Foreign Exchange Market
Explain how the foreign
exchange (FX) market works.
Examine the forces that
determine the exchange rates and whether it is possible to determine future
a Map the implications for businesses.
a Foreign Exchange
market for converting the currency of one country into the currency of another.
a Exchange Rate:
aThe rate at which one
currency is converted into another.
Foreign Exchange Risk:
aThe risk that arises
from changes in exchange rates.
Functions of the Foreign Exchange Market
a Companies receiving payment in foreign currencies need
to convert to their home currency.
a Companies paying foreign businesses for goods or
a Companies invest spare cash for short terms in money
a Speculation: taking advantage changing exchange rates.
Insuring Against FX Risk
a Spot exchange rate: rate of currency exchange on a
a Forward exchange rate: two parties agree to exchange
currencies on a specific future date.
a Currency swap:simultaneous purchase and sale of a
given amount of FX for two different value dates.
Foreign Exchange Trade Growth
The Foreign Exchange Market
It is a 24/7 market.
The markets are integrated. Connected by high-speed computers, it creates one virtual market.
London’s dominance is explained by:
aHistory (capital of the
first major industrialized nation).
Tokyo/Singapore and New York).
Geographical Distribution of Global Foreign
(percentage share of total average daily
The Hierarchy of International Financial
Currency Use on One Side of a FX Transaction
Factors Influencing Currency Value
Economic Theories of Exchange Rate
Base level: rates are
determined by the demand/supply of one currency relative to the demand/supply
Price and Exchange
aLaw of One Price
aPurchasing Power Parity
Interest Rates and
Investor Psychology and
Price and Exchange Rates
Law of One Price:
a In competitive markets free of transportation costs
and 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.
a Example: US/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York should
retail for FFr 250 in Paris (50x5).
Purchasing Power Parity
a By comparing the prices of identical products in
different currencies, it should be possible to determine the ‘real’ or PPP
exchange rate - if markets were efficient.
a In relatively efficient markets (few impediments to
trade and investment) then a ‘basket of goods’ should be roughly equivalent
in each country.
Money Supply and Inflation
PPP theory predicts that changes in relative prices
will result in a change in exchange rates.
aA country with high
inflation should expect its currency to depreciate against the currency of a
country with a lower inflation rate.
occurs when the money supply increases faster than output increases.
Purchasing Power Parity Puzzle.
The Big Mac Index
Purchasing Power Parity: April 2001
United States $2.54 2.54 - - - - - -
- - -
Argentina Peso 2.50 2.50 0.98 1.00 -2
Brazil Real 3.60 1.64
1.42 2.19 -35
Canada C $ 3.33 2.14 1.31 1.56 - 16
2.27 0.99 0.88 - 11
FFr 18.5 2.49 7.28
7.44 - 2
HK $10.70 1.37
4.21 7.80 - 46
Japan ¥ 294 2.38 116 124 - 6
Russia Roule 35.00 1.21 13.8 28.9 - 52
Switzerland SwFr 6.30 3.65 2.48 1.73 44
Macroeconomic Data for Bolivia, April 1984
Interest Rates and Exchange Rates
Theory says that interest rates reflect expectations
about future exchange rates.
aFisher Effect (I = r+l).
aFor 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.
Investor Psychology and Bandwagon Effects
Evidence suggests that neither PPP nor the
International Fisher Effect are good at explaining short term movements in
Explanation may be investor psychology and the
aStudies suggest they
play a major role in short term movements.
aHard to predict.
Exchange Rate Forecasting
a Efficient market: where prices reflect all
available public information.
aEarly studies seem to
confirm the efficient market theory, but recent studies have challenged it.
where prices do not reflect all available information.
(economic theory) or technical (price/volume data) analysis to predict
the exchange rates.
aAnalysis suggest that
professional forecasters are no better than forward exchange rates in predicting future spot rates.
a Freely convertible.
a Externally convertible.
a Not convertible.
a Preserve foreign exchange reserves.
aGovernment afraid of
a Political decision.
a Many countries have some kind of restrictions.
a Barter-like agreements where goods/services are traded
a Helps firms avoid convertibility issue.