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Chapter 2:
The Market for Foreign Exchange
I. Chapter Overview
Chapter 2 begins with a description of the foreign exchange market, in particular the spot
market. After presenting a table of exchange rates, the section explains currency
appreciations and depreciations. It next shows how a pair of bilateral rates can be used to
compute the cross rate for a given currency. The section also demonstrates how to
compute the bid-ask spread and the bid-ask margin for a currency, and distinguishes
between the nominal and real exchange rates.
The next section defines the concept of an "effective" exchange rate as weighted-average
value of a currency relative to a selected group of currencies. Examples of such
weighting include multilateral weights, which reflect the trade flow of the individual
country with all countries included in the index relative to the total trade volume among
all countries included in the index, and bilateral weights, which reflect the trade flow of
the domestic country with respect to each of the countries relative to the total trade of the
domestic country with each of the countries included in the index. A detailed numerical
example is provided for a bilateral weighted effective exchange rate for the U.S. The
next section provides an example of a composite currency, specifically the International
Monetary Fund's Special Drawing Rights. Its construction is discussed in detail.
The next section of the chapter presents foreign exchange arbitrage. An example of
triangular arbitrage is provided. The following section explains and motivatesusing the
concept of derived demandthe supply of and demand for a currency. It then shows the
determination of the equilibrium exchange rate. Finally, it uses the supply and demand
diagram to show how a nations would intervene in the foreign exchange market to
maintain a given exchange value.
The final section of this chapter is devoted to the idea of purchasing power parity, PPP, as
a simple theory of the determination of the exchange rate. Specifically, absolute PPP is
equated to the international law of one price, and is defined as a condition whereby in the
absence of transportation costs, tax differentials or trade restrictions, the price of any two
internationally traded and identical goods or services must be the same once they are
adjusted by the value of the exchange rate between the two national currencies. Relative
PPP, by contrast, is defined as the condition whereby changes in the prices of any two
internationally traded and identical goods or services must be the same once they are
adjusted by the change in the value of the exchange rate between the two national
currencies. The text discusses problems associated with the measurement of these PPP
concepts as applied to baskets of goods, particularly when price deflators such as the CPI
are based on different baskets for different countries. The chapter concludes by indicating
that the empirical evidence tends to favor the weaker relative PPP condition more than it
does the absolute PPP condition, but that both are relatively poor guides to short-run
movements in the exchange rate for most major economies.
II. Outline
A. Exchange Rates and the Market for Foreign Exchange
1. The Role of the Foreign Exchange Market
2. Exchange Rate as Relative Prices
a. Currency Appreciation and Depreciation
b. Cross Rates
3 Bid-Ask Spreads and Trading Margins
a. The Bid-Ask Spread
b. The Bid-Ask Margin
4. Real Exchange Rates
5. The Effect of Price Changes
B. Measuring the Overall Strength or Weakness of a Currency: Effective Exchange
Rates
1. Constructing an Effective Exchange Rate
2. A Two-Country Example of an Effective Exchange Rate
a. Constructing Bilateral Weights
b. Determining Relative Exchange Rates
c. what and Effective Exchange Rate Tells Us
3. Real Effective Exchange Rates
C. Composite Currencies
1. Special Drawing Right (SDR)
2. Calculation of the SDR
D. Foreign Exchange Arbitrage
E. The Demand for and Supply of Currencies
1. The demand for a Currency
a. Illustrating the Demand Relationship: The Demand Curve
b. A Change in Demand
2. The Supply of a Currency
a. Illustrating the Supply Relationship: The Supply Curve
b. A Change in Supply
3. The Equilibrium Exchange Rate
a. Illustrating the Market Equilibrium
b. Example: A Change in Demand
4. Foreign exchange Market Intervention
F. Purchasing Power Parity
1. Absolute Purchasing Power Parity
a. Arbitrage and PPP
b. Absolute PPP
c. Practical Problems and Shortcomings of Absolute PPP
2. Relative Purchasing Power Parity
G. Chapter Summary
III. Fundamental Issues
1. What is the foreign exchange market?
2. What does it mean when a currency has appreciated or depreciated?
3. How is the general value of a currency measured?
4. What is foreign exchange arbitrage?
5. What determines the value of a currency?
6. What is purchasing power parity, and is it useful as a guide to movements in
exchange rates?
