PRINCIPLES OF FINANCE

Chapter 15 (ME)

The Foreign Exchange Market

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Chapter Preview
 In this chapter, we develop a modern view of exchange
rate determination that explains recent behavior in the
foreign exchange market.
 Topics include:
─ Foreign Exchange Market
─ Exchange Rates in the Long Run
─ Exchange Rates in the Short Run
─ Explaining Changes in Exchange Rates
─ The Interest Parity Condition
Foreign Exchange Market
 Mostcountries of the world have their own
currencies: the U.S dollar., the euro in Europe,
the Brazilian real, and the Chinese yuan, just to
name a few.
 The
trading of currencies and banks deposits is
what makes up the foreign exchange market.
What are Foreign
Exchange Rates?
 Two kinds of exchange rate transactions make up
the foreign exchange market:
─ Spot transactions involve the near-immediate
exchange of bank deposits, completed at the spot rate.
─ Forward transactions involve exchanges at some
future date, completed at the forward rate.
USD / AZN Exchange Rate
2011 - 2021
 USD / TRY
8.2871

EUR / USD
1.2085
Exchange Rates
1990–2013
Figure 15.1 Exchange Rates, 1990–2013
Why Are Exchange Rates Important?
 When the currency of your country appreciates
relative to another country, your country’s goods
prices  abroad and foreign goods prices  in your
country.
─ Makes domestic businesses less competitive
─ Benefits domestic consumers (you)
How is Foreign Exchange Traded?
 FX traded in over-the-counter market
1. Involve buying / selling bank deposits denominated in
different currencies.
2. Trades involve transactions in excess of $1 million.
3. Typical consumers buy foreign currencies from retail
dealers.
 FX volume exceeds $4 trillion per day.
Quotation of Exchange Rates
 Direct Quote;
A direct quote is a foreign exchange rate quoted as the
domestic currency per unit of the foreign currency. In other
words, it involves a quote in fixed units of foreign currency
against variable amounts of the domestic currency.
A direct quote of the manat against the U.S. dollar in
Azerbaijan would be 1.7₼ = $1
 The concept of direct quotes versus indirect quotes depends
on the location of the speaker, HOWEVER…
 USD Dollar – Base Currency
 The U.S. dollar is the most actively traded
currency in the world. In the context of trading
rooms and professionals, most currencies are
quoted as the number of foreign currency units
per dollar.
 Therefore; the dollar serves as the base
currency, whether the speaker is in the United
States or elsewhere.
 British Pound
A major exception to the rule that quotes are
dollar-based is that the British pound is the base
whenever it's quoted against other currencies,
including the dollar but with the exception of the
euro.
 Euro
 The European Central Bank intended the currency
to be the financial market's dominant currency. It
specified that the euro should always be the base
currency whenever it is traded.
Exchange Rates in the Long Run

 Exchange rates are determined in markets by the

interaction of supply and demand.
 Animportant concept that drives the forces of
supply and demand is the Law of One Price.
Exchange Rates in the Long Run: Law of
One Price
 TheLaw of One Price states that the price of an
identical good will be the same throughout the
world, regardless of which country produces it.
 Example:American steel costs $100 per ton, while
Japanese steel costs 10,000 yen per ton.
Exchange Rates in the Long Run: Law of One Price
If E = 50 yen/$ then price are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then price are:
American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen

 Law of one price  E = 100 yen/$

Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)
 Thetheory of PPP states that exchange rates between
two currencies will adjust to reflect changes in price
levels.
 PPP  Domestic price level  10%, domestic currency 
10%
─ Application of law of one price to price levels
─ Works in long run, not short run
Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)

 Problems with PPP

─ All goods are not identical in both countries
(i.e., Toyota versus Chevy)
─ Many goods and services are not traded
(e.g., haircuts, land, etc.)
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

 BasicPrinciple: If a factor increases demand for

domestic goods relative to foreign goods, the
exchange rate 
 The four major factors are relative price levels,
tariffs and quotas, preferences for domestic vs.
foreign goods, and productivity.
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

 Relative price levels: a rise in relative price levels

cause a country’s currency to depreciate.

 Tariffsand quotas: increasing trade barriers

causes a country’s currency to appreciate.
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

 Preferences for domestic vs. foreign goods: increased

demand for a country’s good causes its currency to
appreciate; increased demand for imports causes the
domestic currency to depreciate.

