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Foreign Exchange

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Title: Foreign Exchange


1
Foreign Exchange
2
Introduction
  • The volume of international exchange has grown
    tremendously since World War II
  • Whenever an exchange takes place between
    residents of different countries, one kind of
    money has to be exchanged for another
  • Foreign exchange rate between two currencies is
    determined by supply and demand established in
    the foreign exchange market consisting of a
    network of foreign exchange dealers

3
The Equilibrium Exchange Rate
  • The rate at which the quantity of a currency
    demanded is equal to the quantity supplied.
  • At the equilibrium exchange rate, the foreign
    exchange market clears, meaning that the quantity
    of the currency demanded is exactly equal to the
    quantity supplied.

4

What Determines Foreign Exchange Rates?
  • Imports of a country give rise to a demand for
    foreign exchange and a supply of U.S. dollars
  • Exports result in a supply of foreign exchange
    and a demand for U.S. dollars
  • Therefore, trade of the U.S. will be a primary
    contributor to the demand and supply of dollars
    and foreign currency

5
Balance of Payments
  • The record of transactions between the United
    States and its trading partners in the rest of
    the world over a period of time.

6
Trade Deficit
  • Imports are greater than exports.
  • Demand for foreign currency is greater than
    supply
  • Result in a depreciation of the U.S. dollar
  • Encourages exports and discourages imports
  • Eventually the trade balance is in equilibrium at
    the new exchange rate.

7
Trade Surplus
  • Exports are greater than imports.
  • This will result in an appreciation of the U.S.
    dollar and a depreciation of the foreign currency
  • Discourages exports and encourages imports
  • The trade will be balanced at the new exchange
    rate

8
Factors that Effect Supply and Demand
  • Relative prices of U.S. vs. foreign goods
  • Differential inflation rates
  • Differential interest rates
  • Productivity
  • Tastes for U.S. vs. foreign goods
  • Government intervention.

9
Relative Prices of U.S. Versus Foreign Goods
  • Relative increase in price of U.S. goods will
    encourage more imports
  • increase demand for foreign currency
  • tends to depreciate the value of the U.S. dollar
    or an appreciation of the foreign currency
  • Relative decrease in price of U.S. goods will
    result in an appreciation of the U.S. dollar

10
Productivity
  • Increased productivity in U.S. will lower price
    of American goods
  • Increased demand for U.S. goods internationally
  • Increased supply of foreign currency will
    appreciate the value of the dollar while foreign
    currency depreciates

11
Tastes for U.S. Versus Foreign Goods
  • Increased tastes for U.S. goods
  • Increased demand for U.S. goods and increased
    supply of foreign currency
  • Dollar appreciates relative to foreign currency

12
How Global Investors Cause Exchange Rate
Volatility
  • Changes in the factors described above occur
    slowly over time, so they cannot explain the
    often violent short-term movement in exchange
    rates
  • There is considerable day-to-day movement of U.S.
    dollar exchange rates versus major foreign
    currencies

13
International Capital Mobility
  • Funds flow freely across international borders
    and investors can purchase U.S. or foreign
    securities
  • U.S. investors compare the expected return on
    domestic securities versus foreign securities to
    determine which are the most attractive
  • Therefore, changes in preferences of U.S. versus
    foreign securities will result in a change in
    demand and supply of foreign currency and a
    change in the exchange rate

14
International Capital Mobility
  • In this case, expectations of future exchange
    rates play a central role in the decision process
  • When considering investing in foreign securities
    to take advantage of a higher yield, must
    consider the expected movement of future exchange
    rates
  • In order to invest in foreign securities, must
    first purchase foreign currency and eventually
    re-purchase U.S. dollars to bring currency back
    to U.S.

15
International Capital Mobility
  • It is possible that a change in the future
    exchange rate will offset any increased yield by
    holding foreign securities
  • In fact, the international mobility of capital
    will often cause the change in future exchange
    rates that was anticipatedself-fulfilling
    prophesy

16
How Global Investors Cause Exchange Rate
Volatility
  • This suggests that the equilibrium foreign
    exchange rate is sensitive to investor
    expectations of future movement in exchange rates
  • Since these expectations might be quite unstable
    and susceptible to change, this may cause
    considerable short-term volatility in the actual
    exchange rates

17
Fixed Versus Floating Exchange Rates
  • Volatility in foreign exchange rates represents a
    cost of doing business internationally and
    imposes considerable risk on investments overseas
  • Historically governments tried to avoid this cost
    by fixing exchange rates at some predetermined
    level

18
Foreign Exchange Trading Regimes
  • 1944 to 1973
  • Major industrial countries maintained a system of
    fixed exchange rates.
  • Currency values rarely changed.
  • 1973-present
  • Exchange rates fluctuate daily in response to
    changes in supply and demand.

