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International Economics

CHAPTER 8:
FOREIGN EXCHANGE MARKETS
AND FOREIGN EXCHANGE RATES
Dam Thi Phuong Thao
University of Economics and Business, VNU

REVIEW…

BOP

Current
account
Capital
account
Financial
account 0

Export & Net Income Unilateral Non-official Statistical Official

Import receipt transfer reserves discrepancy reserves

Trade Balance
> 0: Surplus < 0: Deficit
Current account Balance

Official Settlements Balance/ Balance of Payment

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PART III: INTERNATIONAL FINANCE

v 1. Balance of Payments

v 2. Foreign exchange markets and foreign exchange rates

ü Foreign exchange markets: Definition, characteristics, functions
and actors.
ü Exchange rates: Definition, classification and exchange rates
Contents

determinants

ü Foreign exchange risks, Hedging and Speculation

v 3. International Monetary System

FOREIGN EXCHANGE MARKETS

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Foreign currency

1. DEFINITION

Gold
The foreign
exchange market
(Forex / FX market) is
the market in which Means of payment quoted in foreign
individuals, firms, currency, e.g. checks, payment cards,
and financial bills of exchange, promissory notes…
institutions buy and
sell foreign
exchange.
Valuable papers quoted in foreign
currency, e.g. government bonds,
corporate bonds, shares,…

•The worldwide volume of foreign exchange trading is enormous

and has significantly increased in recent years

TOTAL
MERCHANDISE
EXPORT (1 year - 2013)
~ 18,609
Characteristics

US$ billion

Source: Bank for International Settlements, Triennial Central Bank survey

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• FX trading takes place in many financial centers;

Trading is concentrated in the largest ones
(London, New York, Tokyo, Frankfurt, Singapore, etc.)
Characteristics

• FX trading centers are connected electronically 24h/day

The market never sleeps
Characteristics

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• Currencies traded in FOREX market:

ü Most frequently traded: USD, EUR , JPY
ü Increasingly important: JPY, MXN, CNY
Characteristics

Source: Bank for International Settlements, Triennial Central Bank survey

• Currencies traded in FOREX market:

USD is often referred to as the dominant vehicle currency

because:
ü The USD is widely used in international transactions,
including the transactions that do not involve US
residents
ü The USD serves a unit of account, the medium of
exchange and store of value in both domestic and
Characteristics

international transactions.

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• No significant difference between exchange rate

quoted in different financial centers
€ 1 = $1.1 in New York
€ 1 = $1.2 in London
-> use $1.1 to buy € 1 in New York
-> sell € 1 in London for $1.2
-> profits of USD 0.1
Characteristics

In NY: demand for EUR increases

-> USD price of EUR increase ( 1 EUR >1.1 USD)
In LD: Supply of EUR increases
-> USD price of EUR decreases (1EUR <1.2 USD)
-> Until the USD price of EUR equals in both markets

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Functions of Foreign Exchange Market

1. Transfer from one nation’s currency to another nations’ currency
-> Facilitating international trade, tourism and investment
Time consuming, inefficient

U.S importers U.K importers

Foreign
U.S tourists exchange U.K tourists
markets $
$
U.S investors U.K investors
£
£
2. Providing some insurance against foreign exchange risks
(The FX market provides the facilities for hedging and speculations)
3. State’s tool of macroeconomics management: The Central Bank increases
or reduces the foreign exchange reserve to influence on the exchange rate
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Central
bank
Foreign
exchange
Commercial
brokers
banks
Individuals,
firms and
households,

1. Immediate users: Individuals and firms can sell (suppliers) or

buy (users) foreign exchange in the foreign exchange market.
2. Commercial banks: Banks operate as a clearing house for the
suppliers and users of foreign exchange.
Actors

3. Foreign exchange brokers: brokers act as intermediaries

between commercial banks (the interbank or whole sale
market)
4. The central bank act as the seller/buyer of last resort when
there is an excess supply or excess demand in FOREX market.

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• The retail part of the market is the foreign exchange

trading that is done by banks with their customers.

