Chapter 2: Exchange rate and

foreign exchange market: an asset-

market based approach
Objective
This chapter reviews the concepts and the role of the
exchange rate in international trade
This chapter discusses the determination of the
exchange rate in the asset market
Contents
The concepts of the exchange rate
The foreign exchange market
The demand for assets
The asset-based determination of the exchange rate
1. The exchange rate and international transactions
What is the exchange rate?

Exchange rate is the price of one currencies in terms of

another currency
 Ex. 1: E(VND/USD): 1 USD = 22500 VND
 Ex. 2: E(USD/EUR): 1 EUR = 1.1788 USD
1. The exchange rate and international transactions
The exchange rate quotation
Direct quotation shows the value of the foreign
currency in terms of the domestic currency
 Ex. 1 USD = 22500 VND
Indirect quotation shows the value of domestic
currency in terms of foreign currencies
 Ex. 1 VND = 0.000044 USD
1. The exchange rate and international transactions
Measuring changes in the exchange rate
The movement in the exchange rate is often expressed
in terms of the percentage change from a benchmark
value
Appreciation/revaluation: means an increase in the
value of a currency in terms of another currency
Depreciation/devaluation refers to a fall in the value
of a currency in terms of another currency
1. The exchange rate and international transactions
The exchange rate and international transactions I

Exchange rates make it possible to compare the price

of goods and services produced in different countries.
The price of a goods produced in one country can be
translated into the price of the same good in terms of
another country’s currency using the exchange rate
 Ex. T-shirt (produced in Vietnam): 225000 VND/ 1 T-shirt
(price in Vietnam)
 10 USD / 1 T-shirt (the price in the U.S. dollar)
1. The exchange rate and international transactions
The exchange rate and international transactions II

A devaluation (or depreciation) of the domestic

currency reduces the price of domestic goods in terms
of the foreign currency
 Ex. Given a 10% devaluation of VND, the dollar price of T-
shirt becomes: 225000/24750 = 9.1 USD
• A revaluation (or appreciation) of the domestic
currency increases the price of domestic goods in terms
of the foreign currency
 Ex. Given a 10% revaluation of VND, the dollar price of T-
shirt becomes: 225000/20250 = 11.1 USD
2. The Foreign Exchange Market
The actors
Commercial banks: bank acts as intermediaries in the market.
A vast majority of the foreign exchange transactions involve
the debiting and crediting of the accounts at commercial banks
Firms, individuals, and organizations: all firms, private and
public organizations and individuals that engage in
international transactions.
Non-bank financial institution: insurance companies or
investment funds can trade foreign currencies
Central banks: central banks often intervene in the foreign
exchange market to affect the demand for and the supply of
foreign exchange and the exchange rate.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market I
Foreign exchange trading takes place in all countries, but
concentrates in three major financial centers (Tokyo, New York
and London)
The global foreign exchange market has been growing rapidly
since 1990.
Large part of foreign trading is conducted through direct
phone, fax and internet.
 The links through phone, fax and internet make each trading
center a part of the single world market that never sleeps.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market II
Most of foreign exchange transactions between two currencies
go through US dollars
 US dollar serves as a vehicle currency and is widely used in
international trade and investment
Exchange rates quotes at different banks and location tend to
converge.
 Any significant difference between the exchange rates quoted at
different locations will trigger arbitrage activities.
2. The Foreign Exchange Market
Arbitrages I
The exchange rate between VND and USD is quoted
at two different banks as follows
 Bank A (bid-ask rates): 22420-22460
 Bank B (bid-ask rates): 22480-22510
Is there any opportunity for arbitrage to take place?
What is the impacts of the arbitrage on the exchange
rate between VND and USD?
2. The Foreign Exchange Market
Foreign exchange transactions I
Spot transactions
Swap transactions
Forward transactions
Future contracs
Option contracts
2. The Foreign Exchange Market
Foreign exchange transactions II
Spot transactions:
 Spot transactions are executed immediately after the
agreement is reached.
 Spot exchange rate: Spot trading employs the current
exchange rate, which is called the spot exchange rate.
 Value date: In practice the spot trading are often
executed two days after the agreement is reached.
 The value date is the date that the parties involved in the
spot transaction actually receive funds they have
purchased.
2. The Foreign Exchange Market
Foreign exchange transactions III
Forward transactions:
 The forward transactions involve trading of foreign
currencies at some date in the future.
 Forward trading uses a forward exchange rate, which is
determined when the transactions is agreed and can be
different from the current spot rate.
 Forward discount and premium: represent the extent to
which the forward rate is lesser (or higher) the spot rate
2. The Foreign Exchange Market
Foreign exchange transactions IV
Forward transactions:
 Forwards transactions is widely used to hedge against the
foreign exchange risk brought about by the movement in the
exchange rate
 Hedging the future receipt of foreign exchange: a firm that
has future receipt in a foreign currency can hedge against
the exchange risk by selling the foreign currency forward.
 Hedging the future payment of foreign exchange: a firm that
has future payment denominated in a foreign currency can
hedge against the exchange risk by purchasing the foreign
currency forward.
2. The Foreign Exchange Market
Foreign exchange transactions
Swap Transactions
 Currency swap: the swap transaction is a spot sale of a currency
combined with a forward repurchase of the currency.
 An exporter has just received one million dollars, but will have to pay
one million dollars for imported inputs in three months. The exporter
may join a swap transaction which allow it to sell one million dollars and
repurchase it three months later.
 Swaps often result in lower fees or transaction costs because
they combine two transactions, and they allow parties to
meet each others needs for a temporary amount of time.
2. The Foreign Exchange Market
Foreign exchange transactions V
Futures contracts: Foreign exchange futures are a forward
contract for a standardized volume of a specific currency
and selected calendar date traded in an organized market.
In the futures market, only few currencies are traded for
standardized amount and at few selected dates.
The trade of futures takes place in an organized market
with few geographical locations.
Future contracts can be sold at any time up until maturity,
but the forward contract cannot.
2. The Foreign Exchange Market
Foreign exchange transactions V
 Currency option: the option contract gives the buyer the right, but not
obligation, to sell or purchase a particular currency at a specified exchange rate
and date.
 The seller of the option must fulfill the contract if the buyer so desires, but the buyer
of the option can forgo the contract if it turns out unprofitable.
 The buyer of a option pays the seller a premium (the option price), which
ranges from 1% to 5% of the contract value
 Put and call options: a call option specifies the right to buy a currency, while
the put option specifies the right to sell a currency.
 European and American options: An European option must be implemented
on the specified date, but the American option can be implemented at any time
before the stated date.
 The amount of the option contract is standardized for the trading that takes
place in the organized market.
3. The demand for foreign currency
Demand for assets