19
1944 Bretton Woods Accord
  • Established the fixed exchange rate system.
  • The U.S. dollar was the official reserve
    currency.
  • A government was obligated to intervene in the
    foreign exchange markets to keep the value of its
    currency within a narrow range.
  • Reserve asset balances such as gold or foreign
    currency holdings were key indicators of a
    governments ability to keep its exchange rate
    stable.

20
Floating Exchange Rates
  • Bretton Woods System collapsed in 1971 when the
    U. S. suspended the international conversion of
    dollars to gold.
  • Since 1973, major industrialized countries have
    participated in a managed float exchange rate
    system.
  • If currency fluctuations become too severe and
    disruptive to the economy, countries may borrow
    funds from the International Monetary Fund (IMF)
    to stabilize their currency.

21
Fixed Exchange Rate System
  • This was the system maintained globally from 1944
    until the early 1970s.
  • It came under the supervision of the
    International Monetary Fund (IMF)
  • After the collapse of the fixed exchange rate
    system, it was resurrected with a more limited
    scope in 1979 for the major European countries

22
Fixed Exchange Rate System
  • The most recent example of a fixed exchange rate
    is the introduction of the Euro as the common
    currency of the 12 members of the European
    Monetary Union
  • This new monetary union sets the exchange rate
    between the Euro and the member countries
    national currencies at a fixed rate
  • Individual member countries are expected to
    maintain domestic economic conditions that will
    not cause these agreed upon exchange rates to
    change

23
International Financial Crises
  • Major problem with a fixed rate system is that it
    contains no self-correcting exchange rate
    mechanism to eliminate a countrys persistent
    balance-of-payment deficit
  • A continual balance-of-payment deficit suggests
    domestic economic structural problems relative to
    the rest of the world
  • Eventually the country will run out of
    international reserves and be forced to devalue
    which will eliminate the deficit

24
International Financial Crises
  • The expectation of a devaluation will cause the
    international financial community to take actions
    that will increase the likelihood of the
    anticipated devaluation
  • Individuals will sell the threatened currency in
    the international market
  • This increases the supply of the currency which
    increases the downward pressure on the value
  • This capital flight will further deplete the
    countrys international reserve and speed up the
    devaluation

25
Managed Float System
  • Currently industrialized countries practice a
    managed float system
  • The exchange rate is permitted to vary within a
    predetermined band
  • If foreign exchange markets attempt to push the
    value of the currency outside the band (both
    above or below), central bank will intervene
  • However, if the central bank is intervening an
    excessive amount, it is likely that country will
    be forced to devalue or revalue its currency to
    recognize structural changes in local economy

26
Central Bank Intervention
  • Direct Intervention
  • Occurs when a countrys central bank sells some
    of its currency reserves for a different
    currency.
  • If the Federal Reserve desired to weaken the
    dollar, it could sell some of its dollar reserves
    in exchange for foreign currencies those
    currencies would appreciate against the dollar.

27
Direct Intervention - Example
  • On July 17, 1998, the Federal Reserve and Japans
    central bank directly intervened in the foreign
    exchange market by using more than 3 billion to
    purchase Japanese yen. The Fed was concerned
    that the continued depreciation of the yen would
    place more downward pressure on the currencies of
    China and Hong Kong, two currencies that had
    remained stable during the Asian crisis.
  • The yens value increased by 5 percent on the day
    of the intervention.
  • Over the next several months, the yens value
    strengthened, and in January 1999, the Fed and
    the Bank of Japan attempted to weaken the yens
    value by selling yen in the foreign exchange
    market.

28
WSJ January 30, 2003
  • Japan No Plan To Guide Yen To Specific Rate
  • TOKYO -- Japan has no intention to guide the yen
    to specific level, a top Finance Ministry
    official said Thursday, repeating that
    authorities only intervene when it's necessary to
    calm volatile markets.
  • Hiroshi Watanabe, the head of the International
    Bureau, said purchasing power parity between
    different countries was only one measure for
    currency levels.
  • "Intervention , fundamentally, is for smoothing
    (volatile markets) or countering sudden moves,"
    Watanabe said.

