Chapter 20 The Foreign Exchange Market Mc Graw-Hill Irwin

Chapter 20 The Foreign Exchange Market Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 20 -1

Learning Objectives • Summarize the fundamental underpinnings of the foreign exchange market. • Explain the distinctions between various measures of the exchange rate. • Differentiate the roles of hedging, arbitrage, and speculation in foreign exchange markets. • Describe the links between the current spot rate and contracts to buy or sell foreign exchange in the future. 20 -2

The Foreign Exchange Rate and the Market for Foreign Exchange • Foreign exchange rate: the price of one currency in terms of another. – e. g. , US$/€ or €/US$ • The foreign exchange rate is determined by the interaction of demand for and supply of foreign exchange. • The foreign exchange market is the worldwide network of markets and institutions that exchange currencies. 20 -3

The Market for Foreign Exchange: Demand • Foreign exchange is demanded by those – wishing to buy goods and services from or send gifts or payments to another country. – wishing to purchase financial assets in another country. – wishing to profit from exchange rate changes (speculation). – wishing to minimize risk from exchange rate changes (hedging). 20 -4

The Market for Foreign Exchange: Supply • Foreign exchange is supplied by those – selling goods and services to or receiving gifts or payments from another country. – in other countries who wish to purchase financial assets in the home country. – wishing to profit from exchange rate changes (speculation). – wishing to minimize risk from exchange rate changes (hedging). 20 -5

The Market for Foreign Exchange S€ $/€ Initially, Qeq euros are traded, and the equilibrium price is eeq D€ Qeq Euros (€) 20 -6

The Market for Foreign Exchange S€ $/€ An increase in U. S. demand for euros causes an appreciation of the euro. e'eq eeq D€ Qeq Q'eq D'€ Euros (€) 20 -7

The Market for Foreign Exchange S€ S'€ $/€ An increase in the supply of euros causes a depreciation of the euro. eeq e'eq D€ Qeq Q'eq Euros (€) 20 -8

The Market for Foreign Exchange: Supply • The total supply and demand foreign exchange includes two components. – One is related to current account transaction. – The other is related to financial flows, including speculation and hedging. 20 -9

The Market for Foreign Exchange SG&S STotal $/€ The total equilibrium exchange rate will only be the same as the one for G&S if the current account is exactly in balance. eeq DG&S Qeq DTotal Euros (€) 20 -10

The Spot Market • The spot market is the daily or current market foreign exchange. • The main participants are large commercial banks trading with each other in the interbank market. • There are many foreign exchange markets, but they all tend to generate the same exchange rate regardless of location. – This is the result of arbitrage. 20 -11

Arbitrage • Arbitrage occurs when individuals see an opportunity to buy something at a low price in one market, then sell it for a higher price in a second market. • This causes prices in all markets to move towards each other. • Arbitrage causes currency prices to be similar across markets, and makes cross rates between currencies consistent. 20 -12

Different Measures of the Spot Rate • How can we measure a country’s overall exchange rate (not just a bilateral rate)? – – Nominal effective exchange rate (NEER) Real exchange rate (RER) Real effective exchange rate (REER) Purchasing power parity (absolute and relative) 20 -13

Different Measures of the Spot Rate: NEER • The NEER is an index that measures the change over time in the nominal value of a country’s currency. • The nominal effective exchange rate weights the exchange rates of each of a country’s trading partners by the volume of trade with each. • NEER is a weighted average of a currency’s exchange rate against a bundle of other currencies. 20 -14

Different Measures of the Spot Rate: RER • However, prices in the two countries may not be constant. • Suppose the dollar appreciates against the euro by 10%, but at the same time U. S. prices rose by more than European prices. – The decline in U. S. competitiveness is more than 10%. • RER=e€/$(price index. US/price index. Eur). 20 -15

Different Measures of the Spot Rate: REER • The REER is an index that measures the change over time in the real value of a country’s currency. • The real effective exchange rate weights the real exchange rates of each of a country’s trading partners by the volume of trade with each. • REER is a weighted average of a currency’s real exchange rate against a bundle of other currencies. 20 -16

Absolute Purchasing Power Parity • In principle, a commodity should have the same price worldwide when measured in a common currency, due to arbitrage. • PPPabs = price level. US/price level. Eur • If cotton costs $0. 5 per pound in the U. S. , and € 0. 35 per pound in Europe, the exchange rate should be $1. 43/€. • However, transportation costs and other differences means absolute PPP doesn’t generally occur. 20 -17

Relative Purchasing Power Parity • Relative PPP takes into account differences in price indexes • PPPrel$/€ = (e $/€)x(PIUS/PIEur). • Relative PPP relates the change in the exchange rate to changes in the two countries’ price levels. 20 -18

The Law of One Price • Under the assumption of no transportation costs and of competitive markets, the “law of one price” states that market exchange rates should, in the long run, equalize the price of traded good in two countries when the prices are expressed in the same currency. • In other words, market exchange rates should converge to the PPP exchange rate between standardized baskets of traded goods. 20 -19

The Law of One Price To better understand the law of one price: - A particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is the following: 1 USD=1. 50 CAD. - If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. - If this process (called “arbitrage”) is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. - This process continues until the goods have again the same price. 20 -20

• But are the market exchange rates equal to their equilibrium value? • No. Market exchange rate movements in the short term are news- and speculation- driven. • In other words, market exchange rates fluctuate daily, often by a large amount. • For instance, the India Rupee might appreciate relative to the USD by 10% in a given week due to speculation. • Shall we then conclude that the average Indian resident had become 10% richer relative to the average American, even though the amount of output produced in the two countries had not changed? 20 -21

