Chapter 11 The Foreign Exchange Market Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Foreign Exchange Market Foreign Exchange Market: A global marketplace made up of banks and dealers/brokers where differing national currencies are bought and sold in spot markets and derivative markets such as forwards, futures, options and swaps Huge sums of money are exchanged on a daily basis over $6 trillion per day ! The main centre for foreign exchange is London followed by New York Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Foreign exchange market turnover (daily average in billions of US Dollars) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Exchange Rate Definitions The exchange rate is simply the price of one currency in terms of another. Foreign currency per units of the domestic currency. $ 1.2500/£1 Domestic currency per units of the foreign currency. £ 0.80/$1 Note: Pound is the domestic currency. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Exchange Rate Definitions Exchange rates are expressed as bid-offer rates. Mid point for the exchange rate: $ 1.2500/£1 Bid Rate: $ 1.2498/£1 Offer Rate: $ 1.2502/£1 Bid Rate: The rate at which a bank willing buy pounds from clients . (i.e sell dollars to clients) Offer Rate: A rate which bank is willing sell pounds to cleints (i.e. buy dollars from clients). Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Which Bank Which Rate ? You work for Bank D and wish to sell £10 million which bank do you trade with and at what rate ? You work for Bank D and wish to buy £10 million which bank do you trade with and at what rate ? Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Exchange rate quotations at close of business Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Characteristics and Participants in the Foreign Exchange Market Main participants: Retail Clients, Commercial Banks, Foreign Exchange Brokers, Central Banks and other authorized agents. Foreign exchange centre: London, Tokyo, New York, Singapore, Frankfurt Communication way via participants: Telephone, computer terminals, telex, fax The most traded currency: US dollar, followed by the Euro Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The organisation of the foreign exchange market Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Arbitrage in the Foreign Exchange Market Financial Centre Arbitrage : This type of arbitrage ensures that the dollar-pound exchange rate quoted in New York is the same as quoted in London. Cross-Currency Arbitrage: Differences to exploit between the exchange rate of different currencies. Example: Dollar-Pound rate: $ 1.25/£1 Dollar-Euro rate: $ 1.15/ € 1 Therefore, exchange rate of Euro-Pound should be €1.0870/ £ 1 If Euro-Pound rate is not equal to $1.0970/ £1, there will be an arbitrage opportunity. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Foreign exchange cross rates on close of business 24 March 2017 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Spot & Forward Exchange Rate The spot exchange rate: The exchange rate between two currencies for immediate delivery Forward exchange rate: The exchange rate between two currencies quoted for a given date in the future. A variety of forward rates may be quoted. (1 month, 3 months, 6 months and a year) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Simple Model for Determining the Spot Exchange Rate The Demand for Foreign Exchange Table 11.4 illustrates the derivation of hypothetical demand for pounds schedule with respect to changes in the exchange rate. As the pound appreciates against the dollar, it moves from $ 1.05/£1 towards $1.45/£1, the price of UK exports to US importers increases. This leads to lower quantity of exports with a reduced demand for pounds. Hence, the demand curve for pounds slopes down from left to the right in Figure 11.2. The factors that result in rightward shift in the demand curve are: A rise in US income, a change in US tastes in favor of UK goods, a rise in the price of US goods. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Derivation of the demand for pounds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The demand for pounds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Simple Model for Determining the Spot Exchange Rate The Supply of Foreign Exchange Table 11.5 illustrates the derivation of hypothetical supply of pounds. As the pound appreciates against the dollar, the costs of US exports become cheaper for UK residents. They demand more US exports. This results in an increase demand for dollars which are purchased by increasing the amounts of pounds supplied in the foreign exchange market. This yields upward sloping supply of pounds. The supply of pounds depend on the UK demand for US exports. The supply curve shifts to the right if there is an increase in UK income, a change in British tastes in favor of US goods or a rise in UK prices. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Derivation of the supply of pounds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The supply of pounds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Simple Model for Determining the Spot Exchange Rate Figure 11.4 shows the determination of dollar-pound exchange rate in the context of a supply and demand framework. When the exchange rate is left to float freely, it is determined by the interaction of the supply and demand curves. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Determination of the dollar-pound exchange rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Alternative Exchange Rate Regimes Floating Exchange Rate Regime Fixed Exchange Rate Regime Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Floating Exchange Rate Regime The authorities do not intervene to buy or sell their currency in the foreign exchange market. They allow the value of their currency to change due to fluctuations in supply and demand of the currency. In Figure 11.5(a), the initial exchange rate is $ 1.25/£1. As there is an increase in demand for UK exports, demand curve shifts from D1 to D2. This leads to appreciation of the pound from $1.25/£1 to $1.40/£1. In Figure 11.5(b), the initial exchange rate is $ 1.25/£1. Due to the increased demand for US exports, supply curve for pound shifts to the right, resulting a depreciation of the pound to $1.10/£1. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Floating exchange regime Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Fixed Exchange Rate Regime A system whereby the exchange rate is fixed against another currency at a given target exchange rate. The central bank of that currency commits itself to buy or sell the currency as appropriate to maintain the fixed rate. Non-sterilized Intervention: Foreign exchange intervention by the authorities to buy or sell the domestic currency which is allowed to affect the domestic money supply and short term interest rate. Sterilized Intervention: Foreign exchange intervention by the authorities which is not allowed to affect the domestic money supply or domestic interest rate. This is because an offsetting open market operation is used to negate the money supply consequences of the foreign exchange intervention. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Fixed exchange-rate regime: demand shock Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Fixed Exchange-Rate Regime: Demand Shock Figure 11.6 (a) & Figure 11.6 (b) Authorities fix the exchange rate at $1.25/£1 where demand curve intersects with the supply curve. If there is an increase in demand for pounds, demand curve shifts from D1 to D2 exchange rate potentially moves to $1.40/£1. Bank of England sells Q1-Q2 of pounds by purchasing US dollars. This shifts the supply of pounds from S1 to S2. This intervention weakens the pound back to at $1.25/£1 . This increases Bank of England’s reserves of US dollars while increasing the amount of pounds in circulation from M1 to M2 and lower the UK interest rate from r1 to r2. As the sale of pounds has increased the UK money supply, the intervention is of the non-sterilized type. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Fixed exchange-rate regime: supply shock Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Fixed Exchange-Rate Regime: Supply Shock Authorities fix the exchange rate at $1.25/£1 where demand curve intersects with the supply curve. If there is an increase in the supply of pounds, supply curve shifts from S1 to S2. Pound rate depreciates to $1.10/£1. Bank of England buys Q1-Q2 of pounds with dollars. This shifts the demand for pounds from D1 to D2. Due to the intervention, the exchange rate returns back to $1.25/£1 . UK money supply decreases from M1 to M2. The interest rate increases from r1 to r2. As buying pounds in the foreign exchange market reduces the money supply, and raises the short term interest rate, this intervention is the non-sterilized type. Non sterilized intervention is highly likely to be effective at strengthening the pound due to the fact there are less pounds in circulation and a higher UK interest rate. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Chinese foreign exchange reserves Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Chinese foreign exchange intervention Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Determination of the Forward Exchange Rate In the forward exchange rate, market buyers and sellers agree to exchange currencies at some specific date in the future. Economic agents involved in this market are divided into three groups. Hedgers Arbitrageurs Speculators Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Hedgers They enter the forward exchange market to protect themselves against exchange rate fluctuations which entail exchange rate risk- the risk of loss due to adverse exchange rate movements. Example Spot Rate $1.25/£1 one year Forward ($1.28/£1) UK importer who is due to pay for goods from the USA to the value of $128,000 in one year’s time. If one year forward rate is $1.28/£1, UK importer has to pay only £100.000 without exchange rate risk. By taking out the forward exchange rate of $1.28/£1 the hedger avoid risk that the future spot rate would be say $1.10/£1 when the goods would cost £116.263 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Arbitrageurs Arbitrageurs are agents that aim to make a riskless profit out of any discrepancies between interest-rate differentials and the forward discount/premium as generated by the covered interest parity condition Forward Discount: A measure expressed as a percentage per amount of the spot rate by which a currency is weaker in the forward market than in the spot market. Forward Premium: A measure expressed as a percentage per annum of the spot rate by which a currency is stronger in the forward market than in the spot market. F: Forward exchange rate S: Spot exchange rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Arbitrageurs Covered Interest Parity: A formula used by banks to calculate a forward exchange rate quotation. CIP formula is used by banks to calculate their forward exchange quotation. F: one year forward exchange rate quotation foreign currency per domestic S: spot exchange rate quotation foreign currency per domestic r: one year domestic interest rate r*: one year foreign exchange rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Example Calculations of the Forward Exchange Rate One-year dollar interest rate: 5% One-year sterling interest rate: 2% Spot rate of dollar against pound: $1.25/£1 One year forward exchange rate of the pound is: One year forward rate of the pound is at annual forward premium of 2.78%. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Calculation of the $/£ forward exchange rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Speculators Speculators are agents that hope to make a profit by accepting exchange rate risk. They engage in forward exchange market because they believe that the future rate corresponding to the date of the quoted forward exchange rate will be different than the quoted forward rate. A speculator hopes to make money by taking an open position. Open Position: A speculative position held by a trader or an institution that has not yet been closed, leading to the possibility of future losses or gains depending on movements in market prices. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Nominal, Real and Effective Exchange Rate Nominal Exchange Rate: An index which tracks the movements of a currency against another currency. It is usually constructed so that a rise represents an appreciation, while a fall represents a depreciation of the indexed currency. Real Exchange Rate: An index which tracks the changes in economic competitiveness of one country’s currency against another country’s currency. It is almost always constructed so that a rise represents a loss of competitiveness, while a fall represents a gain in competitiveness of the indexed currency. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Effective Exchange Rate The Effective Exchange Rate: It is the measure of whether or not the currency is appreciating or depreciating against a weighted basket of foreign currencies. The nominal effective exchange rate provides a reasonable measure of changes in a country’s competitiveness position for periods of several months. To get better idea of the changes in a country’s competitive position over time, real effective exchange rate should be calculated. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Effective Exchange Rate Table 11.9 shows the movements of a hypothetical exchange rate index for the pound, based on the movements in the bilateral nominal exchange rate indices against the dollar and euro. Suppose that UK is conducting 30% of its foreign trade with the USA and 70% of its trade with Europe. This means that a weight of 0.3 is attached to the bilateral exchange rate index with the dollar and 0.7 with the euro. Example: Between Periods 1 and 2, the pound appreciates 10 % against dollar but depreciates 10 % against the euro. As Euro has greater weight than dollar, the effective exchange rate index indicates an overall depreciation of 4%. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Construction of nominal and real exchange rate indices Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 11.10 The evolution of the dollar-pound nominal and real exchange rate, 1973-2017 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The evolution of the yen-dollar nominal and real exchange rate, 1973-2017 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 11.12 The evolution of the dollar-euro nominal and real exchange rate, 1999-2017 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Construction of an effective exchange rate index Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Nominal effective exchange rate indices Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Real effective exchange rate indices Keith Pilbeam ©: Finance and Financial Markets 4th Edition