Download B. Exchange Rates and the Foreign Exchange Market Exchange

B.
Exchange Rates and the Foreign Exchange Market

Exchange rate – price of one currency in terms of another
Ex. - US$1 = HK$7.8 (indirect)
HK$1 = US$0.1282 (direct)

1.
Pacific Exchange Rate Service
Exchange rates and international transactions
a.
Domestic and foreign prices

(1)
Can calculate one country’s prices in terms of the other country’s
currency
Depreciation

(2)
Appreciation

b.
Country’s currency falls relative to another country’s currency
Country’s currency rises relative to another country’s currency
Exchange rates and relative prices

Compute prices of goods relative to one another
2.
The foreign exchange market
a.
The players
(1)
Commercial banks

(2)
Corporations

(3)
When intervening in the market
Characteristics of the market



Financial centers – London, New York, Tokyo, Frankfurt, Singapore
Market always in operation
No difference in rates traded in different financial centers –
arbitrage would eliminate differences

Most transactions involve foreign currency for U.S. dollars
-
c.
Pension funds, insurance companies, hedge funds
Another financial asset that can be traded
Central banks

b.
Multinational companies make and receive payments in foreign
currency
Nonbank financial institutions


(4)
Through handling of international transactions
U.S. dollar is a vehicle currency – widely used for transactions,
even by non-Americans
Spot rates and foreign rates
(1)
Spot rate – current exchange rate (on the spot)
(2)
Forward exchange rate – exchange rate at a future date

Used to lock in exchange rate, hedge against rate going badly
d.
Other instruments
(1)
Foreign exchange swaps

(2)
Futures

(3)
Promise that a specified amount of foreign currency will be
delivered on a specific date in the future
Options

3.
Spot sale of a currency along with a forward purchase of that
currency
Owner has the right to buy or sell a specified amount of foreign
currency at a specified price up to expiration date
Demand for foreign currency assets
a.
Assets and asset returns
(1)
(2)
Rate of return

Percentage return on an asset during a particular period

Demand based on expected rate of return in future
Real rate of return

b.
Rate of return adjusted for inflation
Other factors affecting demand
(1)
(2)
Risk

Variability in the return

Higher risk => lower demand
Liquidity

Speed and cost at which an asset can be converted into cash

Higher liquidity => higher demand
c.
Interest rates

d.
Exchange rates and asset returns

4.
Amount earned by lending currency for a year
Return = interest rate + currency appreciation (or – currency
depreciation)
Equilibrium in the foreign exchange market
a.
Interest parity condition

b.
Foreign exchange market is in equilibrium when deposits of all
currencies offer same expected rate of return
Impact of changes in the current exchange rate on expected returns
c.
5.
The equilibrium exchange rate
Interest rates, expectations, and equilibrium
a.
Effect of changing interest rates on the current exchange rate
b.
Effect of changing expectation on the current exchange rate