• We can’t rely on market exchange rates since they are not (or rarely) equal to their equilibrium value. • Why not rely directly on their equilibrium value then? • This can be done by computing the PPP exchange rate between the price in local currency of a standardized basket composed of traded good across different countries. • This “equilibrium” exchange rate will ensure that the price of this standardized basket is the same in each country when expressed in the same currency 20 -22

Big Mac Index • The Economist introduced in 1986 the PPP exchange rates between the prices in local currency of a standardized basket composed of one Big Mac, a “traded” good which is produced in about 120 countries. • This is the Big Mac index. • A comparison between the Big Max index and the market exchange rate of each country provides a test of the extent to which the currency of this country is over- or under- valued against a currency of reference. 20 -23

Big Mac Index 20 -24

The Forward Market • Most exchanges of currencies takes place two business days after the contract has been completed. • In general, forward exchange rates can be for any period of time into the future. • Suppose a U. S. company agrees to buy 5 trucks from a French company at a price of € 50, 000 each, with delivery in 6 months, the equivalent of $70, 000 at today’s spot exchange rate of $1. 4/€. 20 -25

The Forward Market • What if the euro appreciates to $1. 6/€? – Now the price in dollars has risen to $80, 000. • There are ways to hedge against this potential risk. – The buyer and seller can agree to make the sale at today’s forward exchange rate. – The buyer can purchase a foreign currency option – this gives the buyer the right to a specific exchange rate at a specific time in the future. 20 -26

The Link Between the Foreign Exchange and the Financial Markets • The decision to invest internationally depends on the expected rate of return on the international asset relative to domestic alternatives. • Specifically, investors consider – The domestic interest rate or expected rate of return. – The foreign interest rate or expected rate of return. – Any expected changes in exchange rates. 20 -27

The Link Between the Foreign Exchange and the Financial Markets • An investor would be indifferent between a $1 domestic or foreign investment if her expected return is the same after accounting for expected changes in the spot rate. • Let i. NY = 90 -day interest rate in New York. • Let i. Paris = 90 -day interest rate in Paris. • Let E(e) = the expected spot rate in 90 days. 20 -28

The Link Between the Foreign Exchange and the Financial Markets • An investor would be indifferent if $1(1+i. NY) =[($1)/(e)]x(1+i. Paris)[E(e)], or (1+i. NY)/(1+i. Paris)=E(e)/e. • This can be approximated as (i. NY – i. Paris) ≈ xa, where xa is the expected appreciation of the foreign currency. 20 -29

The Link Between the Foreign Exchange and the Financial Markets • This is called uncovered interest parity (UIP). • If (i. NY – i. Paris) > xa, investments in the U. S. will be more attractive to investors and investment funds would flow into the U. S. • If (i. NY – i. Paris) < xa, investments in France will be more attractive to investors and investment funds would flow into France. 20 -30

The Link Between the Foreign Exchange and the Financial Markets • Naturally, individuals don’t have perfect foresight. • Since expectations can be wrong, there may be an additional premium required to undertake the risk: (i. NY – i. Paris) ≈ xa – RP • If the risk premium is 1%, the gap between the interest rates must be higher for investors to be indifferent. 20 -31

The Link Between the Foreign Exchange and the Financial Markets • So far, we’ve assumed any exchange rate risk is borne by the investor. • In fact, the risk can be hedged in the forward market. • The relationship between the spot and forward rates is usually stated as p = [efwd/e] – 1, where efwd is the forward exchange rate and p is the premium (or discount). 20 -32

The Link Between the Foreign Exchange and the Financial Markets • If the forward market exchange rate is $1. 72/€ and the spot market rate is $1. 70/€, • p = [1. 72/1. 70] – 1 = 1. 2%. • That is, there is a 1. 2% premium on the foreign currency. 20 -33

The Link Between the Foreign Exchange and the Financial Markets • An investor would be approximately indifferent if (i. NY – i. Paris) ≈ p, where p is the percentage premium. • We can also include transactions costs: (i. NY – i. Paris) ≈ p ± transactions costs • This is called covered interest parity (CIP). 20 -34

Simultaneous Adjustments of the Foreign Exchange and Financial Mkts • What happens if (i. NY – i. Paris) > p ± transactions costs? • Investment funds should move from Paris to New York, decreasing the supply of loanable funds in Paris. • This should put upward pressure on interest rates in Paris. 20 -35

International Financial and Exchange Rate Adjustments i. Paris i'P S'€ S€ Paris money market i. P D€ € 20 -36

International Financial and Exchange Rate Adjustments • The conversion of euros into dollars in the spot market increases the supply of euros, thereby putting downward pressure on the euro spot rate (that is, causing the dollar to appreciate). 20 -37

International Financial and Exchange Rate Adjustments S€ e$/€ S'€ e 0 Spot market e' D€ € 20 -38

International Financial and Exchange Rate Adjustments • Investors wish to cover themselves against exchange rate changes will now purchase euros in the forward market. • This will put upward pressure on the euro forward rate. 20 -39

International Financial and Exchange Rate Adjustments e$/€fwd efwd' St€ Forward market efwd Dt€ Dt'€ € 20 -40

International Financial and Exchange Rate Adjustments • When the new funds move to New York, supply of loanable funds increases there. • This will put downward pressure on i. NY. 20 -41

International Financial and Exchange Rate Adjustments i. NY S$ S‘$ N. Y. money market i. NY' D$ $ 20 -42

International Financial and Exchange Rate Adjustments • All of these adjustments work toward reducing the initial inequality. • Eventually, (i. NY – i. Paris) = p ± transactions costs. 20 -43