The Foreign Exchange Market

1
The Foreign Exchange Market
2
Some recent movements

• In the text, they discuss the US/Euro exchange
  rate, and how it has moved.
• The euro was introduced at 1.16/ but fell to
  0.895/ by 2001. By 2004 it was back up to
  1.30/ then it fell again slightly by March
  2004.
• The Canadian/US exchange rate has also shown a
  lot of movement.

3

• From Jan 05 to Dec 06 the Can/US dollar has moved
  from less than 80 cents to almost 91 cents

4

• Monthly exchange rates look smoother.
• Going back to 2000, the variation is even wider,
  from 0.625 to 0.90.

5
Dollar variability

• Currencies vary widely in value over time.
• The US dollar has shown weakness from time to
  time, but has so far maintained its position as
  the world reserve currency.
• The dependence of countries on export-driven
  growth policies help the US dollar.
• Investment into the US both supports the dollar
  and attests to world confidence in its future
  growth

6
The Exchange Rate

• The exchange rate is the price of one currency in
  terms of another currency.
• Example US/ measures how many US it takes to
  buy one Euro.
• The value of the exchange rate may be fixed (like
  any fixed price), but in many countries it is
  determined by the demand and supply of currency

7
The market

• The worldwide network of markets and
  institutions that handle the exchange of foreign
  currencies is known as the foreign exchange
  market .
• There are two main components to the market.
• the spot market is where current transactions for
  immediate delivery of currency take place
• the forward and futures markets are where
  transactions for future delivery of currency take
  place.

8
The Basic Foreign Exchange Market

• Like any market, there is a demand side and a
  supply side to foreign exchange

9
Demand for Foreign Currency (3 types)

• 1. Demand for goods, services or immediate
  purchases, gifts
• goods and services from another country
• demand for currency to send a gift to another
  country
• demand for currency to pay foreign factors
• pay investors
• pay international workers

10
Demand for Foreign Currency (foreign exchange)

• 2. Demand for financial assets
• buy stocks from another country
• buy bonds from another country
• open a bank account in another country
• buy a business in another country

11
Demand for Foreign Exchange (3 types)

• 3. Hedging and speculation
• If you need to pay a foreign seller in the near
  future, you may buy foreign currency now if you
  are worried that its value will rise by the time
  the payment is due. (hedging)
• If you want to make a profit off the change in
  value, you may buy the currency today to sell the
  currency tomorrow at a higher value (speculation)

12
The Demand for Foreign currency

• The sum of the three demands constitute the
  demand for foreign currency
• These demands correspond to debit items in the
  balance of payments

13
The Supply of Foreign currency

• The sum of the three demands constitute the
  demand for foreign currency
• These demands correspond to debit items in the
  balance of payments

14
Supply of Foreign Currency (3 types)

• 1. Sale of goods, services or immediate
  purchases, gifts
• goods and services from OUR country
• demand for OUR currency to send a gift to OUR
  country
• supply of currency when foreign companies need to
  pay domestic factors
• pay investors
• pay workers working abroad

15
Supply of Foreign Currency (foreign exchange)

• 2. Purchases of OUR financial assets
• People from other countries
• buy stocks from OUR country
• buy bonds from OUR country
• open a bank account in OUR country
• buy a business in OUR country

16
Supply of Foreign Exchange

• 3. Hedging and speculation
• If a foreign seller needs to pay in Canadian
  dollars in the near future, they may buy OUR
  currency now (selling theirs) if they are worried
  that its value will rise by the time the payment
  is due. (hedging)
• If speculators want to make a profit off the
  change in value, they may buy OUR currency today
  (selling foreign currency) to sell OUR currency
  tomorrow at a higher value (speculation)

17
The market for Foreign Exchange

• The foreign currency market defines demand an
  supply of a foreign currency.
• Therefore, when the demand for foreign currency
  increases, the price of foreign currency rises,
  this means
• the value of our currency falls!
• The following slide shows the demand and supply
  of foreign currency

18
The Basic Foreign Exchange Market
e /
S
S
eeq
D
D
Euros ()
Qeq
19
Movement in the market

• An increase in demand for the foreign currency
  results in a rightward shift of the demand curve.
• It now takes more domestic currency to buy the
  foreign currency.
• Therefore, when e rises, the value of the foreign
  currency rises and the value of OUR currency
  falls. We call this an appreciation of the
  foreign currency or a depreciation of OUR
  currency in relation to the foreign currency