29
WSJ January 31, 2003
  • Japan's Hush-Hush Intervention Sparks USD Rally,
    For Now
  • Of DOW JONES NEWSWIRES NEW YORK -- Sometimes
    softly, softly does it, as the yen's decline on
    Friday shows.
  • The announcement by Japan's Ministry of Finance
    overnight that it undertook covert currency
    market intervention this month to weaken the yen
    drove the Japanese currency to its biggest drop
    against the dollar in three weeks on Friday. It
    has left the greenback dancing around the
    important psychological Y120 mark, up from a
    session low of Y118.88 and helped fire a
    broad-based dollar rebound.
  • As the world's second-biggest economy hovers on
    the brink of a renewed economic downturn,
    currency market intervention is one of the few
    recourses Japan's policy makers have at their
    disposal to encourage growth.
  • But in the past, the Ministry of Finance - the
    guardian of Japan's currency policy - has been
    much more open with its market forays. This time,
    the confirmation that it has been quietly
    stepping into the market marks a clear - and
    intelligent - shift that has already nervous
    currency traders closely second-guessing any
    rapid slips in the yen. For a short while at
    least, this new deft strategy may continue to
    bear fruit, U.S.-based analysts say.

30
WSJ February 3, 2003
  • Dollar Gains Against YenAs Intervention Fears
    Loom
  • NEW YORK -- The dollar gave a split performance,
    rising against the yen on anticipation that Japan
    may intervene again to weaken its currency, but
    falling against the Swiss franc on worries about
    prospects for a U.S.-led war with Iraq.
  • The dollar ended the New York day lower against
    the euro and the Swiss franc -- a classic refuge
    currency in times of war -- but higher against
    the yen and the pound.
  • Early in the New York session, some
    stronger-than-expected U.S. economic reports
    helped improve dollar sentiment, but jitters
    ahead of Secretary of State Colin Powell's
    appearance at the U.N. Wednesday wiped out many
    of its gains.

31
Indirect Intervention
  • The Fed can attempt to lower interest rates by
    increasing the U.S. money supply.
  • Lower U.S. interest rates tend to discourage
    foreign investors from investing in U.S.
    securities, thereby putting downward pressure on
    the dollar.

32
Indirect Intervention during the Peso Crisis
  • 1994 Mexico experienced a large balance of
    trade deficit.
  • The peso was stronger than it should have been
    and that encouraged Mexican firms and consumers
    to buy an excessive amount of imports.
  • On December 20, 1994, Mexicos central bank
    devalued the peso by about 13.
  • Stock prices plummeted as many foreign investors
    sold their shares and withdrew their funds from
    Mexico in anticipation of further devaluation in
    the peso.
  • On December 22, the central bank allowed the peso
    to float freely, and it declined by 15.
  • The central bank increased interest rates as a
    form of indirect intervention to discourage
    foreign investors from withdrawing their
    investments in Mexicos debt securities.

33
Speculating with Exchange Rates
  • The risk associated with fluctuations in the
    exchange rate.
  • You have 1 million to invest. Interest rates in
    Germany are
  • much higher than in the U.S., so you decide to
    invest in a one-
  • year German T-bill with a market yield of 9.
    What is your
  • holding-period yield for the year?
  • Today Exchange dollars for marks 1.6 DM/
  • Invest in German T-bills at 9.
  • In one year Exchange marks for dollars. Suppose
    the dollar strengthened relative to marks 2
    DM/.
  • DM 1,744,000/(2 DM/) 872,000
  • Your return is not 9 but 12.8.

34
International Money and Capital Markets
  • Capital mobility
  • The extent to which savers can move funds across
    national borders for the purpose of buying
    financial instruments issued in other countries.
  • International money markets
  • Markets for cross-border exchange of financial
    instruments with maturities of less than one
    year.
  • International capital markets
  • Markets for cross-border exchange of financial
    instruments that have maturities of a year or
    more.

35
International Financial Integration
  • International financial integration
  • A process through which financial markets of
    various nations become more alike and more
    interconnected.
  • Arbitrage
  • Purchasing an asset at the current price in one
    market and profiting by selling it at a higher
    price in another market.