• The interbank part of the foreign exchange market

involves banks trading with other banks in foreign
exchange market.
Actors

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EXCHANGE RATES

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Definition of exchange rate

v Exchange rate is the PRICE of one country's currency in units

of another country's currency
v An exchange rate can be quoted in two ways:
• Direct way (American way): as the amount of domestic
currency that one unit of foreign currency can buy
1 unit of foreign currency = x units of domestic currency
E.g. In VN: 1 USD = 20.000 VND

• Indirect way (European way): as the amount of foreign

currency that one unit of domestic currency can buy .
1 unit of domestic currency = x units of foreign currency
E.g. In EU: 1 EUR = 1.3 USD
In GB: 1 GBP = 1.5 USD

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Exercises
1. Which is a direct quotation and
which is an indirect quotation from
the US perspective?

a. 1 GBP = 1.5 USD

b. 1 USD = 120 JPY

Answer: a. Direct; b. Indirect

2. Which way of quotation is applying

in Vietnam?

Answer: Direct
1 USD = 21.000 VND

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Classification

• Spot rate
– A spot transaction involves agreement between two parties to
exchange currencies and execute the deal immediately or
within two business days.
– Spot rate is the rate agreed in spot transactions (reported on a
real-time basis on many financial websites).

E.g. Today, Anna goes to VCB to buy USD

The spot rate (the rate at that time) is 1 USD = 20.000 VND.
VCB -> Anna: 1.000 USD
Anna -> VCB: 20.000.000 VND (immediately or within two
business days)

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Classification

• Forward rate
– A forward transaction involves agreement between two
parties to exchange currencies on a specific future date and at
a specific rate that agreed today.
– Forward rate is the rate agreed in forward transactions, often
quoted for 30, 90 or 180 days into the future

E.g. On 01/01, A&B agree to exchange €100 with USD in 3-

months (01/04) from today at $1.01 = € 1.
+ No currencies paid out at the time the contract is signed (01/01)
+ Three months later (01/04), A get the €100 from B for $101,
regardless of what the spot rate is at that time.

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Classification

• Forward rate (continue)

- The different between the current forward rate value of a
currency and its current spot exchange rate value is
identified as the forward premium or forward discount
- If the forward rate is below the current spot rate, the
foreign currency is said to be at a forward discount
- If the forward rate is above the current spot rate, the
foreign currency is said to be at a forward premium.

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Classification

FR - SR 12
FDorFP = x x100
SR t
FD: Forward discount
FP: Forward premium
FR: Forward rate
SR: Spot rate
t: term (e.g. 3m forward rate -> t=3)

E.g. The spot rate is $1 = €1 and the

3m forward rate is $0.99 = €1
0.99 - 1 12
FD = x x100 = -4%
1 3

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Exercises
4. The spot rate is $1 = €1 and the six
month forward rate is $1.01 = €1.
Calculate the FD or FP in these cases

5. The 3 month forward rate is 1EUR=

1.21 USD while the spot rate is 1EUR =
1.20 USD. What is the annualized forward
premium or discount of the euro?
A. 6.67 percent premium
B. 6.67 percent discount
C. 3.33 percent premium
D. 3.33 percent discount

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Classification

• Cross exchange rate

– the exchange rate between a pair of currencies (other than
$) determined when the exchange rate between each of
currencies with respect to the $ is established.

– For example: $2 = £1; $1.25 = €1

-> £1 = €1.6

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Exercises
6. Suppose the exchange rates between
euro, Yen and dollar are as follows:
1 dollar = 95 Yen
1 euro = 1.3112 dollars

What is the cross rate between Yen and

euro
A. 1 euro = 124.5640 Yen
B. 1 euro = 98.3133 Yen
C. 1 euro = 72.4527 Yen
D. None of the above

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Exercises
7. Suppose the exchange rates between
British pound, euro and dollar are as
follows:
1 pound = 1.5672 dollars
1 euro = 1.3112 dollars
What is the cross-rate between British
pound and euro
A. 1 pound = 0.8367 euro
B. 1 pound = 1.1952 euro
C. 1 pound = 2.0549 euro
D. None of the above

