Chapter 20
The Foreign
Exchange Market
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
20-1
Learning Objectives
• Summarize the fundamental
underpinnings of the foreign
exchange market.
• Explain the distinctions between
various measures of the exchange
rate.
• Differentiate the roles of hedging,
arbitrage, and speculation in foreign
exchange markets.
• Describe the links between the
current spot rate and contracts to buy
or sell foreign exchange in the future.
20-2
The Foreign Exchange Rate and
the Market for Foreign Exchange
• Foreign exchange rate: the price of one
currency in terms of another.
– e.g., US$/€ or €/US$
• The foreign exchange rate is
determined by the interaction of
demand for and supply of foreign
exchange.
• The foreign exchange market is the
worldwide network of markets and
institutions that exchange currencies.
20-3
The Market for Foreign
Exchange: Demand
• Foreign exchange is demanded by
those
– wishing to buy goods and services from
or send gifts or payments to another
country.
– wishing to purchase financial assets in
another country.
– wishing to profit from exchange rate
changes (speculation).
– wishing to minimize risk from exchange
rate changes (hedging).
20-4
The Market for Foreign
Exchange: Supply
• Foreign exchange is supplied by
those
– selling goods and services to or
receiving gifts or payments from another
country.
– in other countries who wish to purchase
financial assets in the home country.
– wishing to profit from exchange rate
changes (speculation).
– wishing to minimize risk from exchange
rate changes (hedging).
20-5
The Market for Foreign
Exchange
S€
$/€
Initially, Qeq euros are
traded, and the
equilibrium price is eeq.
eeq
D€
Qeq
Euros (€)
20-6
The Market for Foreign
Exchange
S€
$/€
An increase in U.S.
demand for euros
causes an appreciation
of the euro.
e'eq
eeq
D€
Qeq Q'eq
D'€
Euros (€)
20-7
The Market for Foreign
Exchange
S€ S'€
$/€
An increase in the
supply of euros causes
a depreciation of the
euro.
eeq
e'eq
D€
Qeq Q'eq
Euros (€)
20-8
The Market for Foreign
Exchange: Supply
• The total supply and demand for
foreign exchange includes two
components.
– One is related to current account
transaction.
– The other is related to financial flows,
including speculation and hedging.
20-9
The Market for Foreign
Exchange
SG&S
STotal
$/€
The total equilibrium
exchange rate will only
be the same as the one
for G&S if the current
account is exactly in
balance.
eeq
DG&S
Qeq
DTotal
Euros (€)
20-10
The Spot Market
• The spot market is the daily or
current market for foreign exchange.
• The main participants are large
commercial banks trading with each
other in the interbank market.
• There are many foreign exchange
markets, but they all tend to
generate the same exchange rate
regardless of location.
– This is the result of arbitrage.
20-11
Arbitrage
• Arbitrage occurs when individuals
see an opportunity to buy something
at a low price in one market, then
sell it for a higher price in a second
market.
• This causes prices in all markets to
move towards each other.
• Arbitrage causes currency prices to
be similar across markets, and
makes cross rates between
currencies consistent.
20-12
Different Measures of the
Spot Rate
• How can we measure a country’s
overall exchange rate (not just a
bilateral rate)?
–
–
–
–
Nominal effective exchange rate (NEER)
Real exchange rate (RER)
Real effective exchange rate (REER)
Purchasing power parity (absolute and
relative)
20-13
Different Measures of the
Spot Rate: NEER
• The NEER is an index that measures
the change over time in the nominal
value of a country’s currency.
• The nominal effective exchange rate
weights the exchange rates of each
of a country’s trading partners by the
volume of trade with each.
• NEER is a weighted average of a
currency’s exchange rate against a
bundle of other currencies.
20-14
Different Measures of the
Spot Rate: RER
• However, prices in the two countries
may not be constant.
• Suppose the dollar appreciates
against the euro by 10%, but at the
same time U.S. prices rose by more
than European prices.
– The decline in U.S. competitiveness is
more than 10%.
• RER=e€/$(price indexUS/price indexEur).
