Foreign Exchange Market Basics

Preview The basics of exchange rates Exchange rates and the prices of goods The foreign exchange markets

1. The Foreign Exchange Market Characteristics of the market: Trading occurs mostly in major financial cities: London, New York, Tokyo, Frankfurt, Singapore. Infrastructures or supportive system of market transactions are important. The volume of foreign exchange has grown rapidly. About 90% of transactions involved US dollars.

2. FX Markets Instruments Spot Forwards: closely related to Expected Future Spot FX rate Futures Options Swap

3. Spot Rates and Forward Rates Spot FOREX rate or S is exchange rate for currency exchanges “on the spot”, or when trading is executed in the present. current spot FOREX rate = St Spot FOREX rate of the future = St+1 expected future FOREX rate for the next period = tSt+1 e Forward rates or F is today’s exchange rate for currency exchanges that will occur at a future (“forward”) date: Rates are negotiated between individual institutions in the present, but the exchange occurs in the future. Contract is done today; the rate is set and known today Delivery will be done in the future; forward dates are typically 30, 90, 180 or 360 days in the future.

4. Definitions of Exchange Rates: Direct Quotation Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency(E) . For Canadians, E = E units of Canadian dollars to get one unit of U.S. dollar = E Canadian$/U.S.$ This quotation make the best economics sense: How much does a Honda cost? $3,000 How much does a unit of U.S. dollar cost = Canadian $1.02

Different Notation for FX Rates Some textbooks use S (Do not be confused with ‘S’ for Supply) Thus we will use E and/or S together.

4. Depreciation and Appreciation Depreciation is a decrease in the value of a currency relative to another currency. Appreciation is an increase in value. Suppose that our quotation of S per FOREX goes up: Canadian $1/U.S.$1 -- Canadian $1.20/U.S.$1 FOREX becomes more expensive; Appreciation of FOREX (U.S. dollar) Depreciation of domestic currency (Canadian dollar)

Depreciation and Appreciation (cont.) Appreciation is an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. $1/€1 -> $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable

5. Forward Rate and Future FX Rate Forward FX rate is the FX rate set today for a future delivery; thus it is based on today(time t)’s expectations of what S might be at time t+1. Thus “the expected future spot FX rate is equal to the Forward FX rate”. tSet+1 = Ft+1 The difference between Forward Rate of t+1 and Actual Rate(realized) of t+1 is Random Errors tSet+1 = St+1 + random errors Therefore, forward rate is, on average, equal to expected future FX rate; “Forward FX rate is the best predictor for future FX rate”. Ft+1 = St+1 + random errors On Average, Ft+1 = St+1 because the average of random errors is zero.

Forward Premium tells the expected change in S: Δ% Se = (Se – S)/S If FOREX market is efficient, then Se = F Δ% Se = (F- S)/ S Forward premium(+) or discount(-) is equal to the market’s expected change in FX rates.

Numerical example in class: If you are a Canadian exporter with delayed receivable of U.S. $ 1 million; U.S. forward premium is 0.01. Are you going to have capital gains or loss from FX market? (Answer) expected capital gains = 1.01-1.00 = F-S = Se - S

*Test of FOREX Market Efficiency t Se t+1 = St+1+ e Note that F has replaced Se Thus, Ft+1 = St+1 + e Forward Rate is the best predictor for the future spot rate.