IV. Chapter Features
1. Online Notebook: “Online Foreign exchange Services”
This notebook examines to rise of Internet sites offering foreign exchange services.
An important feature of these Web based services is that it allows for smaller trades and
can be very beneficial for the increasing number of firms engaged in international
transactions. Although Web-based foreign exchange trading only accounts for about 15
percent of the overall market value, it is expected to increase in the near future.
For Critical Analysis: If most of the Online trades are small-valued transactions, then
they are not likely to have much of an impact on exchange rates levels and volatility. If,
however, big firms such as Mastercard start conducting transactions via the Web, then
these transactions may impact exchange value which are typically determined by interbank transactions.
2. Policy Notebook: "The Big Mac Index"
This feature describes the Economist magazine's popular Big Mac index, a regular annual
feature of the magazine. The index compares the average price of a Big Mac among
different countries in dollar prices after adjusting for the exchange rate. Comparisons of
these dollar prices are used to imply over- or undervaluation of a currency using the
underlying PPP theory.
For Critical Analysis: Exchange values are determined by transactions in a vast array of
goods, services, and financial assets. Hence, exchange rates are not likely to respond to
international price differentials of a single good. Rather, the prices of a single good, such
as a Big Mac will adjust.
3. Management Notebook: "Does the Border Between Canada and the United States
Matter?"
The notebook applies the idea of purchasing power parity to compare prices of goods in
cities similar distances apart. In one pair of cities, the cities are located in the same
country; while another pair of cities will be located in adjoining countries. A comparison
should allow us to see whether, after controlling for distance between the cities, a border
seems to matter for international prices. A study cited indicates that the border between
the U.S. and Canada is equivalent to 1,780 miles. Thus, a border still seems to matter,
even after a free trade agreement like NAFTA.
For Critical Analysis: If prices in the U.S. and Canada showed evidence of price
stickiness, we may expect the spot exchange rate between these countries to remain
relatively constant, if PPP holds. If PPP does not hold, it is likely that the exchange rate
would adjust to overall price differentials between the two economies.
V. Answers to End of Chapter Questions
1. Because it costs fewer dollars to purchase a euro after the exchange rate change, the
euro depreciated relative to the dollar. The rate of depreciation (in absolute value)
was [(1.2168 – 1.2201)/1.2201]100 = 0.27 percent.
2. If we take the inverse of each rate, the formula provided in the questions becomes:
1 
 1
S  S 
 S  
 S  S new 
old
 new
  100   old   1  100   old
  100.


 S
1
S


new


 new  


S
old


Returning to the table on page 37, the pound appreciation is:
[(0.5511 – 0.5501)/0.5501]*100 = 0.18, which is the same value derived on page 39.
3. Note that the rates provided are the foreign currency prices of the U.S. dollar. Every
value has been rounded to two decimal places which may cause some differences in
answers.
Australia
Britain
Canada
Switzerland
United States
A$
0.42
0.95
0.90
0.65
£
2.35
2.23
2.11
1.54
C$
1.06
0.45
0.94
0.69
Sfr
1.12
0.47
1.06
0.73
$
1.53
0.65
1.45
1.37
-
4. The cross rate is 1.702/1.234 = 1.379 (€/£), which is smaller in value than that
observed in the London market. The arbitrageur would purchase £587,544
($1,000,000/1.702) with the $1 million in the New York market. Next they would
use the £587,544 in London to purchase €837,250 (£587,544*1.425). Finally, they
would sell the €837,250 in the New York market for $1,033,167 (€837,250*1.234).
