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• Explain how the foreign exchange market works.
• Examine the forces that determine exchange rates.
• Consider whether it is possible to predict future rates
movements.
• Map the business implications.
Foreign Exchange Market:
The foreign exchange market is where currency trading takes place. It is
where banks and other official institutions facilitate the buying and
selling of foreign currencies.
This enables companies based in different countries that use different
currencies to trade with each other
Exchange Rate:
The rate at which one currency is converted into another.
Foreign Exchange Risk:
Probability of loss occurring from an adverse movement in foreign
exchange rate.
• Direct quotation
– price of F currency, expressed in terms (units) of H currency
(H/F)
• Indirect quotation
– price of H currency, expressed in terms (units) of F currency
(F/ H)
• Supply
– Foreign demand for domestic goods & services
(exports of goods & services).
– Foreign demand for domestic financial assets (capital inflows)
– Use of reserves by the central bank (The balance of payments)
• Demand
– Domestic demand for foreign goods & services
(imports of goods & services).
– Domestic demand for foreign financial assets
(capital outflows)
– Build up of reserves by the central bank.
(The balance of payments)
Spot rate:
Currencies traded for immediate delivery at rates prevailing at the
time of transaction. Actual delivery (electronic transfer) may take
two working days
Forward rate:
The Forward Rate is the rate that appears in a contract to exchange a
currency in the future. (delivery at a specified future date).
Currency speculation:
Buying and holding a currency for sale at a higher rate in the near
future.
• Appreciation – market increase in value of currency
• Depreciation – market decrease in value of currency
• Devaluation – official decrease in value of currency
(change in central parity)
• Revaluation – official increase in value of currency
(change in central parity)
• When Czechs buy from foreigners and make investments
abroad (outflow of capital), their actions generate a demand for
foreign currency in the foreign exchange market.
• On the other hand, when Czechs sell products and assets
(including bonds) to foreigners, their transactions will generate
a supply of foreign currency (in exchange for koruna) in the
foreign exchange market.
• The exchange rate will bring the quantity of foreign exchange
demanded into equality with the quantity supplied.
Foreign Exchange
market
Koruna price
(of foreign currency)
S (exports
+ capital inflow)
Depreciation
of koruna
•
P1
D(imports + capital outflow)
Appreciation
of koruna
Q
•
•
Czechs demand
foreign currencies to
import goods &
services and make
investments abroad.
Foreigners supply
their currency in
exchange for koruna
to purchase czech
exports and
undertake
investments in the
Czech Republic.
Quantity
of currency
The exchange rate brings quantity demanded into balance with the quantity supplied
and will bring (imports + capital outflow) into equality with (exports + capital inflow).
• When equilibrium is present in the foreign exchange
market, the following relation exists:
Imports + Capital Outflow = Exports + Capital Inflow
• This relation can be re-written as:
Imports - Exports = Capital Inflow – Capital Outflow
• The right side of this equation (capital inflow minus capital
outflow) is called net capital inflow.
• Net capital inflow may be:
– positive, reflecting a net inflow of capital, or,
– negative, reflecting a net outflow of capital.
Imports - Exports =
Capital Inflow – Capital Outflow
• The left side of the equation above is called the trade balance.
– When imports exceed exports, this is referred to as a trade deficit.
– On the other hand, if exports exceed imports, this is referred to as a
trade surplus.
• When the exchange rate is determined by market forces, trade deficits will
be closely linked with a net inflow of capital.
– Conversely, trade surpluses will be closely linked with a net outflow of
capital.
Leakages and Injections from the Circular Flow of Income
• Equilibrium in the foreign exchange market implies:
(1)
Imports + Capital Outflow = Exports + Capital Inflow
• The equation may be re-written as:
(2)
Imports - Exports = Capital Inflow
• Or, more simply:
- Capital Outflow
Imports - Exports = Net Capital Inflow
• Equilibrium in the loanable funds market implies:
(3) Net Saving + Net Capital Inflow = Investment + Budget Deficit
• Substituting for net capital inflow from above:
(4) Net Saving + Imports - Exports = Investment + Budget Deficit
Leakages and Injections from the Circular Flow of Income
(4)
Net
Saving + Imports - Exports = Investment + Budget Deficit
• As Budget deficit = (government purchases - taxes):
Government
Net
(5) Saving
+ Imports - Exports = Investment + Purchases - Taxes
• Which may be re-written as:
Government
Net
(6) Saving + Imports + Taxes = Investment + Purchases + Exports
Leakages
Injections
• Therefore, when the loanable funds and foreign exchange
markets are in equilibrium, leakages from the circular flow
of income (savings + imports + taxes) are equal to
injections into it (investment + government purchases +
exports).
The Circular Flow Diagram
• Macro equilibrium will be present
when the flow of expenditures on
goods & services (top loop) is
equal the flow of income to
resource owners (bottom loop).
• This condition will be present
when the injections (investment,
government purchases, & exports)
into the circular flow … equal the
leakages (saving, taxes, and
imports) from it.
