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Lecture 10

Foreign Exchange Market

Outline
A. B. C. D. E. F.

Foreign Exchange Market and Its Functions The Nature of Foreign Exchange Market Exchange Rate Determination Exchange Rate Forecasting Convertibility and Government Policy Managerial Implications

A. Foreign Exchange Market and Its Functions


People in different countries make economic transactions in different monies ($,, ,,, ), requiring conversion from one type of money (currency) to another whenever economic transactions crosses international borders. Foreign Exchange is the termed as the currency of another country that is needed to carry out international transactions. Foreign exchange market (FOREX) is the market where currencies are exchanged.
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A. Foreign Exchange Market and Its Functions


Foreign exchange market


A market for converting the currency of one country into the currency of another. Its a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems

Exchange rate
 

Price determined in the FOREX market is the exchange rate. Its the rate at which one currency is converted into another The risk that arises from changes in exchange rates
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Foreign exchange risk




Most traded currencies


Rank 1 2 3 4 5 6 7 8-9 8-9 10 11 12 13 14 Currency United States dollar Euro Japanese yen Pound sterling Swiss franc Australian dollar Canadian dollar Swedish krona Hong Kong dollar Norwegian krone New Zealand dollar Mexican peso Singapore dollar South Korean won ISO 4217 code (Symbol) USD ($) EUR () JPY () GBP () CHF (Fr) AUD ($) CAD ($) SEK (kr) HKD ($) NOK (kr) NZD ($) MXN ($) SGD ($) KRW ( ) Other Total % daily share (April 2007) 86.3% 37.0% 17.0% 15.0% 6.8% 6.7% 4.2% 2.8% 2.8% 2.2% 1.9% 1.3% 1.2% 1.1% 14.5% 200%
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Source: Triennial Central Bank Survey (December 2007), BIS

A. Foreign Exchange Market and Its Functions


The foreign exchange market serves two functions


Currency conversion Conversion: companies receive payment in foreign currencies and they have to convert these payments to their home currency Payments: companies pay foreign businesses for goods or services Investments: companies invest spare cash for short terms in money market accounts Currency Speculation: companies take advantage of changing exchange rates
 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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A. Foreign Exchange Market and Its Functions


Insuring against foreign exchange risk


To understand how the foreign exchange market provides insurance to protect against foreign exchange risk we need to understand
Spot exchange rate Forward exchange rate Currency swap

A. Foreign Exchange Market and Its Functions


Spot exchange rate
 

The rate of currency exchange on a particular day Example:


When a HK tourist in London goes to a bank to convert HK$ into , the exchange rate is the spot rate for that day.

Spot exchange rate is determined through the interaction of relative demand and supply of that currency compared to others (discussed later).

A. Foreign Exchange Market and Its Functions


Forward exchange rate
 

forward exchange rates are the exchange rates governing future transactions such as when two parties agree to exchange currencies and execute the deal at some specific future date. Example: Suppose a US firm imports PCs (at 200,000 each) from Japanese supplier and can sell them immediately at $2000 in US. The firm needs to pay the Japanese supplier in in 30 days when the shipment arrives.
Suppose current spot exchange rate $1 = 120
 If it buys now to pay after 30 days, then costs are $1,667 (200,000/ 120) - spot transaction  But it does not have the money to pay the supplier until it can sell the computer

Suppose it expects the future spot rate after 30 days to be $1 = 95


 Then if it waits till it sells the computer, it expects to pay 200,000 or $2,105 (200,000/ 95) to the Japanese supplier after 30 days (future spot transaction)

Suppose the 30-day forward exchange rate is $1 = 110


 If it enters into a 30-day forward transaction at $1 = 110  Needs to pay 200,000 or $1,818 (200,000 /110) to a Japanese supplier after 30 days
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A. Foreign Exchange Market and Its Functions


Currency swap
  

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Moving out of one currency into another for a limited period without incurring foreign exchange risk. Common example of Swap: spot against forward
Spot exchange rate: $1 = 120 90-day forward exchange: $1 = 110 Convert $1 and get 120 now at spot rate ($1 = 120). Convert 120 and get $1.09 at forward rate ($1 = 110) 90 days from now Profit after 90 days: $1.09 - $1= $0.09!
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A Currency Swap Illustration


Swiss national comes to HK on a one-year job contract and wants to live in the convenient company apartment. Company gives her two options:
 

Rent the apartment for HK$400,000/year, OR Buy the apartment for HK$5m and then resell to company for $5m after a year.

