CHAPTER F IVE
International
Economics
Foreign Exchange Markets and
Exchange Rates
Dominick Salvatore
John Wiley & Sons, Inc.
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Learning Goals:
Understand the meaning and functions of the
foreign exchange market
Know what the spot, forward, cross, and
effective exchange rates are
Understand the meaning of foreign exchange
risks, hedging, speculation, and interest arbitrage
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Introduction
Foreign Exchange Market
Where individuals, firms and banks buy and
sell foreign currencies or foreign exchange.
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Functions of the Foreign Exchange Markets
1. Transfer purchasing power from one nation and
currency to another.
Demand for currency arises when:
Tourists visit another country
Domestic firm wants to import from other countries
Individual wants to invest abroad
Supply of currency arises from:
Foreign tourist expenditures
Export earnings
Receiving foreign investments
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Functions of the Foreign Exchange Markets
2. Provide credit for foreign transactions
Credit is needed when goods are in transit, and to
allow the buyer time to resell the goods to make
the payment.
3. Provide the facilities for hedging and speculation.
About 90% of foreign exchange trading reflects
purely financial transactions, and only about 10%
trade financing.
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Functions of the Foreign Exchange Markets
Participants
Those needing currency to fund transactions
Tourists, importers, exporters, investors, etc.
Commercial banks
Serve as the clearinghouses for currency exchange
Foreign exchange brokers
Clearinghouse for surpluses and shortages between
the commercial banks
Central banks
Buyer or seller of last resort in the foreign exchange
market
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Foreign Exchange Rates
Assume only two economies, the United States
and the European Monetary Union.
Domestic currency = dollar ($)
Foreign currency = euro (€)
The exchange rate between the dollar and the
euro (R) is equal to the number of dollars needed
to purchase one euro.
R = $/€
If R = $/€ = 1, then one dollar is required to purchase
one euro.
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Foreign Exchange Rates
Under a flexible exchange system, R is determined by
the intersection of market demand and supply curves
for euros.
Depreciation is an increase in the domestic price of the
foreign currency.
If the dollar price of the euro increases from $1 to $1.50,
the dollar has depreciated.
Appreciation refers to a decline in the domestic price
of the foreign currency.
If the dollar price of the euro decreases from $1 to
$0.50, the dollar has appreciated.
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FIGURE 14-1 The Exchange Rate Under a Flexible Exchange
Rate System.
Foreign Exchange Rates
Cross exchange rate
Once the exchange rate between each of a pair of
currencies with respect to the dollar is established,
the exchange rate between the two currencies
themselves, or cross exchange rate, can be
calculated.
Example:
Suppose $/€ exchange rate is $1.25 and the $/£
exchange rate is $2.
$ value of £ 2
R = €/£ = = = 1.60
$ value of € 1.25
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Foreign Exchange Rates
Effective exchange rate
A weighted average of the exchange rates
between the domestic currency and the
nation’s most important trading partners.
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Foreign Exchange Rates
Arbitrage
The purchase of currency in one market for
immediate re-sell in another market.
For example, $/€ = 0.99 in New York and 1.01 in
Frankfurt.
An arbitrageur purchase euros at $0.99 in New York
and immediately resell them in Frankfurt for $1.01.
Thus realizing a profit of $0.02 per euro.
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Foreign Exchange Rates
Arbitrage keeps the exchange rate between
any two currencies the same across different
markets.
The purchase/re-selling closes differences in
exchange rates by reducing currency available
in the low price market and increasing
availability in the high price market.
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Foreign Exchange Rates
When only two currencies and two monetary
centers are involved in arbitrage, as in the
preceding example, we have two-point
arbitrage.
When three currencies and three monetary
centers are involved, we have triangular, or
three-point, arbitrage.
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Foreign Exchange Rates
For example, suppose exchange rates are as
follows:
$1 = €1 in New York; €1 = £0.64 in Franfurt;
£0.64 = $1 in London.
These cross rates are consistent because
$1 = €1 = £0.64.
There is no possibility of profitable arbitrage.
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Foreign Exchange Rates
However, if $0.96 = €1 in New York.
Then use $0.96 to purchase € 1 in New York, use the
€1 to buy £0.64 in Frankfurt,
and exchange the £0.64 for $1 in London, thus
realizing a $0.04 profit on each euro so transferred.
If $1.04 = €1 in New York.
Use $1 to purchase £0.64 in London, exchange
the £0.64 for € 1 in Frankfurt, and exchange the €1
for $1.04 in New York, thus making a profit of $0.04
on each euro so transferred.
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The Exchange Rate and the Balance of
Payments
Examine the relationship between the exchange rate
and the nation’s balance of payments using Figure
14.2.
With and , the equilibrium exchange rate is R =
$/€ = 1 at which €200 million are demanded and
supplied per day.
Suppose that the U.S. demand for euros shifts up to
’.
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FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange
Rate System.
The Exchange Rate and the Balance of
Payments
If the U.S. wanted to maintain the exchange rate fixed at R = 1,
U.S. monetary authorities would have to satisfy the excess
demand for €250 million per out of its official reserve holdings
of euros.
