Foreign Exchange
Introduction
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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
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.
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What Determines Foreign Exchange
Rates?
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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
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.
Trade Deficit
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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.
Trade Surplus
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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
Factors that Effect Supply and
Demand
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Relative prices of U.S. vs. foreign goods
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Differential inflation rates
Differential interest rates
Productivity
Tastes for U.S. vs. foreign goods
Government intervention.
Relative Prices of U.S. Versus
Foreign Goods
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Relative increase in price of U.S. goods
will encourage more imports
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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
Productivity
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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
Tastes for U.S. Versus Foreign
Goods
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Increased tastes for U.S. goods
Increased demand for U.S. goods and
increased supply of foreign currency
Dollar appreciates relative to foreign
currency
How Global Investors Cause
Exchange Rate Volatility
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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
International Capital Mobility
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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
International Capital Mobility
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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.
International Capital Mobility
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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
anticipated—self-fulfilling prophesy
How Global Investors Cause
Exchange Rate Volatility
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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
Fixed Versus Floating
Exchange Rates
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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
Foreign Exchange Trading
Regimes
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1944 to 1973
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Major industrial countries maintained a
system of fixed exchange rates.
Currency values rarely changed.
1973-present
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Exchange rates fluctuate daily in response
to changes in supply and demand.
1944 Bretton Woods Accord
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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 government’s ability to keep its exchange
rate stable.
Floating Exchange Rates
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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.
Fixed Exchange Rate System
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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
Fixed Exchange Rate System
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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
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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
International Financial Crises
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Major problem with a fixed rate system is that
it contains no self-correcting exchange rate
mechanism to eliminate a country’s 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
International Financial Crises
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The expectation of a devaluation will cause
the international financial community to take
actions that will increase the likelihood of the
anticipated devaluation
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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
country’s international reserve and speed up the
devaluation
Managed Float System
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Currently industrialized countries practice a
managed float system
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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
Central Bank Intervention
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Direct Intervention
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Occurs when a country’s 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.
Direct Intervention - Example
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On July 17, 1998, the Federal Reserve and Japan’s 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 yen’s value increased by 5 percent on the day of the
intervention.
Over the next several months, the yen’s value strengthened,
and in January 1999, the Fed and the Bank of Japan attempted
to weaken the yen’s value by selling yen in the foreign exchange
market.
WSJ January 30, 2003
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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.
WSJ January 31, 2003
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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.
WSJ February 3, 2003
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Dollar Gains Against Yen
As 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.
Indirect Intervention
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The Fed can attempt to lower interest
rates by increasing the U.S. money
supply.
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Lower U.S. interest rates tend to
discourage foreign investors from investing
in U.S. securities, thereby putting
downward pressure on the dollar.
Indirect Intervention during
the Peso Crisis
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1994 – Mexico experienced a large balance of trade deficit.
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On December 20, 1994, Mexico’s central bank devalued the
peso by about 13%.
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The peso was stronger than it should have been and that
encouraged Mexican firms and consumers to buy an excessive
amount of imports.
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 Mexico’s debt securities.
Speculating with Exchange
Rates
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The risk associated with fluctuations in the exchange rate.
You have $1 million to invest. Interest rates in Germany are
much higher than in the U.S., so you decide to invest in a oneyear German T-bill with a market yield of 9%. What is your
holding-period yield for the year?
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Today: Exchange dollars for marks: 1.6 DM/$
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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
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Your return is not 9% but –12.8%.
International Money and Capital
Markets
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Capital mobility:
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International money markets:
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The extent to which savers can move funds across
national borders for the purpose of buying financial
instruments issued in other countries.
Markets for cross-border exchange of financial
instruments with maturities of less than one year.
International capital markets:
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Markets for cross-border exchange of financial
instruments that have maturities of a year or more.
International Financial
Integration
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International financial integration:
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A process through which financial markets
of various nations become more alike and
more interconnected.
Arbitrage:
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Purchasing an asset at the current price in
one market and profiting by selling it at a
higher price in another market.
Putting a Lid on Open Financial
Markets: Capital Controls
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Capital controls:
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Legal restrictions on the ability of a nation’s
residents to hold and trade assets
denominated in foreign currencies.
Malaysia Softens on Ringgit Peg 1/12/04
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Malaysian Prime minister Abdullah Ahmad Badawi's new administration has
wasted no time in floating a trial balloon about a potentially major economicpolicy 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.
Mfg, Labor Grps Hire Law Firm On Case
Vs China On Forex
Jan 30, 2004
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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.
Vehicle Currencies
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Vehicle currency:
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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.
Exchange Rate
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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.
Foreign Exchange Markets and Spot
Exchange Rates
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Spot market:
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A market for contracts requiring the
immediate sale or purchase of an asset.
Spot exchange rate:
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The spot-market price of a currency
indicating how much of one country’s
currency must be given up in immediate
exchange for a unit of another nation’s
currency.
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
Foreign Exchange Rates
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Spot exchange rate vs. Forward
exchange rate
Appreciation vs. Depreciation
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1997: Britain (Pound)
1999: Britain (Pound)
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The pound has depreciated by 2.51%:
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.5902
.6054
(1.6517-1.6943)/1.6943=-2.51%
The dollar has appreciated by 2.58%:
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1.6943
1.6517
(.6054-.5902)/.5902=2.58%
When a country’s currency appreciates, the country’s
goods abroad become more expensive and foreign
goods in that country become cheaper.
Conversely, when a country’s currency depreciates,
its goods abroad become cheaper and foreign goods
in that country become more expensive.
Foreign Exchange Market
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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