Foreign Exchange

PowerPoint slides prepared b

Andreea Chiritescu
Eastern Illinois University
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for
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classroom use

Foreign-Exchange Market
Foreign-exchange market
Organizational setting
Within which individuals, businesses,
governments, and banks
Buy and sell foreign currencies and other
debt instruments

Largest and most liquid market in the

world
Dominated by four currencies
U.S. dollar, euro, Japanese yen, British
pound
2011 Cengage Learning.
All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
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Foreign-Exchange Market
Foreign-exchange market
Transactions between commercial
banks and their commercial
customers
Domestic interbank market conducted
through brokers
Active trading in foreign exchange
with banks overseas
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Reading Foreign-Exchange
Quotations
Exchange rate
Price of one currency in terms of another
Number of units of foreign currency
required to purchase one unit of domestic
currency
Is determined where demand for the
currency equals its supply

Currency depreciation
It takes more units of a nations currency
to purchase a unit of some foreign
currency

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected
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Reading Foreign-Exchange
Quotations

Currency appreciation

It takes fewer units of a nations currency

to purchase a unit of some foreign
currency

Cross exchange rate

Exchange rate between any two
currencies (such as the franc and the
pound)
Derived from the rates of these two
currencies in terms of a third currency
(the dollar)

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Exchange-Rate Determination
Exchange rate in a free market
Determined by both supply and demand
conditions
Changes in demand and supply cause
fluctuations in exchange rate

Demand for foreign exchange

Derived demand
Driven by foreigner demand for domestic
goods and assets
Corresponds to the debit items on a
countrys balance of payments

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GLOBALIZATI
ON

WEAK DOLLAR IS A BONANZA FOR

EUROPEAN TOURISTS

When dollars exchange value depreciates

Foreign tourists realize a good bargain on
goods purchased in America
Delighted American tourist industry
Tourists could afford to stay longer
Stay at nicer and more expensive hotels
Take more tours
Eat at more restaurants
Shop with bargain-basement enthusiasm.

Air fares to and from the United States

declined

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Exchange-Rate Determination
Supply of foreign exchange
Amount of foreign exchange that will
be offered to the market
At various exchange rates, all other
factors held constant

Equilibrium exchange rate

Determined by the market forces of
supply and demand
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FIGURE
11.1

Exchange-rate determination

The equilibrium exchange rate is established at the point of intersection of the supply
and demand schedules of foreign exchange. The demand for foreign exchange
corresponds to the debit items on a nations balance-of-payments statement; the
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for
use as permitted
in a license
distributed
with a certain product
or credit
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supply
of foreign
exchange
corresponds
to the
website for classroom use

Exchange-Rate Determination
Increase in the demand for pounds
Shift rightward
The dollar will depreciate against the
pound

Decrease in demand for pounds

Shift leftward
The dollar will appreciate

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Exchange-Rate Determination
Increase in the supply of pounds
Rightward shift
The dollar appreciate against the
pound

Decrease in the supply of pounds

Leftward shift
Dollar depreciation

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TABLE 11.6

Advantages and disadvantages of a

strengthening and weakening dollar

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Nominal and Real Exchange Rates

Nominal exchange-rate index of the
U.S. dollar
Average value of the dollar
Not adjusted for changes in prices levels
In the U.S. and its trading partners

if increasing
Dollar appreciation relative to the
currencies of the other nations in the
index
Loss of competitiveness for the U.S.
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Nominal and Real Exchange Rates

Nominal exchange-rate index of the
U.S. dollar
If decreasing
Dollar depreciation relative to the other
currencies in the index
Improvement in U.S. international
competitiveness

Based on nominal exchange rates

that do not reflect changes in price
levels in trading partners
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Nominal and Real Exchange Rates

Real exchange-rate index of the U.S.
dollar
Embodies the changes in prices in the
countries in the calculation
Nominal exchange rate adjusted for
relative price levels
Average value of the dollar based on
real exchange rates
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Arbitrage
Exchange arbitrage
Simultaneous purchase and sale of a
currency
In different foreign-exchange markets
To profit from exchange-rate differentials
in the two locations

Brings about an identical price for the

same currency in different locations
Results in one market
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Foreign-Exchange Market
Speculation

Speculation

Attempt to profit by trading on

expectations about prices in the future
Deliberate assumption of exchange risk

Stabilizing speculation
Goes against market forces by
moderating or reversing a rise or fall in a
currencys exchange rate
Useful function for bankers and
businesspeople, who desire stable
exchange rates

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Foreign-Exchange Market
Speculation
Destabilizing speculation
Goes with market forces by
reinforcing fluctuations in a currencys
exchange rate
Can disrupt international transactions
High cost of hedging impeding
international trade
Disrupt international investment activity

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TRADE
CONFLICTS

How to play the falling (rising) dollar

Depreciating dollar
Purchase foreign currency
Purchase bonds denominated in a
foreign currency
Purchase stocks of foreign
corporations, denominated in foreign
currencies
Savings account denominated in a
foreign currency
Variety of currency derivatives

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A currency might depreciate

because

There is a balance of payments

deficit.
Demand for other currencies rises as
domestic consumers buy more
imports.
Interest rates fall relative to other
countries. People move their savings
to bank accounts overseas.
Inflation rises relative to other
countries.

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A currency might appreciate

because

There is a balance of payments

surplus.
Demand for other currencies falls as
overseas consumers buy more
exports.
Interest rates rise relative to other
countries. This attract savings from
overseas residents.
Inflation is lower relative than in other
countries.

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected
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