International Macroeconomics

- Chapter 2: Foreign exchange market

and exchange rates -

Dr. Yvonne Sperlich

Geneva School of Economics
and Management (GSEM)
University of Geneva

Spring semester 2020

1
Slides based on Feenstra/Tayler 2011
Content of chapter

• Exchange Rate Essentials

• Exchange Rates in Practice
• The Market for Foreign Exchange
• Arbitrage and Spot Exchange Rates
• Arbitrage and Interest Rates
• Conclusions

© 2014 Worth Publishers 2

International Economics, 3e | Feenstra/Taylor
Why exchange rates matter?

 Exchange rates affect large flows of international trade by

influencing the prices in different currencies.

 Foreign exchange also facilitates massive flows of

international investment, which include direct investments
as well as stock and bond trades.

 In the foreign exchange market, trillions of dollars are

traded each day and the economic implications of shifts in
the market can be dramatic.

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In this chapter, we begin to study the nature and
impact of activity in the foreign exchange market.
The topics we cover include:
=> exchange rate basics,
=> basic facts about exchange rate behavior,
=> foreign exchange market, and
two key market mechanisms: arbitrage and
expectations

4
1. Exchange rate - Basics

An exchange rate (E) is the price of some foreign currency

expressed in terms of a home (or domestic) currency.

Because an exchange rate is the relative price of two

currencies, it may be quoted in either of two ways:
->The number of home currency units that can be exchanged
for one unit of foreign currency.
->The number of foreign currency units that can be exchanged
for one unit of home currency.

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Definition:
To avoid confusion, we must specify which country is the
home country and which is foreign.
When we refer to a particular country’s exchange rate, we
will quote it in terms of units of home currency per units of
foreign currency.

For example, Denmark’s exchange rate with the Eurozone is

quoted as Danish krone per euro (or kr/€).

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Exchange Rate Quotations This table shows major exchange rates as they might
appear in the financial media. Columns (1) to (3) show rates on December 31, 2012.
For comparison, columns (4) to (6) show rates on December 31, 2011. For example,
column (1) shows that at the end of 2012, one U.S. dollar was worth 0.996
Canadian dollars, 5.659 Danish krone, 0.759 euros, and so on. The euro-dollar rates
appear in bold type.

??
Appreciations and Depreciations

 If one currency buys more of another currency, we

say it has experienced an appreciation—its value
has risen, appreciated, or strengthened.

 If a currency buys less of another currency, we say

it has experienced a depreciation—its value has
fallen, depreciated, or weakened.

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In U.S. terms, the following holds true:

 When the U.S. exchange rate E$/€ rises, more dollars are needed
to buy one euro. The price of one euro goes up in dollar terms,
and the U.S. dollar experiences a depreciation (see E$/€=1.298->
1.318).

 When the U.S. exchange rate E$/€ falls, fewer dollars are needed
to buy one euro. The price of one euro goes down in dollar terms,
and the U.S. dollar experiences an appreciation

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To determine the size of an appreciation or depreciation, we
compute the proportional change, as follows (expressed in
American terms E$/€ rises):

In 2011, at time t, the dollar value of the euro was

E$/€,t = $1.298.

In 2012, at time t + 1, the dollar value of the euro was

E$/€,t+1 = $1.318. (E$/€=1/E€/$=> 1.318=1/0.759)

The change in the dollar value of the euro was

Δ E$/€,t = 1.318 − 1.298 = + $0.020.

The percentage change was

Δ E$/€,t/E$/€,t = +0.020/1.298 = +1.54%.

Thus, the euro appreciated against the dollar by 1.54%. 10

Similarly, over the same year (expressed in European terms: E€/$
falls):

In 2011, at time t, the euro value of the dollar was

E€ /$,t = €0.770.

In 2012, at time t + 1, the euro value of the dollar was

E€ /$,t+1 = €0.759.

The change in the dollar value of the euro was

ΔE€ /$,t = 0.759 − 0.770 = −€0.011.

The percentage change was

ΔE€/$,t / E€/$,t = −0.011/0.770 = −1.43%.

Thus, the dollar depreciated against the euro by 1.43%. 11

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??
Multilateral exchange rates
We calculate multilateral exchange rate changes for baskets of
currencies using trade weights to construct an average of all
bilateral changes. The resulting measure is called the change in the
effective exchange rate. For example:

Suppose 40% of Home trade share with country I and 60% is with
country II. Home’s currency appreciates 10% against I but
depreciates 30% against II.

