The Foreign Exchange Market

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Chapter 17
The Foreign Exchange Market
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Definitions

• Exchange Rate
• The price of one currency in terms of another
  currency.
• Foreign Exchange Market
• A market in which trading of currency and bank
  deposits denominated in particular currencies
  takes place.
• Currency Appreciation the increase in its value.
• Currency Depreciation the fall in its value.

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• What Are Foreign Exchange Rates?
• There are 2 kinds of exchange rate transactions
• 1. Spot Transactions involve the immediate
  (two-day) exchange of bank deposits.
• 2. Forward Transactions involve the exchange of
  bank deposits at some specified future date.
• There are 2 kinds of exchange rates
• 1. Spot Exchange Rate is the exchange rate for
  the spot transaction.
• 2. Forward Exchange Rate  is the exchange rate
  for the forward transaction.

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• How is Foreign Exchange Traded?
• The foreign exchange market is organized as an
  over the counter market.
• There are several hundred dealers (mostly banks)
  stand ready to buy and sell deposits denominated
  in foreign currencies.

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• Why Are Exchange Rates Important?
• Because they affect the relative price of
  domestic and
• foreign goods, and therefore affecting
  preferences for
• domestic and foreign goods.
• Example
• Assume the price of the European good is 2 Euros.
•  
•  

Year Price Kuwaiti good Exchange rate of Euro Price European good in KW Better to buy which good?
2000 700 Fils 285 Fils _____ Fils _________
2008 700 Fils 425 Fils _____ Fils _________
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• Conclusion
• When currency appreciates, the country's goods
  abroad (its exports) become more expensive and
  foreign goods in that country (its imports)
  become cheaper.
• ? in EXR ? ? Exports and ? Imports
• When currency depreciates, the country's goods
  abroad (its exports) become cheaper and foreign
  goods in that country (its imports) become more
  expensive.
• ? in EXR ? ? Exports and ? Imports
• Result Net Exporting countries prefer low EXR,
  while net importing countries prefer high EXR.

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• Factors Affecting Exchange Rates in the Long Run
• 1. Relative Price Level
• A rise in a country's price level (relative to
  the foreign
• price level) causes its currency to depreciate.
•  2. Trade Barriers (Tariffs and Quotas)
• Tariffs and quotas cause a country's currency to
• appreciate in the long run.
•  

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• 3. Preferences for Domestic versus Foreign Goods
• Increased demand for imports causes the domestic
  currency to depreciate.
• Increased demand for a country's exports causes
  its
• currency to appreciate.
• 4. Productivity
• As a country becomes more productive (relative to
  the
• other country) its currency appreciates.

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 Factor Change in Factor Response of the Exchange Rate
Domestic Price Level ?
Trade Barriers ?
Import Demand ?
Export Demand ?
Productivity ?
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Fixed Euro Rates These are the fixed rates as
announced on 31 December 1998. Currency 1 euro
 

Austrian Schilling 13.7603 Greek Drachma 340.750
Belgian Franc 40.3399 Irish Punt 0.787564
Deutsche Mark 1.95583 Italian Lira 1936.27
Dutch Guilder 2.20371 Luxembourg Franc 40.3399
Finnish Markka 5.94573 Portuguese Escudo 200.482
French Franc 6.55957 Spanish Peseta 166.386
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• Exchange Rate of the Euro vs the Dollar
  (2004-2008)