1. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 1 An Introduction to International Economics Chapter 11: The Foreign Exchange Market and Exchange Rates Dominick Salvatore John Wiley & Sons, Inc.

2. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 2 Foreign exchange markets Foreign exchange markets are the collection of markets where currencies are converted. Historic exchange rates –Federal Reserve Bank data WWW link Current exchange rates –XE.com WWW link

3. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 3 Functions of the exchange rate markets Transfer purchasing power between currencies Provide credit for foreign transactions

4. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 4 Participants in foreign exchange markets Those needing currency to fund transactions –Purchase of goods –Tourism –Foreign investment

5. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 5 Participants in foreign exchange markets Those needing currency to fund transactions Commercial banks –Serve as the clearinghouses for currency exchange

6. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 6 Participants in foreign exchange markets Those needing currency to fund transactions Commercial banks Foreign exchange brokers –Clearinghouse for surpluses and shortages between the commercial banks

7. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 7 Participants in foreign exchange markets Those needing currency to fund transactions Commercial banks Foreign exchange brokers Central banks –Buyer or seller of last resort in the foreign exchange markets

8. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 8 Supply and demand model Demand for foreign currency in the foreign exchange markets is driven by transactions requiring foreign currency. –Imports –Asset flows abroad ¥/day $/¥ D¥D¥

9. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 9 Supply and demand model Supply for foreign currency in the foreign exchange markets is driven by transactions requiring dollars. –Exports –Asset flows to the U.S. –Use of the dollar as the “international currency” ¥/day $/¥ D¥D¥ S¥S¥

10. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 10 Supply and demand model The equilibrium exchange rate occurs at the intersection of the supply and demand curves. ¥/day $/¥ D¥D¥ S¥S¥ Equilibrium

11. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 11 Changes to equilibrium Depreciation –An increase in the domestic currency price of a foreign currency. Example –Suppose that the supply of yen falls due to a decrease in the role of the dollar as the “international currency.” –Since more dollars are required to buy yen, the dollar has weakened or depreciated. ¥/day $/¥ D¥D¥ S¥S¥ Equilibrium

12. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 12 Changes to equilibrium Appreciation –An decrease in the domestic currency price of a foreign currency. Example –Suppose that the supply of yen increases from an increased desire to purchase U.S. goods. –Since fewer dollars are required to buy yen, the dollar has strengthened or appreciated. ¥/day $/¥ D¥D¥ S¥S¥ Equilibrium

13. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 13 Types of exchange rates Spot exchange 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.

14. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 14 Types of exchange rates Spot exchange rate Forward exchange 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. –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 sport rate.

15. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 15 Types of exchange rates Spot exchange rate Forward exchange rate Cross exchange rate –The exchange rate between currencies A and B given the exchange rate between currency A and C and between B and C. –Example Suppose dollar/yen exchange rate is $0.01 and the dollar/pound exchange rate is $2. The cross exchange rate between yen and pounds is $2 ÷ $0.01 = 200 ¥/£.

16. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 16 Types of exchange rates Spot exchange rate Forward exchange rate Cross exchange rate Effective exchange rate –The effective exchange rate is a weighted average of the exchange rates between the domestic currency and the nation’s most important trading partners. Federal Reserve Bank data –WWW linkWWW link

17. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 17 Are exchange rates uniform internationally? Differences in exchange rates in different markets are closed by arbitrage. –Arbitrage is the purchase of currency in one market for immediate re-sell in another market. –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.

18. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 18 Exchange rates and the BOP Suppose the going exchange rate is 120 ¥. At this exchange rate the balance of payments is in disequilibrium. –Debits in the balance of payments (assuming only the U.S. and Japan contribute the BOP) will be given by A. ¥/day $/¥ D¥D¥ S¥S¥ 120 ¥ A

19. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 19 Exchange rates and the BOP At this exchange rate the balance of payments is in disequilibrium. –Debits in the balance of payments (assuming only the U.S. and Japan contribute the BOP) will be given by A. –Credits in the balance of payments will be given by B. ¥/day $/¥ D¥D¥ S¥S¥ 120 ¥ AB

20. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 20 Exchange rates and the BOP At this exchange rate the balance of payments is in disequilibrium. In the absence of intervention, the exchange rate would fall to C to bring the exchange rate and the balance of payments into equilibrium. ¥/day $/¥ D¥D¥ S¥S¥ 120 ¥ AB C

21. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 21 Exchange rates and the BOP If either Japan or the U.S. wishes to prevent this exchange rate movement, the missing units of ¥ may be provided to the market. –The provision of A to B units of ¥ to the market keep the exchange rate from falling. ¥/day $/¥ D¥D¥ S¥S¥ 120 ¥ AB C

22. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 22 Exchange rates and the BOP These units of ¥ generate an offsetting Official Reserve Settlement Balance to bring the balance of payments into equilibrium. ¥/day $/¥ D¥D¥ S¥S¥ 120 ¥ AB

23. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 23 Foreign exchange futures Foreign exchange futures are forward currency contracts for standardized currency amounts and select dates. –Standard currency amounts ¥12.5 million £62,500 €125,000

24. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 24 Foreign exchange futures Foreign exchange futures are forward currency contracts for standardized currency amounts and select dates. –Standard currency amounts –Select dates 3 rd Wednesday in March, June, September, and December

25. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 25 Foreign exchange futures Foreign exchange futures are forward currency contracts for standardized currency amounts and select dates. –Standard currency amounts –Select dates –Market International Monetary Market of the Chicago Mercantile Exchange

26. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 26 Foreign exchange options A foreign exchange option specifies a right – but not an obligation – to buy (call option) or sell (put option) a standard amount of currency on or before a specified date.

27. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 27 Foreign exchange risk In the absence of significant exchange rate intervention, exchange rates fluctuate significantly over time. Risks of exchange rate movements –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.

28. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 28 Foreign exchange risk Risks of exchange rate movements –Contracted future foreign currency payments may become more expensive if the domestic currency falls in value. –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.

29. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 29 Hedging Hedging is the avoidance of a foreign exchange risk. Options –Buy at the current spot rate and deposit the receipts in an interest earning account until the funds are needed. Keeps funds tied into a foreign currency until needed.

30. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 30 Hedging Hedging is the avoidance of a 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 this will entail paying a forward premium which increases the cost of the transaction.

31. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 31 Hedging Hedging is the avoidance of a 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 –Buy a call option If not exercised, the premium is lost.

32. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 32 Speculation Speculation 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.

33. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 33 Speculation Speculation is the acceptance of foreign exchange risk in the hope of making a profit. Stabilizing speculation –Speculation that acts to moderate fluctuations in currency values.

34. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 34 Speculation Speculation is the acceptance of foreign exchange risk in the hope of making a profit. Stabilizing speculation Destabilizing speculation –Speculation that serves to amplify fluctuations in exchange rate values.

35. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 35 Interest arbitrage Interest arbitrage is the transfer of short-term liquid funds abroad to earn a higher rate of return. –Covered interest arbitrage occurs when the transfer abroad does not entail exchange rate risk. Example –Suppose the spot rate is ¥100/$1. –Converting $1,000 at this rate yields ¥100,000. –If interest rates in Japan are 8% vs. 5% in the U.S., in one year the funds in Japan will earn ¥8,000 vs. $50 in the U.S. –If a forward contract to sell ¥108,000 was initially signed at the rate of ¥101/$1, $1,069.31 will be obtained. This is greater than the $1,050 that would have been obtained in the U.S.

36. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 36 Interest arbitrage Interest arbitrage is the transfer of short-term liquid funds abroad to earn a higher rate of return. –Covered interest arbitrage occurs when the transfer abroad does not entail exchange rate risk. –Uncovered interest arbitrage occurs when the transfer abroad does entail exchange rate risk. The previous example would demonstrate uncovered interest arbitrage if the return of funds to the U.S. was done at the future spot rate rather than by a forward contract.

37. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 37 Covered interest arbitrage parity Covered interest arbitrage is essentially without risk. Therefore, all profitable movements of funds should occur.

38. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 38 Covered interest arbitrage parity Covered interest arbitrage is essentially without risk. Therefore, all profitable movements of funds should occur. The movement of funds to exploit profitable arbitrage possibilities should move interest rates, the spot rate, and the forward rate so as to eliminate profitable opportunities.

39. Dale R. DeBoer University of Colorado, Colorado Springs 11 - 39 Covered interest arbitrage parity The movement of funds to exploit profitable arbitrage possibilities should move interest rates, the spot rate, and the forward rate so as to eliminate profitable opportunities. Once the profitable opportunities are closed, the following parity condition will hold: –e t = [(1 + r Japan )/(1 + r US )] f 360 e t is the spot exchange rate ($/¥) f 360 is the 1 year forward rate ($/¥) r Japan is the interest rate in Japan r US is the interest rate in the U.S.