To find the change in Home’s effective exchange rate by multiply

each exchange rate change by the trade share and sum up:
(−10% • 40%) + (30% • 60%) = (−0.1 • 0.4) + (0.3 • 0.6) =
−0.04 + 0.18 = 0.14 = +14%.

Home’s effective exchange rate has depreciated by 14%. ??

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In general, suppose there are N currencies in the basket, and
Home’s trade with all N partners is:
Trade = Trade1 + Trade2 + . . . + TradeN.

Applying trade weights to each bilateral exchange rate change, the

home country’s effective exchange rate (E effective) will change
according to the following weighted average:

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Effective Exchange Rates: Change in value of Shows the value of the
the US$ dollar using two different
baskets of foreign
currencies. Against a
basket of 7 major
currencies, the dollar had
depreciated by 35% by
early 2008.
Against a broad basket of
26 currencies, the dollar
had lost only 25% by 2008.
This is because the dollar
was floating against the
major currencies, but the
broad basket included
important U.S. trading
partners (such as China)
that maintained fixed or
tightly managed exchange
rates against the dollar to
limit their appreciation 15
against US$.
Example: Using the Exchange Rate to Compare Prices in a Common
Currency
Now pay attention, 007! This table shows how the hypothetical cost
of James Bond’s next tuxedo in different locations depends on the
exchange rates that prevail.

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Bonds has first convert the prices in a common currency

Scenario 1)Difficult choice for Bond: Same price for all suits.

Scenario 2) HK$ has depreciated against £, but US$ has

appreciated against £. HK has lowest price.

Scenario 3) Compared to 1): HK$ has appreciated (14 instead of

15); US$ depreciated (2.1 instead of 2): NY has best price.

Scenario 4) Compared to 1): Pound has depreciated against both

currencies; best price London.

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2. Exchange rate regimes: Fixed vs floating
There are two major types of exchange rate regimes—
fixed and floating:

Fixed (or pegged) exchange rates fluctuate in a narrow range (or

not at all) against some base currency over a sustained period. A
country’s exchange rate can remain rigidly fixed for long periods
only if the government intervenes in the foreign exchange market
in one or both countries.

Floating (or flexible) exchange rates fluctuate in a wider range, and

the government makes no attempt to fix it against any base
currency. Appreciations and depreciations may occur from year to
year, each month, by the day, or every minute.

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Exchange Rate Behavior: Selected Developed Countries, 1996-2012

Shows the exchange rates of three currencies against the U.S. dollar.
The U.S. dollar is in a floating relationship with the yen, the pound,
and the Canadian dollar (or loonie). A floating regime, or free float.
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Exchange Rate Behavior: Selected Developed Countries, 1996-2012

Shows exchange rates of three currencies against the euro, introduced in 1999. The
pound and the yen float against the euro. Danish krone - a fixed exchange rate.
There is only a tiny variation around this rate, no more than plus or minus 2%. This
type of fixed regime is known as a band (0.134 euro per krone) or 7.44 krone per
euro) 20
Exchange Rate Behavior: Selected Developed Countries, 1996-2012

India: fixed rate of 35 rupees per dollar until depreciation 1997; after
managed float or limited flexibility policy (prevent abrupt currency
movements even after 1997)
Thailand/South Korea: same pattern, except that 1997 depreciation
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was larger/sudden => exchange rate crises (SK 2008 mini-crises too)
 Exchange Rate Behavior: Selected Developed Countries, 1996-2012

Colombia: Crawling peg. The Colombian peso is allowed to crawl

gradually, it steadily depreciates at an almost constant rate for
several years from 1996 to 2002.
Dollarization occurred in Ecuador in 2000, which is when a country
unilaterally adopts the currency of another country 25.000surces p.$) 22
Argentina: Had fixed rate, then exchange rate crisis, then limited
flexibility policy with band of 3 pesos per $, after 2008 …..
Currency Unions and dollarization

Currency Union: transnational structure with a common central bank,

e.g. Euro

Dollarization: reasons can be different:

o Country too small (costs of an own central bank)e.g. Pitcairn Islands
o Problems to manage own monetary policy; better to import stable
monetary policy from abroad, e.g. Panama

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Exchange Rate Regimes of the World

Next figure shows an IMF classification of exchange rate regimes

around the world, which allows us to see the prevalence of
different regime types across the whole spectrum from fixed to
floating.
The classification covers 192 economies for the year 2008, and
regimes are ordered from the most rigidly fixed to the most freely
floating.