People can hold their wealth in various forms or assets,

such as bonds, stocks, bank deposits, gold and precious
metals, cash, real estate, ...
The demand for assets depends on the following:
The return to assets: the expected return to assets
Risks
Liquidity
3. The demand for foreign currency
Rate of return to assets I

The return to an asset measures the change in the value of

the investment in the asset between two dates.
The change in the value of an assets is brought about by
the change in
 (i) Its price and
 (i) The interest earned during a period of time.
3. The demand for foreign currency
Rate of return to assets II
 Return to an asset: examples
 Example 1: An investor bought 1000 USD in early 2008 at the exchange rate 1
USD = 16000 VND. In 2010, the exchange rate was 1 USD = 19200 VND.
What is the return to the investment in US dollars.
 The rate of return = (19200 - 16000)/16000 *100 = 20%

 Example 2: An investor bought 1 share of the stock issued by a commercial bank

at the price of 50000 VND per share. The investor received a dividend of 2000
VND per share at the year end, and the price of the stock also rose to 58000
VND at the year end. What is the return to the stock.
 The rate of return = (60000 - 50000)/50000 *100 = 20%
3. The demand for foreign currency
Rate of return to assets III
Expected return to assets
 Since people do not know the return to an asset before they
buy the asset, the demand for an asset largely depends on
the expected return to the asset.
 The expected return to an asset measures the change in the
expected value of the asset using its expected prices and
interest over a given period
3. The demand for foreign currency
Rate of return to assets IV
The real return to an asset
 Because the value of assets measured in terms of money, the
change to the value of money has an impact on the value of
asset.
 The demand for an asset depends not only on the nominal
return to the asset, but also on its real rate of return.
 The expected real rate of return to an asset is the expected
nominal rate of return minus the (expected inflation during a
given period.
3. The demand for foreign currency
Rate of return to assets V
The real return to an asset
 Example 1: A saver deposits 1 million VND at a bank. The
one-year interest rate is 8%, and the expected inflation over
the next year is 6%. What is the real rate of return to the
bank deposit
 Example 2: A saver deposits 1 million VND at a bank. The
one-year interest rate is 10%, and the expected inflation
over the next year is 12%. What is the real rate of return to
the bank deposit
3. The demand for foreign currency
Risk and liquidity
 The risk of an asset refers to the uncertainty of its expected
return.
 Given all other things equal, the more risky an asset is, the lower
the demand for it.
 The liquidity of an asset refers to the speed and cost of
disposing an asset. All else equal, the more liquid an asset
is, the higher the demand for it.
3. The demand for foreign currency
Perfect AssetSubstitutability
 Perfect asset substitutability: assets have the same degree of
risks and liquidity.
 Under the assumption of perfect asset substitutability, the
rate of return is the only factor that influences the demand
for assets.
 In this chapter, we consider the case of perfect asset
substitutability, i.e. we assume that domestic and foreign
assets have the same degree of risks and liquidity.
3. The demand for foreign currency
Domestic and foreign deposits
Domestic currency deposits
 The interest rate is the rate of return to the deposit at the
bank. When you deposit money, you are buying the asset
‘deposit’
 The rate of return to domestic currency deposits is the interest rate
offered on the deposits.
 Example: A saver deposits 10 millions VND at a
commercial bank with annual interest rate of 7%. After one
year, he will receive 700000 VND in interest. The rate of
return is 7%
3. The demand for foreign currency
Domestic and foreign deposits
The exchange rate and foreign assets
 The return to the foreign currency deposit consists of not
only the interest rate, but also the expected change in the
exchange rate.
 Example: Suppose the annual interest rate offered on the
dollar deposit is 2%. Vietnamese dong is expected to
depreciate by 3% against US dollar over next year. What is
the expected rate of return on the dollar deposit?
3. The demand for foreign currency
The rate of return to foreign assets
The rate of return to a foreign-currency denominated
asset is (approximately) equal to the interest offered by
the foreign asset plus the expected depreciation of
domestic currency.
Rate of return to foreign deposit
Rate of Return= R* + (Ee – E)/E
Where R* is the interest rate offered to foreign

