, some underlying security. For example, the value of a futures contract to buy corn at some future point in time (at a specific price determined today) is derived from the price of corn. Derivatives are an integral part of a successful risk management program because they offer an inexpensive means of changing a firm’s risk profile . A firm’s risk profile describes how the firm’s value or cash flows change in response to changes in some risk factor.

57. Derivative Markets: Cont’d   Common risk factors are: Interest rates commodity prices stock market indexes, and foreign exchange rates. I nvestors can use derivative securities to speculate on these risk factors . The most common types of derivative contracts are: Forwards Futures Options, and swaps.

58. 4.2 Forward Markets   A forward market is a financial marketplace where contracts are made today for the purchase or sale of assets at a future date, with the price agreed upon at the time the contract is made. Contracts that call for future delivery of: Domestic or foreign currency A security, or a commodity. Involves two parties agreeing today on a price, called the forward price . Contrast to a cash market transaction in which the buyer and seller conduct their transaction today at the spot price . The buyer of a forward contract is said to have: A long position and Is obligated to pay the forward price for the asset.

59. Forward Markets: Cont’d The seller of a forward contract is said to have: A short position and Is obligated to sell the asset for the forward price. Settlement date is the future date or future agreement date on which: the buyer pays the seller the seller delivers the asset to the buyer Both parties to the contract are bound by the contract and are not released from that obligation early unless they renegotiate the contract prior to the settlement date. Individual parties to forward contracts are exposed to potential loss should their counterparty default rather than honor his or her obligation on the settlement date.

60. Forward Markets: Cont’d Forward Price = Current Price + Borrow Cost For I nstance 1, consider Hilary, a portfolio manager who plans to buy 1-month Treasury bills in 2 months. The total face amount of securities she plans to buy is $5 million. The current price for 3-month Treasury bills is $992,537 per $1 million face amount. If the current, effective , annual risk-free rate over the 2 months is 3 percent . On the basis of the given information what would be the fair forward price per face amount?, Total forward price to buy $5 million face value security?

61. Forward Markets: Cont’d Solution: 1. Forward price per face amount, Forward Price (FP) = Current Price ( CP ) ( 1+r ) n = $992,537 (1+0.03/12) 2 = $ 997,506 2. Total Forward Price. Total Forward Price = ($ 997,506 x 5)= $ 4,987,530

62. Forward Markets: Cont’d If the asset had any storage costs: Forward Price = Current Price + Borrow Cost + Storage Costs If the asset had any paid income: Forward price = Current Price + Borrow Cost – Income When an exporter wishes to guarantee a forward exchange rate, he or she can go to any one of a number of banks or foreign exchange dealers and enter into a forward contract . For example 2. Assume, the exporter of corn made forward exchange contract of the dollar price with a major bank. The contract guarantees delivery of a certain amount of foreign currency (say , 2 million British pounds) for exchange into a specific amount of dollars ($ 3.7 million, if the exchange rate is $ 1.85 = £1 ) on a specific day (90 days hence ).

63. Forward Markets: Cont’d If a corn exporter sold 1 million bushels of corn at £2 per bushel with payment due in 90 days. How much dollar the exporter, will receive from the major Bank, if the exchange rate during the payment is $1.9 = £1)? Solution : Exporter receives = £2 million x $1.85 = $ 3.7 million

64. 4.3 Futures Markets Like forward contracts, futures contracts involve two parties agreeing today on a price at which the purchaser will buy a given amount of a commodity or financial instrument from the seller at a fixed date sometime in the future. The markets for the two types of instruments are sufficiently different, however, that the two contracts are called by different names.

65. 4.3.1 Differences Between Futures and Forward Markets Forward Markets Traded in the informal over-the-counter market. Not standardized in quantities, delivery periods, and grades of deliverable items. More default riskier, b/c it made informal market. may default if prices change dramatically before the delivery date or no offset prior to delivery. Future Markets Traded on an organized exchange , such as the Chicago Board of Trade or the Chicago Mercantile Exchange. Standardized in quantities, delivery periods, and grades of deliverable items Less default risk, b/c it made in organized market or offset prior to delivery.

66. Differences Between Futures and Forward Markets: Cont’d Usually, not requiring daily cash settlement, called marking-to-market (no zero sum game). Usually, requiring daily cash settlement, called marking-to-market (Zero-sum game) or almost all contracts are offset prior to delivery. For example, that you have promised to sell and deliver 5,000 bushels of corn at the end of December (i.e., taken a short position in the corn futures). If you now agree to buy and pick up 5,000 bushels of corn at the end of December (i.e ., take a long position), your net position is zero.

