foreign exchange markets

International Economics
International Economics
An Overview
An Overview
Foreign Exchange___
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Foreign exchange
Foreign exchange market

Largest and most liquid market in the world __ total world turnover in a
single day in 2006 was USD 1400 billion (approx).

No central market - key markets in several cities around the world

Participating banks and brokers are in constant contact via phone and
computer

Three general types of transaction

Between banks and their customers

Domestic interbank market conducted through brokers

Trading with overseas banks____
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The Major Players

The major players are____


Individuals: tourists, migrants

Firms: importers and exporters

Banks: short position, long position, square position

Governments/ monetary authorities: market intervention

International agencies: lending

Two tier market: First tier: ultimate customer and banker

Second tier: between banks

Classifications of participants__

Non-banking entities: business transactions and hedging

Banks: foreign exchange dealers

Arbitrageurs: profit seeking from variations in rates in
different markets

Speculators: profit seeking from movements in exchange
rates
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Foreign exchange

Types of FX transactions

Spot transactions - executed nearly immediately

Forward transactions - agreement to buy or sell a currency
at a date in the future, at a rate agreed in advance

Currency swaps - agreement to trade one currency for
another now, and to trade currencies back again later, both
at prices agreed at the beginning
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Foreign exchange
Foreign exchange quotations

Exchange rate is the price of one currency in terms of another

One country’s currency has depreciated when more of it is
needed to buy a unit of a foreign currency (is worth less relative
to the other currency) [ direct quote like $ 1 = Rs. 39.75]

A currency has appreciated when less of it is needed to buy a
foreign currency (is worth more relative to the other currency)

Two –way quote: $ 1 = INR 39.72 / 77

With a spread of .05
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Foreign exchange
Foreign exchange quotations

Cross exchange rate between two currencies is
calculated from their exchange rates with a third,
benchmark currency - frequently the US dollar

Since USD is the anchor currency, any INR / CAD
rate will be given by dealer in India with the help of
cross rates___ through INR / USD and CAD / USD
rates
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Foreign exchange markets
Forward markets, futures & options

Forward contracts obligate buyer to buy or sell a certain amount
of foreign currency at a future date_ margin money deposited
with the seller bank

Usually made between banks and firms who expect to
receive or make payments in foreign currency; the amount
of currency and the date are set by the agreement
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Some concepts


Appreciation

Depreciation

Cross rates

Anchor currency

Arbitrage

Speculation

Open position

Close position
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Foreign exchange markets
Forward markets, futures & options

Futures, traded on special exchanges, are contracts
to trade given amounts of currencies at a specified
date

Only a small number of major currencies can
be so traded, and only in fixed lots with fixed
trade dates
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Foreign exchange markets
Forward markets, futures & options

Options provide the holder with the right (but not the obligation)
to buy or sell foreign currencies at an agreed rate within a
period of time, in return for a fee paid to the seller of the option

Options to buy are called call options, and those to sell are
called put options

Options are frequently used to reduce risk from exchange
rate changes

Other concepts__ Option : In-the-money: Out-of-the money:
At –the- money

Asset price, strike price
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Exchange rate determination
Foreign exchange markets
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Theory #1: Purchasing power parity [ Cassel, 1927]
Versions of
PURCHASING
POWER

PARITY
Versions of
PURCHASING
POWER
PARITY
Law of One Price
Absolute PPP
Relative PPP
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The Law of One Price

A commodity will have the same price in terms of common
currency in every country

In the absence of frictions (e.g. shipping costs, tariffs, )

Example
Price of wheat in France (per bushel): P
€
Price of wheat in U.S. (per bushel): P
$
S
€/$
= spot exchange rate
P
€
=
s

€/$
• P
$
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Absolute PPP

Extension of law of one price to a basket of goods

Absolute PPP examines price levels

Apply the law of one price to a basket of goods with
price P
€
and P
US
(use upper-case P for the price of the
basket):
where P
€
= Σ
i
(w
FR,i
• p
€,i
)
P
US

