1. Foreign Exchange Market Basics

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

3. 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.

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

5. 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.

6. 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

7. 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.

8. 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)

9. 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

10. 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 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 = St random errors
On Average, Ft+1 = St+1 because the average of random errors is zero.

11. 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.

12. 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 = = F-S = Se - S

13. *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.