The Foreign Exchange Market


Chapter Focus

a  Explain how the foreign exchange (FX) market works.

a  Examine the forces that determine the exchange rates and whether it is possible to determine future rates movement.

a  Map the implications for businesses.


a Foreign Exchange Market:

aA 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.

a Foreign Exchange Risk:

aThe risk that arises from changes in exchange rates.

Functions of the Foreign Exchange Market

a Currency Conversion

a Companies receiving payment in foreign currencies need to convert to their home currency.

a Companies paying foreign businesses for goods or services.

a Companies invest spare cash for short terms in money market accounts.

a Speculation: taking advantage changing exchange rates.

a Insuring Against FX Risk

a Spot exchange rate: rate of currency exchange on a particular day.

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.

FX Transactions

Foreign Exchange Trade Growth

The Foreign Exchange Market

a It is a 24/7 market.

a The markets are integrated.  Connected by high-speed computers, it creates one virtual market.

a London’s dominance is explained by:

aHistory (capital of the first major industrialized nation).

aGeography (between Tokyo/Singapore and New York).

Geographical Distribution of Global Foreign Exchange Activity
(percentage share of total average daily turnover)

The Hierarchy of International Financial Centers

Currency Use on One Side of a FX Transaction

Factors Influencing Currency Value

Economic Theories of Exchange Rate Determination

a  Base level: rates are determined by the demand/supply of one currency relative to the demand/supply of another.

a  Price and Exchange Rates:

aLaw of One Price

aPurchasing Power Parity (PPP)

a  Interest Rates and Exchange Rates.

a  Investor Psychology and Bandwagon Effects.

Price and Exchange Rates

a 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).

a 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

a 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.

aInflation occurs when the money supply increases faster than output increases.

a 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

Euro                      2.57         2.27           0.99                0.88                 - 11

France             FFr 18.5        2.49           7.28                 7.44                       - 2

Hong Kong    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 -October 1985

Interest Rates and Exchange Rates

a Theory says that interest rates reflect expectations about future exchange rates.

aFisher Effect (I = r+l).

aInternational Fisher Effect:

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

a Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates.

a Explanation may be investor psychology and the bandwagon effect.

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.

a  Inefficient market: where prices do not reflect all available information.

aUse fundamental (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.

Currency Convertibility

a   Freely convertible.

a   Externally convertible.

a   Not convertible.

a Preserve foreign exchange reserves.

aService international debt.

aPurchase imports.

aGovernment afraid of capital flight.

a   Political decision.

a   Many countries have some kind of restrictions.

a   Countertrade.

a  Barter-like agreements where goods/services are traded for goods/services.

a  Helps firms avoid convertibility issue.