Topic 9 (Part 1)

The Foreign
Exchange
Market

Introduction
Question: What is the foreign exchange
market?
Answer:
The foreign exchange market is a market for
converting the currency of one country into that
of another country
Question: What is the exchange rate?
Answer:
The exchange rate is the rate at which one
currency is converted into another

The Functions of Foreign

Exchange Market
The purpose of foreign exchange market
1. is used to convert the currency of one
country into the currency of another
2. provides some insurance against foreign
exchange risk - the adverse
consequences of unpredictable changes
in exchange rates
Events in the foreign exchange market
affect firm sales, profits, and strategy
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When do Firms Use the

Foreign Exchange
Market?
International companies use the foreign
exchange market when
the payments they receive for exports, the income
they receive from foreign investments, or the
income they receive from licensing agreements
with foreign firms are in foreign currencies
they must pay a foreign company for its products
or services in its countrys currency
they have spare cash that they wish to invest for
short terms in money markets
they are involved in currency speculation - the
short-term movement of funds from one currency
to another in the hopes of profiting from shifts in
exchange rates
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Insuring Against Foreign

Exchange Risk
The foreign exchange market provides
insurance to protect against foreign
exchange risk - the possibility that
unpredicted changes in future exchange rates
will have adverse consequences for the firm
A firm that insures itself against foreign
exchange risk is hedging
To insure or hedge against a possible adverse
foreign exchange rate movement, firms
engage in forward exchanges - two parties
agree to exchange currency and execute the
deal at some specific date in the future
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Insuring Against Foreign

Exchange Risk
The market performs this function
using:
1. spot exchange rates
2. forward exchange rates
3. currency swaps

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What is the Difference

between Spot Rates and
Forward Rates?

1. Spot exchange rate is the rate at which a

foreign exchange dealer converts one currency
into another currency on a particular day
spot rates change continually depending on the supply and
demand for that currency and other currencies

2. Forward exchange rate occurs when two

parties agree to exchange currency and execute
the deal at some specific date in the future
To insure or hedge against a possible adverse foreign
exchange rate movement, firms engage in forward
exchanges
forward rates for currency exchange are typically quoted for
30, 90, or 180 days into the future
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What is a Currency
Swap?
3. Currency swap is the simultaneous purchase
and sale of a given amount of foreign
exchange for two different value dates
Swaps are transacted:
between international businesses and their banks
between banks
between governments when it is desirable to
move out of one currency into another for a
limited period without incurring foreign exchange
rate risk

9-8

The Nature of the

Foreign Exchange Market
The foreign exchange market is a global
network of banks, brokers, and foreign
exchange dealers connected by electronic
communications systems
the most important trading centers are
London, New York, Tokyo, and Singapore
the market is always open somewhere in
the worldit never sleeps
Most transactions involve U.S. dollars on
one side
the U.S. dollar is a vehicle currency

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Do Exchange Rates Differ

Between Markets?
High-speed computer linkages between
trading centers mean there is no significant
difference between exchange rates in the
differing trading centers
If exchange rates quoted in different markets
were not essentially the same, there would
be an opportunity for arbitrage - the process
of buying a currency low and selling it high
Most transactions involve dollars on one side
it is a vehicle currency along with the
euro, the Japanese yen, and the British pound
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How are Exchange

Rates Determined?
Exchange rates are determined by the
demand and supply for different
currencies
Three factors impact future
exchange rate movements:
1. A countrys price inflation
2. A countrys interest rate
3. Market psychology
There is another factor. What is it? Sp.
9-11

How do Prices
Influence Exchange
Rates?
To understand how prices and exchange rates are linked, we

need to understand the law of one price, and the theory of

purchasing power parity
The law of one price states that in competitive markets
free of transportation costs and barriers to trade, identical
products sold in different countries must sell for the same
price when their price is expressed in terms of the same
currency
Purchasing power parity theory (PPP) argues that given
relatively efficient markets (markets in which few
impediments to international trade and investment exist)
the price of a basket of goods should be roughly
equivalent in each country
predicts that changes in relative prices will result in a change in
exchange rates

9-12

Big Mac
Index 2012
Source: The Economist

9-13

Prices and Exchange

Rates
A positive relationship exists between the inflation rate
and the level of money supply
PPP predicts that changes in relative prices will result
in changes in exchange rates, at least in the short run
when inflation is relatively high, a currency should
depreciate

So, if we can predict inflation rates, we can predict

how a currencys value might change
the growth of a countrys money supply determines its
likely future inflation rate
when the growth in the money supply is greater than the
growth in output, inflation will occur

Empirical testing of PPP theory suggests that it is most

accurate in the long run, and for countries with high
inflation and underdeveloped capital markets
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Interest Rates and