20-15
Different Measures of the
Spot Rate: REER
• The REER is an index that measures
the change over time in the real
value of a country’s currency.
• The real effective exchange rate
weights the real exchange rates of
each of a country’s trading partners
by the volume of trade with each.
• REER is a weighted average of a
currency’s real exchange rate
against a bundle of other currencies.
20-16
Absolute Purchasing
Power Parity
• In principle, a commodity should
have the same price worldwide when
measured in a common currency, due
to arbitrage.
• PPPabs = price levelUS/price levelEur
• If cotton costs $0.5 per pound in the
U.S., and €0.35 per pound in Europe,
the exchange rate should be $1.43/€.
• However, transportation costs and
other differences means absolute
PPP doesn’t generally occur.
20-17
Relative Purchasing
Power Parity
• Relative PPP takes into account
differences in price indexes
• PPPrel$/€ = (e $/€)x(PIUS/PIEur).
• Relative PPP relates the change in
the exchange rate to changes in the
two countries’ price levels.
20-18
The Law of One Price
• Under the assumption of no transportation
costs and of competitive markets, the “law of
one price” states that market exchange rates
should, in the long run, equalize the price of
traded good in two countries when the prices
are expressed in the same currency.
• In other words, market exchange rates should
converge to the PPP exchange rate between
standardized baskets of traded goods.
20-19
The Law of One Price
To better understand the law of one price:
- A particular TV set that sells for 750 Canadian Dollars [CAD] in
Vancouver should cost 500 US Dollars [USD] in Seattle when the
exchange rate between Canada and the US is the following: 1
USD=1.50 CAD.
- If the price of the TV in Vancouver was only 700 CAD, consumers in
Seattle would prefer buying the TV set in Vancouver.
- If this process (called “arbitrage”) is carried out at a large scale, the
US consumers buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods more costly to them.
- This process continues until the goods have again the same price.
20-20
• But are the market exchange rates equal to their equilibrium
value?
• No. Market exchange rate movements in the short term are
news- and speculation- driven.
• In other words, market exchange rates fluctuate daily, often
by a large amount.
• For instance, the India Rupee might appreciate relative to the
USD by 10% in a given week due to speculation.
• Shall we then conclude that the average Indian resident had
become 10% richer relative to the average American, even
though the amount of output produced in the two countries
had not changed?
20-21
• We can’t rely on market exchange rates since they are not (or
rarely) equal to their equilibrium value.
• Why not rely directly on their equilibrium value then?
• This can be done by computing the PPP exchange rate
between the price in local currency of a standardized basket
composed of traded good across different countries.
• This “equilibrium” exchange rate will ensure that the price of
this standardized basket is the same in each country when
expressed in the same currency
20-22
Big Mac Index
• The Economist introduced in 1986 the PPP exchange
rates between the prices in local currency of a
standardized basket composed of one Big Mac, a
“traded” good which is produced in about 120
countries.
• This is the Big Mac index.
• A comparison between the Big Max index and the
market exchange rate of each country provides a test
of the extent to which the currency of this country is
over- or under- valued against a currency of
reference.
20-23
Big Mac Index
20-24
The Forward Market
• Most exchanges of currencies takes
place two business days after the
contract has been completed.
• In general, forward exchange rates
can be for any period of time into the
future.
• Suppose a U.S. company agrees to
buy 5 trucks from a French company
at a price of €50,000 each, with
delivery in 6 months, the equivalent
of $70,000 at today’s spot exchange
rate of $1.4/€.
20-25
The Forward Market
• What if the euro appreciates to
$1.6/€?
– Now the price in dollars has risen to
$80,000.
• There are ways to hedge against this
potential risk.
– The buyer and seller can agree to make
the sale at today’s forward exchange
rate.
– The buyer can purchase a foreign
currency option – this gives the buyer the
right to a specific exchange rate at a
specific time in the future.
20-26
The Link Between the Foreign
Exchange and the Financial
Markets
• The decision to invest internationally
depends on the expected rate of
return on the international asset
relative to domestic alternatives.
• Specifically, investors consider
– The domestic interest rate or expected
rate of return.
– The foreign interest rate or expected
rate of return.