 Productivity: if a country is more productive relative

to another, its currency appreciates.
Exchange Rates in the Long Run: Factors Affecting
Exchange Rates in Long Run
Table 15.1 Summary Summary Factors That Affect
Exchange Rates in the Long Run
Exchange Rates in the Short Run

 Inthe short run, an exchange rate is the price of

domestic bank deposits in terms of foreign bank
deposits.
 The usual approach to supply-demand analysis
focused on import/export demand
 Here, we emphasize stocks rather than flows,
because flows are small relative to the domestic
and foreign asset stocks.
Exchange Rates in the Short Run: Supply
Curve Analysis
 We will use the US as the “home country,” so domestic
assets are denominated in US dollars. We will use
“euros” the generically represent any foreign country's
currency.
 Dollar assets supplied is primarily the quantity of bank
deposits, bonds, and equities in the United States. This
is fairly fixed in the short-run.
 The quantity supplied at any exchange rate does not
change, so the supply curve, S, is vertical.
Exchange Rates in the Short Run:
Demand Curve Analysis
 Thedemand curve traces out the quantity demanded at
each current exchange rate
 American prices are set in USD, so for Europeans to pay
for their USD purchases, they must first exchange their
euros for USD. That is, they will demand USD.
 Asthe euro value of USD falls, Europeans will demand
more dollar to buy the less-expensive USD products,
resulting in a downward- sloping demand curve for dollar.
Exchange Rates in the Short Run: Supply
and Demand Curves
Figure 15.3 Equilibrium in the Foreign Exchange Market
Explaining Changes in Exchange Rates

 Tounderstand how exchange rates shift in

time, we need to understand the factors that
shift expected returns for domestic and foreign
deposits.
 Wewill examine these separately, as well as
changes in the money supply and exchange rate
overshooting.
Explaining Changes in Exchange Rates:
Increase in iD
Figure 15.4 Response to an Increase in the Domestic Interest Rate, iD
Explaining Changes in Exchange Rates: Increase in iF
Figure 15.5 Response to an Increase in the Foreign Interest Rate, iF
Explaining Changes in Exchange Rates: Increase in Expected
Future FX Rates
Figure 15.6 Response to an Increase in the Expected Future Exchange Rate, Ee t+1
Explaining Changes in Exchanges Rates
 Similar to determinants of exchange rates in the long-
run, the following changes increase the demand for
foreign goods (shifting the demand curve to the right),
increasing
─ Expected fall in relative U.S. price levels
─ Expected increase in relative U.S. trade barriers
─ Expected lower U.S. import demand
─ Expected higher foreign demand for U.S. exports
─ Expected higher relative U.S. productivity
Explaining Changes in Exchanges Rates (a)
Table 15.2 Summary: Summary Factors That Shift the Demand Curve for
Domestic Assets and Affect the Exchange Rate
Explaining Changes in Exchanges Rates (b)
Table 15.2 Summary Summary Factors That Shift the Demand Curve for
Domestic Assets and Affect the Exchange Rate
Applications

Our analysis allows us to take a look at the response of

exchange rates to a variety of macro-economic factors.
For example, we can use this framework to examine (1)
the impact of changes in interest rates, and (2) the
impact of money growth.
Application: Interest Rate Changes

 Changes in domestic interest rates are often cited

in the press as affecting exchange rates.
 We must carefully examine the source of the
change to make such a statement. Interest rates
change because either (a) the real rate or (b) the
expected inflation is changing. The effect of each
differs.
Effect of Changes in Interest Rates on the
Equilibrium Exchange Rate

 When the domestic real interest rate increases,

the domestic currency appreciates. We have
already seen this situation in Figure 15.4.
 When the domestic expected inflation increases,
the domestic currency reacts in the opposite
direction—it depreciates.
Effect of Changes in Interest Rates on the Equilibrium Exchange Rate
Figure 15.7 Effect
of a Rise in the
Domestic Interest
Rate as a Result of
an Increase in
Expected Inflation
The Practicing Manger:
Profiting from FX Forecasts
 Forecasters look at factors discussed here
 FX forecasts affect financial institutions managers'
decisions
 If forecast Euro appreciate, yen depreciate,
─ Make more euros assets, less yen assets
─ FX traders sell yen, buy euros
 PROBLEMS
 A dealer based in New York City provides a spot exchange rate quote of
12.4035 MXN/USD to a client in Mexico City. The inverse of 12.4035 is
0.0806.
 From the perspective of the Mexican client, the most accurate statement
is that the:
 direct exchange rate quotation is equal to 0.0806.
 direct exchange rate quotation is equal to 12.4035.
 indirect exchange rate quotation is equal to 12.4035.
 If the bid/offer quote from the dealer was 12.4020 ~ 12.4060 MXN/USD,
then the bid/offer quote in USD/MXN terms would be closest to:
 0.08061 ~ 0.08063.
 0.08063 ~ 0.08061.
 0.08062 ~ 0.08062.
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 Solution to 1:
 B is correct. A direct exchange rate uses the domestic currency as the
price currency and the foreign currency as the base currency. For an
MXN/USD quote, the MXN is the price currency; therefore, the direct
quote for the Mexican client is 12.4035 (it costs 12.4035 pesos to
purchase 1 US dollar). Another way of understanding a direct exchange
rate quote is that it is the price of one unit of foreign currency in terms
of your own currency. This purchase of a unit of foreign currency can be
thought of as a purchase much like any other you might make; think of
the unit of foreign currency as just another item that you might be
purchasing with your domestic currency. For example, for someone based
in Canada, a liter of milk currently costs about CAD1.25 and USD1 costs
about CAD1.03. This direct currency quote uses the domestic currency
(the Canadian dollar, in this case) as the price currency and simply gives
the price of a unit of foreign currency that is being purchased.
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 Solution to 2:
 A is correct. An MXN/USD quote means the amount of MXN
the dealer is bidding (offering) to buy (sell) USD1. The
dealer’s bid to buy USD1 at MXN12.4020 is equivalent to the
dealer paying MXN12.4020 to buy USD1. Dividing both terms
by 12.4020 means the dealer is paying (i.e., selling) MXN1
to buy USD0.08063. This is the offer in USD/MXN terms: The
dealer offers to sell MXN1 at a price of USD0.08063. In
USD/MXN terms, the dealer’s bid for MXN1 is 0.08061,
calculated by inverting the offer of 12.4060 in MXN/USD
terms (1/12.4060 = 0.08061). Note that in any bid/offer
quote, no matter what the base or price (quoted)
currencies, the bid is always lower than the offer.