currency deposits, E is the current exchange

rate, Ee is the expected exchange rate
4. Equilibrium in the foreign exchange market
Equilibrium in the foreign exchange market
The foreign exchange market is in equilibrium when bank
deposits of all currencies offer the same rate of return.
If the dollar deposit offers a higher rate of return as
compared to the dong deposit, investors will move from
dong deposit to dollar deposit, and thus creating excess
demand for dollar.
If the dollar deposit offers a lower rate of return as
compared to the dong deposit, investors will move toward
dong deposit from dollar deposit, and thus creating excess
demand for dong.
4. Equilibrium in the foreign exchange market
Interest parity condition (UIP)
The interest parity condition establish an equality
between the rates of return on domestic-currency
deposits and foreign currency deposits (uncovered
interest parity – UIP)
 R = R* + (Ee – E)/E
 Here R is the interest rate on domestic-currency deposits
The UIP shows the difference in interest rates equals to
the expected rate of depreciation of domestic currency.
 R – R* = (Ee – E)/E
When the interest parity condition holds, the foreign
exchange market is in equilibrium
4. Equilibrium in the foreign exchange market
Adjustment to equilibrium

If the UIP condition does not hold, the exchange rate will adjust
to bring about the equilibrium in the foreign exchange market
 Question 1: what would happen if the rate of return on foreign
currency deposits is higher than that of domestic currency deposits?
 R < R* + (Ee – E)/E
 Question 2: What would happen if the rate of return on foreign
currency deposits is lower than that of domestic currency deposits
 R > R* + (Ee – E)/E
4. Equilibrium in the foreign exchange market
Graph Presentation
 Expected return on Exchange rate FCD return
foreign currency curve
 In the graph, the vertical
schedule indicates the
current exchange rate, and
the horizontal schedule
indicates the rate of return
on domestic and foreign
deposits measured in
terms of domestic
currency. The return to FC
deposits is described by a
downward-sloping curve.
Expected rate
of return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
 The equilibrium DCD return
FCD return
exchange rate
 The return to domestic
currency deposit if
.B
indicated with a vertical
line. The equilibrium in
the foreign exchange E1 A
market is reached at point
A where the expected .
C
return on domestic
currency deposits and
foreign currency deposits R1
Expected rate
are equal.
of return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate DCD return
Adjustment to FCD return
equilibrium
The exchange rate
will adjust to E2 .B

maintain the
equilibrium in the E1 A
foreign exchange .
market E3 C

R1
Expected rate
of return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
Home interest rate DCD return
FCD return
and the current
exchange rate
An increase in the .

interest rate on
domestic currency E1 A
deposit raises the
B
rate of return on DC E2
deposits, causing an
appreciation of R1 R2
domestic currency. Expected rate
of return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
Foreign interest DCD return

rate and the

exchange rate E2 B
A higher foreign .

interest rate raises

the rate of return on E1 A
foreign currency
deposits (R* + (Ee – FCD return
E)/E), causing a
depreciation of
R1 R2
domestic currency. Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
The expected DCD return

exchange rate and

the current exchange
E2 B
rate .
A rise in the
expected exchange
rate raises the rate of E1 A

return on foreign
FCD return
currency deposits
(R* + (Ee – E)/E),
causing the current R1 R2
exchange rate to rise. Expected rate
of return