20
The Basic Foreign Exchange Market
e /
S
e
eeq
D
D
Euros ()
Qeq
Q
21
Increase in supply of foreign currency

• When foreign currency supply increases, the
  supply curve shifts right
• the price of the foreign currency falls
• This means the value of our own currency rises,
  (our currency appreciates and the foreign
  currency depreciates)

22
The Basic Foreign Exchange Market
e /
S
S
eeq
e
D
Euros ()
Q
Qeq
23
Demand and supply and the current account

• The demand and supply of foreign exchange can be
  broken into 2 components
• Goods services (current account)
• financial transactions
• These sum to total demand and supply
• The equilibrium exchange rate is determined by
  the total demand and supply

24
Demand and supply and the current account

• In the following slide, the equilibrium exchange
  rate is lower than the rate needed for a current
  account balance
• (our exchange rate would be more valuable than
  would be the case if there were only current
  account transactions)
• Therefore, there is a current account deficit
  (shown as Q2 Q1)
• this deficit is also the surplus in financial
  transactions. (Qeq-Q1) (Qeq-Q2)Q2-Q1

25
Demand and supply and the current account
SGS
e
STotal
eeq
DTotal
DGS
Qeq
Q2
Q1
Foreign Ex
26
Concept checks

• The market for international currency is called
  the

27
Concept checks

• The market for current transactions of foreign
  exchange to be delivered immediately is called..

28
Concept checks

• The two markets for future transactions in
  foreign exchange are called

29
Concept checks

• The three sources of demand for foreign exchange
  are

30
Concept checks

• An increase in demand for foreign currency
  results in __________ of our currency and
  ___________________ of the foreign currency

31
Concept checks

• If the foreign exchange rate is too high for our
  current account transaction, this means we will
  have a current account __________
  (surplus/deficit) and a capital account
  ______________ (surplus/deficit)

32
The Spot Market

• The spot market is the day-to-day purchase and
  sale of foreign exchange
• The largest players in the spot market are the
  commercial banks, followed by
• Multi-national corporations
• large nonbank financial institutions, like
  insurance companies
• government agencies including central banks
• (not in order of importance)

33
The Spot Market

• Most transactions take place with crediting and
  debiting accounts
• Therefore, the bulk of currency transactions are
  in the Interbank market
• Transactions made by brokers who receive a small
  fee for trading
• this is why you always lose a bit if you sell a
  currency then buy it back

34
Arbitrage

• Arbitrage is the act of buying and selling
  something in two different markets and making a
  profit from it.
• With many different currencies, the most common
  kind of arbitrage is triangular arbitrage
• this occurs when an actor in the exchange market
  can use trade between three currencies to make a
  profit

35
Arbitrage

• If I can use US dollars, sell them to buy euros,
  sell euros and buy yen, then sell yen and buy US
  dollars, and make a profit, I have succeeded at
  triangular arbitrage
• Example
• dollar sterling rate 1.60/
• dollar Swiss franc rate is 0.70/Sfr
• and Sfr/ 2 Sfr/
• an arbitrageur would use to buy 2 francs (need
  1.40), then buy 1 then buy and make 0.20
  profit.

36
Arbitrage

• The role of arbitrage in the market is to drive
  all rates toward equality.
• In the previous example, the undervalued currency
  (franc-sterling price) would be pushed up, and
  the overvalued currency (dollar-sterling price)
  would be pushed down by arbitrage transactions.

37
Measures of the Spot rate

• The spot rate is sometimes called the nominal
  exchange rate, nominal meaning in name
• There are various kinds of information missing
  when we look at the spot rate between two
  countries, and so we build other measures to
  capture this information

38
Measures of the Spot rate

• The missing information is
• How does one currency value change against the
  value of currencies of all its trading partners?
• How does the currency value change in relation to
  purchasing power, when each country may have a
  different inflation rate?

39
Measures of the Spot rate

• First problem
• We can measure the value of a currency against
  all of its partners by
• building an index using a trade-weighted average
  for changes in the value of the currency.
• This is called the Nominal Effective Exchange
  Rate (NEER)

40
Measures of the Spot rate

• We pick a year against which to measure, and let
  this equal 1.
• Then we see how each currency changes over time.
• Then we find the average change, using each
  change in exchange rate times the value of
  exports and imports from that country

41
Measures of the Spot rate - example

• Using 3 countries (partly fictitious)

42
Example

• NEER (1.056x0.4) 0.94x 0.38 1.027x0.22
• 1.006

43
Example.

• In this example, the US dollar has stayed very
  stable, appreciating very slightly against its
  trading partners.
• Note, the countries included in the basket
  matter.
• We included only 3 largest trading partners.
• You repeat this calculation with 5.