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 PROBLEMS
 On February 1, the euro is worth $0.8984. By May 1,
it has moved to $0.9457.

 a) By what percentage has the euro appreciated or

depreciated against the dollar during this three-month
period?

 b. By what percentage has the dollar appreciated or

depreciated against the euro during this period?

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 PROBLEMS

a) Since the euro is now worth more in dollar terms, it has

appreciated against the dollar.
(0.9457 - 0.8984)/0.8984 = 5.27%.

b) The flip side of euro appreciation is dollar

depreciation. The dollar has depreciated by an amount
equal to

1 1
-
0.9457 0.8984 = 0.8984 - 0.9457 = - 5.00%
1 0.9457
0.8984

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 PROBLEMS
 In early August 2002, North Korea reduced the official
value of the won from $0.465 to $0.0067. The black
market value of the won at that time was $0.005.

 a) By what percentage did the won devalue?

 b) Following the initial devaluation, what further percentage

devaluation would be necessary for the won to equal its black
market value?

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 PROBLEMS

a) the won devalued

($0.0067-$0.465)/$0.465)=98.56%.

b) ($0.005-$0. 0067)/$0. 0067)=- 25.37%.

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 PROBLEMS
On Friday, September 13, 1992, the lira was worth DM
0.0013065. Over the weekend, the lira devalued against
the DM to DM 0.0012613.

a) By how much had the lira devalued against the DM?

b) By how much had the DM appreciated against the lira?
c) Suppose Italy borrowed DM 4 billion, which it sold to prop up the
lira. What were the Bank of Italy’s lira losses on this currency
intervention?
d) Suppose Germany spent DM 24 billion in an attempt to defend
the lira. What were the Bundesbank’s DM losses on this currency
intervention?

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 PROBLEMS

a) the lira devalued by

(0.0012613 - 0.0013065)/0.0013065 = -3.46%.

b) the DM appreciated against the lira by

[(1/0.0012613) - (1/0.0013065)]/(1/0.0013065)
=3.58%.

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 c) Prior to devaluation, DM billion was worth Lit (4
billion/0.0013065). Following devaluation, the DM 4 billion
borrowing would cost Lit (4 billion/0.0012613) to repay.
Hence, the Italian government would lose Lit 4 billion x
[(1/0.0012613) - (1/0.0013065)] = Lit 109,716,164,344 or DM
138,384,998 at the new exchange rate.

 d) The Bundesbank would have bought Lit 24

billion/0.0013065. Following lira devaluation, these lira
would be worth DM (24 billion/0.0013065) x 0.0012613, or
DM 23,169,690,012. The result is a foreign exchange loss for
the Bundesbank of DM 830,309,988 on this currency
intervention.
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 Who says what What it means
Please quote prices for buying and selling 10 million US dollars against
Dealer says SPOT THB 10 Thai Baht ,for delivery on the spot date, which is 2 working days in the
future

I sell Baht at 25.216 per dollar, but when I am buying Baht the rate is
Counterparty says 16 26 25.226 per dollar. The "Big Figure" of 25.2 is assumed to be known by all
the players in the market

I buy 10 million dollars. He could also have said just BUY, or AT 26, it
Dealer says I BUY 10
would have meant the same thing

Counterparty says MY THB TO

This is where the dealer's bank must pay the Baht the dealer has sold
BANGKOK BANK, BANGKOK

Dealer says MY USD TO

Pay my dollars into my account at Chase Manhattan Bank, New York City
CHASE, NYC
Counterpart says TO
The dealer has made the deal, the counterparty now confirms that he
CONFIRM AT 25.226 I SELL 10
agrees with the details
MIO USD

Dealer says VAL 26AUG96 The currencies will be exchanged on 26 August 1996