Suppose interest rate on a 1 year $5m loan in HK = 10% p.a. If she takes the loan, interest cost = 10% of $5m = $500,000 > rent Suppose interest rate in Switzerland on loan is 5%


Assume current spot exchange rate is 1CHF = 5HKD. Then, borrow CHF1m (= $5m) and pay interest cost = 5% of CHF1m = CHF 50,000 = $250,000 < rent

=> Borrow money in Swiss Francs (CHF)!! But what about future exchange or currency risk?



SUPPOSE future spot rate after one year is 1CHF = 5.2HKD. Then after one year need to pay CHF 1.05m =$5.46m. So need to pay extra ($5.46m-$5m) = $460,000 which is > rent! (Too much of currency risk!!)

Suppose one year forward exchange rate is 1CHF = 5.1HKD.




Then take loan in Swiss Francs and enter into a CURRENCY SWAP
Convert CHF 1m into $5m spot transaction (at 1CHF = 5HKD) Make forward transaction of converting $5.355m into CHF 1.05m (at 1CHF = 5.1 HKD) one year from now

=> Net cost of owning apartment = $355,000 < RENT

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A. Foreign Exchange Market: Turnover

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A. Foreign Exchange Market: Composition of Turnover

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A. Foreign Exchange Market: Turnover by Currency Pair

Source: Triennial Central Bank Survey (2007)

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B. The Nature of Foreign Exchange Market


It is a 24/7 market because major financial institutions have offices all around the world


Example: Tokyo, London and New York exchange markets are all shut for only 3 hours out of every 24 hours.

Daily traded volumes are HUGE: $3.2 trillion in 2007 (25 times greater than volume of trade!) Londons dominance as a foreign exchange market is explained by:
 

History (capital of the first major industrialized nation). Geography (between Tokyo/Singapore and New York).

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B. The Nature of Foreign Exchange Market


Foreign exchange market is an integrated and connected electronic network, such that one virtual market is created


A global network of banks, brokers and foreign exchange dealers connected by electronic communications systems

Foreign exchange dealers Connected by electronic communications systems

Banks

Brokers
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B. The Nature of Foreign Exchange Market


Important role of US dollars in foreign exchange markets


US dollar is considered as the primary currency in exchange markets


Example: A dealer wishes to sell Korean won for Brazilian real will usually sell the won for US dollars and then use the dollars to buy real

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B. Factors Influencing Currency Value


Economic Factors
       

Inflation Interest Rates Monetary and Fiscal Policy Balance of Payments International Competitiveness Monetary Reserves Government Controls and Incentives Importance of Currency in World

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B. Factors Influencing Currency Value


Political Factors
 

Current Political Policies and Philosophies Uncertainty in Political Climate

Other Factors
 

Asset Market Models (Expectations) Forward Exchange Market Prices

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C. Exchange Rate Determination


Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another.


Demand for a currency represents foreign residents need for that currency to complete intended transactions (buy goods or financial assets)
E.g. Japanese demand Euros () in order to buy German goods.

Supply for a currency represents domestic residents need for foreign currency to complete intended transactions with a foreign country
E.g. German demand Yen () when they want to buy Japanese goods. They need to sell in order to buy .
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C. Exchange Rate Determination


Determination of freely floating exchange rates
P
per one

Market for Euros ()


S

What causes shift in demand for Euros? Change in taste, e.g. Japanese want more German goods. Changes in relative national incomes, e.g. Japanese incomes rise, causing an increase in demand for German goods.

150 140 e*

e**

D/ D

Changes in relative return on financial assets, e.g. German bonds earn more than Japanese bonds. Similar reasons for supply changes.
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60

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Quantity of (billions)

C. Exchange Rate Determination: Currency Appreciation and Depreciation


Currency Appreciation


When a currency becomes more valuable its price in terms of other currency increases, i.e. more of the other currency is needed to buy one unit of this currency and the currency is said to have appreciated. When a currency becomes less valuable its price in terms of other currency decreases, i.e. less of the other currency is needed to buy one unit of this currency and the currency is said to have depreciated.

Currency Depreciation


Note: For any currency combination, if one currency appreciates in terms of the other then the other must necessarily depreciate and vice versa.