The profit is #33,167.
5. Total trade is (163,681 + 160,829 + 261,180 + 210, 590) = 796,280. Trade with the
Euro area is (163,681 + 261,180) = 424,861. Trade with Canada is (160,829 +
210,590) = 371,419. The weight assigned to the euro is 424,861/796/280 = 0.53 and
the weight assigned to the Canadian dollar is 0.47. (Recall the weights must sum to
unity.)
Because the base year is 2003, the 2003 EER is 100. The value of the 2004 EER is:
[(0.82/0.88)•0.53 + (1.56/1.59)•0.47]•100 = (0.4939 + 0.4611)•100 = 95.4964, or
95.5. This represents a 4.5 percent depreciation of the U.S. dollar.
6. The real effective exchange rate (REER) for 2003 is still 100. The real rates of
exchange are, for 2003, 0.88•(116.2/111.3) = .9187, 1.59•(116.2/111.7) = 1.6541, and
for 2004, 0.82•(119.0/114.4) = 0.8530, 1.56•(119.0/115.6) = 1.6059. The value of the
2004 REER is:
[(0.8530/0.9187)•0.53 + (1.6059/1.6541)•0.47]•100 = (0.4921 + 0.4563)•100 = 94.84,
or 94.8. This represents a 5.2 percent depreciation of the U.S. dollar in real terms
7. This is a nominal appreciation of the euro relative to the U.S. dollar. The percent
change is [(1.19 – 1.05)/1.05]•100 = 13.3 percent.
8. The January 200 real exchange rate is 1.05•(107.5/112.7) = 1.0016. The May 2004
real rate is 1.19•(116.4/122.2) = 1.1335.
9. In real terms the euro appreciated relative to the U.S. dollar. The rate of appreciation
is [(1.1335 – 1.0016)/1.0016]*100 = 13.17 percent.
10. Absolute PPP suggests the May 2004 exchange rate should be 122.2/116.4 = 1.0498.
The actual exchange rate is 1.19. Hence, the euro is overvalued relative to the U.S.
dollar by (1.19 – 1.0498)/1.0498]•100 = 13.35 percent.
11. Relative PPP can be used to calculate a predicted value of the exchange rate as:
SPPP = 1.05•[(122.2/112.7)/(116.4/107.5)] = 1.0014.
12. The actual exchange rate is 1.19. Hence, the euro is overvalued relative to the U.S.
dollar by (1.19 – 1.0014)/1.0014]•100 = 18.83 percent.
VI. Multiple Choice Questions
1. A market that involves the immediate sale or purchase of an asset is known as a(n)
A.
B.
C.
D.
currency market.
bond market.
spot Market.
free market.
Answer: C
2. The minimum value of a spot currency transaction is generally
A.
B.
C.
D.
$100,000.
$500,000.
$1 million.
$5 million.
Answer: C
3. If the currency-per-U.S. dollar exchange rate of the New Zealand dollar is 1.5, what is
one New Zealand dollar worth in terms of U.S. dollars?
A. $0.50
B. $0.67
C. $1.00
D. $1.50
Answer: B
4. Suppose exchange rate of the Argentinean peso relative to the U.S. dollar is 3
(Peso/$). If the peso were to undergo a 50 percent depreciation, the new exchange
value would be:
A. 1.5. B. 4.5. C. 3.5.
D. 0.5..
Answer: B
5. For which of the following sets of exchange rates has the cross rate been correctly
calculated?
A.
B.
C.
D.
£1 = 2 Swiss francs; $1.50 = £1; $1 = 0.75 Swiss francs
¥200 = $1.00; 1 ringgit = $0.15; 20 ringgit = ¥1
£1 = 1.5 euro; 3 Swiss francs = 2 euros; 2.25 Swiss francs = £1
¥100 = $1.00; 1 ringgit = $0.15; 20 ringgit = ¥1
Answer: C
6. A Korean trader wishes to make a purchase of Czech crystal worth 3 million Czech
korunas. Unfortunately, there is no published value of the Korean won to Czech
koruna exchange rate. In order to calculate the current price of the crystal in won, the
trader will need to calculate
A.
