Thank You for Attention

Explain how the foreign exchange market works. Examine the forces that determine exchange rates. Consider whether it is possible to predict future rates movements. Map the business implications.

The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income. The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments. The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. The goods & services market coordinates the demand for and supply of domestic production (GDP).

GDP = C + I + G + NX

Foreign Exchange Market: The foreign exchange market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. This enables companies based in different countries that use different currencies to trade with each other Exchange Rate: The rate at which one currency is converted into another. Foreign Exchange Risk: Probability of loss occurring from an adverse movement in foreign exchange rate.

Direct quotation –price of F currency, expressed in terms (units) of H currency (H/F) Indirect quotation –price of H currency, expressed in terms (units) of F currency (F/ H)

Supply –Foreign demand for domestic goods & services (exports of goods & services). –Foreign demand for domestic financial assets (capital inflows) –Use of reserves by the central bank. (The balance of payments) Demand –Domestic demand for foreign goods & services (imports of goods & services). –Domestic demand for foreign financial assets (capital outflows) –Build up of reserves by the central bank. (The balance of payments)

Spot rate: Currencies traded for immediate delivery at rates prevailing at the time of transaction. Actual delivery (electronic transfer) may take two working days Forward rate: The Forward Rate is the rate that appears in a contract toexchange a currency in the future. (delivery at a specified future date). Currency speculation: Buying and holding a currency for sale at a higher rate in the near future.

Appreciation – market increase in value of currency Depreciation – market decrease in value of currency Devaluation – official decrease in value of currency (change in central parity) Revaluation – official increase in value of currency (change in central parity)

When Czechs buy from foreigners and make investments abroad (outflow of capital), their actions generate a demand for foreign currency in the foreign exchange market. On the other hand, when Czechs sell products and assets (including bonds) to foreigners, their transactions will generate a supply of foreign currency (in exchange for koruna) in the foreign exchange market. The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied.

Foreign Exchange market Quantity of currency Koruna price (of foreign currency) S (exports + capital inflow) D (imports + capital outflow) Q P1P1 Depreciation of koruna Appreciation of koruna Czechs demand foreign currencies to import goods & services and make investments abroad. Foreigners supply their currency in exchange for koruna to purchase czech exports and undertake investments in the Czech Republic. The exchange rate brings quantity demanded into balance with the quantity supplied and will bring (imports + capital outflow) into equality with (exports + capital inflow).

Imports + Capital Outflow = Exports + Capital Inflow Imports = - Exports Capital Inflow – Capital Outflow When equilibrium is present in the foreign exchange market, the following relation exists: This relation can be re-written as: The right side of this equation (capital inflow minus capital outflow) is called net capital inflow. Net capital inflow may be: –positive, reflecting a net inflow of capital, or, –negative, reflecting a net outflow of capital.

Imports = - Exports Capital Inflow – Capital Outflow The left side of the equation above is called the trade balance. –When imports exceed exports, this is referred to as a trade deficit. –On the other hand, if exports exceed imports, this is referred to as a trade surplus. When the exchange rate is determined by market forces, trade deficits will be closely linked with a net inflow of capital. –Conversely, trade surpluses will be closely linked with a net outflow of capital.

Loanable Funds market Supply of loanable funds D0D0 Q1Q1 r2r2 r1r1 D1D1 D2D2 Domestic saving Q2Q2 Quantity of Funds Interest Rate Capital outflow Capital inflow r0r0 Q0Q0 Demand and supply in the loanable funds market will determine the interest rate. When demand for loanable funds is strong (D2), real interest rates will be high (r2) and there will be a inflow of capital. In contrast, weak demand (D 1 ) and low interest rates (r 1 ) will lead to capital outflow.

Governments limit convertibility to preserve their foreign exchange reserves. Freely Convertible: Country’s government allows both residents and nonresidents to purchase unlimited amounts of foreign currency Externally convertible: Only nonresidents may convert it into a foreign currency without any restrictions Nonconvertible: Neither residents nor nonresidents are allowed to convert it into foreign currency Countertrade Companies can deal with non-convertibility problem by engaging in countertrade Range of barter-like agreements by which goods & services can be traded for other goods & services

Exchange rate changes as a result of changes in particular macroeconomic indicators: –Differences in the rates of inflation: increase in the domestic rate of the level of prices  depreciation of the domestic currency –Differences in the interest rates: higher domestic interest rates  appreciation of the domestic currency –Differences in the level of income: higher domestic income  depreciation of the domestic currency –Relative economic growth rates –Expectations –Other factors (political and psychological factors)

If the Japanese assets have a higher expected rate of return than the U.S. assets. Traders around the world will recognize a chance to make a profit by selling U.S. assets and buying Japanese assets. As traders and investors sell dollar-denominated assets and buy yen-denominated assets. This increases demand for yen. This leads to appreciation of yen against dollar. This appreciation continues till the point when investors are indifferent between holding U.S. or Japan assets. This means the return from both the assets will be equal.

Lets assume U.S. interest rate to be 5%. Lets call it R the domestic expected rate of return. Suppose that future yen/dollar exchange rate is 100 and Japanese interest rates are 5%. If current exchange rate is also 100 yen/dollar, then R f the expected rate of return from foreign assets equals R.

But if current exchange rate is 105 yen/dollar and the future expected exchange rate is 100 yen/dollar, that means dollar is expected to depreciate. The dollar is expected to fall by 4.8%. This depreciation of dollar will increase the expected return from foreign assets R f to 9.8% (5% interest rate plus 4.8% expected depreciation of dollar).

Alternatively, if current exchange rate is 97 yen/dollar and the expected future exchange rate is 100 yen/dollar. The dollar is expected to appreciate by 3.1%. This would imply that the expected rate of return from foreign assets R f will fall to 1.9% (5% interest rate minus 3.1% expected appreciation of dollar).

Alternately if the domestic real interest rates fall, it will lead to shifting of expected real rate of return towards left. This would result in falling of exchange rates. That means depreciation of the domestic currency.

Yen/USD USD (quantity) 100 D S D’ S’

Real exchange Rate: R = E. PF / P E - nominal exchange rate P - price level of domestic good PF - price level of foreign good R - real exchange rate Decrease of R is real appreciating and vice versa.... ! Purchasing Power Parity (PPP) Holds that the prices of identical goods should be the same in all countries. It is simply the law of one price applied to the international market.

Demand & supply of one currency relative to the demand & supply of another currency is important because foreign exchange movements influence –Export opportunities –Profitability of trade & investment deals –Price competitiveness of foreign imports Impact on foreign exchange rate movement –Country’s price inflation –Its interest rate –Market psychology

Indirect interventions: –Monetary policy: open market operations (increasing/decreasing the interest rate) directly related to the change in the quantity of money, and, consequently, to the change in prices in the country –Fiscal policy: changes in the level of government spending and the taxation of the residents, as well as the size of the government suficit/deficit restrictive fiscal policy  causes depreciation of the domestic currency expansive fiscal policy  causes appreciation of the domestic currency –other forms of intervention: various forms of public communication between the CB representatives and the government

schematic representation of the influence of various factors on the market exchange rate:

Pegged exchange rate: Currency value is fixed relative to a reference currency (US dollar $ 1 = 8.28 Chinese yuan) Floating exchange rate: Exchange rate for converting one currency into another is continuously adjusted based on supply & demand Dirty float system: Currency nominally allowed to float & Government will step in if it deviates too far from fair value