Exchange Rates
Question: How do interest rates affect
exchange rates?
Answer:
The Fisher Effect states that a countrys nominal
interest rate (i) is the sum of the required real rate
of interest (r ) and the expected rate of inflation
over the period for which the funds are to be lent
(l )
in other words, i = r + I
So, if the real interest rate is the same
everywhere, any difference in interest rates
between countries reflects differing expectations
about inflation rates

Interest Rates
and Exchange Rates
The International Fisher Effect states that
for any two countries the spot exchange rate
should change in an equal amount but in the
opposite direction to the difference in
nominal interest rates between two countries
In other words:
(S1 - S2) / S2 x 100 = i $ - i
where i $ and i are the respective nominal
interest rates in two countries (in this case the
US and Japan), S1 is the spot exchange rate at
the beginning of the period and S2 is the spot
exchange rate at the end of the period
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How does Investor

Psychology
Influence Exchange
Rates?

The bandwagon effect occurs when

expectations on the part of traders turn
into self-fulfilling prophecies - traders can
join the bandwagon and move exchange
rates based on group expectations
government intervention can prevent the
bandwagon from starting, but is not always
effective
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Exchange Rate Forecasting

Question: Should companies invest in
exchange rate forecasting services to help
with decision-making?
There are two schools of thought
1.The efficient market school argues that forward
exchange rates do the best possible job of forecasting
future spot exchange rates, and, therefore, investing in
forecasting services would be a waste of money
An efficient market is one in which prices reflect all available
information
if the foreign exchange market is efficient, then forward
exchange rates should be unbiased predictors of future
spot rates
Most empirical tests confirm the efficient market hypothesis
suggesting that companies should not waste their money on
forecasting services

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Exchange Rate Forecasting

2. The inefficient market school argues that
companies can improve the foreign exchange
markets estimate of future exchange rates by
investing in forecasting services
An inefficient market is one in which prices do
not reflect all available information
in an inefficient market, forward exchange
rates will not be the best possible predictors
of future spot exchange rates and it may be
worthwhile for international businesses to
invest in forecasting services
However, the track record of forecasting services
is not good
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Approaches to
Forecasting
Question: How are exchange rates predicted?
There are two approaches to exchange rate
forecasting:
1.Fundamental analysis draws upon economic
factors like interest rates, monetary policy,
inflation rates, or balance of payments information
to predict exchange rates
2.Technical analysis charts trends with the
assumption that past trends and waves are
reasonable predictors of future trends and waves

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Currencies Convertibility
Question: Are all currencies freely
convertible?
A currency is freely convertible when a government
of a country allows both residents and non-residents to
purchase unlimited amounts of foreign currency with
the domestic currency
A currency is externally convertible when nonresidents can convert their holdings of domestic
currency into a foreign currency, but when the ability of
residents to convert currency is limited in some way
A currency is nonconvertible when both residents
and non-residents are prohibited from converting their
holdings of domestic currency into a foreign currency
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Currencies Convertibility
Most countries today practice free
convertibility, although many countries
impose some restrictions on the amount of
money that can be converted
Countries limit convertibility to preserve
foreign exchange reserves and prevent
capital flight - when residents and
nonresidents rush to convert their holdings of
domestic currency into a foreign currency
When a countrys currency is nonconvertible,
firms may turn to countertrade - barter like
agreements by which goods and services can
be traded for other goods and services
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Chapter 9 (Part 2)

The
International
Monetary

What is the International

Monetary System?
The international monetary system refers
to the institutional arrangements that
countries adopt to govern exchange rates
A floating exchange rate system exists
when a country allows the foreign exchange
market to determine the relative value of a
currency
Examples - the U.S. dollar, the European Unions
euro, the Japanese yen, and the British pound
A dirty float exists when the value of a currency
is determined by market forces, but with central
bank intervention if it depreciates too rapidly
against an important reference currency
- China adopted this policy in 2005
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What is the International

Monetary System?
A fixed exchange rate system exists when
countries fix their currencies against each
other
countries fix their currencies against each other at
a mutually agreed upon value
prior to the introduction of the euro, some
European Union countries operated with fixed
exchange rates within the context of the
European Monetary System (EMS)

A pegged exchange rate system exists

when a country fixes the value of its currency
relative to a reference currency
Many developing countries have pegged exchange
rates
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Gold Standard
The gold standard refers to a system in which
countries peg currencies to gold and guarantee
their convertibility
the gold standard dates back to ancient times when
gold coins were a medium of exchange, unit of
account, and store of value
payment for imports was made in gold or silver

later, payment was made in paper currency which

was linked to gold at a fixed rate
in the 1880s, most nations followed the gold
standard
$1 = 23.22 grains of fine (pure) gold
under the gold standard one U.S. dollar was defined as
equivalent to 23.22 grains of "fine (pure) gold

