The Foreign Exchange Market
Lecture 5

1. Foreign exchange market - the currency of one country is traded for another currency

2. Who uses foreign currencies?

   1. International banks - transfers billions in foreign currencies with other banks

   2. Businesses, especially involved in imports and exports

   3. International investors

      1. Hedge - invest in a variety of countries to reduce risk

      2. Speculation - buy currency for a low price and sell for high price

         • Gambling

      3. Arbitrage - an investors sees a price difference of same currency in two markets; he buys currency for a low price and sells to the high price market

         • Price differences disappear

   4. Tourists

   5. Central banks and government – manipulate exchange rates

3. Characteristics

   1. Most transactions are electronic transfers

      • Largest market

      • $3.2 trillion per day in 2007

      • Trade occurs 24 hours per day, 7 days per week

   2. Spot market – the exchange of currencies occur immediately between buyers and sellers

      • Retail - small agents buy and sell foreign currencies

        • Two exchange rates

        • Selling price is always higher than buying price

        • The price spread is commission

      • Wholesale - network of about 2,000 banks and brokerage firms

        • Large transactions

      • International clearing system - exchange of electronic deposits

      • Similar to a clearing house for checks and wire transfers

   3. Derivatives – contracts involving the exchange of currencies in the future

1. Cross Rate - calculate the exchange rate for currencies that are rarely traded

1. Example 1
   • Pesos to U.S. dollars: pesos 11.43 / $1
   • Euros to U.S. dollars: € 0.6944 / $1
   • Trick - keep currency units; correct calculation has units fall out
   • Calculate pesos to euros: (ps 11.43 / $1) ($1 / 0.6944 €) = ps 16.46 / 1 €
2. Example 2
   • KM to euros: KM 2 / 1 €
   • Euros to U.S. dollars: € 0.714 / 1$
   • Calculate KM to U.S. dollars: (KM 2 / €)($1 /€ 0.714) = KM 1.428 / $1

2. Intermarket Arbitrage - profit from price differences

1. Example 1
   • Trader at Citibank has $100,000
     • Citibank $1.54 / 1 pound
     • National Westminster € 1.6 / 1 pound
     • Deutsche Bank $0.97 / 1 €
   • Calculate the cross rate = ($1.54 / 1 pound) / (€ 1.6 / 1 pound) = $0.9625 / 1 €
   • Arbitrage exists
     • Step 1 - Convert dollars to pounds at Citibank: $100,000 / ($1.54 / pound) = 64,935.06 pounds
     • Step 2 - Convert pounds to €s at National Westminster: (64,935.06 pounds)(€ 1.6 / 1 pound) = 103,896.10 €
     • Step 3 - Convert €s to dollars at Deutsche: (1,038,961.04 €)($0.97 / 1 €) = $100,779.22
   • The gain is $779.22
2. Example 2
   • Trader at Citibank has 500,000 €
     • Citibank KM 2 / 1 €
     • Unibank $0.67 / 1 KM
     • Spark Bank $1.3 / 1 €
   • Calculate the cross rate = (KM 2 / 1 €) / ($0.67 / 1 KM) = $1.34 / 1 €
   • Arbitrage exists
     • Step 1 - Convert €s to KM at Citibank: (500,000 €)(KM 2 / 1 €) = 1,000,000 KM
     • Step 2 - Convert KM to $ at National Unibank: (1,000,000 KM)($ 0.67 / 1 KM) = $670,000
     • Step 3 - Convert $ to € at Spark Bank: ($670,000) / ($1.3 / 1 €) = 515,384.61 €
   • The gain is 15,0384.61€

1. Use demand and supply functions

• Assumptions
  • No government interference
  • Flexible exchange rates

2. Trade between Mexico and U.S.

• Exchange rate - the dollar price of 1 peso
  • Amount of $s per 1 peso
• Import - U.S. residents and firms purchase goods and services from Mexico
  • U.S. firms buy Mexican goods
  • U.S. firm needs pesos to pay for it
  • Demand for pesos increases
  • Converting dollars to pesos causes supply of dollars to increase on foreign exchange market
• Export - U.S. residents and firms sell goods and services to Mexico.
  • U.S. firms sell computers to Mexican firms.
  • Mexican firms need dollars to pay for it.
  • Demand for dollars increases.
  • Converting pesos to dollars causes supply of pesos to increase

3. Demand for currencies - Demand for pesos in one market creates a supply of U.S. dollars in other market, and vice-versa

• Moving from Point A to Point B causes exchange rate to go down
• Point A : $ 1/10 per 1 peso [$1 = 10 pesos]
• Point B: $ 1/20 per 1 peso [$1 = 20 pesos]
• The $ appreciated, because $1 buys more pesos
• The peso depreciated, because 1 peso buys less dollars
• The price of U.S. goods became more expensive, while Mexican goods become cheaper
  • U.S. imports increase, while Mexican imports decrease
  • U.S. exports decrease, while Mexican exports increase

4. Terminology

• Appreciation - currency becomes more valuable; can buy more of another currency
• Depreciation - currency becomes less valuable; can buy less of another currency
• Strong - currency is relatively valuable against a basket of currencies
• Weak - currency is relatively less valuable against a basket of currencies

5. Supply of currencies

• Moving from Point A to Point B causes exchange rate to go up

  • The $ depreciated in value

  • The peso appreciated in value

  • The price of U.S. goods became cheaper, while Mexican goods become more expensive

    • U.S. imports decrease, while Mexican imports increase

    • U.S. exports increase, while Mexican exports decrease

Note - For Mexicans to buy more U.S. cheaper products, they need dollars. They convert pesos into dollars, causing more pesos to be supplied on the market.