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Classification

– Bid rate/ Buying rate

The rate at which the quoting bank is willing to buy the foreign exchange.
– Ask rate/ Selling rate/ Offer rate
The rate at which the quoting bank is will to sell the foreign exchange.
– Bank note rate
The rate applied to foreign coins, paper money, travel’s check and credit cards
– Transaction rate
The rate applied to FX deposit accounts
– Opening rate
The rate of the first FX contract of the day
– Closing rate
The rate of the last FX contract of the day

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Tỷ giá các ngoại tệ của Hội sở chính Ngân hàng TMCP Ngoại thương Việt Nam ngày 08/11/2013

M ua tiền m ặt/Bid M ua chuyển khoản/ Bid Bán/ Ask rate/ Offer

M ã NT Tên ngoại tệ rate (Cash) rate (transaction) rate

AUD AUST.DOLLAR 19657.77 19776.43 20034.17

CAD CANADIAN DOLLAR 19872.38 20052.86 20314.19

CHF SW ISS FRANCE 22703.75 22863.8 23161.77
DKK DANISH KRONE 0 3752.69 3832.14

EUR EURO 28010.58 28094.86 28461

GBP BRITISH POUND 33494.84 33730.96 34102.28
HKD HONGKONG DOLLAR 2679.61 2698.5 2744.62

INR INDIAN RUPEE 0 331.29 345.14

JPY JAPANESE YEN 206.06 208.14 215.59
KRW SOUTH KOREAN W ON 0 18.03 22.05

KW D KUW AITI DINAR 0 73845.91 75409.2

M YR M ALAYSIAN RINGGIT 0 6574.42 6660.1
NOK NORW EGIAN KRONER 0 3450.96 3524.02

RUB RUSSIAN RUBLE 0 590.47 722.37

SAR SAUDI RIAL 0 5458.46 5801.6
SEK SW EDISH KRONA 0 3196.07 3250.7

SGD SINGAPORE DOLLAR 16690.42 16808.08 17095.38

THB THAI BAHT 659.59 659.59 687.16
USD US DOLLAR 21080 21080 21145

Tỷ giá được cập nhật lúc 08/11/2013 09:00 và chỉ m ang tính chất tham khảo

http://www.vietcombank.com.vn/exchangerates/

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Exercises
8. Suppose the exchange rate between
dong and dollar is quoted at TECHCOBANK
as follows: 21027~21123 (bid-ask rates).
Suppose you need to purchase 1000
dollars. How much do you have to pay?

A. 21123000 dong
B. 21027000 dong
C. 21095000 dong
D. None of the above

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Exercises
9. Suppose the exchange rate between
dong and US dollar is quoted at
TECHCOBANK as follows: 20860~20910
(bid-ask rates). You sell 1000 dollars to the
bank. How much would you receive?
A. 20910000 dong
B. 20860000 dong
C. 20900000 dong
D. None of the above

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Equilibrium Exchange Rate

• Under a flexible exchange rate system
R = $/€
S€

$: Domestic currency
1.5 G €: Foreign currency

1.0 E

H
0.5
D€

0 100 200250 Million Eur/day

The exchange rate is the PRICE of foreign currency in terms of domestic

currency or the domestic price of foreign currency.
-> Basically, the equilibrium exchange rate is determined at the
intersection of the nation’s aggregate demand and supply curves for the
foreign currency (E.g. R=1.0)

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Depreciation and Appreciation of a Currency

• Currency Depreciation occurs when the value of one currency falls against
another currency.
• Currency Appreciation occurs when the value of one currency rises
against another currency
• When exchange rate R (price of foreign currency in terms of domestic
currency) increases -> Foreign currency appreciates and domestic
currency depreciates.
E.g. Before 1 USD = 20.000 VND-> Now 1 USD = 21.000 VND
-> Appreciation of USD and Depreciation of VND

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Depreciation and Appreciation of a Currency

E.g. Before 1 USD = 20.000 VND-> Now 1 USD = 21.000 VND

-> Appreciation of USD and Depreciation of VND

• Appreciation encourage import, restrain export -> worsen trade account

and current account
ü Price of U.S T-Shirt $20 -> before 400.000đ, now 420.000đ
-> Vietnamese buy less U.S T-Shirt -> EX of U.S reduces
ü Price of VN T-Shirt 200.000đ -> before $10, now $9.52
-> American buy more VN T-Shirt -> IM of U.S incrases

• Depreciation encourages export, reduces import -> improve trade

account and current account

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Devaluation and Revaluation of a Currency

• Under fixed exchange rate system

– To get a desired/fixed exchange rate, the central banks
have to intervene into the supply curve of foreign currency
through buying/selling foreign exchange from/into FOREX
market.
– If a country’s government acts to reduce the fixed value of
its currency (buying foreign currency), the change is called
Devaluation.
– If a country’s government acts to raise the fixed value of its
currency (selling foreign currency), the change is called
Revaluation.