B.
C.
D.
the real exchange rate.
a cross rate.
the purchasing power parity rate.
South Korea's effective exchange rate.
Answer: B
7. Suppose the exchange rate between the U.S. dollar and the Canadian dollar is 1.37
(C$/$), while the exchange rate for the British pound is 0.66 (£/$). What is the cross
rate of Canadian dollars to the British pound (C$/£)?
A. 2.08
B. 1.37
C. 0.66
D. 0.48
Answer: A
8. An American tourist is planning to visit Mexico. The exchange rate at which the
tourist can buy pesos in a retail bank is the:
A.
B.
C.
D.
bid price.
ask price.
forward rate.
cross rate.
Answer: B
9. Suppose the bid price of British pounds is $1.49 U.S., and the ask price is $1.51 U.S.
What is the bid ask margin?
A. 0.02%
B. 0.99%
C. 1.01%
D. 1.32%
Answer: D
10. The spot exchange rates published in financial newspapers are:
A.
B.
C.
D.
nominal exchange rates.
real exchange rates.
effective exchange rates.
forward exchange rates.
Answer: A
11. Which of the following exchange rates is adjusted for price changes?
A.
B.
C.
D.
Nominal exchange rate.
Real exchange rate.
Effective exchange rate.
Forward exchange rate.
Answer: B
12. The table below reports the movements of prices and exchange rates for the U.S. and
Indonesia over a year's time.
Indonesian rupiah/$U.S.
Indonesian price level (CPI)
U.S. price level (CPI)
July 1, 2003
July 1, 2004
_____________________________
2,435
14,500
100
152
100
102
During this time, the Indonesian rupiah experienced a nominal
A.
B.
C.
D.
depreciation and a real appreciation.
depreciation and a real depreciation.
appreciation and a real appreciation.
appreciation and a real depreciation.
Answer: B
13. Based on the values in the table below, the percentage change in the value of the
rupiah was ___________ and the rate of inflation in Indonesia was __________.
Indonesian rupiah/U.S.
Indonesian price level (CPI)
U.S. price level (CPI)
A.
B.
C.
D.
16.8% depreciation, 2%
495.5% depreciation, 52%
16.8% appreciation, 52%
495.5% appreciation, 52%
Answer: D
14. The effective exchange rate is
July 1, 2003
July 1, 2004
____________________________
2,435
14,500
100
152
100
102
A. the exchange rate facing large banks and other high-volume traders.
B. the exchange rate facing retail customers.
C. the nominal exchange rate adjusted for inflation.
D. a measure of the weighted-average value of a currency relative to a selected group
of countries.
Answer: D
15. An exchange rate that is weighted by the share of each partner in a nation's trade is an
example of a
A.
B.
C.
D.
spot exchange rate.
effective exchange rate.
nominal exchange rate.
real exchange rate.
Answer: B
16. The Special Drawing Right (SDR) is a
A.
B.
C.
D.
means by which banks offer their best clients preferential loan rates.
preliminary form of the proposed common currency in Europe.
composite currency created by the International Monetary Fund.
type of bank account used by currency traders.
Answer: C
17. A currency trader engaging in spatial arbitrage would be doing what?
A. Purchasing real estate in major financial centers.
B. Purchasing an asset in one market and simultaneously selling it at a different price
in another market.
C. Choosing an investment portfolio that contained assets from many different
countries.
D. Selling borrowed currency in the hopes that there will be a large appreciation.
Answer: B
18. The demand for a currency is an example of
A.
B.
C.
D.
an aggregate demand.
a derived demand.
spatial arbitrage.
a perfectly elastic demand.
Answer: B
19. A depreciation of the Japanese yen relative to the U.S. dollar is illustrated as a:
A.
