Chapter 3
The Foreign Exchange Market
The foreign exchange market – a financial market where national currencies are traded.
Spot market – contracts for immediate delivery (within 48 hours).
Forward market – future delivery at a fixed price.
Foreign exchange rate – the price of currency in terms of another.
Two equivalent ways to quote exchange rate:
$/DM or DM/$ = 1/($/DM)
Domestic currency appreciation (depreciation) = foreign currency depreciation (appreciation)
Supply and Demand for Foreign Currency: A Preliminary Analysis
Demand for foreign currency (supply of domestic currency) arise from the debit items in the BOP accounts
- demand for foreign goods and services
- payment of investment income
- demand for foreign assets
- foreign currency speculation (foreign currency will appreciate in the future)
- hedging (eliminating foreign currency risk by acquiring foreign currency now for payment in the future)
The demand curve is downward sloping because of the demand for foreign goods and services. Payment of investment income and unilateral transfers
are not much affected by the exchange rate. Assume demand for foreign currency arising from capital account transaction is not much affected by the
exchange rate.
Supply of foreign currency (demand for domestic currency) arise from credit items in BOP accounts
Same factors as demand
Supply curve is upward sloping
Determination of the equilibrium exchange rate (see diagram)
U.S. has a current account deficit (Q2 – Q 1)
U.S. has a capital account surplus (Q*-Q1) – (Q*-Q2) = (Q2 – Q1)
Thus current account deficit = capital account surplus
The Spot Market
Principal players: Commercial banks, multinational corporations, and central banks.
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Commercial banks: most foreign currency transactions involve the debit or credit of bank accounts here and abroad.
Interbank market (wholesale market): trades between bank involving a dealer
Interbank trading: does not involve a dealer
Multinationals: corporations, financial institutions, etc.
Central banks: foreign exchange intervention
Arbitrage: buy low, sell high
Arbitrage – ensures that the same currencies will sell for the same price anywhere in the world.
Example: $/DM = $.55 in NY, $/DM = $.50 in Toronto
Arbitrage opportunity: buy DM in Toronto and sell in NY.
Price of DM will rise in Toronto and fall in NY; DM appreciates in Toronto but depreciates in NY
Will equalize if there are no transaction costs
Will not equalize if there are transaction costs but there will be no profit opportunity
Triangular Arbitrage
Triangular Arbitrage – an arbitrage involving three currencies.
Currency Cross Rates – given two exchange rates involving three currencies, the third exchange rate can be calculated using a process called cross
rates.
Examples: suppose we have $/C$ = .72359 and $/DM = .55448
The DM/C$ cross rate can be calculated as the ratio
$ / C$
$ / DM
=
.72359
.55448 = 1.3049
This cross rate can then be compared to the market DM/C$ exchange rate. If the cross rate does not equal the market exchange rate (ignoring
transaction costs), a triangular arbitrage opportunity exists.
Example: suppose the market DM/C$ = 1.25
Buy 1 million DM for $554,480
Buy C$ with the DM at market rate of DM/C$ = 1,25 =DM1,000,000/1.25 = C$800,000
Buy $ with C$ (C$800,000 x .72359) = $578,800
Profit before transaction costs = $578,800 - $554,480 = $24,320
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Result of triangular arbitrage activities:
$/DM rate increases
DM/C$ rate increases
$/C$ rate decreases
Cross Rate Equality - Foreign exchange market will be in equilibrium when the market rate equals the cross rate (assume no transaction costs).
Different Measures of the Spot Rate
Bilateral exchange rate – the exchange rate between two currencies.
Effective exchange rate – a constructed index used to measure the relative position of one currency against an average of a basket of foreign
currencies.
See Table 1 for calculation.
EER = 1 for the base year.
If EER is less (greater) than 1 for a given year, the currency is stronger (weaker) against the average price of a basket of foreign currencies.
Real Exchange Rate (RER) – the relative price of domestic and foreign goods and services when foreign goods and services are measured in domestic
currency price.
RER$ / DM ,1997  e$ / DM ,1997 x
PGermany,1997
PUS ,1997
e$ / DM  nominal exchange rate
P = price index
International trade is affected by the change in the relative price.
A change in relative price (RER) can be the result of a) change in the nominal exchange rate; b) change in the domestic price; c) change in the foreign
price.
Level.
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Example: a 10% decrease in the foreign price level and accompanied by a 10% depreciation of the domestic currency will not affect RER and
therefore trade.
Real appreciation (depreciation) – a decrease (increase) in RER.
Real effective exchange rate (REER) – see Table 2.
Purchasing Power Parity (PPP) – based on the law of one price. Attempts to measure the true equilibrium exchange rate.
Absolute PPP:
PPP$ / DM ,1998 
Pus,1998
Pgermany,1998
Market rate > (<) PPP rate, $ is under (over) valued.
Relative PPP:
RELPPP$ / DM ,1998  e$ / DM ,base year
PUS ,1998
PGermany,1998
Country with the faster inflation rate will experience a depreciation of the exchange rate.
Forward Market – foreign currency to be delivered at a future date for a fixed price (forward rate).
Participants: mostly hedgers and speculators.
Demand for forward contracts:
Hedgers: to protect an uncovered or open position.
Speculators: engage in intertemporal arbitrage, by exploiting the difference between the forward rate and the expected future spot rate.
Long position – purchase foreign currency forward.
Supply of forward contracts:
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Hedgers
Speculators taking a short position.
Futures Contracts
Traded on the Chicago Mercantile Exchange through a broker, all contracts are guaranteed by CME.
Only four specific maturity dates – the third Wednesday of March, June, September, December.
Futures are re-saleable up to the maturity date.
Currency Options
Contracts are traded on the Philadelphia Exchange.
Gives the holder the right to buy (call option) foreign currency (for $) or sell (put option) foreign currency up to the expiration date.
The option contract itself can be traded.
Interest rate, exchange rate, and International Capital Flows
Uncovered interest parity:
i$  i DM  xa
i$ = U.S. interest rate or expected return (%)
iDM = interest rate or expected return (%) from a foreign asset
xa 
e$ / DM ,t
E ( e$ / DM ,t 1  e$ / DM ,t )
> 0 expected depreciation of $
< 0 expected appreciation of $
International capital flow when the parity condition does not hold.
Adjustment to equilibrium can take place in all three markets, or in a subset of the markets.
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When foreign and domestic assets are not perfect substitutes, e.g., foreign asset has more risk, a risk premium has to be added to the expected return of
foreign bond to compensate for the higher risk
i$  iDM  xa  RP
RP = risk premium (%)
Covered Interest Parity:
I$ - iDM = p
F$ / DM  e$ / DM
p
e$ / DM
p > 0, foreign currency is at a premium
P = 0, par
P < 0, foreign currency is at a discount
Adjustments in the financial markets (figures 4 and 5).
Empirical studies show that adjustments are mostly in foreign exchange market.
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