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 A Spectrum of Exchange Rate Regimes

Countries use an ultrahard peg called a currency board (e.g. Bosnia:

1 €=1.95 BAM), while 35 others have a hard peg(variations of less 25
then +/- 1%).
An additional 43 counties have bands, crawling pegs or bands, while 46
countries have exchange rates that either float freely, managed floats are
allowed to float within wide bands.

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3. The Market for foreign exchange
The world over are set in the foreign exchange market (or forex or
FX market).

The forex market is not an organized exchange: trade is conducted

“over the counter.”

In April 2010, the global forex market traded, $4 trillion per day in
currency (20% more than in 2007)

The three major foreign exchange centers are located in the

United Kingdom, the United States, and Japan.

Other important centers for forex trade include Hong Kong, Paris,
Singapore, Sydney, and Zurich.
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The Spot contract

The simplest forex transaction is a contract for the immediate

exchange of one currency for another between two parties. This
is known as a spot contract.

The exchange rate for this transaction is often called the spot
exchange rate.

The use of the term “exchange rate” always refers to the spot
rate for our purposes.

The spot contract is the most common type of trade and appears
in almost 90% of all forex transactions

Transaction costs: Fees and commissions for middlemen

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Derivatives

In addition to the spot contracts other

forex contracts include forwards, swaps,
futures, and options.

Collectively, all these related forex

contracts are called derivatives because
the contracts /pricing are derived from the
spot rate.

The spot and forward rates closely track

each other

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Foreign exchange derivatives

Forwards
A forward contract differs from a spot contract in that the two
parties make the contract today, but the settlement date for
the delivery of the currencies is in the future, or forward. The
time to delivery, or maturity, varies. However, because the price
is fixed as of today, the contract carries no risk.

Swaps
A swap contract combines a spot sale of foreign currency with a
forward repurchase of the same currency. This is a common
contract for counterparties dealing in the same currency pair
over and over again. Combining two transactions reduces
transactions costs.??

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Futures
A futures contract is a promise that the two parties holding the
contract will deliver currencies to each other at some future
date at a prespecified exchange rate, just like a forward
contract. Unlike the forward contract, futures contracts are
standardized, mature at certain regular dates, and can be
traded on an organized futures exchange.

Options
An option provides one party, the buyer, with the right to buy
(call) or sell (put) a currency in exchange for another at a
prespecified exchange rate at a future date. The buyer is under
no obligation to trade and will not exercise the option if the
spot price on the expiration date turns out to be more
favorable.??
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Derivatives allow investors to engage in hedging (risk avoidance)
and speculation (risk taking).

Example 1: Hedging. As chief financial officer of a U.S. firm, you

expect to receive payment of €1 million in 90 days for exports to
France. The current spot rate is $1.20 per euro. Your firm will
incur losses on the deal if the dollar weakens to less than $1.10
per euro. You advise that the firm buy €1 million in call options
on dollars at a rate of $1.15 per euro, ensuring that the firm’s
euro receipts will sell for at least this rate. This locks in a minimal
profit even if the spot rate falls below $1.15. This is hedging.

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Example 2: Speculation. The market currently prices one-year
euro futures at $1.30, but you think the dollar will weaken to
$1.43 in the next 12 months. If you wish to make a bet, you
would buy these futures, and if you are proved right, you will
realize a 10% profit ???. Any level above $1.30 will generate a
profit. If the dollar is at or below $1.30 a year from now,
however, your investment in futures will be a total loss. This is
speculation.

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Private Actors
Most forex traders work for commercial banks.
Ex. Apple Inc. has sold computers worth of 1 mill Euro to a
German Distributor (spot rate $1.30 per euro). Deutsche Bank
sells 1 Mio € in the forex market to get 1.3 mio US$ and
transfers it to the Apple’s Bank. = Interbank trading
About 3/4th of all forex transactions globally are handled by
just 10 banks (highly concentrated market: UBS, Citigroup etc)

Government actions
Some governments engage in policies that restrict trading,
movement of forex, or restrict cross-border financial
transactions (form of capital control, e.g Malaysia during the
Asian financial crisis 1997). Fix or control forex prices
(interventions by central bank): stand ready to buy or sell own
currency (see how to peg…) 34
.
4. Arbitrage and Spot Rates Arbitrage
Arbitrage is a trading strategy that exploits profit opportunities
arising from price differences (no-arbitrage conditions-market
equilibrium – spot rates equal)

Arbitrage with two currencies

Suppose you trade $ and £. Exchange rate in NY: E £/$=£0.50per
dollar and exchange rate in London: E $/£=£0.55 per dollar.