B.
C.
D.
rightward movement along the demand curve for Japanese yen.
leftward movement along the demand curve for Japanese yen.
shift rightward in the demand for Japanese yen.
shift leftward in the demand for Japanese yen.
Answer: A
20. An increase in the demand for French goods and services will:
A.
B.
C.
D.
induce a rightward shift in the demand for euros.
induce a leftward shift in the demand for euros.
result in a leftward movement along the demand curve for euros.
result in a leftward movement along the demand curve for euros.
Answer: A
21. The demand for the U.S. dollar in terms of Swedish krona:
A.
B.
C.
D.
is perfectly inelastic.
shifts leftward in response to an increase in Swedish demand for U.S. goods.
is upward sloping.
may also be represented as the supply of Swedish krona in terms of U.S. dollars.
Answer: D
22. An increase in U.S. demand for foreign assets will result in a:
A.
B.
C.
D.
rightward shift in the supply of U.S. dollars.
rightward movement along the supply schedule for U.S. dollars.
a leftward shift in the supply of U.S. dollars.
a leftward movement along the supply schedule for U.S. dollars.
Answer: A
23. If U.S. demand for German products increases at the same time as German demand
for U.S. products rises, what is the effect on the U.S. dollar to euro exchange rate?
A.
B.
C.
D.
The U.S. dollar will appreciate relative to the euro.
The U.S. dollar will depreciate relative to the euro.
The U.S. dollar will not change relative to the euro.
The U.S. dollar may appreciate, depreciate, or remain unchanged relative to the
euro.
Answer: D
24. An increase in the demand for the Canadian dollar will lead to
A. an appreciation of the Canadian dollar and a higher quantity of Canadian dollars
traded.
B. a depreciation of the Canadian dollar and a higher quantity of Canadian dollars
traded.
C. an appreciation of the Canadian dollar and a lower quantity of Canadian dollars
traded.
D. a depreciation of the Canadian dollar and a lower quantity of Canadian dollars
traded.
Answer: A
25. An increase in the supply of the Mexican peso will lead to:
A.
B.
C.
D.
an appreciation of the peso and a higher quantity of pesos traded.
a depreciation of the peso and a higher quantity of pesos traded.
an appreciation of the peso and a lower quantity of pesos traded.
a depreciation of the peso and lower quantity of pesos traded.
Answer: B
26. Which basket of goods would be most likely to exhibit absolute purchasing power
parity?
A. The goods in the Consumer Price index.
B. Specialized luxury goods, which are subject to different tax rates across countries.
C. Locally produced goods, such as transportation services, which are not easily
traded.
D. Highly tradable commodities, such as wheat.
Answer: D
27. The difference between relative and absolute purchasing power parity (PPP) is
A. relative PPP includes a measure of the aggregate price level in each country,
while PPP does not.
B. empirical studies show that relative PPP holds in both the short and long run, w
while absolute PPP holds only in the short run.
C. relative PPP relates interest rate differentials, while absolute PPP relates goods
prices.
D. relative PPP implies that exchange rate movements will offset changes in relative
prices over time, while absolute PPP implies that exchange-rate adjusted prices
will always be equal.
Answer: D
28. If the price of a pair of shoes in the U.S. is $80, the price of the same pair of shoes in
Germany is €120, and the exchange rate is 1.5 $/€, the euro:
A.
B.
C.
D.
is correctly valued according to PPP.
is overvalued according to PPP.
is undervalued according to PPP.
correctly valued according to relative PPP.
Answer: B
29. Assume that PPP holds in the long run. If the price of a tradable good is $20 in the
U.S. and 100 pesos in Mexico and the exchange rate is 7 pesos/$, which of the
following changes might we expect in the future?
A. an increase in the price of the good in the U.S.
B a decrease in the price of the good in Mexico.
C. an appreciation of the peso in nominal terms.
D. a depreciation of the peso in nominal terms.
Answer: C