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Exercises
3. If the U.S. wants to devaluate
the USD against the GBP, what
should Federal Reserve System
(FED, U.S Central bank) do?

Answer:
- It should buy GBP in the foreign
exchange market

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Exchange rate determinants

Exchange rate are determined by the demand for and supply of foreign currency
-> Any factors that affect the demand for and supply of foreign currency may
affect exchange rate.
R = CD/CF
S2
SF vTrade in goods and services
S1 • Exports é S -> S1
• Exports ê S -> S2
• Imports é D -> D1
• Imports ê D -> D2

vForeign Investment
• Foreign inv. in the nation é S -> S1
• Foreign inv. in the nation ê S -> S2
• Nation’s inv. abroad é D -> D1
D1 • Nation’s inv. abroad ê D -> D2

DF
D2
0 QCF

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Exchange rate determinants

vEconomic variables
üReal income
üReal interest rate
üInflation rate
üOther economic variables

vThe market’s expectation

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1. Real income and the exchange rate

R = $/£
• Real income of a country increases may
increase the country’s demand for S
imports from foreign country, and
investment in foreign country. 1
-> demand for foreign currency increases 2
-> exchange rate increases

• Real income of a country decreases may R1

R
decrease the country’s demand for
R2
imports from foreign country, and
investment in foreign country. D1
-> demand for foreign currency decreases D
-> exchange rate decreases D2
0 Million of £

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2. Real interest rate and the exchange rate

• Short-term real interest rate in a R = $/¥

country is lower than in foreign S2
S
country
-> This country invests more in
foreign country and foreign country
invests less in this country.
-> demand for foreign currency
increases and supply of foreign R1
currency decreases
R
-> exchange rate increases
D1
Differential in real interest rates is D
the main factor for the change in the
exchange rate in the short term. 0 Million of ¥

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2. Real interest rate and the exchange rate

Nominal interest rate and real interest rate

in the short term, 2006 (%)
Country Nominal interest rate Inflation rate Real interest rate
(1) (2) (3) = (1) – (2)
Canada 4.0 2.0 2.0
France 2.4 1.6 0.8
Germany 3.1 1.7 1.4
India 13.5 13.2 0.3
Italy 4.6 2.0 2.6
Japan 0.4 0.0 0.4
Korea 2.8 2.3 0.5
Mexico 7.2 3.7 3.5
U.S 4.7 3.3 1.4
U.K 6.8 3.4 3.4
Source: International Financial Statistics, Ạugust 2007

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3. Inflation and the exchange rate

• Law of one price: A good must sell for the same price in all
locations

• PPP – Purchasing Power Parity: Global exchange rates should

eventually adjust to make the price of identical baskets of tradable
goods the same in each country.

• Exchange rate tends to change at an equal rate of differential in

inflation rate between domestic and foreign countries.
E.g. if the inflation rate in Vietnam is 4% higher than China, then the
purchasing power of VND will decrease 4% in compared with CNY.
-> VND will depreciate against CNY 4%

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4. Other economic variables

v Bilateral trade relation

• Currency of the nation that has deficit in trade balance tends to
depreciate against foreign currency.
v Consumer’s tastes
• Consumer’s tastes in favor of domestic or imported goods
v Investment profitability
v Product’s availability
v Changes in productivity
v Trade policy

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5. Expectation and the exchange rate

• Expectation of the market changes in the future may lead to changes in

exchange rate at the present time.
• People expect that USD will appreciate in the future
-> everyone buy USD
-> demand for USD increases
-> USD really appreciate in the current market
• People expect that USD will depreciate in the future
-> everyone sell USD
-> supply of USD increases
-> USD really depreciate in the current market

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FOREIGN EXCHANGE
RISK, HEDGING AND
SPECULATION

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Spot exchange vs. Forward exchange transactions

• Spot exchange transaction:

ü An agreement to exchange currencies at a specific rate (spot rate) and
execute the deal immediately or within two business days.
ü Spot rates are reported on a real-time basis on many financial websites.