44

• NEER

45

• NEER
• 1.006

46
The NEER

• The NEER is good for measuring nominal changes
  against all trading partners.
• The next problem is to take account of changes in
  prices as well as changes in nominal exchange
  rates, in order to see if the purchasing power of
  a country has changed.

47
The Real Exchange Rate (RER)

• The real exchange rate adjusts for changes in
  prices in the two countries.
• It is simply the exchange rate times the ratio of
  price indices (example, the consumer price index)
  for the countries
• Example yen / dollar
• RER2003 e/,2003 X(U.S. price index 2003)
• (Jap. price index 2003)

48
RER

• Using 1995 as the base year, (base year 100)
• the Japanese price index in 2003 is 101.0
• The US price index 2003 is 120.7
• recall, yen/ ex rate is 115.94
• RER115.94 x (120.7/101.0)138.55

49
RER

• RER138.55
• Note, the exchange rate in 1995 was 94.06
• This means that the US dollar appreciated by 47.3
  percent from 94.06 to 138.55.
• This means that US purchasing power has
  increased, and that US goods have become much
  more expensive relative to Japanese goods.

50
REER

• The Real Effective Exchange Rate
• This measures the changes in the real exchange
  rate against a weighted average of all countries.

51
Purchasing Power Parity

• PPP (absolute) says that what we buy in one
  country should cost the same in another country,
  once you adjust for the exchange rate.
• PPP (relative) says that if prices in the home
  country are rising faster than prices in the
  partner country, then the home country currency
  should depreciate.

52
Purchasing Power Parity

• PPP (absolute) rarely holds.
• PPP (relative) sometimes holds.
• The explanations for this range from the
  influence of sticky prices (we will see later) to
  the effect of the non-traded sector and
  distribution services within a country affecting
  home prices.

53
Foreign Exchange

• 2nd half

54
Foreign Exchange

• Last class we talked about the exchange rate and
  the spot exchange rate.
• At the end of class, we were introduced to the
  idea of purchasing price parity (PPP), which says
  that goods that trade should cost roughly the
  same in all countries.
• The PPP value of a currency is the exchange rate
  that would exist if PPP held.

55
Big Mac Index

• The Economist publishes something called The Big
  Mac Index which compares prices of Big Mac
  hamburgers
• If the Big Mac is overpriced in a market, the
  currrency is overvalued.
• For example, if the US price is 3, and the
  Canadian price is C3.20, but our exchange rate
  is 11, then the Canadian dollar is higher in
  value than implied by the price of the Big Mac.

56
Big Mac Index

• To calculate the Big Mac PPP value for the
  currency, simply divide the price of the Big Mac
  in the foreign currency by the U.S. price.
• This tells us what the currency would be valued
  at, if PPP held.
• This is compared to the actual value of the
  currency to predict whether the currency should
  rise of fall in the near future.
• Conceived in fun, the index has proven to be a
  useful indicator of future exchange rate
  movements.

57
More PPP

• The Big Mac PPP is an absolute measure of PPP.
• The relative PPP exchange rate can be calculated
  using a base exchange rate and relative prices.

58
More PPP

• For countries 1 and 2, we calculate the PPP1/2rel
  by
• PPP1/2rele1/2base X PI1cur/PI2cur
• where rel relative
• base is base year
• current is current year
• Using Table 1 (corrected). Japan/US
• 2003PPP/rel 113.7/ X (101.0/120.7) 95.14
• This means Japans currency should have
  appreciated, not depreciated to 115.94 by 2003

59
More PPP

• The prediction that Japans currency should have
  appreciated aligns with the fact that the RER
  shows that the US dollar has appreciated more in
  real terms than in nominal terms, as shown last
  class.
• Enough on PPP, lets turn now to dates of
  transactions in currency and forward and futures
  markets

60
Some terminology for spot market

• Exchange rates vary by the moment, but most
  transactions take place 2 days from the day the
  contract was struck. This is called the value
  date.
• The difference between a purchase price for
  currency and a sale price is called
• the retail spread or
• the retail trading margin.

