ECON 511 International Finance & Open

Macroeconomy

CHAPTER TWO

The Foreign Exchange Market

I. The Foreign Exchange Market

• Foreign exchange is highly liquid assets denominated in a foreign currency.

• The foreign exchange rate is the price of one nation’s currency in terms of another’s.

• Foreign exchange market is referred to the trading of foreign exchange by large commercial banks located in few financial centers.

• Main participants in this market are retail customers, commercial banks, foreign exchange brokers, and central banks.

II. Exchange Rates • Purchasing and selling of foreign exchange within the

foreign exchange market.

• The exchange rate is the rate at which two different monies trade for each other .

• Formally, the exchange rate ( also known as the foreign exchange rate, forex rate or FX rate) between two countries specifies how much one currency is worth in terms of the other.

• Note: there is an “ISO codes” to describe currencies. This code is created by the International Organization for Standardization ( Canadian Dollar “CAD”, US Dollar “USD”,

Japanese Yen “JPY”)

II.i Spacial Arbitrage

• Arbitrage means buying an item where it is cheap and immediately selling it where it is dear.

• The foreign exchange market is geographically isolated but highly integrated, this is because of the extremely low transactions costs.

• Communication takes place continuously by telephone and computer network.

• Exchange rates in different centers are closely aligned (How ??) .

• Spatial arbitrage quickly eliminates differences in exchange rates between centers.

II.ii Triangular Arbitrage

• Let ignore transaction costs, and assuming the Law of One Price prevails for each exchange rate. Now consider the following example:- Buying JPY 100 with USD 1 & then selling JPY 100 for USD 1.

- This is true for every pair of currencies in the table below:

Suppose buying CAD 1.25 for USD 1, then buying JPY 125 for your CAD 1.25. Thus, the same initial dollar purchase has netted you more yen.

You could now sell your JPY 125 for USD 1.25

Buys USD CAD JPY

USA USD 1 1.25 100

Canada CAD 0.8 1 100

Japan JPY 0.01 0.01 1

III. Forward Exchange • Using a forward contract to contract for future sale or

purchase of foreign exchange.

• Like a spot contract, in the forward market a forward contract specifies “quantity of foreign exchange to be purchased or sold” , a price, and a future date on which the transaction is to take place.

• The price specified in a forward contract is referred to as the forward exchange rate.

• The two primary functions of the forward market are hedging and speculation.

III.i Hedging

• Forward market can be used to hedge the currency risk.

• For example; if you’re a US exporter who expects to receive payment of JPY ‘1m’ in 1 month. Because of exchange rate variation between USD/JPY, you are exposed to currency risk. What should you do to avoid such risk?

• Exchange rate variability creates an incentive to hedge.

• The extent of hedging will depend on its cost (HOW!!).

III.ii Speculation

• Forward market can also be used for pure speculation.

• For example; if you expect in 1 month a spot rate of USD/CAD= 0.8, while the current 1 month forward rate is USD/CAD= 0.81. Therefore, you might choose to bet on your expected future spot rate by buying Canadian dollars forward for US dollar, in anticipation of selling them for a profit. Is this risky?

• Empirically, the forward rates are to be more closely linked to current than to the future spot rates. Therefore, the forward rate might be the best possible predictor of the future spot rate.

• In fact, Levich (1981) shows that commercial banks set the forward rate to insure that covered interest parity holds.

• This places emphasis on the current spot rate and interest rates as determinants of the forward rate rather than on the expected future spot rate.

• Speculation in the spot market may exceed that in the forward market.

III.iii Covered Interest Party

• The forward rate allows you to lock in effective return from holding foreign currency.

• Thus, you can spend St to buy a unit of foreign exchange today (time t) and then immediately sell it forward (T-t)days in the future for Ft . Your effective return is then:

fdt= (Ft – St) / St

where fd is the forward discount on the domestic currency or forward premium on foreign exchange

• However, if the effective return is your concern you can do better!!! Instead of holding foreign currency for time t, you can invest in a foreign

currency denominated interest bearing asset. let (it*) be the risk free return available on foreign currency denominated

assets. Thus, you can raise your effective return to (it*) + (fdt)

If (it) is the risk free effective return on domestic currency denominated assets.

Since (it*) + (fdt) & (it) are risk free rate of return measured in the domestic currency each of the risk free return, then both must be equaled

(it*) + (fdt) = (it) For simplicity, rewriting the above to (it) - (it*) =(fdt)

• Accordingly, the portfolio capital is “mobile” to the extent that international financial markets are frictionlessly integrated. Domestic & foreign residence are on equal footing in the purchase and

sale of domestic and foreign assets.As a result, it is expected that opportunities for risk free profit making to

be quickly and completely exploited. Thus, the most basic measure of international capital mobility is the

disappearance of arbitrage opportunities in international financial market.

Covered Interest Parity (CIP) is thus a basic condition of perfect capital mobility, and deviations from CIP are primary indicator of imperfection or frictions in international capital markets.

IV. The Demand & Supply in the Foreign Exchange Market

• Simple standard demand & supply framework to analyze the foreign exchange market.

IV.i Under Flexible Rate Regime

• Demand for & supply of each currency in the foreign exchange market determine the exchange rate .

Case One: Consider R= 0.5

• A shortage of foreign exchange would cause individuals to bid up its price as they offer to buy Euro denominated deposits in exchange for dollar-denominated ones.

Case Two: Consider R= 1.5

•A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones.

Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

IV.ii Under Fixed Rate Regime

• The pegged or fixed exchange rate is a practice that works much like fixing the price of any good.

• Demand & supply of foreign exchange still exist, but do not determine the exchange rate as they would in the flexible regime.