Can we make profits?

. 35
Yes, we can buy 1$ for 0.50 £ in NY and sell it in London for 0.55£.

Three different possibilities:

 Spot rate higher in London
 Spot rate higher in NY
 Spot rates the same in both markets
Arbitrage occurs in the first two cases.

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No arbitrage conditions. Arbitrage ensures that trade of currencies
in NY along the path AB occurs at the same exchange rate as via
London along path ACDB. At B the pounds received must be the
same. Regardless of the route taken to get to B.

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Arbitrage with three currencies

Example: Suppose euros can be obtained E€/$=€0.8 per dollar and

pounds E£/€:=£0.7 per euro.
Starting with 1$, we can buy 0.8€ and buy then 0.7x0.8 pounds. =>
pound-dollar exchange rate for combined trade: 0.56 pounds per
dollar.
If exchange rate on direct way from dollars to pounds is less
attractive: E£/$=0.5. We can trade 1$ for 0.56£ via euro and then
trade 0.56£ for 1.12$ by direct trade (0.56/0.50=1.12): 0.12 cents
profit.

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In general, three outcomes are again possible.

 The direct trade from dollars to pounds has a better rate:

E£/$ > E£/€ E€/$

 The indirect trade has a better rate: E£/$ < E£/€ E€/$

 The two trades have the same rate and yield the same result:
E£/$ = E£/€ E€/$. Only in the last case are there no profit
opportunities. This no-arbitrage condition:

The right-hand expression, a ratio of two exchange rates, is

called a cross rate
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 Arbitrage and cross rate

Triangular arbitrage ensures that the direct trade of currencies along

the path AB occurs at the same exchange rate as via a third currency
along path ACB. The pounds received at B must be the same on both
paths, and 40
Cross rates and vehicle currencies

The majority of the world’s currencies trade directly with only

one or two of the major currencies, such as the dollar, euro,
yen, or pound (Kenyan shilling, for Paraguayan guarani).

Many countries do a lot of business in major currencies such as

the U.S. dollar, so individuals always have the option to engage
in a triangular trade at the cross rate.

When a third currency, such as the U.S. dollar, is used in these

transactions, it is called a vehicle currency because it is not the
home currency of either of the parties involved in the trade and
is just used for intermediation

US most used 85% of all global trade with currencies. 41

5. Arbitrage and interest rates
An important question for investors is in which currency they
should hold their liquid cash balances.
Ex: Suppose Trader in NYBank could leave the bank’s cash in
euro (2% euro interest rate) or in a US deposit (4% dollar
interest rate) Which is the best investment? Would selling euro
deposits and buying dollar deposits make a profit for a banker?

These decisions drive demand for dollars versus euros and the
exchange rate between the two currencies.

The Problem of Risk

Riskless arbitrage (e.g. hedge exchange rate risk by using
forward contract) and risky arbitrage (e.g. wait until maturity
and use spot contract) lead to two important implications, called
parity conditions.
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Riskless Arbitrage: Covered Interest Parity
Contracts to exchange euros for dollars in one year’s time carry
an exchange rate of F$/ € dollars per euro. This is known as the
forward (exchange) rate.

If you invest in a dollar deposit, your $1 placed in a U.S. bank

account will be worth (1 + i$) dollars in one year’s time. The
dollar value of principal and interest for the U.S. dollar bank
deposit is called the dollar return.

If you invest in a euro deposit, you first need to convert the

dollar to euros. Using the spot exchange rate, $1 buys 1/E$/€
euros today. These 1/E $/€ euros would be placed in a euro
account earning i€, so in a year’s time they would be worth
(1 + i€)/E$/€ euros
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To avoid that risk, you engage in a forward contract today to
make the future transaction at a forward rate F$/€.

The (1 + i€)/E$/€ euros you will have in one year’s time can then
be exchanged for (1 + i€)F$/€/E$/€ dollars, or the dollar return
on the euro bank deposit.
Three outcomes possible:
 US deposit has higher dollar return
 Euro deposit has higher dollar return
 Both deposits some dollar return

This is called covered interest parity (CIP) because all exchange

rate risk on the euro side has been “covered” by use of the
forward contract.
44
Example to calculate forward rate:

Suppose the euro interest rate is 3%, the dollar interest rate 5%
and the spot rate
$1.30 per euro: 1.30 x (1.05)/(1.03)=$1.3252 per euro.