– Any expected changes in exchange
rates.
20-27
The Link Between the Foreign
Exchange and the Financial
Markets
• An investor would be indifferent
between a $1 domestic or foreign
investment if her expected return is
the same after accounting for
expected changes in the spot rate.
• Let iNY = 90-day interest rate in New
York.
• Let iParis = 90-day interest rate in
Paris.
• Let E(e) = the expected spot rate in
90 days.
20-28
The Link Between the Foreign
Exchange and the Financial
Markets
• An investor would be indifferent if
$1(1+iNY) =[($1)/(e)]x(1+iParis)[E(e)], or
(1+iNY)/(1+iParis)=E(e)/e.
• This can be approximated as
(iNY – iParis) ≈ xa, where xa is the
expected appreciation of the foreign
currency.
20-29
The Link Between the Foreign
Exchange and the Financial
Markets
• This is called uncovered interest
parity (UIP).
• If (iNY – iParis) > xa, investments in the
U.S. will be more attractive to
investors and investment funds
would flow into the U.S.
• If (iNY – iParis) < xa, investments in
France will be more attractive to
investors and investment funds
would flow into France.
20-30
The Link Between the Foreign
Exchange and the Financial
Markets
• Naturally, individuals don’t have
perfect foresight.
• Since expectations can be wrong,
there may be an additional premium
required to undertake the risk:
(iNY – iParis) ≈ xa – RP
• If the risk premium is 1%, the gap
between the interest rates must be
higher for investors to be indifferent.
20-31
The Link Between the Foreign
Exchange and the Financial
Markets
• So far, we’ve assumed any exchange
rate risk is borne by the investor.
• In fact, the risk can be hedged in the
forward market.
• The relationship between the spot
and forward rates is usually stated
as
p = [efwd/e] – 1, where efwd is the
forward exchange rate and p is the
premium (or discount).
20-32
The Link Between the Foreign
Exchange and the Financial
Markets
• If the forward market exchange rate
is $1.72/€ and the spot market rate is
$1.70/€,
• p = [1.72/1.70] – 1 = 1.2%.
• That is, there is a 1.2% premium on
the foreign currency.
20-33
The Link Between the
Foreign Exchange and the
Financial Markets
• An investor would be approximately
indifferent if
(iNY – iParis) ≈ p, where p is the
percentage premium.
• We can also include transactions
costs:
(iNY – iParis) ≈ p ± transactions costs
• This is called covered interest parity
(CIP).
20-34
Simultaneous Adjustments of
the Foreign Exchange and
Financial Mkts
• What happens if
(iNY – iParis) > p ± transactions costs?
• Investment funds should move from
Paris to New York, decreasing the
supply of loanable funds in Paris.
• This should put upward pressure on
interest rates in Paris.
20-35
International Financial and
Exchange Rate Adjustments
iParis
i'P
S'€
S€
Paris money market
iP
D€
€
20-36
International Financial and
Exchange Rate Adjustments
• The conversion of euros into dollars
in the spot market increases the
supply of euros, thereby putting
downward pressure on the euro spot
rate (that is, causing the dollar to
appreciate).
20-37
International Financial and
Exchange Rate Adjustments
e$/€
S€
S'€
e0
e'
Spot market
D€
€
20-38
International Financial and
Exchange Rate Adjustments
• Investors wish to cover themselves
against exchange rate changes will
now purchase euros in the forward
market.
• This will put upward pressure on the
euro forward rate.
20-39
International Financial and
Exchange Rate Adjustments
e$/€fwd
efwd'
St€
Forward market
efwd
D t€
Dt'€
€
20-40
International Financial and
Exchange Rate Adjustments
• When the new funds move to New
York, supply of loanable funds
increases there.
• This will put downward pressure on
iNY.
20-41
International Financial and
Exchange Rate Adjustments
iNY
iNY
iNY'
S$
S‘$
N.Y. money market
D$
$
20-42
International Financial and
Exchange Rate Adjustments
• All of these adjustments work
toward reducing the initial inequality.
• Eventually,
(iNY – iParis) = p ± transactions costs.
20-43