• Hence, when equilibrium is present
in the loanable funds and foreign
exchange markets, injections equal
leakages and Macro equilibrium
will be present.
•
Demand and
supply in the
loanable funds
market will
determine the
interest rate.
• When demand
for loanable funds is
strong (D2), real
interest rates will be
high (r2) and there
will be a inflow of
capital.
Supply of
loanable
funds
Capital
inflow
r2
r0
r1
D2
Capital
outflow
D1 D0
Q1 Q0
•
Loanable Funds
market
Domestic
saving
Interest
Rate
Q2
Quantity
of Funds
In contrast, weak demand (D1) and low interest rates (r1) will lead to capital outflow.
•
Governments limit convertibility to preserve their foreign exchange reserves.
Freely Convertible:
• Country’s government allows both residents and nonresidents to purchase unlimited
amounts of foreign currency
Externally convertible:
• Only nonresidents may convert it into a foreign currency without any restrictions
Nonconvertible:
• Neither residents nor nonresidents are allowed to convert it into foreign currency
Countertrade
• Companies can deal with non-convertibility problem by engaging in countertrade
• Range of barter-like agreements by which goods & services can be traded for other
goods & services
•
Exchange rate changes as a result of changes in particular macroeconomic
indicators:
– Differences in the rates of inflation:
• increase in the domestic rate of the level of prices ⇒ depreciation of the
domestic currency
– Differences in the interest rates:
• higher domestic interest rates ⇒ appreciation of the domestic currency
– Differences in the level of income: higher domestic income ⇒ depreciation of
the domestic currency
– Relative economic growth rates
– Expectations
– Other factors (political and psychological factors)
• If the Japanese assets have a higher expected rate of return than the U.S. assets.
Traders around the world will recognize a chance to make a profit by selling U.S.
assets and buying Japanese assets.
• As traders and investors sell dollar-denominated assets and buy yen-denominated
assets. This increases demand for yen. This leads to appreciation of yen against
dollar.
• This appreciation continues till the point when investors are indifferent between
holding U.S. or Japan assets. This means the return from both the assets will be
equal.
• Lets assume U.S. interest rate to be 5%. Lets call it R the domestic expected rate of
return.
• Suppose that future yen/dollar exchange rate is 100 and Japanese interest rates are
5%.
• If current exchange rate is also 100 yen/dollar, then Rf the expected rate of return
from foreign assets equals R.
• But if current exchange rate is 105 yen/dollar and the future expected exchange rate
is 100 yen/dollar, that means dollar is expected to depreciate. The dollar is expected
to fall by 4.8%.
• This depreciation of dollar will increase the expected return from foreign assets Rf
to 9.8% (5% interest rate plus 4.8% expected depreciation of dollar).
• Alternatively, if current exchange rate is 97 yen/dollar and the expected future
exchange rate is 100 yen/dollar. The dollar is expected to appreciate by 3.1%.
• This would imply that the expected rate of return from foreign assets Rf will fall
to 1.9% (5% interest rate minus 3.1% expected appreciation of dollar).
• Alternately if the domestic real interest rates fall, it will lead to shifting of
expected real rate of return towards left.
• This would result in falling of exchange rates.
• That means depreciation of the domestic currency.
Yen/USD
S
S’
105
100
97
D’
D
USD (quantity)
Real exchange Rate:
R = E . PF / P
• E - nominal exchange rate
• P - price level of domestic good
• PF - price level of foreign good
• R - real exchange rate
• Decrease of R is real appreciating and vice versa .... !
• Purchasing Power Parity (PPP)
• Holds that the prices of identical goods should be the same in all
countries.
• It is simply the law of one price applied to the international market.
• Demand & supply of one currency relative to the demand & supply of
another currency is important because foreign exchange movements
influence
– Export opportunities
– Profitability of trade & investment deals
– Price competitiveness of foreign imports
• Impact on foreign exchange rate movement
– Country’s price inflation
– Its interest rate
– Market psychology
•
Indirect interventions:
– Monetary policy:
• open market operations (increasing/decreasing the interest rate)
• directly related to the change in the quantity of money, and, consequently, to the
change in prices in the country
– Fiscal policy:
• changes in the level of government spending and the taxation of the residents, as
well as the size of the government suficit/deficit
• restrictive fiscal policy ⇒ causes depreciation of the domestic currency
• expansive fiscal policy ⇒ causes appreciation of the domestic currency
– other forms of intervention:
• various forms of public communication between the CB representatives and the
government
schematic representation of the influence of various factors on the market exchange rate:
Economic happenings:
- change in productivity
- change in wages
- change in the price of electricity
Economic policy:
- monetary
- fiscal
- prices
- interest rates
- inco me levels
- political factors
- psychological factors
- expectations
Supply of and
demand for foreign
exchange
Exchange
rate
Pegged exchange rate:
• Currency value is fixed relative to a reference currency
(US dollar $ 1 = 8.28 Chinese yuan)
Floating exchange rate:
• Exchange rate for converting one currency into another is
continuously adjusted based on supply & demand
Dirty float system:
• Currency nominally allowed to float & Government will step in if it
deviates too far from fair value