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C. Exchange Rate Determination


Prices are related to exchange rate movements in terms of:
  

The Law of One Price Purchasing Power Parity (PPP) Theory Money supply and price inflation International Fisher Effect determines the relationship between interest rates and exchange rates Exchange rate can be affected by investor psychology and Bandwagon effects
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Interest Rate and Exchange Rate




Investor Psychology


C. Exchange Rate Determination: Law of One Price


In competitive markets where
 

transportation costs are assumed to negligible there are no trade barriers

Identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example: 1 = $1.50. A jacket selling for $75 in New York should sell for 50 in London ($75/1.50) If the jacket costs 40 in London Convert $60 to get 40 and buy a jacket in London. Sell it in New York for $75 => Profit of $15 per jacket (arbitrage) Increased demand in London would raise their price Increased supply in New York would lower their price This will continue until prices are equalized: e.g. 44 in London and $66 in New York (at 1 = $1.50)

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C. Exchange Rate Determination: Purchasing Power Parity (PPP) Theory


By comparing the prices of identical products in different currencies Possible to determine the real or PPP exchange rate if law of one price was true for all goods and services

Implication of PPP
 In relatively efficient markets (few impediments to trade and

investment), a basket of goods in different countries should cost roughly equivalent  If a basket of goods costs $200 in US and 20,000 in Japan PPP theory predicts that the $/ exchange rate should be $200/ 20,000 or $0.01/ (or $1 = 100) 25

C. Exchange Rate Determination: Purchasing Power Parity (PPP) Theory


PPP Theory postulates that changes in relative prices will result in a change in exchange rates


A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate Example:
A basket of goods costs $200 in US and 20,000 in Japan => $1 = 100 by PPP No price inflation in US but 10% in Japan => the basket of good in Japan will cost 22,000 in future. If there is no change in future exchange rate then PP is violated. => $1 = 110 in future, i.e. has depreciated by 10% against $
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Exchange Rate Determination: Purchasing Power Parity (PPP) Theory


In real life we see evidence of departure from the predictions of PPP theory, the reasons for which maybe:
 

Transportation costs and trade restrictions (including non-tradable goods) Menu costs
costs to firms of updating menus, price lists, brochures, and other materials when prices change in an economy leading to sticky prices

 

Goods may not be perfect substitutes Other factors, such as real interest rates, etc., may dominate in the short-run
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Non-Tradables? Haircuts as Tradables (Source: Greg Mankiws Blog)


Economists often use haircuts as a prototypical nontradable good. But maybe we need to find a new example:
The

financial crisis has hit Eastern Europe particularly hard, leading to strong depreciation pressure on exchange rates. As a result, traditional non-tradable goods have suddenly become tradable. The Polish village of Osinow Dolny at the PolishGerman border has approx. 200 inhabitants, 100 of which are active hairdressers. Germans come from as far as Berlin (70 km) to take advantage of the zloty exchange rate, which went from 3.30 per euro in the summer of 2008 to well over 4 now. "Salon Teresa" at the end of main street charges 9 euros for ladies and 4 for men.

Illustrates the forces that tend to push exchange rates toward purchasing-power parity.

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Menu Costs, Defeated


(Source: http://gregmankiw.blogspot.com/2009/03/menucosts-defeated.html)

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C. Exchange Rate Determination: Money Supply and Price Inflation


Inflation occurs when:


money supply increases faster than output increases a country with a high inflation rate will see depreciation in its currency exchange rate the relative demand and supply conditions in foreign exchange market
The dollar will depreciate against currencies of countries with slower monetary growth
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PPP Theory tells us that:




Increase in a countrys money supply changes:




C. Exchange Rate Determination: Interest Rates and Exchange Rates


Some theories show that interest rates reflect expectations about future exchange rates Fisher Effect states that:
 

nominal interest rate (i) is the sum of real interest rate (r) and expected rate of inflation (I) i = r + I real interest rates in different countries are equalized
Example:

If r in US = 10% and r in Switzerland = 6%, investors would borrow money from Switzerland and put it in US (I) Demand for money in Switzerland interest rate in Switzerland (II) Supply of money in US interest rate in US Real interest rates in US and Switzerland are equalized
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C. Exchange Rate Determination: Interest Rates and Exchange Rates


PPP Theory provides linkage between inflation and exchange rates Fisher Theory provides link between interest rates and inflation => PPP + Fisher Theory = International Fisher Theory provides a link between interest rates and exchange rates


Since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates

International Fisher Effect: Linkage between interest rates and exchange rates
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C. Exchange Rate Determination: Interest Rates and Exchange Rates


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 the two countries

The relationship between the changes in spot exchnage rate and nominal interest rates between any two countries/economic unions (e.g. US and EU) can be charaterized as : S1  S 2 v100 ! i$  i S2 where, S1 and S2 are the spot exchange rates at the beginning of the period and the end of the period respectively and i $ and i are the respective nominal interest rates in US and EU.
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C. Exchange Rate Determination: International Fisher Effect


