In the lecture that started this series. This is the fourth one in the series. In the first lecture, I put up a set of balance sheets that probably mystified you a bit at the beginning. But now I'm going to repeat them and we're going to talk about them a little more, okay? I talked about the money view of foreign exchange motivated it by saying let's think of a surplus country that has a $10 due to item, okay? And that $10 due to item is due from it's a $10 due from Due from item from a deficit country. And we're trying to think about and it's $10 because the dollar is the world reserve currency. And so these countries, neither one of which is the United States, okay, are paying each other in dollars. They're invoicing their trade in dollars and they're actually settling their trade in dollars. So there's a $10 due from and a $10 due to. And to make it an interesting problem we say that the deficit country doesn't have any dollars. So, what do they do now? What do they do now? And, I put in the middle between them a foreign exchange dealer, okay. Who can make this transaction go and allow this settlement in the following way. By buying from the deficit country, okay? $10 times the spot exchange rate of foreign exchange, okay? Plus $10, times the spot exchange rate of foreign exchange. So the deficit country, that's their, I call it fx because it's not the dollar, but it's their domestic currency, is the point, okay? So, the deficit country is paying in its domestic currency, okay and the, And the surplus country is receiving this payment. Okay, so that's paid, okay. This, you could just go through the steps a little bit more. So, the deficit country is selling foreign exchange to the dealer who's creating a new liability, okay, $10 spot to the credit of the deficit country here, okay. And then the deficit country pays that out, okay here, okay, so that's how the payment happens, okay? So, let me just clean this. Do you see all this? I'm going to clean all this up because we are going to add more stuff to it. I'm just going to erase the things that have cancelled, okay, so we have what's left over. Unless you stop me, all right. Well, we can also forget about the surplus country for now, because he's happy, he's paid. He's got $10 spot and he's done. And then you can forget about the deficit country to he has paid as far as he's concerned, okay? It's all done, he's settled up. But the fx dealer is not happy, okay, because the fx dealer has a short position in dollars and a long position in fx and he is exposed to currency risk, to price risk. If this spot exchange rate, if this s here, okay? This spot exchange rate changes. You could lose a lot of money, okay? This is not a good idea to be exposed to this. And this is what I laid out four lectures ago, how would you hedge this risk if you're a foreign exchange dealer? Okay and I show you. I urged you to think of this, as the spot dealer, hedges in the forward market. Okay, hedges in the forward market. And a forward market in exchange is like a matched term deposit, short position in term deposit long position, in different currencies. And you want to do it exactly the opposite obviously in order to hedge of what you've got in your spot. So I'm going to add here a $10. 10S, FX term deposit. Then I'm going to add on this side, $10 term deposit. So you see, there´s dollars on this spot, here and dollar terms here. There is FX spot here and there is FX term here. And, just to remind you the notation we are using R* for the interest rate on that term deposit, on that FX one and R without a star for the one on the dollar, okay? This hedging is using covered interest parody that idea right there that we´re, the very first equation there. Hedging a spot transaction in the forward market. Okay, so this is what I had in mind when I was telling you the story about HFT, right? That you're doing this thing in order to help out some customers, but now you gotta worry about yourself, [LAUGH] okay? And the way you do that is by hedging in the forward market, and now you're covered. You're covered in a sense, okay, not in a complete sense, but in a sense you're covered. Because if the spot rate changes, and the forward rate changes at the same time, okay, you're going to be okay. You're going to be okay, because you lose on one side, but both sides move with each other. There's going to be some basis risk, we're going to come into this, okay. But you're hedged against the big exchange rate movement. This is how foreign exchange, this is why you wind up having $4 trillion worth of foreign exchange trading right. because this was just, I want to make a payment here and a payment there, but this required two trades here, okay. But I have this dealer trading, and who they're, who are they trading with? All right, this is not the end of the, who are they trading with? So let me, let me just now, so this is the first step. Let me draw a line under this, okay? Just to indicate that we're now dealing with another dealer or another agent but I'm going to put them on the same balance sheet here. Because they are neither of these countries okay. They are speculators in fact. And obviously the FX dealer is whoever it is that they are trading with has just taken the exact opposite position so let's just write that in there. That's going to be a $10 term deposit here. At interest rate R, and there's going to be a 10S FX term deposit here, At interest rate R* and so this first dealer. We call the matched book dealer. No it's not exactly matched, you're hedging a long FX spot position with a short FX forward position, okay? But it's a hedge. You're hedged and so we're going to call them a matched book dealer. This one here is naked, is a speculate dealer, okay. Because they, but they're speculating. The point is, they are speculating not in the spot market, okay? But in the forward market, okay? In the In the forward market. So they don't have this necessity to come up with spot dollars if somebody demands it. This is all in the sort of credit dimension of the world here. Okay. And that I call that the speculative dealer. This speculative dealer is basically borrowing at the dollar rate of interest, you could say they have a forward exchange position. But that's equivalent to borrowing at the dollar rate of interest and lending at the foreign rate of interest. So it's a carry trade in that way, okay? And they're doing it because they're hoping to make money. And the risk in them not making money is that the foreign rate changes in some way. Or the spot rate that they are expecting moves dramatically. But there's a spread there maybe between these interest rates that makes them happy. This is a deficit country that has to make a payment to a surplus country in dollars which is not their own currency. How does the world facilitate that? That's the whole point of banking and all these dealers, okay is to make sure that mutually beneficial trading can happen even if people have different currencies and different whatever. And that's what finance people get paid for, okay? is making these mutually, and they of course can shave off the top, okay, their own share. And you see here we got all these transactions, this is simple little thing, but there is all these transactions that are necessary to make this thing go. It may be that one dealer takes all of this on it's own books, is willing to do this. It may be as we'll see that in fact no dealer will do any of this, okay. And so it's a Central Bank that is doing this okay? But at the moment, let's think of it as a private dealer because then we can apply our little model of the economics of the dealer function. That's where I want to go now.