Dale R. DeBoer

1
An Introduction to International Economics

• Chapter 11 The Foreign Exchange Market and
  Exchange Rates
• Dominick Salvatore
• John Wiley Sons, Inc.

2
Foreign exchange markets

• Foreign exchange markets are the collection of
  markets where currencies are converted.
• Historic exchange rates
• Federal Reserve Bank data
• WWW link
• Current exchange rates
• XE.com
• WWW link

3
Functions of the exchange rate markets

• Transfer purchasing power between currencies
• Provide credit for foreign transactions

4
Participants in foreign exchange markets

• Those needing currency to fund transactions
• Purchase of goods
• Tourism
• Foreign investment

5
Participants in foreign exchange markets

• Those needing currency to fund transactions
• Commercial banks
• Serve as the clearinghouses for currency exchange

6
Participants in foreign exchange markets

• Those needing currency to fund transactions
• Commercial banks
• Foreign exchange brokers
• Clearinghouse for surpluses and shortages between
  the commercial banks

7
Participants in foreign exchange markets

• Those needing currency to fund transactions
• Commercial banks
• Foreign exchange brokers
• Central banks
• Buyer or seller of last resort in the foreign
  exchange markets

8
Supply and demand model

• Demand for foreign currency in the foreign
  exchange markets is driven by transactions
  requiring foreign currency.
• Imports
• Asset flows abroad

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Supply and demand model

• Supply for foreign currency in the foreign
  exchange markets is driven by transactions
  requiring dollars.
• Exports
• Asset flows to the U.S.
• Use of the dollar as the international currency

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Supply and demand model

• The equilibrium exchange rate occurs at the
  intersection of the supply and demand curves.

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Equilibrium
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Changes to equilibrium

• Depreciation
• An increase in the domestic currency price of a
  foreign currency.
• Example
• Suppose that the supply of yen falls due to a
  decrease in the role of the dollar as the
  international currency.
• Since more dollars are required to buy yen, the
  dollar has weakened or depreciated.

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Equilibrium
Equilibrium
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Changes to equilibrium

• Appreciation
• An decrease in the domestic currency price of a
  foreign currency.
• Example
• Suppose that the supply of yen increases from an
  increased desire to purchase U.S. goods.
• Since fewer dollars are required to buy yen, the
  dollar has strengthened or appreciated.

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Equilibrium
Equilibrium
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Types of exchange rates

• Spot exchange rate
• The exchange rate that calls for payment and
  receipt of the foreign exchange within two
  business days from the date when the transaction
  was made.

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Types of exchange rates

• Spot exchange rate
• Forward exchange rate
• The exchange rate that calls for delivery of the
  foreign exchange one, three, six, twelve or
  twenty-four months after the date the contract is
  signed.
• Forward discount
• The percentage per year by which the forward rate
  is below the spot rate.
• Forward premium
• The percentage per year by which the forward rate
  is above the sport rate.

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Types of exchange rates

• Spot exchange rate
• Forward exchange rate
• Cross exchange rate
• The exchange rate between currencies A and B
  given the exchange rate between currency A and C
  and between B and C.
• Example
• Suppose dollar/yen exchange rate is 0.01 and the
  dollar/pound exchange rate is 2.
• The cross exchange rate between yen and pounds is
  2 0.01 200 /.

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Types of exchange rates

• Spot exchange rate
• Forward exchange rate
• Cross exchange rate
• Effective exchange rate
• The effective exchange rate is a weighted average
  of the exchange rates between the domestic
  currency and the nations most important trading
  partners.
• Federal Reserve Bank data
• WWW link

17
Are exchange rates uniform internationally?

• Differences in exchange rates in different
  markets are closed by arbitrage.
• Arbitrage is the purchase of currency in one
  market for immediate re-sell in another market.
• The purchase/re-selling closes differences in
  exchange rates by reducing currency available in
  the low price market and increasing availability
  in the high price market.

18
Exchange rates and the BOP

• Suppose the going exchange rate is 120 .
• At this exchange rate the balance of payments is
  in disequilibrium.
• Debits in the balance of payments (assuming only
  the U.S. and Japan contribute the BOP) will be
  given by A.

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120
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Exchange rates and the BOP

• At this exchange rate the balance of payments is
  in disequilibrium.
• Debits in the balance of payments (assuming only
  the U.S. and Japan contribute the BOP) will be
  given by A.
• Credits in the balance of payments will be given
  by B.

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120
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A
B
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Exchange rates and the BOP

• At this exchange rate the balance of payments is
  in disequilibrium.
• In the absence of intervention, the exchange rate
  would fall to C to bring the exchange rate and
  the balance of payments into equilibrium.

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120
C
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A
B
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Exchange rates and the BOP

• If either Japan or the U.S. wishes to prevent
  this exchange rate movement, the missing units of
  may be provided to the market.
• The provision of A to B units of to the market
  keep the exchange rate from falling.

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120
C
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A
B
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Exchange rates and the BOP

• These units of generate an offsetting Official
  Reserve Settlement Balance to bring the balance
  of payments into equilibrium.