67. Futures Markets: Cont’d For instance, suppose that in December 2022, Paige (long position) decides to buy a 10-year Treasury note of $100,000 face amount futures contract for delivery in June 2023 at a price of $110, 391. At the same time, Jake (short position) decides to sell a Treasury note futures contract if he can get a price of $110,391 or higher . Required: 1. If the price of the Treasury note decreases to $110,000. Who worse off and Gain from this result? Paige’s loss is Jake’s gain Paige is worse off because she must pay $110,391 for Treasury notes that are now worth $110,000 (i.e., a loss of $391). Jake now has agreed to sell the Treasury notes for $110,391 and they are only worth $110,000 (i.e., a gain of $391).

68. Futures Markets: Cont’d 2. If the price of Treasury notes increases to $110,400. Who worse off and Gain from this result? Paige’s gain is Jake’s loss. Paige is gain because she must pay $110,391 for Treasury notes that are now worth $110,400 (i.e., a gain of $9). Jake is worse off because he is obligated to sell Treasury notes for $110,391, which is less than what he could sell them for in the spot market of $110,400 (i.e., a loss of $9 ). Long positions benefit from price increases. Short positions benefit from price decreases .

69. Futures Markets: Cont’d To minimized the above type of problem (default risk) in Future contract, there is initial margin or marked to market. There is deposit money with the exchange to guarantee that they keep their part of the bargain. This deposit is called the initial margin requirement. If the market price of new contracts on the exchange moves adversely, buyer or seller may have to deposit more money in order to meet the maintenance margin requirement.

70. Futures Markets: Cont’d Assume the above example, Paige and Jake each posted an initial margin requirement of $1,890 with the exchange, so the exchange holds a total of $3,780 in margin deposits . Now, as before, suppose that the price of the Treasury note futures contract fell to 110,000. At that point, Paige’s long contract has lost $391 in value and Jake has gained an equal amount. Because futures contracts are marked to market every day, $391 is deducted from Paige’s margin account and $391 is deposited in Jake’s margin account .

71. Futures Markets: Cont’d Therefore, on the bases of this new future price ($110,000) and initial margin (guarantee ) The futures price is set to the new futures price of $110,391 to $110,000. After the contracts are marked to market Paige has $1,499 ($ 1,890-$391 ) in her margin account . Jake has $2,281 ($1,890 + $391 ) in his margin account.

72. 5.1 Foreign Exchange Market The price of one currency in terms of another is called the exchange rate. For Example: $1 = 55.911 ETB , Nov 20,2023 Exchange rates are highly volatile. For Example, Figure 5.1.1: Exchange Rates, 1990-2010, Note that a rise in these plots indicates a strengthening of the currency (weakening of the dollar ).

73. Foreign Exchange Market: Cont’d The exchange rate affects the economy and our daily lives . Example, when the ETB becomes more valuable relative to foreign currencies (U.S . dollar): Foreign goods (American) become cheaper for Ethiopians and Ethiopians goods become more expensive for foreigners (Americans). When the ETB falls in value: F oreign goods become more expensive for Ethiopians and Current Ethiopian goods become cheaper for foreigners(Americans). situation in our country

74. Foreign Exchange Market: Cont’d How foreign goods, services or financial assets are traded? We have to go to foreign exchange market to exchange your currency. When an American firm buys foreign goods, services, or financial assets, for example, U.S. dollars ( typically, bank deposits denominated in U.S. dollars) must be exchanged for foreign currency (bank deposits denominated in the foreign currency ). The trading of currencies and bank deposits denominated in particular currencies takes place in the foreign exchange market.

75. 5.2 What Are Foreign Exchange Rates? There are two kinds of exchange rate transactions. Spot transactions Predominant ones Spot exchange rate is the exchange rate for the spot transaction , 2. Forward transactions Exchange of bank deposits at some specified future date. F o rward exchange rate is the exchange rate for the forward transaction.

76. What Are Foreign Exchange Rates ?: Cont’d Appreciation Vs Depreciation When a currency increases in value, it experiences appreciation When it falls in value and is worth fewer U.S. dollars, it undergoes depreciation. For Example, Euro1 = $1.18 to Euro1 = $1.23 Which currency is appreciated or depreciated? Euro appreciated by 4.2% (1.23-1.18)/1.18, and Dollar Depreciated by -4.7% (0.81-0.85)/0.85

77. 5.3 Why Are Exchange Rates Important? Affect the relative price of domestic and foreign goods i.e. domestic goods in terms of foreign currency or foreign goods in terms of domestic currency. A country’s currency appreciates (rises in value relative to other currencies) the country’s goods abroad become more expensive Foreign goods in that country become cheaper A country’s currency depreciates Goods abroad become cheaper and Foreign goods in that country become more expensive.

78. Why Are Exchange Rates Important ?: Cont’d Example, Suppose that John, an American, decides to buy a bottle of win from France. If the price of the wine in France 1,000 euros and exchange rate is $ 1.09 to the euro. Now suppose that John delays his purchase by two months, at which time the euro has appreciated to $1.4 per euro. If the domestic price of the bottle remains 1,000 euros. H ow much dollar expected from John, if he didn’t delay?, How much dollar expected from John, if he purchase by delaying two months as the result of euro appreciation?