36
Putting a Lid on Open Financial Markets Capital
Controls
  • Capital controls
  • Legal restrictions on the ability of a nations
    residents to hold and trade assets denominated in
    foreign currencies.

37
Malaysia Softens on Ringgit Peg 1/12/04
  • Malaysian Prime minister Abdullah Ahmad Badawi's
    new administration has wasted no time in floating
    a trial balloon about a potentially major
    economic-policy shift -- changing the currency's
    peg to the dollar.
  • Mr. Abdullah has said there is no plan to alter
    the ringgit's value from 3.80 to the dollar,
    where it has remained for more than five years,
    But analysts say it is high time to consider
    letting the Malaysian currency strengthen against
    the wilting dollar and that 2004 would be a good
    year for a change in the fixed-rate system
  • Enormous changes have taken place in Asia since
    then-Prime Minister Mahathir Mohamad clamp the
    ringgit to the dollar in September 1998.
  • The peg was one of a series of measures,
    including controls to keep capital from pouring
    out of the country, that the government imposed
    during the regional financial crisis, when
    currencies regionwide plunged and economies were
    thrown into deep recession.
  • Malaysia's drastic moves were criticized by
    Western governments and the International
    Monetary Fund at the time, but many critics now
    concede the peg and capital controls helped
    stabilize the Malaysian economy.

38
Mfg, Labor Grps Hire Law Firm On Case Vs China On
Forex Jan 30, 2004
  • A group of 39 manufacturing, agriculture and
    labor trade associations and unions have hired a
    law firm to develop a case against China for
    manipulating its currency.
  • "We believe that the Chinese practice of
    intervening heavily to control its currency at a
    significantly undervalued level - as much as 40
    - against the dollar conveys an artificial trade
    advantage that is affecting U.S. production and
    jobs," Mears said.
  • China tightly manages its currency, both through
    intervention and capital controls , effectively
    pegging it at 8.3 yuan per U.S. dollar. U.S.
    manufacturers want China to revalue to a stronger
    rate, arguing the yuan is undervalued, giving
    Chinese producers an unfair competitive advantage.

39
Vehicle Currencies
  • Vehicle currency
  • A commonly accepted currency that is used to
    denominate a transaction that does not take place
    in the nation that issues the currency.
  • Almost 70 percent of U.S. paper currency and
    coins circulate abroad.

40
Exchange Rate
  • The number of units of foreign currency that can
    be acquired with one unit of domestic money.
  • Appreciated when a currency has increased in
    value relative to another currency.
  • Depreciated when a currency has decreased in
    value relative to another currency.

41
Foreign Exchange Markets and Spot Exchange Rates
  • Spot market
  • A market for contracts requiring the immediate
    sale or purchase of an asset.
  • Spot exchange rate
  • The spot-market price of a currency indicating
    how much of one countrys currency must be given
    up in immediate exchange for a unit of another
    nations currency.

42
Exchange Rate Quotations
  • EXCHANGE RATES
  • Wednesday, February 19, 2003
  • The New York foreign exchange selling rates
    below apply to trading among banks in amounts of
    1 million and more, as quoted at 4 p.m. Eastern
    time by Bankers Trust Co., Dow Jones Telerate
    Inc., and other sources. Retail transactions
    provide fewer units of foreign currency per
    dollar.
  • Currency U.S.
    equiv. per U.S. Country Wed. Wed.
  • Australia (Dollar) .5942 1.6829

43
Foreign Exchange Rates
  • Spot exchange rate vs. Forward exchange rate

44
Appreciation vs. Depreciation
  • 1997 Britain (Pound) 1.6943 .5902
  • 1999 Britain (Pound) 1.6517 .6054
  • The pound has depreciated by 2.51
  • (1.6517-1.6943)/1.6943-2.51
  • The dollar has appreciated by 2.58
  • (.6054-.5902)/.59022.58
  • When a countrys currency appreciates, the
    countrys goods abroad become more expensive and
    foreign goods in that country become cheaper.
  • Conversely, when a countrys currency
    depreciates, its goods abroad become cheaper and
    foreign goods in that country become more
    expensive.

45
Foreign Exchange Market
  • Over-the-counter market
  • Dealers (banks)
  • Most trades involve the buying and selling of
    bank deposits denominated in different
    currencies.
  • Transactions in excess of 1 million
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