61
Forward and future markets

• Often contracts to buy or sell something are made
  now, but delivery isnt for a long time.
• For example, a Winnipeg window producer may
  contract to buy machinery for US100,000 for
  delivery in 3 months.
• If the exchange rate is 1.3 C/US, then the
  cost is C130,000

62
Forward and future markets

• The exchange rate can change dramatically in 3
  months.
• If the purchaser simply waits and pays the spot
  rate on the day of the transaction, then they are
  taking an uncovered or open position on the
  currency and bearing all the risk of currency
  change.

63
Forward and future markets

• If the purchaser is risk averse, they may buy the
  currency now and hold it until the purchase date.
• This is costly because, money is tied up until in
  our example, 130,000 would be tied in US
  currency waiting for a future transaction.

64
Forward market

• An alternative to holding currency is to buy it
  in the forward market.
• This allows for a contract to be written today
  that will be executed on a set day in the future,
  (usually 1 month, 2 months, etc.)
• Forward exchange rates are posted every day.

65
Forward market

• If the forward rate is higher than the spot rate,
  there is a forward rate premium.
• This means that the currency represented in the
  denominator is expected to appreciate.
• If the forward rate is lower than the spot rate,
  there is a forward discount.
• The currency in the denominator is expected to
  depreciate.

66
Forward market

• In the next slide you will see a table of US/C
  forward exchange rates posted by the Pacific
  Exchange Rate service.
• The first column is the time period,
• The second shows the forward rate
• The third shows the premium in basis points
  (1/100th of a cent). The premium shows that the
  Canadian dollar is expected to appreciate, and
  also reflects volatility of the dollar.

67
Forward market

• The fourth column shows the Implied Forward
  Interest Rate Differential
• This is the difference in interest rates implied
  by the change in the exchange rates.
• We will get back to this later in the class.

68
Forward Rates(Pacific Exchange Rate Service)
69
The Forward Market

• The next slide shows a graph of Canadian dollar
  premiums over time, based on the previous table.
• It shows that, the longer into the future a
  purchaser would like to reserve Canadian currency
  for, the more they will need to pay.

70
Canadian premiums measured in US
71
Speculation

• Speculators may buy or sell in the forward market
  depending on whether they expect a currency to
  appreciate or depreciate.
• If a speculator expects that the actual spot rate
  will be higher than the posted forward rate will
  buy a currency. This is called taking a long
  position in the currency.
• (note, here we are using US/C for the Canadian
  exchange rate Canada is the foreign currency
  in this case)

72
Speculation

• If a speculator expects that the actual spot rate
  will be lower than the posted forward rate will
  sell the currency in the forward market
  (expecting to buy it back at a lower rate). This
  is called taking a short position in the
  currency.
• (note, here we are using US/C for the Canadian
  exchange rate Canada is the foreign currency
  in this case)

73
Speculation and currency

• The more a currency fluctuates, the higher will
  be the premium to buy at a future date.
• The forward market is a market of individual
  buyers and sellers (though these may be brokers)
• The forward market provides an easy way to hedge
  for investors unfamiliar with the foreign
  currency market

74
Futures Contracts

• Futures contracts are like forward contracts with
  the following differences
• they are entered into through the Chicago
  Mercantile Exchange
• the contracts are for standard amounts
• the contracts are for standard dates (third
  Wednesday of March, June, Sept, Dec.)
• a margin deposit is required. A margin is a fixed
  percent of the contract
• the futures contract is resalable up to maturity

75
Futures Contracts

• Because of the resalability and the standardized
  nature of the contract, future contracts may
  appeal more to small investors and speculators.
• Speculators buy on margin and this margin is
  all that is paid to the broker.
• The change in the exchange rate times the percent
  they paid (minus broker fees) represents their
  daily gain or loss.

76
Foreign currency option

• This is a contract that gives the option
  purchaser the opportunity to buy currency at a
  fixed price on a given date.
• In this case, if the currency in question is more
  expensive than the option cost, the buyer will
  exercise the option.
• If the currency spot rate is lower than the
  option cost, the buyer will not exercise the
  option
• The cost of the option is a fee for the right to
  exercise the option.

77
Foreign currency option

• Our window manufacturer could buy a forward or
  future contract on US dollars to be paid on or
  before the date of delivery of equipment, or
• they could buy an option to purchase US dollars
• In this case, they would only exercise the option
  if the price of US dollars in the option contract
  is lower than the spot rate at the time the
  currency is needed.