The exchange rate between currencies was based

on the gold par value - the amount of a currency
needed to purchase one ounce of gold

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Strength of the Gold

Standard
The great strength of the gold standard was that it
contained a powerful mechanism for achieving
balance-of-trade equilibrium - when the income a
countrys residents earn from its exports is equal to
the money its residents pay for imports
The gold standard worked well from the 1870s until
1914
but, many governments financed their World War I
expenditures by printing money and so, created inflation

People lost confidence in the system

demanded gold for their currency putting pressure on
countries' gold reserves, and forcing them to suspend gold
convertibility

The Gold Standard ended in 1939

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Bretton Woods System

In 1944, representatives from 44 countries
met at Bretton Woods, New Hampshire, to
design a new international monetary system
The goal was to build an enduring economic
order that would facilitate postwar economic
growth

Under the Bretton Woods Agreement

a fixed exchange rate system was established
all currencies were fixed to gold, but only the
U.S. dollar was directly convertible to gold
devaluations could not to be used for
competitive purposes
a country could not devalue its currency by
more than 10% without IMF approval
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What Institutions were

Established at Bretton
Woods?

The Bretton Woods agreement also established two

multinational institutions
1.The International Monetary Fund (IMF) to maintain
order in the international monetary system through a
combination of discipline and flexibility

requiring fixed exchange rates stopped competitive

devaluations and brought stability to the world trade
environment
fixed exchange rates imposed monetary discipline on
countries, limiting price inflation
in cases of fundamental disequilibrium, devaluations were
permitted
the IMF lent foreign currencies to members during short
periods of balance-of-payments deficit, when a rapid
tightening of monetary or fiscal policy would hurt domestic
employment
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What Institutions were

Established at Bretton
Woods?
2. The World Bank to promote general
economic development - also called the
International Bank for Reconstruction
and Development (IBRD)
Countries can borrow from the World Bank in
two ways
1. under the IBRD scheme, money is raised
through bond sales in the international capital
market

borrowers pay a market rate of interest - the bank's

cost of funds plus a margin for expenses.

2. through the International Development Agency,

an arm of the bank created in 1960

IDA loans go only to the poorest countries

10-30

The Collapse of the Fixed

System

Bretton Woods worked well until the late 1960s

The collapse of the Bretton Woods system can be traced
to U.S. macroeconomic policy decisions (1965 to 1968)
It collapsed when huge increases in welfare programs
and the Vietnam War were financed by increasing the
money supply and causing significant inflation
Other countries increased the value of their currencies
relative to the U.S. dollar in response to speculation the
dollar would be devalued
However, because the system relied on an economically
well managed U.S., when the U.S. began to print money,
run high trade deficits, and experience high inflation, the
system was strained to the breaking point the U.S.
dollar came under speculative attack
The Bretton Woods Agreement collapsed in 1973

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Which is Better Fixed

Rates or Floating Rates?
Floating exchange rates provide:
1.Monetary policy autonomy
removing the obligation to maintain exchange
rate parity restores monetary control to a
government

2.Automatic trade balance adjustments

under Bretton Woods, if a country developed a
permanent deficit in its balance of trade that
could not be corrected by domestic policy, the
IMF would have to agree to a currency
devaluation
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Which is Better Fixed

Rates or Floating Rates?
But, a fixed exchange rate system
1.Provides monetary discipline
ensures that governments do not expand
their money supplies at inflationary rates

2.Minimizes speculation
causes uncertainty

3.Reduces uncertainty
promotes growth of international trade
and investment
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Exchange Rate Regimes

in Practice
Currently, there are several different
exchange rate regimes in practice
In 2006:
14% of IMF members follow a free float policy
26% of IMF members follow a managed float
system
28% of IMF members have no legal tender of
their own
the remaining countries use less flexible
systems such as pegged arrangements, or
adjustable pegs
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Exchange Rate Regimes in

Practice
Exchange Rate Policies, IMF Members, 2006

10-35

Pegged Exchange Rate

System
A country following a pegged
exchange rate system, pegs the
value of its currency to that of another
major currency
popular among the worlds smaller
nations
adopting a pegged exchange rate
regime can moderate inflationary
pressures in a country
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Currency Board
Countries using a currency board commit
to converting their domestic currency on
demand into another currency at a fixed
exchange rate
the currency board holds reserves of foreign
currency equal at the fixed exchange rate to
at least 100% of the domestic currency
issued
the currency board can issue additional
domestic notes and coins only when there
are foreign exchange reserves to back them
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