79. Why Are Exchange Rates Important ?: Cont’d Solution: 1. How much dollar expected from John, if he didn’t delay? Win cost = 1,000 euros x $1.09/euro = $1,090 2. How much dollar expected from John, if he purchase by delaying two months as the result of euro appreciation? Wine Cost = 1,000 euros x $1.4/euro = $1,400

80. Why Are Exchange Rates Important ?: Cont’d Take into account the above example, the same currency appreciation, however, makes the price of foreign goods in that country less expensive. The importer of France decides to buy Dell computer from America. The Dell computer priced at $2,000 costs. How much euro expected from Importer, if he didn’t delay?, How much euro expected from Importer, if he purchase by delaying two months as the result of euro appreciation?

81. Why Are Exchange Rates Important ?: Cont’d Solution: How much euro expected from Importer, if he didn’t delay? Dell Computer cost = $2,000 x 0.917 euro/$ = 1,835 euros 2. How much euro expected from Importer, if he purchase by delaying two months as the result of euro appreciation ? Dell Computer cost = $2,000 x 0.715 euro /$ = 1,429 euros Conclusion, t hus, A appreciation of the euro higher the cost of French goods in America but reduces the cost of American goods in France

82. Why Are Exchange Rates Important ?: Cont’d Solution: How much euro expected from Importer, if he didn’t delay? Dell Computer cost = $2,000 x 0.917 euro/$ = 1,835 euros 2. How much euro expected from Importer, if he purchase by delaying two months as the result of euro appreciation ? Dell Computer cost = $2,000 x 0.715 euro /$ = 1,429 euros Conclusion, t hus, A appreciation of the euro higher the cost of French goods in America but reduces the cost of American goods in France

83. Why Are Exchange Rates Important ?: Cont’d A depreciation of the euro lowers the cost of French goods in America but raises the cost of American goods in France. If the euro drops in value to $ 1.00 from $1.09, Win bottle of will cost only $ 1,000 (1,000 euros x $1.00/euro) instead of $ 1,090, and the Dell computer will cost 2,000 euros ($2,000 x 1 euro/$) rather than 1,429 euros. Depreciation of a currency makes it easier for domestic manufacturers: to sell their goods abroad makes foreign goods less competitive in domestic markets. The prices foreign goods are expensive cost of vacationing abroad all rose as a result of the weak domestic currency.

84. Why Are Exchange Rates Important ?: Cont’d Appreciation of a currency makes it harder for domestic manufacturers: to sell their goods abroad makes foreign goods high competitive in domestic markets. The prices foreign goods are cheap cost of vacationing abroad all reduce as a result of the strong domestic currency.

85. 4.4 How Is Foreign Exchange Traded? You cannot go to a centralized location to watch exchange rates being determined. Currencies are not traded on exchanges such as the New York Stock Exchange. Instead , the foreign exchange market is organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. Because these dealers are in constant telephone and computer contact , the market is very competitive; in effect, it functions no differently from a centralized market.

86. 4.5 Exchange Rates in the Long Run ? Like the price of any good or asset in a free market, exchange rates are determined by the interaction of supply and demand . Methods to determine exchange rate in the long run: Law of One Price Theory of Purchasing Power Parity 1. Law of one Price If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world no matter which country produces it.

87. Exchange Rates in the Long Run ?: Cont’d Example, Suppose that American steel costs $100 per ton and identical Japanese steel costs 10,000 yen per ton . What is the exchange rate on the basis of law of one price? Solution: $100 = 10,000 yen, Thus $1 = 100 yen or 1 yen=$0.01 S o that one ton of American steel sells for 10,000 yen in Japan (the price of Japanese steel) and one ton of Japanese steel sells for $100 in the United States (the price of U.S. steel).

88. Exchange Rates in the Long Run ?: Cont’d If the exchange rate were 200 yen to the dollar ($1 = 200 yen), How much dollar Japanese steel would sell in United States? How much yen America steel would sell in Japanese? Solution: 1. How much dollar Japanese steel would sell in United States? Steel Cost = $50 (10,000 yen /200 yen per dollar), half of America steel 2. How much yen America steel would sell in Japanese? Steel Cost = 20,000 yen ($100 x 200 yen/dollar), twice the price of Japanese steel.

89. Exchange Rates in the Long Run ?: Cont’d Thus, Because American steel would be more expensive than Japanese steel in both countries and is identical to Japanese steel, the demand for American steel would go to zero. Exercise Recently, the yen price of Japanese steel has increased by 10% (to 11,000 yen) relative to the dollar price of American steel (unchanged at $100). By what amount must the dollar increase or decrease in value for the law of one price to hold true?

90. End of Chapter Two