Alternatively, EMU monetary authorities would have to
purchase dollars and supply euros to the foreign exchange
market to prevent an appreciation of the euro.
If, under a freely flexible exchange rate system, the exchange
rate would rise (i.e., the dollar would depreciate) from R = 1.00
to R = 1.50.
The U.S. would not lose any of its official euro reserves.
Indeed, international reserves would be entirely unnecessary
under such a system.
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The Exchange Rate and the Balance of
Payments
Under a managed floating exchange rate system, U.S.
can intervene in foreign exchange markets to
moderate the depreciation (or appreciation) of the
dollar.
U.S. might limit the depreciation of the dollar to R =
1.25 by supplying to the foreign exchange market the
excess demand for €100 million per day, out of its
official euro reserves.
Under such a system, part of the potential deficit in
the U.S. balance of payments is covered by the loss of
official reserve assets of the United States, and part is
reflected in the form of a depreciation of the dollar.
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Spot rate
The exchange rate that calls for payment and receipt
of the foreign exchange within two business days
from the date when the transaction was made.
Forward rate
The exchange rate that calls for delivery of the
foreign exchange one, three, six, twelve or twenty-
four months after the date the contract is signed.
No currencies are paid out at the time the contract is
signed.
Forward contracts for longer periods are not
common because of the great uncertainties involved.
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Forward discount
The percentage per year by which the forward rate is
below the spot rate.
For example, if the spot rate is $1 = €1 and the three-month
forward rate is $0.99 = €1, the euro is at a 3-month forward
discount of 1 cent or 1 percent (or at a 4 percent forward
discount per year) with respect to the dollar.
Forward premium
The percentage per year by which the forward rate is
above the spot rate.
If the 3-month forward rate is $1.01 = €1, the euro is at a
forward premium of 1 cent or 1 percent for three months, or
4 percent per year.
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Forward discounts (FD) or premiums (FP) can be
calculated formally with the following formula:
FR - SR
FD or FP = x 4 x 100
SR
where FR = forward rate and SR = spot rate
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Currency Swap
A spot sale of a currency combined with a
forward repurchase of the same currency – as
part of a single transaction.
Most interbank trading involving the purchase
or sale of currencies for future delivery are
done as currency swaps.
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Foreign Exchange Futures
Forward currency contracts for standardized
currency amounts and select dates trade on an
organized market.
Traded currencies:
Japanese yen
Canadian dollar
British pound
Swiss franc
Australian dollar
Mexican peso
Euro
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Spot and Forward Rates, Currency Swaps,
Futures, and Options
Foreign Exchange Options
Contracts giving the purchaser the right, but not
the obligation, to buy (call option) or to sell (put option)
a standard amount of a traded currency on a
stated date (European option) or any time before the
stated date (American option) at a stated price (strike or
exercise price).
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Foreign Exchange Risks, Hedging, and
Speculation
Whenever a future payment must be made or received
in foreign currency, a foreign exchange risk is
involved because spot rates vary over time.
The frequent and relatively large fluctuations in
exchange rates shown in Figure 14.3 impose foreign
exchange risks on all individuals, firms, and banks that
have to make or receive future payments denominated
in a foreign currency.
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FIGURE 14-3 Exchange Rates of the G-7 Countries and Effective
Exchange Rate of the Dollar, 1970-2012.
Foreign Exchange Risks, Hedging, and
Speculation
Contracted future foreign currency payments may
become more expensive if the domestic currency
falls in value.
Example:
A contract requires a €100,000 payment in three
months time.
If the exchange rate is currently $1/€1, the
expected dollar cost is $100,000.
If the exchange rate changes to $1.10/ €1 in three
months, the dollar cost rises to $110,000.
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Foreign Exchange Risks, Hedging, and
Speculation
Contracted future foreign currency receipts may
fall in value if the domestic currency increases in
value.
Example:
A producer expects to receive a payment of
€100,000 in three months time.
If the exchange rate is currently $1/€1, the
expected dollar receipt is $100,000.
If the exchange rate changes to $0.90/ €1 in three
months, the dollar receipt falls to $90,000.
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Foreign Exchange Risks, Hedging, and
Speculation
Hedging is the avoidance of foreign exchange risk.
Options:
1. Buy at the current spot rate and deposit the receipts in
an interest earning account until the funds are needed.
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Foreign Exchange Risks, Hedging, and
Speculation
For example, an importer could borrow € 100,000 at the
spot rate of SR = $1/€1 and leave this sum on deposit in a
bank (to earn interest) for three months, when payment is
due.
By so doing, the importer avoids the risk that the
spot rate in three months will be higher than today’s spot
rate and that he or she would have to pay more than
$100,000 for the imports.
The cost of insuring against the foreign exchange risk in
this way is the positive difference between the interest rate
the importer has to pay on the loan of €100,000 and the
lower interest rate he or she earns on the deposit of €
100,000.
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Foreign Exchange Risks, Hedging, and
Speculation
2. Buy a forward contract
The importer could buy euros forward for
delivery (and payment) in three months at
today’s three-month forward rate.