• Forward exchange transaction:

ü An agreement today to buy or sell a specified amount of a foreign
currency at a specified future date at a rate agreed upon today (forward
rate) -> the deal will be executed at some specific date in the future.
ü Forward rates are often quoted for 1 month, 3 months, 6 months in the
future. 3 months are the most common.
ü Forward premium or discount refers to the difference between current
forward rate and current spot rate

In practice, the forward and spot exchange rates are not necessarily equal, but
they move closely together.

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Exercise
Thượng Đình exports sport shoes to a US
firm and will receive payment of 10.000
USD in three months. On March 1, the spot
rate of the USD and VND was 1 USD =
20.000 VND, and the 3-month forward rate
was 1USD = 19.500VND. On March 1,
Thượng Định negotiated a forward contract
with a bank to sell 10.000USD forward in
three months. The spot rate of USD and
VND on June 1 is 1USD=20.500VND.
Thương Đình will receive -------- VND for
the USD?
a.200 million VND
b.195 million VND
c.205 million VND
d.210 million VND

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Foreign exchange Options

ü Foreign exchange option is a forward contract in which an

investor can, but does not have to, exchange currency at a
specific rate at a specific future date.
ü Call option: a contract giving the option buyer the right, but
not the obligation, to buy foreign currency at a known price at
a specific future date (the European option) or at any time
during the period of the option (the American option).
ü Put option: a contract giving the option buyer the right, but
not the obligation, to sell foreign currency at a known price at
a specific future date (the European option) or at any time
during the period of the option (the American option)

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Foreign exchange Options

ü The buyer of the option has the choice to buy/sell or forgo

the deal if it turns out to be unprofitable -> Greater
flexibility
ü The seller of the option must fulfill the contract if the
buyers so desires
ü Option price: the buyer has to pay the seller a premium for
the privilege (often 1-5% of the contract’s value)

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Foreign exchange risk :

-Occurs when a person’s or firm’s financial welfare can
be affected by changes in the exchange rate
FOREIGN EXCHANGE RISK

E.g.
+ A U.S importer buys 100,000EUR of goods from EU,
and will pay in three months
+ The current spot rate $1 = €1
-> the current USD value of the payment is $100.000
+ Three month later, the spot rate $1.10 = €1
-> U.S importer has to pay $110.000 ($10.000 higher)

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Hedging : the action to avoid foreign exchange risk

1. In spot market

• The exporters with future receipts denominated in foreign

currencies can borrow the amount they will receive and
exchange it for domestic currency. Later they repay the
loan with the payment they receive.

• The importers with future payments denominated in the

foreign currency can borrow in the domestic currency,
exchange it for the foreign currency, and deposit the
HEDGING

amount of the foreign currency for future payment.

• Advantage: Traders are certain about his future receipts or

payment.
• Disadvantage: Traders must borrow or tie up his/her own
funds

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1.In spot market

E.g. A U.S exporter will receive €100.000 in 3 month.

The spot rate is $1 = €1 How can he hedge against the
foreign exchange risk in the spot market?
HEDGING

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1.In spot market

E.g. A U.S exporter will receive €100.000 in 3 month.

The spot rate is $1 = €1 How can he hedge against the
foreign exchange risk in the spot market?

The U.S exporter will:

oBorrow €100.000
HEDGING

oExchange € to $, at spot rate $1 = €1

-> certainly $100.000 in hand
oAfter 3m, receive the payment of €100.000 -> use it to
repay the loans

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1.In spot market

E.g. A U.S importer needs to pay €100.000 in 3 months.

The spot rate $1 = €1. How can he hedge against the
foreign exchange risk in the spot market?