This is the way to determine the forward rate for forward

contracts.

Easy to see why forward contracts are called “derivative” contracts:

To get the price of a forward contract F, we need first the spot rate
E plus the interest rates.

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 Arbitrage and covered interest parity

Under CIP, returns to holding dollar deposits accruing interest

going along the path AB must equal the returns from investing in
euros going along the path ACDB with risk removed by use of a
forward contract. Hence, at B, the riskless payoff must be the 46
same on both paths, and:
 Evidence on Covered Interests Parity: Financial liberalization

Shows the difference in monthly pound returns on deposits in British pounds and
German marks using forward cover from 1970 to 1995. In the 1970s, the
difference was positive and often large: traders would have profited from
arbitrage by moving money from pound deposits to mark deposits, but capital
controls prevented them from freely doing so. 47
CIP holds when capital markets are open
Riskless Arbitrage: Uncovered Interest Parity

Suppose same scenario as before: we have to decide whether to

invest $1 in dollar or euro deposits.
In this case, traders face exchange rate risk and must make a
forecast of the future spot rate. We refer to the forecast as
which we call the expected exchange rate.

Based on the forecast, you expect that the euros you

will have in one year’s time will be worth when
converted into dollars; this is the expected dollar return on euro
deposits.

48
Three outcomes are possible:

 US deposit higher expected dollar return

 Euro deposit higher expected dollar return
 Both deposits same return

The expression for uncovered interest parity (UIP) is:

49
Arbitrage and Uncovered Interest Parity Under CIP, returns to holding
dollar deposits accruing interest going along the path AB must equal
returns from investing in euros going along the risky path ACDB. Hence, at
B, the expected payoff must be 50
the same on both paths, and
What Determines the Spot Rate?
Ex: Suppose euro interest rate 2%, dollar interest rate 4% and
expected future spot rate $1.40 per euro.

=> 1.40 x (1.02)/(1.04)=$1.3731 per euro

But how can the expected future exchange rate be forecast?

See next two chapters!

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Application: Evidence on Uncovered Interest Parity

Relationship between expected future spot rate and forward rate:

Dividing the UIP by the CIP, we obtain

or

Although the expected future spot rate and the forward rate are
used in two different forms of arbitrage—risky and riskless, in
equilibrium they should be exactly the same!

If both covered interest parity and uncovered interest parity hold,

the forward must equal the expected future spot rate.

Investors have no reason to prefer to avoid risk by using the

forward rate, or to embrace risk by awaiting the future spot rate.
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Application: Test Uncovered Interest Parity

If the forward rate equals the expected future spot rate, the
expected rate of depreciation (between today and the future
period) equals the forward premium (the proportional
difference between the forward and spot rates):

While the left-hand side is easily observed (data), the

expectations on the right-hand side are typically unobserved

Ex: spot rate $1.00 per euro, forward rate $1.05: Forward
premium: 0.05 or 5%; and if expected future 53
spot rate is also $1.05, the expected rate of depreciation is 5%.
Evidence on Interest Parity When UIP and CIP hold, the 12-month forward premium
should equal the 12-month expected rate of depreciation. A scatterplot showing
these two variables should be close to the diagonal 45-degree line.
Using evidence from surveys of individual forex traders’ expectations over the period
1988 to 1993, UIP finds some support, as the line of best fit is close to the diagonal 54
Uncovered Interest Parity: A Useful Approximation
We can rewrite the equation on page 49:

The UIP approximation equation says that the home interest rate
equals the foreign interest rate plus the expected rate of
depreciation of the home currency.
Suppose the dollar interest rate is 4% per year and the euro 3%. If
UIP is to hold, the expected rate of dollar depreciation over a
year must be 1%. The total dollar return on the euro deposit is
approximately equal to the 4% that is offered by dollar deposits
?? 55
Summary:

How Interest Parity Relationships Explain Spot and Forward

Rates In the spot market, UIP provides a model of how the spot
exchange rate is determined. To use UIP to find the spot rate, we
56
need to know the expected future spot rate and the prevailing
interest rates for the two currencies.
In a forward market CIP provides a model of how the forward
exchange rate is determined. We derive the forward rate from
the current spot rate and the two interest rates.
57