If the euro is at a three-month forward premium
of 4 percent per year, the importer will have to
pay $101,000 in three months for the €100,000
needed to pay for the imports.
The hedging cost will be $1,000 (1 percent of
$100,000 for the three months).
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Foreign Exchange Risks, Hedging, and
Speculation
3. Buy a call option
For example, suppose that an importer knows that he must
pay €100,000 in three months and the 3-month forward
rate of the pound is FR=$1/€1.
The importer could purchase an option to purchase €
100,000 in three months, say at $1/€1, and pay now the
premium of, say, 1 percent (or $1,000 on the $100,000
option).
If in 3 months the spot rate of the pound is SR = $0.98/€1,
the importer could let the option expire unexercised and
get the €100,000 at the cost of only $98,000 on the spot
market.
The $1,000 premium can be regarded as an insurance
policy.
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Foreign Exchange Risks, Hedging, and
Speculation
Speculation, the opposite of hedging, is the
acceptance of foreign exchange risk in the hope
of making a profit.
Example:
If the speculator expects the spot rate in three
months time to be $1/€1, she may sell euros at a
current three month forward rate of $1.10/€1
with the expectation that she will be able to buy
euros to cover her sale at the lower spot rate.
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Foreign Exchange Risks, Hedging, and
Speculation
Stabilizing Speculation
The purchase of a foreign currency when the
domestic price falls or is low, in the expectation
that it will soon rise, leading to a profit, OR
The sale of a foreign currency when the domestic
price rises, in the expectation that it will fall.
Stabilizing speculation moderates fluctuations in
exchange rates over time, serving a useful
function.
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Foreign Exchange Risks, Hedging, and
Speculation
Destabilizing Speculation
The sale of a foreign currency when the domestic
price falls or is low, in the expectation that it will
fall even lower, OR
The purchase of a foreign currency when the
domestic price rises, in the expectation that it will
rise even higher.
Destabilizing speculation magnifies fluctuations
in exchange rates over time, and can be very
disruptive to international flow of trade and
investments.
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
Interest arbitrage is the transfer of short-term
liquid funds abroad to earn a higher rate of
return.
Uncovered interest arbitrage occurs when the transfer
abroad entails foreign exchange risk due to the
possible depreciation of the foreign currency during
the investment period.
Carry trade is the borrowing of fund in low-yielding
currencies and lending in high-yielding currencies.
If the higher-yielding currency depreciates during the
period of the investment, however, the investor runs the
risk of losing money
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
E.G:
Suppose that the interest rate on EMU three-month
treasury bills is 6 percent at an annual basis in New York
and 8 percent in Frankfurt.
A U.S. investor exchanges dollars for euros at the current
spot rate and purchase EMU treasury bills to earn
the extra 2 percent interest at an annual basis.
When the EMU treasury bills mature, the U.S. investor
may want to exchange the euros invested plus the interest
earned back into dollars.
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
E.G:
However, by that time, the euro may have depreciated so
that the investor would get back fewer dollars per euro
than he paid.
If the euro depreciates by 1 percent at an annual basis
during the three months of the investment, the U.S.
investor nets only about 1 percent from this foreign
investment (the extra 2 percent interest earned minus the
1 percent lost from the depreciation of the euro) at an
annual basis (1/4 of 1 percent for the three months of the
investment).
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
E.G:
If the euro depreciates by 2 percent at an annual basis
during the three months, the U.S. investor gains nothing,
and if the euro depreciates by more than 2 percent, the
U.S. investor loses.
Of course, if the euro appreciates, the U.S. investor gains
both from the extra interest earned and from the
appreciation of the euro.
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
Interest arbitrage is the transfer of short-term
liquid funds abroad to earn a higher rate of
return.
Covered interest arbitrage is the spot purchase of the
foreign currency to make the investment and the offsetting
simultaneous forward sale of the foreign currency to
cover, or remove, the foreign exchange risk.
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
Covered interest arbitrage example:
Continue the previous example and assume that the euro is at a forward
discount of 1 percent per year.
The U.S. investor exchanges dollars for euros at the current exchange
rate and at the same time sells forward a quantity of euros equal to the
amount invested plus the interest he will earn at the prevailing forward
rate.
The euro is at a forward discount of 1 percent per year, the U.S. investor
loses 1 percent on an annual basis on the foreign exchange transaction to
cover the foreign exchange risk.
The net gain is thus the extra 2 percent interest earned minus the 1
percent lost on the foreign exchange transaction, or 1 percent on an
annual basis (1/4 of 1 percent for the three months or quarter of the
investment).
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Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
Efficiency of Foreign Exchange Markets
Markets are efficient if prices reflect all possible
information.
The foreign exchange market is efficient if
forward rates accurately predict future spot
rates
Empirical evidence is mixed.
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Eurocurrency or Offshore Financial Markets
Eurocurrency refers to commercial bank deposits
outside the country of their issue.
Eurodollar - A deposit denominated in U.S. dollars
in a British commercial bank.
Eurosterling - A pound sterling deposit in a French
commercial bank.
Eurodeposit - A deposit in euros in a Swiss bank.
The market in which the borrowing and lending
of these balances takes place is the Eurocurrency
market.
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