• Central banks must stand ready to absorb any excess demand for or supply of a currency to maintain the pegged rate.

• Central banks must step into the market , such action called a policy of intervention in the foreign exchange market.

• Case One: Suppose the US government decides to peg the exchange rate between dollars & Euros at 1.5

• Case Two: Suppose the US government decides to peg the exchange rate between dollars & Euros at 0.5

Case One: Consider R= 1.5

• The quantity supplied of euro exceeds the quantity demanded. Dollar denominated deposits are more attractive relative to the euro ones. Thus, surplus of euro in the foreign exchange market at (R=1.5) creates a tendency for the exchange rate to fall as individuals try to sell euro deposits in exchange for dollar ones.

• As a result, US Fed steps in to buy up the surplus euro denominated deposits(individuals sell euro denominated deposits to the Fed in return for dollar ones at R=1.5).

• The distance between points B and G at R=1.5 represents the level of required intervention.

• What is the case of revaluation of the dollar?

Case Two: Consider R= 0.5

•A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones.

Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

Case Two: Consider R= 0.5

• The quantity demanded for euro exceeds the quantity supplied. Euro denominated deposits are more attractive relative to the Dollar ones. Thus, shortage of euro in the foreign exchange market at (R=0.5) creates a tendency for the exchange rate to increase as individuals try to buy euro deposits in exchange for dollar ones.

• As a result, US Fed steps in to sell euro denominated deposits (from where Fed has them ) by buying dollar denominated deposits.

• The distance between points H and C at R=0.5 represents the level of required intervention.

• What is the case of devaluation of the dollar?

Case Two: Consider R= 0.5

•A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones.

Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

V. Balance of Payment (BOP)

• BOP is defined as a summary statement in which all TRANSACTIONS of the RESIDENTS in a nation with the residents of all other nations (NON-RESIDENTS) which are recorded during a particular PERIOD of time (usually one calendar year).

• BOP consists of Current Account, Capital & Financial Account, and Balance of official settlements.

• What goes in the CA ? Good & Services Balance (Exports & Imports) + Income Good & Services Balance (Exports & Imports) + Income

Account + Current Transfers (Unilateral Transfers)Account + Current Transfers (Unilateral Transfers)

• What goes in the C& FA ? Records international borrowing, lending, purchases, and sales of

assets:

* Direct investments * Direct investments * Portfolio investment* Portfolio investment* Other investments * Other investments

• What goes in the Balance of official settlements?• Monetary gold Monetary gold (gold reserves)(gold reserves)• Special drawing rights Special drawing rights (SDR)(SDR)• Reserve position in IMF Reserve position in IMF (local currency, gold, others)(local currency, gold, others)• Foreign exchangeForeign exchange ( foreign currency reserves)( foreign currency reserves)

Note: { CA balance + CFA balance + Official Note: { CA balance + CFA balance + Official settlements balance + Statistical discrepancy = 0}settlements balance + Statistical discrepancy = 0}

Example .Example . Kuwait exports $ 500 mn. of oil to be paid for in three months.

• Note the following: Note the following:

– Exports of oil are entered as credits (lead to receipts of payments lead to receipts of payments from foreignersfrom foreigners)

– The payment itself is entered as a capital outflow (debit), why?why?

When Kuwait agrees to wait for three months for payments, it extends a credita credit to foreign importers (capital outflows). This is an This is an increase in domestic assets abroad (i.e. a debit)increase in domestic assets abroad (i.e. a debit)

(+) Credit (-) Debit

OIL EXPORTS 500

CAPITAL OUTFLOWS (an increase in Kuwaiti assets abroad)

500

VI. Purchasing Power Parity Theory (PPP) VI. Purchasing Power Parity Theory (PPP)

(1) The Law of One Price (LOOP)(1) The Law of One Price (LOOP)

• the same good (x) in different competitive markets must sell sell for the same pricefor the same price in the absence of transportation costs and trade barriers between these markets i.e.,

PPxx= (S) . (P= (S) . (P**xx))

(2) Absolute PPP:(2) Absolute PPP:

• Is the application of the law of one price across countries for all goodsall goods and services, or for representative groups (baskets) of goods and services:

P = (S) . (PP = (S) . (P**) ) S= P/P*S= P/P*

• According to the equation, the equilibrium exchange rate between two currencies equals the ratio of the price levels in the two nations

• If the price of a bushel of wheat in USA is $1 and in EMU area is €1 then the exchange rate between the two currencies is $1/€1 = 1. This is the LOOP.

• According to LOOP (a given commodity should have the same (a given commodity should have the same price, so that the purchasing power of the two currencies is at price, so that the purchasing power of the two currencies is at parity)parity).

• If the price of the good is different (e.g., $ 0.5 in USA and $ 1.5 in EMU area), firms would purchase the good in USA and resell it in EMU area. This commodity arbitragecommodity arbitrage causes the price of wheat to be the same in the two markets (assuming no transportation costs or subsidies ..etc).

(3) Relative PPP theory(3) Relative PPP theory

• ChangeChange in the exchange rate should be proportional to the relative change in the price levels (inflationinflation) in the two nations over the same period.

S1 = ((pS1 = ((p11/p/p00)/(p)/(p**11/p/p**

00)).S)).S00

• S1 and S0 are exchange rates in period (1) and base period (0).

• Example, if S0 = $1/€1, and there is no change in the price level of the EMU area, while in the US the price increases by 50% the US $ should depreciate by 50% compared to the base period. [(1.5/1)/(1/1) . 1= $1.5/ € 1 (i.e. (1.5-1)/1 = 50% depreciation)]