International Fisher Effect Example:


Suppose the nominal interest rate is 10% in US and 6% in Japan


Greater expected inflation rates in US

 

Suppose the current spot exchange rate is 1$ = 100 Then the spot exchange rate in the future between dollar and yen should be:
(100 S2) / S2 = (10 6)/100 => 100 (100 - S2) = 4 S2 => 104 S2 = 10000 => => S2 = 10000/104 96 in future we expect $ to depreciate by 4% against
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C. Exchange Rate Determination: International Fisher Effect


International Fisher Effect Example:


Alternatively, by Fisher effect we get


For US: 10 = r$ + I$ For Japan: 6 = r + I => r$ = 10 - I$ => r = 6 - I

Since real interest rate must be the same in all countries, hence r$ = r
=> 10 - I$ = 6 - I => I$ - I = 4

US should expect a inflation rate 4% higher than Japan. But according to PPP theory a country with a 4% higher relative inflation rate should expect a 4% depreciation in its currency.
Therefore we should expect a 4% depreciation in $ with respect to
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C. Exchange Rate Determination: Investor Psychology and Bandwagon Effects


Evidence suggests that neither PPP Theory nor International Fisher Effect are good at explaining short term movements in exchange rates Possible explanations are:

Investor Psychology The Bandwagon Effects

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C. Exchange Rate Determination: Investor Psychology and Bandwagon Effects


Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join the bandwagon and move exchange rate based on group expectations Example:


Investors moved in a herd in response to a bet placed by George Soros who shorted the British pounds and bought German marks

It is hard to predict investor psychology and bandwagon effect Sometimes, government intervention can prevent the bandwagon from starting,


but at other times it is ineffective and only encourages traders to further speculate

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C. Exchange Rate Determination: Other Factors


Other factors


Asset Market Model


Increasingly, the proportion of foreign exchange transactions due to trading of currency based financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market.

Balance of Payments Model


Trade deficit will reduce a nations Forex reserves which ultimately depreciates the value of its currency. The cheaper currency gives a price advantage to the countrys exports and disadvantage to imports. Therefore future imports fall and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

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D. Exchange Rate Forecasting: Efficient Markets


Efficient market hypothesis: prices in markets reflect all available public information.


If FOREX markets are efficient then forward exchange rates will be unbiased predictors of future spot rates.

Traditionally, economics and finance theories have assumed that FOREX markets are efficient, but recent studies relying on empirical evidence on markets have challenged that assumption.
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D. Exchange Rate Forecasting: Inefficient Markets


Inefficient market hypothesis: prices do not reflect all available information.


In this case forward exchange rates are not unbiased predictors of future spot rates and hence estimates of future spot rates based on forward rates can be improved. But how? Two schools of thought: Fundamental Analysis
 Use economic theory to construct sophisticated econometric models for predicting exchange rate movement.

Technical Analysis
 Use technical (price/volume data) analysis to predict the exchange rates. 

Analysis suggests that professional forecasters are no better than forward exchange rates in predicting future spot rates.
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E. Convertibility and Government Policy


A currency is said to be:
Freely convertible E.g. US currency
The government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency

Non-residents can convert their holdings of domestic currency into a foreign currency, but the ability of residents to convert currency is limited in some way

Externally convertible E.g. Russian currency

Non-convertible E.g. African currency

Both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
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E. Convertibility and Government Policy


Free convertibility is the norm in the world today


although many countries impose some restrictions on the amount of money that can be converted Preserve foreign exchange reserves
Service international debt. Purchase imports.

The main reason to limit convertibility is to:




Prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency) a range of barter-like agreements by which goods and services can be traded for other goods and services It is used in international trade when a countrys currency is nonconvertible
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Countertrade refers to:


 

F. Managerial Implications
International businesses must understand the influence of exchange rates on the profitability of trade and investment deals Transaction Exposure


The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

Translation Exposure


The impact of currency exchange rate changes on the reported financial statements of a company
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E. Managerial Implications
Economic Exposure


The extent to which a firms future international earning power is affected by changes in exchange rates

If a company wants to know how the value of a particular currency will change over the long term in the foreign exchange market,  it should take a close look at all those economic level fundamentals that appear to predict long run exchange rate movements  Example: The growth in a countrys money supply, its inflation rate and nominal interest rates When governments restrict currency convertibility, firms must find ways to facilitate international trade and investment

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