78
Foreign currency option

• There are two types of options
• Call option gives the purchaser of the option
  the right to purchase currency at a future date.
• Put option gives the purchaser of the option the
  right to sell a currency at a future date.
• The cost of the option is called the premium

79
Foreign currency option

• A participant in this market could take four
  different actions
• 1. Buy a call option purchase an option to buy
  a currency
• 2. Buy a put option purchase the option to sell
  a currency
• 3. Sell a call option sell another actor the
  option to buy a currency
• 4. Sell a put option sell another actor the
  option to sell a currency.

80
Foreign currency option

• The most the purchaser of an option can lose is
  the premium. The purchaser can gain if the option
  price differs from the spot rate in her favour.
• The most the seller can gain is the premium. The
  net gain (or loss) will again depend on the
  spread between the option rate and the spot rate
  at the time the option is exercised.

81
Foreign Exchange Markets and Financial Markets

• The spot market, forward market and futures
  market all interact with the financial markets to
  determine both the exchange rates and the
  interest rates in various countries
• This is because investment flows are determined
  by rates of return in different countries

82
Foreign Exchange Markets and Financial Markets

• Investor considers 3 elements when deciding where
  to invest
• domestic interest rate or expected rate of return
• foreign interest rate or expected rate of return
• expected changes in the exchange rate

83
Foreign Exchange Markets and Financial Markets

• This creates a relationship between these
  variables
• It does NOT lead to interest rate equality across
  countries

84
Foreign Exchange Markets and Financial Markets

• The investor wants equal return whether investing
  in the home or foreign country.
• For example, investing in New York or London for
  a 90-day period, the investor would like the same
  yield on every 1
• 1(1iNY)(1/e)(1iLondon)E(e)

85
Foreign Exchange Markets and Financial Markets

• 1(1iNY)(1/e)(1iLondon)E(e)
• LHS earnings in New York
• RHS earnings in London changed back to US .
• E(e) is the expected spot rate in 90 days
• We can rewrite this as
• 1(1iNY)(1)(1iLondon)E(e)/e

86
Foreign Exchange Markets and Financial Markets

• 1(1iNY)(1)(1iLondon)E(e)/e
• Example
• At 8 interest per year, 90-day earning is 2.
  Investing 1000 in New York would yield 1020 in
  90 days.
• Now, if money is invested in London

87
Foreign Exchange Markets and Financial Markets

• 1(1iNY)(1)(1iLondon)E(e)/e
• Current spot rate is 1.60/, interest rate is 12
  percent (90-day 3 )
• Investment yields
• 1000/(1.60/1)(1.03)643 in 90 days
• If the 90-day expected spot rate is
• 1.5845/, then the yield is
• (643)(1.5845/) 1020.

88
Foreign Exchange Markets and Financial Markets

• We can rewrite this equality to find a slightly
  different relationship between interest rates and
  exchange rates.
• 1(1iNY)(1)(1iLondon)E(e)/e
• E(e)/e is the expected appreciation of the
  foreign currency
• Let E(e)/e 1xa

89
Foreign Exchange Markets and Financial Markets

• Start with
• (1iNY)/(1iLondon)(1xa)
• Rearrange
• (1iNY)(1iLondon) 1 xa
• (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
  xa
• (iNY iLondon)/ (1 iLondon) xa
• which is almost the same as
• (iNY iLondon) xa

90
Foreign Exchange Markets and Financial Markets

• (iNY iLondon) xa
• Because investor is bearing all the risk of
  changes in the exchange rate, this is called
• uncovered interest rate parity (UIP)
• If (iNY iLondon) gt xa , then investments in the
  US are more attractive,
• If (iNY iLondon) lt xa , then investments in
  London are more attractive

91
Foreign Exchange Markets and Financial Markets

• (iNY iLondon) xa
• However, there are many types of risk involved in
  foreign investment,
• There may be a risk in earning the return or
  repatriating funds.
• Therefore the difference in interest rates may
  need to be higher than xa .

