Title: Foreign Exchange
1Foreign Exchange
2Introduction
- 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
3The 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.
4What 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
5Balance 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.
6Trade 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.
7Trade 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
8Factors 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.
9Relative 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
10Productivity
- 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
11Tastes 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
12How 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
13International 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
14International 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.
15International 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
16How 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
17Fixed 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
18Foreign 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.
191944 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.
20Floating 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.
21Fixed 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
22Fixed 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
23International 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
24International 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
25Managed 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
26Central 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.
27Direct 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.
28WSJ 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.
29WSJ 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.
30WSJ 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.
31Indirect 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.
32Indirect 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.
33Speculating 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.
34International 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.
35International 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.
36Putting 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.
37Malaysia 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.
38Mfg, 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.
39Vehicle 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.
40Exchange 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.
41Foreign 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.
42Exchange 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
43Foreign Exchange Rates
- Spot exchange rate vs. Forward exchange rate
44Appreciation 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.
45Foreign 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