THE FOREX MARKET

DR. GORMUS

Foreign Exchange Market

Most countries of the world have their

own currencies: the U.S dollar., the euro
in Europe, the Brazilian real, and the
Chinese yuan, just to name a few.
The trading of currencies and banks
deposits is what makes up the foreign
exchange market.

What are Foreign Exchange Rates?

Two kinds of exchange rate transactions

make up the foreign exchange market:

Spot transactions involve the nearimmediate exchange of bank deposits,

completed at the spot rate (S).
Forward transactions involve a contract
signed today to make an exchange at some
future date, completed at the forward
rate (F).

Why Are Exchange Rates Important?

When the currency of your country

appreciates relative to another country,
your countrys goods prices abroad
and foreign goods prices in your
country.

Makes domestic businesses less

competitive
Benefits domestic consumers (you)

Why Are Exchange Rates Important?

For example, in 1999, the euro was

valued at $1.18. On June 7, 2013, it was
valued at $1.32.

Euro appreciated 11% (1.32 1.18) / 1.18

Dollar depreciated 11% (0.76 0.85) / 0.85
Note:

0.75 1 / 1.32, and 0.85 1 / 1.18

How is Foreign Exchange

Traded?

FX traded in over-the-counter market

1.

2.

3.

Involve buying / selling bank deposits

denominated in different currencies.
Trades involve transactions in excess of $1
million.
Typical consumers buy foreign currencies
from retail dealers, such as American
Express.

FX volume exceeds $4 trillion per day.

Exchange Rates in the Long

Run

Exchange rates are determined in

markets by the interaction of supply and
demand.
An important concept that drives the
forces of supply and demand is the Law
of One Price.

Exchange Rates in the Long Run:

Law of One Price

The Law of One Price states that the

price of an identical good will be the
same throughout the world, regardless
of which country produces it.
Example: American steel costs $100 per
ton, while Japanese steel costs 10,000
yen per ton.

Exchange Rates in the Long Run:

Law of One Price

Law of one price E 100 yen/$

Exchange Rates in the Long Run:

Theory of Purchasing Power Parity
(PPP)

The theory of PPP states that exchange

rates between two currencies will adjust
to reflect changes in price levels.
PPP Domestic price level 10%,
domestic currency 10%

Application of law of one price to price

levels
Works in long run, not short run

Exchange Rates in the Long Run:

Theory of Purchasing Power Parity
(PPP)

Problems with PPP

All goods are not identical in both countries

(i.e., Toyota versus Chevy)
Many goods and services are not traded
(e.g., haircuts, land, etc.)

Exchange Rates in the Long Run:

Factors Affecting Exchange Rates in
Long Run

Explaining Changes in Exchanges Rates

Here are how some of the factors impact demand curves

Application: Interest Rate

Changes

Changes in domestic interest rates are

often cited in the press as affecting
exchange rates.
We must carefully examine the source of
the change to make such a statement.
Interest rates change because either (a)
the real rate or (b) the expected inflation
is changing. The effect of each differs.

Effect of Changes in Interest Rates

on the Equilibrium Exchange Rate

When the domestic real interest rate

increases, the domestic currency
appreciates.
When the domestic expected
inflation increases, the domestic
currency reacts in the opposite direction
it depreciates. This is shown on the
next slide.

Effect of Changes in Interest Rates

on the Equilibrium Exchange Rate
Effect of a Rise in the Domestic Interest Rate as a Result of an
Increase in Expected Inflation

Interest Parity Condition

The interest parity condition relates

foreign/domestic interest rates with FX
rates.
Derived from expected returns.

Interest Parity Condition

An investor can earn interest rate of id on

US dollars and can borrow at the same
rate
Also, the same investor can earn interest
rate of if in the foreign country (lets
assume Germany for this example) and
can borrow at the same rate.
St is the spot rate and E(St+1) is the
expected spot rate next period

Uncovered Interest Rate

Parity

(1+id) = (1/St) (1+if) E(St+1)

Means: there should be no difference between investing

in the US vs. taking your dollars, converting them to
Euros, investing in Germany wait for a year and convert
those Euros back to dollars.
This equilibrium should hold as long as:
E(St+1) = St+1

In other words: as long as what you predict the spot rate will
be is the same as what it actually becomes in one year, this
parity should hold.

What if it doesnt?

Then, there is an arbitrage opportunity (receiving more return

than you should)

Covered Interest Rate Parity

This time, instead of using our

Expectations, we plug in the actual
Forward rate (F)
This assures us that there are no
expected surprises and if there are, it
creates an arbitrage opportunity.
(1+id) = (1/St) (1+if) F365

or
(1+i ) = (F
d
365/St) (1+if)

Covered Interest Rate Parity

Here is an example:
The interest rate in the US is 2%. The
Current Spot rate for Euros is 1.58. In
Germany, the interest rate is 3% and the
Forward price for Euros is 1.54. Is there an
arbitrage opportunity? If yes, how would
you take advantage of this?

Covered Interest Rate Parity

(1+0.02) = (1.54/1.58)(1+0.03)
1.02 > 1.00
This means that the equivalent interest rate in US is higher
then the one in Germany. Do we borrow at the higher rate or
invest at the higher rate? Of course you would want to borrow
at the cheaper rate and invest at the higher rate.
So, Yes, there is an arbitrage opportunity. You would borrow in
Germany, Convert the Euros to Dollars, Invest in the US while
getting into a forward contract. Wait for one year, collect your
proceeds in dollars.
..and convert your dollars back to Euros (using the forward
rate which is already agreed upon).
You should end up with more Euros then the German interest
rate pays.