The U.S importer will:

oBorrow/put aside $100.000
HEDGING

oExchange $ to € -> €100.000 in hand

oPut €100.000 into deposit account for 3 months
oAfter 3m, withdraw € in deposit account to make the
payment.

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2. In forward market

•The exporters with future receipts in x months denominated

in foreign currencies could sell forward the amount they
would receive for delivery in x months. After x months, he
would implement the forward contract to sell this amount of
foreign currency.

•The importers with future payments in x months

denominated in the foreign currency could buy forward of
foreign currency for delivery in x months. After x months, he
HEDGING

would implement the forward contract to purchase foreign

currency.

•Advantage: Traders are certain about his future receipts or

payment; don’t need to borrow or tie up his own funds

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2. In forward market

E.g. A U.S exporter will receive 1 million euro in 3

months. How can he hedge against the foreign exchange
risk in the forward market?

The U.S exporter will:

HEDGING

o Sell forward 1 million euro for delivery in three

month.
o After 3 months, implement the forward
contract to sell one million euro

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2. In forward market

E.g. A U.S importer needs to pay 1 million euro in 3

months. How can he hedge against the foreign exchange
risk in the forward market?

The U.S importer will:

o Buy forward 1 million euro for delivery in three
HEDGING

month.
o After 3 months, implement the forward
contract to purchase one million euro

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3. In options market

•The exporters could buy a put option to sell the future receipt
denominated in foreign currencies. When he receives the
payment, he may choose either exercise the option or forgo
the option and sell the received foreign currency to the market
at spot rate at that time, depending on which is more
beneficial.
•The importers could buy a call option to buy foreign
currencies for future payment. When he has to make the
payment, he can choose either exercise the option or or forgo
the option and buy the needed foreign currency from the
HEDGING

market at spot rate at that time, depending on which is more

beneficial.
•Advantage: The option transaction gives the buyer a greater
flexibility. The buyer of an option don’t need to implement the
option if it turns out unprofitable.
•Disadvantage: However, the buyer has to pay a premium for
this privilege.

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3. In options market

E.g. A U.S importer has to pay €100,000 in 3 months. How can

he hedge against the foreign exchange risk in the option
market? Calculate the cost of purchasing EUR. Assume the
exercise rate is 1.2 USD per EUR and the premium (option
price) is 1% of the contract value.

o The U.S importer will buy a call option to purchase

€100,000 in 3 months
HEDGING

oAfter 3 months, he will implement the contract and

pay $120.000 to purchase €100,000
oAt the same time, he has to pay the premium of
$1200 ($120.000*1%)
oSo the total cost = 120,000+1,200=121,200 USD

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3. In options market

E.g. A U.S exporter will receive €100,000 in 3 months. How

can he hedge against the foreign exchange risk in the options
market?
The exercise rate is $1.2= €1. The premium (option price) is
1% of the contract value. Calculate how much the exporter
will receive.

The U.S exporter will:

HEDGING

oBuy a put option to sell €100,000 in 3 month

oAfter 3 months, implement the contract and receive
$120,000 (=€100,000 *1.2$/€)
oAt the same time, he has to pay the premium of $1.200
(=$120,000 *1%)
oSo the net receipt is $118,800

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3. In options market

E.g. An importer buys a call option to buy €100,000 in three

months at $1 = €1, and pay the premium of 1% ($1000)
3 months later, the spot rate is $0.98=€1. What should the
importer do?

o If importer buy €100,000 at the spot market

HEDGING

-> total cost = $98,000 + $1,000 = $99,000

o If importer buy €100,000 from option seller
-> total cost = $100,000 + $1,000 = $101,000
-> Importer should let the option unexercised and buy € at
the spot market

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3. In options market

E.g. An importer buys a call option to buy €100,000 in three

months at $1 = €1, and pay the premium of 1% ($1000)
3 months later, the spot rate is $1.02=€1. What should the
importer do?

oIf importer buy €100,000 at the spot market

HEDGING

-> total cost = $102,000 + $1,000 = $103,000

oIf importer buy €100,000 from option seller
-> total cost = $100,000 + $1,000 = $101,000
-> The Importer exercise the option

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Speculation: typically involves the short-term

movement of funds from one currency to another in the
hopes of profiting from shifts in exchange rates.