1. Americans demand more Mexican products, ceteris paribus

• The equilibrium exchange rate is at P* and quantity exchanged is Q*
  1. Demand for pesos increases
  2. The dollar depreciates, while peso appreciates
  3. U.S. products become cheaper to Mexicans
  4. U.S. exports rise, while Mexican exports fall
  5. U.S. imports decrease, while Mexican imports rise

2. The real interest rate is higher in Kazakhstan than the U.S.

1. Original market price and quantity are P* and Q*
2. U.S. investors increase demand for tenge, wanting to earn higher interest rate
3. Kazakh citizens invest more within their country, decreasing supply of tenge
4. If two functions shift
   • Quantity or price becomes indeterminate
   • In this case, U.S. dollar depreciates, while tenge appreciates
   • Quantity of tenge becomes indeterminate

3. The inflation rate is higher in Mexico than the U.S.

1. Original market price and quantity are P* and Q*
2. Price of Mexican goods becomes expensive
3. Price of U.S. goods become relatively cheaper
4. Mexican increase demand for U.S. goods, increasing demand for dollars
5. U.S. citizens buy more domestic goods, decreasing their demand for Mexican goods and hence a decrease in supply of dollars
6. U.S. dollar appreciates while peso depreciates

4. Federal Reserve System (U.S. central bank) increases dollars on international market; the Fed buys foreign currencies by using U.S. dollars. This increases the demand for foreign currencies.

1. U.S. dollars increase, increasing supply of dollars
2. U.S. dollar depreciates while tenge appreciates
3. Note – There are two markets for each example. The omitted market will have the supply or demand function shift in the opposite direction

5. Investors believe the U.S. dollar will depreciate.

1. Investors reduce their demand for U.S. dollars, causing the demand to shift left
2. U.S. dollar depreciates while € appreciates. This becomes a self-fulfilling prophecy. The investors' beliefs turned into reality.

6. The United States has faster productivity growth than Europe.

1. Higher productivity causes U.S. products to become cheaper. Europeans buy more U.S. products because they are cheaper, causing the demand for U.S. dollars to increase and shift right.
2. Americans buy less European goods. Thus, Americans have a lower demand for euros, which means they convert fewer euros into U.S. dollars. The supply of dollars decreases and shifts left.
3. U.S. dollar appreciates while the euro depreciates. The quantity of dollars is indeterminate.

7. The United States imposes tariffs on Mexican goods.

1. Americans buy less Mexican products because they are more expensive. Thus, Americans reduce their demand for pesos, causing the demand to shift left
2. U.S. dollar appreciates while the peso depreciates. This makes the U.S. export industries less competitive.
3. Mexico could also impose tariffs on U.S. products.

Fixed Exchange Rates – government enters market and fixes the exchange rate

1. Also called pegged exchange rate

2. Gov. or central bank requires a cache of currency reserves

3. Gov. does not specify an exact price

4. Gov. specifies a band

   • Exchange rate is allowed to move within band

   • If exchange rate falls outside of band, then gov. interferes in market to bring exchange rate back into the band

5. Example – United Arab Emirates uses a fix exchange rate of $1 = 3 dirhams

6. Demand for the Dirham falls and price is outside of band

• The central bank has to buy Dirhams off the exchange market, causing the supply function to decrease

  • The central bank needs to exchange Dirhams for a strong currency like U.S. dollars or euros

  • Central bank requires a cache of reserves

• Terminology

  • If the central bank allows the currency to appreciate permanently outside the band, it is called a revaluation.

  • If the central bank allows the currency to depreciate permanently outside the band, it is a devaluation.

• A devaluation could trigger capital flight

  • Example 1 - Asian Financial Crisis

    • The Thai government maintained a fixed exchange rate of the baht

    • When it devalued the currency in 1997, the foreigners cashed in their investments, leading to outflows

    • Crisis spread to Indonesia, Malaysia, the Philippines, and South Korea

    • Indonesia and Thailand experienced 20% declines in manufacturing

    • Crisis reached Russia and Brazil in 1998 IMF bailed out Indonesia, South Korea, and Thailand

    • IMF imposed austerity

      • Reduce gov. spending

      • Increase taxes)

    • IMF wanted countries to raise interest rates

      • Contractionary monetary policy

      • Could trigger a recession or strenghten a recession

    • Worse policy to impose when economies are contracting

  • Example 2 - Mexico's Peso Crisis

    • Fund managers invested approx. $45 billion into Mexican stocks and bonds to earn higher interest rate

    • Peso appreciated and Mexican gov. could not finance balance-of-payments deficit

      • Trade deficit

      • Strong peso caused rising imports and falling exports

    • Gov. devalued peso in Dec. 1994

    • Investors started massive withdrawals from Mexico

    • Peso depreciated by 40%

    • Crisis began to spread to Asia and Latin America

    • IMF's bailout package was $53 billion

• Rule of Incompatible Trinity

  • A gov. or central bank can only control two of the following:

    • Independent monetary policy

    • Free flow of capital

    • Fixed exchange rate

  • Example 1 - Hong Kong pegs its exchange rate and allows the free flow of capital

    • Thus, it does not have independent monetary policy

  • Example 2 - China restricts the free flow of capital

    • Thus, it has independent monetary policy and can peg its exchange rate