Transcript Foreign exchange

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:
Buys
USD
CAD
JPY
USA
USD
1
1.25
100
Canada
CAD
0.8
1
100
Japan
JPY
0.01
0.01
1
 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
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
• 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?
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 (NONRESIDENTS) 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
Account + Current Transfers (Unilateral Transfers)
• What goes in the C& FA ?
Records international borrowing, lending, purchases, and sales of
assets:
* Direct investments
* Portfolio investment
* Other investments
•
What goes in the Balance of official settlements?
• Monetary gold (gold reserves)
•Special drawing rights (SDR)
•Reserve position in IMF (local currency, gold, others)
•Foreign exchange ( foreign currency reserves)
Note: { CA balance + CFA balance + Official
settlements balance + Statistical discrepancy = 0}
Example . Kuwait exports $ 500 mn. of oil to be paid for in three
months.
•
Note the following:
– Exports of oil are entered as credits (lead to receipts of payments
from foreigners)
– The payment itself is entered as a capital outflow (debit), why?
When Kuwait agrees to wait for three months for payments, it
extends a credit to foreign importers (capital outflows). This is an
increase in domestic assets abroad (i.e. a debit)
(+) Credit
OIL EXPORTS
CAPITAL OUTFLOWS (an increase in
Kuwaiti assets abroad)
(-) Debit
500
500
VI. Purchasing Power Parity Theory (PPP)
(1) The Law of One Price (LOOP)
•
the same good (x) in different competitive markets must sell
for the same price in the absence of transportation costs and
trade barriers between these markets i.e.,
Px= (S) . (P*x)
(2) Absolute PPP:
•
Is the application of the law of one price across countries for
all goods and services, or for representative groups (baskets)
of goods and services:
P = (S) . (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
price, so that the purchasing power of the two currencies is at
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 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
•
Change in the exchange rate should be proportional to the
relative change in the price levels (inflation) in the two nations
over the same period.
S1 = ((p1/p0)/(p*1/p*0)).S0
•
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)]