Speculators vs. hedgers:

- Speculators accept and seek out a foreign exchange
risk, in the hope of making a profit.
- A hedger seeks insurance against a foreign exchange
SPECULATION

risk

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1. In spot market
• Speculator expects that a currency will appreciate in the
future
-> he will buy the currency now, put into deposit to earn
interest, and resell when the currency actually appreciates.

E.g. Spot rate VND 20.000 = USD 1

Expectation: spot rate in 3 month VND 21.000 = USD 1
SPECULATION

(Appreciation of USD)

Speculators will:
o Buy USD now at the price of VND 20.000 per USD
o Put USD into deposit to earn interest
o After 3 month, sell USD at the price of VND 21.000 per USD
-> expected profit of VND 1.000 per USD

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1. In spot market
• Speculator expects that foreign currency will depreciate
against domestic currency in the future
-> he will borrow the foreign currency, exchange to the
domestic currency. When the foreign depreciates, buy foreign
currency and repay the loans.

E.g. Spot rate VND 20.000= USD 1

SPECULATION

Expectation: spot rate in 3 month VND 19.000 = USD 1

(Depreciation of USD)

Speculators will:
o Borrow USD
o Exchange USD to VND at the price of VND 20.000 per USD
o After 3 months, buy USD at the price of VND19.000 per USD
and repay the loan
-> Expected profit of VND 1.000 per USD

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2. In forward market

• Speculator expects that a currency will appreciate

-> he signs a forward contract to buy the currency

• Speculator expects that a currency will depreciate

-> he signs a forward contract to sell the currency

• Right expectation: gain profits

SPECULATION

• Wrong expectation: incur losses

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2. In forward market

3m forward rate: $1.40 = €1

Expectation: spot rate in 3 month $1.50 = €1
(Appreciation of €)

Speculators will:
SPECULATION

oSign a forward contract to buy € at exercise rate $1.40

= €1
oAfter 3 months, sell the € received at $1.50 = €1

Results: 3 months later

+ Spot rate $1.50= €1 -> gain profit of $0.10 per euro
+ Spot rate $1.45= €1 -> gain profit of $0.05 per euro
+ Spot rate : $1.30= €1 -> incur loss

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2. In forward market

3m forward rate: $1.40 = €1

Expectation: spot rate in 3 month $1.35 = €1
(Depreciation of €)

Speculators will:
oSign a forward contract to sell € at exercise rate
SPECULATION

$1.40 = €1
oAfter 3 months, buy € at $1.35 = €1 and sell it to the
partner in forward contract.

Results: 3 months later

+ Spot rate $1.35= €1 -> gain profit of $0.05 per euro
+ Spot rate $1.45= €1 -> incur loss

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3. In options market

• Speculator expects that a currency will appreciate in 3

months
-> Buy a call option contract to buy the currency in 3 months.
After 3 month, he can exercise the options or not , depending
which is more profitable

• Speculator expects that currency 1 will depreciate against

SPECULATION

currency 2 in the future

-> Borrow in currency 2, exchange to currency 1, buy a put
option contract to sell the currency 1 in x month and then
repay the loans.

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Exercise
A speculator expects EUR will appreciate.
He buys a call option to buy EUR 100.000
with the exercise rate of 1.2USD /EUR.
The option premium is USD0.1 per EUR.
Calculate his gain or loss in these two
cases:

a. On the expiration date, the spot rate

reaches 1.4 USD/EUR.
b. On the expiration date, the spot rate
reaches 1.1 USD/EUR.

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Answer

a. The cost of purchasing 100,000 euro in

the option market is:
1.2*100,000 + 0.1*100,000 = USD 130,000
- The revenue from selling 100,000 euro in
the spot market is:
1.4*100,000 + 0.1*100,000 = USD
150,000
-> He will exercise the deal.

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Answer
b. The cost of purchasing 100,000 euro in the
option market is:
1.2*100,000 + 0.1*100,000 = USD 130,000

The revenue from selling 100,000 euro in the

spot market is:
1.1*100,000 +0.1*100,000 = USD 120,000

-> He will forgo the deal and only pays the

option premium of USD 10,000

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END OF CHAPTER 8

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