= Σ
i
(w
US,i
• p
US,i
)
S
€/$
= P
€
/ P
US
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Relative PPP
Absolute PPP:
For PPP to hold in one year:
P
€
(1 + i
€
) = E(s
€/$
) • P
$
(1 + i
$
),

or: P
€
(1 + i
€
) = s
€/$
[E(s
€/$
)/s
€/$
)] • P
$
(1 + i
$
)
Using absolute PPP to cancel terms and rearranging:
Relative PPP:
P
€
=
s
€/$
• P
$
1 +
i
€
= E(
s
€/$

)
1 +
i
$

s
€/$
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Relative PPP

Main idea – The difference between (expected) inflation
rates equals the (expected) rate of change in exchange
rates:
1 +
i
€
= E(
s
€/$
)
1 +
i
$

s
€/$
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Interest Rate Parity
START (today) END (in one
year)
$117,228
$117,228 • 1.0224 = $119,854
r
$
=2.24%
$117,228 • 0.83215 = 97,551€
s
€/$
=0.83215
r
€
=2.51%
97,551€ • 1.0251 = 100,000€
f
€/$
=0.83435
One year
(Invest in $)
(Invest in €)
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Summary of theories #1 and #2:
.
Difference in
interest rates

1 + r
€
1 + r
$
Exp. difference in
inflation rates
1 + i
€
1 + i
$
Difference between
forward & spot rates
f
€r/$
s
€/$
Expected change
in spot rate
E(s
€/$
)
s
€/$
Relative PPP
Interest
Rate
parity
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Theory #3: The Fisher condition

Main idea: Market forces tend to allocate resources to their
most productive uses

So all countries should have equal real rates of interest

Relation between real and nominal interest rates:
(1 + r
Nominal
) = (1 + r
Real
)(1 + i )
(1 + r
Real
) = (1 + r
Nominal
) / (1 + i )
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Theory #4: Expectations theory of forward rates

Main idea:

The forward rate equals expected spot
exchange rate
Expectations theory
of forward rates:
f

€/$
= E(
s
€/$
)
f
€/$
= E(
s
€/$
)

s
€/$

s
€/$
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Important Relations

1. i = R + п [ nominal interest = real interest + inflation rate]

Fisher Equation

2. F = S + S [ ( i – i* )/ 1+i* ] , or

(F – S )/ S = ( i – i* ) [ approx.]  Covered interest parity


3. i = r + x

[ nominal rate = real rate + expected rate of depreciation of
exchange rate] ==, uncovered interest parity

4. Forward rate is the unbiased expected value of future
spot rate

These four relations can be related like the next slide==. 
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Summary of all four theories
.
Difference in
interest rates
1 + r
€
1 + r
$
Exp. difference in
inflation rates
1 + i
€
1 + i
$
Difference between
forward & spot rates
f
€/$

s
€/$
Expected change
in spot rate
E(s
€/$
)
s
€/$
Fisher
Theory
Relative PPP
Interest
Rate
parity
Exp. Theory
of forward
rates
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Foreign exchange
Impact of an appreciating Indian Rupee

Pros

Lower prices on
foreign goods

Keeps inflation down


Foreign travel is
cheaper

Less expensive to
invest abroad

Cons

Exporters’ products
become more
expensive abroad

Imports-competing
firms face price
competition

Travel more expensive
for foreign tourists

Slows inflow of foreign
investment
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Foreign exchange
Impact of a depreciating Indian Rupee

Pros


Exporters can sell
abroad more easily

Less competition for
Indian firms from
imports

Foreign tourism is
encouraged

Indian capital markets
more attractive

Cons

Higher prices on
imports

Upward pressure on
inflation

Travel abroad more
expensive

Harder for Indian firms
to expand into foreign
markets
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Foreign exchange markets
Arbitrage and hedging

Exchange arbitrage involves taking advantage of exchange rate
differences in different markets to make a profit

Helps equalize exchange rates globally

Three point Arbitrage__ Pound, Dollar and Euro__ example

Three point arbitrage___ let GBP 1 = $ 1.50,
GBP 1 = franc 4, and franc 1 = $ 0.50
 arbitrage facility can make a profit by buy and sell of currency
through 3-point arbitrage

Interest arbitrage involves taking advantage of differences in
international interest rates to get a higher return__

Subject to exchange rate risk