International Economics CHAPTER F O U R T E E N 14 International Economics Foreign Exchange Markets and Exchange Rates . Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand the meaning and functions of the foreign exchange market Know what the spot, forward, cross, and effective exchange rates are Understand the meaning of foreign exchange risks, hedging, speculation, and interest arbitrage Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Market Introduction Foreign Exchange Market Where individuals, firms and banks buy and sell foreign currencies or foreign exchange. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Functions of the Foreign Exchange Markets Transfer purchasing power from one nation and currency to another. Demand for currency arises when: Tourists visit another country Domestic firm wants to import from other countries Individual wants to invest abroad Supply of currency arises from: Foreign tourist expenditures Export earnings Receiving foreign investments Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Functions of the Foreign Exchange Markets Provide credit for foreign transactions Credit is needed when goods are in transit, and to allow the buyer time to resell the goods to make the payment. Provide the facilities for hedging and speculation. About 90% of foreign exchange trading reflects purely financial transactions, and only about 10% trade financing. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Functions of the Foreign Exchange Markets Participants Those needing currency to fund transactions Tourists, importers, exporters, investors, etc. Commercial banks Serve as the clearinghouses for currency exchange Foreign exchange brokers Clearinghouse for surpluses and shortages between the commercial banks Central banks Buyer or seller of last resort in the foreign exchange market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Rates Assume only two economies, the United States and the European Monetary Union. Domestic currency = dollar ($) Foreign currency = euro (€) The exchange rate between the dollar and the euro (R) is equal to the number of dollars needed to purchase one euro. R = $/€ If R = $/€ = 1, then one dollar is required to purchase one euro. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Rates Under a flexible exchange system, R is determined by the intersection of market demand and supply curves for euros. Depreciation is an increase in the domestic price of the foreign currency. If the dollar price of the euro increases from $1 to $1.50, the dollar has depreciated. Appreciation refers to a decline in the domestic price of the foreign currency. If the dollar price of the euro decreases from $1 to $0.50, the dollar has appreciated. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 14-1 The Exchange Rate Under a Flexible Exchange Rate System. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Rates Cross exchange rate Once the exchange rate between each of a pair of currencies with respect to the dollar is established, the exchange rate between the two currencies themselves, or cross exchange rate, can be calculated. Example: Suppose $/€ exchange rate is $1.25 and the $/£ exchange rate is $2. R = €/£ = = = 1.60 $ value of £ $ value of € 1.25 2 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Rates Effective exchange rate A weighted average of the exchange rates between the domestic currency and the nation’s most important trading partners. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Rates Arbitrage The purchase of currency in one market for immediate re-sell in another market. Arbitrage keeps the exchange rate between any two currencies the same across different markets. The purchase/re-selling closes differences in exchange rates by reducing currency available in the low price market and increasing availability in the high price market. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange Rate System. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Spot and Forward Rates, Currency Swaps, Futures, and Options Spot rate The exchange rate that calls for payment and receipt of the foreign exchange within two business days from the date when the transaction was made. Forward rate The exchange rate that calls for delivery of the foreign exchange one, three, six, twelve or twenty-four months after the date the contract is signed. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Spot and Forward Rates, Currency Swaps, Futures, and Options Forward discount The percentage per year by which the forward rate is below the spot rate. Forward premium The percentage per year by which the forward rate is above the spot rate. where FR = forward rate and SR = spot rate FD or FP = x 4 x 100 FR - SR SR Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Spot and Forward Rates, Currency Swaps, Futures, and Options A spot sale of a currency combined with a forward repurchase of the same currency – as part of a single transaction. Most interbank trading involving the purchase or sale of currencies for future delivery are done as currency swaps. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Spot and Forward Rates, Currency Swaps, Futures, and Options Foreign Exchange Futures Forward currency contracts for standardized currency amounts and select dates trade on an organized market. Traded currencies: Japanese yen Canadian dollar British pound Swiss franc Australian dollar Mexican peso Euro Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Spot and Forward Rates, Currency Swaps, Futures, and Options Foreign Exchange Options Contracts giving the purchaser the right, but not the obligation, to buy (call option) or to sell (put option) a standard amount of a traded currency on a stated date (European option) or any time before the stated date (American option) at a stated price (strike or exercise price). Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Whenever a future payment must be made or received in foreign currency, a foreign exchange risk is involved because spot rates vary over time. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Contracted future foreign currency payments may become more expensive if the domestic currency falls in value. Example: A contract requires a €100,000 payment in three months time. If the exchange rate is currently $1/€1, the expected dollar cost is $100,000. If the exchange rate changes to $1.10/ €1 in the intervening months, the dollar cost rises to $110,000. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Contracted future foreign currency receipts may fall in value if the domestic currency increases in value. Example: A producer expects to receive a payment of €100,000 in three months time. If the exchange rate is currently $1/€1, the expected dollar receipt is $100,000. If the exchange rate changes to $0.90/ €1 in the intervening months, the dollar receipt falls to $90,000. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 14-3 Exchange Rates of the G-7 Countries and Effective Exchange Rate of the Dollar, 1970-2012. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Hedging is the avoidance of foreign exchange risk. Options: Buy at the current spot rate and deposit the receipts in an interest earning account until the funds are needed. Buy a forward contract Typically entails paying a forward premium, increasing the cost of the transaction. Buy a call option If not exercised, the premium is lost. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Speculation, the opposite of hedging, is the acceptance of foreign exchange risk in the hope of making a profit. Example: If the speculator expects the spot rate in three months time to be $1/€1, she may sell euros at a current three month forward rate of $1.10/€1 with the expectation that she will be able to buy euros to cover her sale at the lower spot rate. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Stabilizing Speculation The purchase of a foreign currency when the domestic price falls or is low, in the expectation that it will soon rise, leading to a profit, OR The sale of a foreign currency when the domestic price rises, in the expectation that it will fall. Stabilizing speculation moderates fluctuations in exchange rates over time, serving a useful function. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Exchange Risks, Hedging, and Speculation Destabilizing Speculation The sale of a foreign currency when the domestic price falls or is low, in the expectation that it will fall even lower, OR The purchase of a foreign currency when the domestic price rises, in the expectation that it will rise even higher. Destabilizing speculation magnifies fluctuations in exchange rates over time, and can be very disruptive to international flow of trade and investments. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Interest Arbitrage and the Efficiency of Foreign Exchange Markets Interest arbitrage is the transfer of short-term liquid funds abroad to earn a higher rate of return. Uncovered interest arbitrage occurs when the transfer abroad entails foreign exchange risk due to the possible depreciation of the foreign currency during the investment period. Carry trade is the borrowing of fund in low-yielding currencies and lending in high-yielding currencies. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Interest Arbitrage and the Efficiency of Foreign Exchange Markets Interest arbitrage is the transfer of short-term liquid funds abroad to earn a higher rate of return. Covered interest arbitrage is the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of the foreign currency to cover, or remove, the foreign exchange risk. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Interest Arbitrage and the Efficiency of Foreign Exchange Markets Markets are efficient if prices reflect all possible information. The foreign exchange market is efficient if forward rates accurately predict future spot rates Empirical evidence is mixed. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 14-4 Covered Interest Arbitrage. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Eurocurrency or Offshore Financial Markets Eurocurrency refers to commercial bank deposits outside the country of their issue. Eurodollar - A deposit denominated in U.S. dollars in a British commercial bank. Eurosterling - A pound sterling deposit in a French commercial bank. Eurodeposit - A deposit in euros in a Swiss bank. The market in which the borrowing and lending of these balances takes place is the Eurocurrency market. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Eurocurrency or Offshore Financial Markets Reasons for Offshore Deposits Interest rates on short term deposits abroad are often higher than domestic rates. International corporations often find it convenient to hold balances abroad for short periods in currency they need for payments. International corporations can overcome domestic credit restrictions by borrowing in the Eurocurrency market. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Eurocurrency or Offshore Financial Markets Eurobonds - long-term debt securities sold outside the borrower’s country to raise long-term capital in a currency other than the currency of the nation where the bonds are sold. Euronotes - medium-term financial instruments used by corporations, banks and countries to borrow medium-term funds in a currency other than the currency in which the notes are sold. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 14.1 The Dollar as the Dominant International Currency Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 14.3 Foreign Exchange Quotations Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 14.4 Size, Currency, and Geographic Distribution of the Foreign Exchange Market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 14.6 Size and Growth of Eurocurrency Market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

𝐾(1+ 𝑖 4 ) < = > 𝐾 𝑆𝑅 1+ 𝑖∗ 4 𝐹𝑅 Appendix: Derivation of the Formula for the Covered Interest Arbitrage Margin From Formula 14A-1: 𝐾(1+ 𝑖 4 ) < = > 𝐾 𝑆𝑅 1+ 𝑖∗ 4 𝐹𝑅 Dividing by K and omitting the division by 4 1+𝑖=( 𝐹𝑅 𝑆𝑅 )(𝐼+𝑖∗) Solving for the FR and rearranging 𝐶𝐼𝐴𝑀= (𝑖−𝑖∗) (1−𝑖∗) − (𝐹𝑅−𝑆𝑅) 𝑆𝑅 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.