92
Foreign Exchange Markets and Financial Markets

• We incorporate a risk premium into the previous
  equation as
• (iNY iLondon) xa RP
• If iNY 6 and the RP 2, then
• (iLondon xa ) must equal 8 for the New York
  investor to invest in the UK.
• Changes in the risk premium can affect investment
  flows as well as changes in interest rates and
  expected changes in the currency values

93
Foreign Exchange Markets and Financial Markets

• We incorporate a risk premium into the previous
  equation as
• (iNY iLondon) xa RP
• If iNY 6 and the RP 2, then
• (iLondon xa ) must equal 8 for the New York
  investor to invest in the UK.
• Changes in the risk premium can affect investment
  flows as well as changes in interest rates and
  expected changes in the currency values

94
Covered Interest Parity

• Foreign investors do not need to take chances
  with the future spot rate, of course.
• They can cover their exchange rate risk by
  transactions on the forward market

95
Covered Interest Parity

• The link between the current exchange rate and
  the forward rate is discussed in terms of premium
  and discount
• The foreign currency is at a premium if the
  forward rate is higher than the current spot rate
• The foreign currency is at a discount if the
  forward rate is lower than the current spot rate

96
Covered Interest Parity

• Let
• p efwd/e 1
• p is the premium, measured in percentage terms.
• p gt 0 if the currency is at a premium,
• p lt 0 if the currency is at a discount.

97
Covered Interest Parity

• We can perform similar arithmetic to the
  uncovered case to show that the difference
  between interest rates in two countries should
  equal the exchange rate premium.

98
Covered Interest Parity

• Recall the uncovered interest rate equality
  starting point.
• 1(1iNY)(1)(1iLondon)E(e)/e
• E(e)/e can be replaced with efwd/e
• efwd/e p 1
• and

99
Covered Interest Rate Parity

• Start with
• (1iNY)/(1iLondon)(1p)
• Rearrange
• (1iNY)(1iLondon) 1 p
• (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
  p
• (iNY iLondon)/ (1 iLondon) p
• which is almost the same as
• (iNY iLondon) p

100
Covered Interest Parity

• Start with
• (1iNY)/(1iLondon)(1p)
• Rearrange
• (1iNY)(1iLondon) 1 p
• (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
  p
• (iNY iLondon)/ (1 iLondon) p
• which is almost the same as
• (iNY iLondon) p

101
Covered Interest Parity

• As the title of the last few slides suggest, the
  equality
• (iNY iLondon) p
• is called covered interest parity
• Covered interest parity tells us that there is a
  45 degree line that relates the difference in
  interest rates to the forward premium

102
Covered Interest Parity
iNY iLondon ()
CIP
p (-)
p ()
iNY iLondon (-)
103
Covered Interest Parity

• Note
• If the interest rate in New York is higher than
  that expected for interest rate parity, we would
  expect the interest rate difference to fall, or
  the exchange rate premium to rise, or both.
• If the interest rate in New York is lower than
  that expected for interest rate parity, we would
  expect the interest rate difference to rise, or
  the exchange rate premium to fall, or both.
• There is some room for transactions costs, and so
  the equality will be approximate.

104
Covered Interest Parity and Uncovered Interest
Parity

• We could do the same graph for uncovered interest
  parity, simply changing p to xa.
• There is some room for transactions costs, and so
  the equality will be approximate.
• If CIP holds the foreign currency premium is
  equal to the difference in interest rates between
  the two countries
• If UIP also holds, it means the expected
  appreciation of the foreign currency is also
  equal to the difference between the two interest
  rates.
• If this is the case, we say we have an efficient
  foreign exchange market

105
Market adjustments

• We now have linked
• interest rates in New York to
• interest rates in London,
• the spot exchange rate and the
• forward exchange rate.
• Lets consider a disequilibrium situation and see
  how the markets adjust.
• If iNY iLondon gt p .

106
Market adjustments

• In the London money market there would be an
  decrease in supply of money as investment flows
  to New York
• In the London exchange market there would be an
  increase in supply of currency as investors sell
  s to buy s to invest in New York

107
Market adjustments

• In the New York money market there would be an
  increase in supply of money as investment flows
  to New York
• In the forward exchange market there would be an
  increase in demand for currency as investors want
  to buy s in the future to repatriate s invested
  in New York

108
Market adjustments

• In the investment markets, the decrease in supply
  of funds in London and the increase of supply of
  funds in New York push the interest rates to
  decrease the differential.
• In the currency market, the increase in supply of
  currency in the spot market and increased demand
  in the forward market cause the premium to rise.
• Both these moves would get the markets back to
  CIP.

109
You do

• Reproduce the four graphs from the book for the
  case where
• iNY iLondon gt p