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120
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A
B
23
Foreign exchange futures

• Foreign exchange futures are forward currency
  contracts for standardized currency amounts and
  select dates.
• Standard currency amounts
• 12.5 million
• 62,500
• 125,000

24
Foreign exchange futures

• Foreign exchange futures are forward currency
  contracts for standardized currency amounts and
  select dates.
• Standard currency amounts
• Select dates
• 3rd Wednesday in March, June, September, and
  December

25
Foreign exchange futures

• Foreign exchange futures are forward currency
  contracts for standardized currency amounts and
  select dates.
• Standard currency amounts
• Select dates
• Market
• International Monetary Market of the Chicago
  Mercantile Exchange

26
Foreign exchange options

• A foreign exchange option specifies a right but
  not an obligation to buy (call option) or sell
  (put option) a standard amount of currency on or
  before a specified date.

27
Foreign exchange risk

• In the absence of significant exchange rate
  intervention, exchange rates fluctuate
  significantly over time.
• Risks of exchange rate movements
• Contracted future foreign currency payments may
  become more expensive if the domestic currency
  falls in value.
• Example
• A contract requires a 100,000 payment in three
  months time.
• If the exchange rate is currently 1/1, the
  expected dollar cost is 100,000.
• If the exchange rate changes to 1.10/ 1 in the
  intervening months, the dollar cost rises to
  110,000.

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Foreign exchange risk

• Risks of exchange rate movements
• Contracted future foreign currency payments may
  become more expensive if the domestic currency
  falls in value.
• Contracted future foreign currency receipts may
  fall in value if the domestic currency increases
  in value.
• Example
• A producer expects to receive a payment of
  100,000 in three months time.
• If the exchange rate is currently 1/1, the
  expected dollar receipt is 100,000.
• If the exchange rate changes to 0.90/ 1 in the
  intervening months, the dollar receipt falls to
  90,000.

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Hedging

• Hedging is the avoidance of a foreign exchange
  risk.
• Options
• Buy at the current spot rate and deposit the
  receipts in an interest earning account until the
  funds are needed.
• Keeps funds tied into a foreign currency until
  needed.

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Hedging

• Hedging is the avoidance of a foreign exchange
  risk.
• Options
• Buy at the current spot rate and deposit the
  receipts in an interest earning account until the
  funds are needed.
• Buy a forward contract
• Typically this will entail paying a forward
  premium which increases the cost of the
  transaction.

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Hedging

• Hedging is the avoidance of a foreign exchange
  risk.
• Options
• Buy at the current spot rate and deposit the
  receipts in an interest earning account until the
  funds are needed.
• Buy a forward contract
• Buy a call option
• If not exercised, the premium is lost.

32
Speculation

• Speculation is the acceptance of foreign exchange
  risk in the hope of making a profit.
• Example
• If the speculator expects the spot rate in three
  months time to be 1/1, she may sell euros at a
  current three month forward rate of 1.10/1 with
  the expectation that she will be able to buy
  euros to cover her sale at the lower spot rate.

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Speculation

• Speculation is the acceptance of foreign exchange
  risk in the hope of making a profit.
• Stabilizing speculation
• Speculation that acts to moderate fluctuations in
  currency values.

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Speculation

• Speculation is the acceptance of foreign exchange
  risk in the hope of making a profit.
• Stabilizing speculation
• Destabilizing speculation
• Speculation that serves to amplify fluctuations
  in exchange rate values.

35
Interest arbitrage

• Interest arbitrage is the transfer of short-term
  liquid funds abroad to earn a higher rate of
  return.
• Covered interest arbitrage occurs when the
  transfer abroad does not entail exchange rate
  risk.
• Example
• Suppose the spot rate is 100/1.
• Converting 1,000 at this rate yields 100,000.
• If interest rates in Japan are 8 vs. 5 in the
  U.S., in one year the funds in Japan will earn
  8,000 vs. 50 in the U.S.
• If a forward contract to sell 108,000 was
  initially signed at the rate of 101/1,
  1,069.31 will be obtained. This is greater than
  the 1,050 that would have been obtained in the
  U.S.

36
Interest arbitrage

• Interest arbitrage is the transfer of short-term
  liquid funds abroad to earn a higher rate of
  return.
• Covered interest arbitrage occurs when the
  transfer abroad does not entail exchange rate
  risk.
• Uncovered interest arbitrage occurs when the
  transfer abroad does entail exchange rate risk.
• The previous example would demonstrate uncovered
  interest arbitrage if the return of funds to the
  U.S. was done at the future spot rate rather than
  by a forward contract.

37
Covered interest arbitrage parity

• Covered interest arbitrage is essentially without
  risk. Therefore, all profitable movements of
  funds should occur.

38
Covered interest arbitrage parity

• Covered interest arbitrage is essentially without
  risk. Therefore, all profitable movements of
  funds should occur.
• The movement of funds to exploit profitable
  arbitrage possibilities should move interest
  rates, the spot rate, and the forward rate so as
  to eliminate profitable opportunities.

39
Covered interest arbitrage parity

• The movement of funds to exploit profitable
  arbitrage possibilities should move interest
  rates, the spot rate, and the forward rate so as
  to eliminate profitable opportunities.
• Once the profitable opportunities are closed, the
  following parity condition will hold
• et (1 rJapan)/(1 rUS) f360
• et is the spot exchange rate (/)
• f360 is the 1 year forward rate (/)
• rJapan is the interest rate in Japan
• rUS is the interest rate in the U.S.