The Foreign Exchange

Market

Based on slides for

Financial Markets and Institutions
by Mishkin and Eakins
 Foreign Exchange Market
 Two kinds of exchange rate transactions make up the foreign exchange
market:
 Spot transactions involve
the near-immediate
exchange of bank deposits,
completed at the spot
rate

 Forward transactions
involve exchanges at some
future date, completed at
the forward rate
 Why Are Exchange Rates Important?
 Part of the reason that American businesses became less competitive
relative to their foreign counterparts in the mid-1980s, though,
competitiveness increased by the 2000s can be found in exchange rates
 In the 1980s, the dollar was strong, and US goods were expensive to foreign
buyers
 By the 1990s and 2000s, the dollar had weakened and American goods
became cheaper while American businesses became more competitive

 When the currency of your country appreciates relative to another

country, your country's goods prices  abroad and foreign goods prices
 in your country
1. Makes domestic businesses less competitive
2. Benefits domestic consumers (you)

 Ex: in 1999, the euro was valued at $1.18. On June 23, 2010, it was
valued at $1.23. How much did the Euro and the Dollar appreciate or
depreciate respectively?
 How is Foreign Exchange Traded?
 FX traded in over-the-counter market
1. Most trades involve buying and selling bank deposits
denominated in different currencies
2. Trades in the foreign exchange market involve transactions
in excess of $1 million
3. Typical consumers buy foreign currencies from retail
dealers, such as American Express

 FX volume exceeds $3 trillion per day

 Exchange Rates in the Long Run:
Law of One Price
 Exchange rates are determined in markets by the interaction of
supply and demand
 An important concept that drives the forces of supply and
demand is the Law of One Price
 Law of One Price
 The price of an identical good will be the same throughout the world,
regardless of which country produces it

 Ex: American steel $100/ton, Jap steel 10,000 yen/ton E = 50 American Japanese
yen/$ Steel Steel
1. When exchange rate is 50 yen/$ and 100 yen/$,
what is the price of; In US $ 100 $ 200

a) American Steel in Japan In Japan 5,000 yen 10,000 yen

b) Japanese Steel in U.S.
2. What should be the Equilibrium Exchange Rate E = 100 American Japanese
yen/$ Steel Steel
3. If the yen price of Japanese steel increased by 10%
In US $ 100 $ 100
to 11,000 yen relative to the dollar price of American
steel (unchanged at $100), by What amount must In Japan 10,000 yen 10,000 yen
the dollar increase or decrease in value for the law
of one price to hold?  Law of one price  E = 100 yen/$
 Exchange Rates in the Long Run:
Theory of Purchasing Power Parity (PPP)
 The theory of PPP states that exchange rates between two
currencies will adjust to reflect changes in price levels
 In the long run exchange rates should move towards rates that would
equalize an identical basket of goods (i.e. Law of One Price);

IPD - IPF = SD/F/SD/F

 The Theory of PPP suggests that if one currencies price level rises
relative to another’s, it’s currency should depreciate and the other
country’s currency should appreciate

 PPP  Domestic price level  10%, domestic currency  10%

 Application of law of one price to price levels

 Works in long run, not short run

 Exchange Rates in the Long Run:
Theory of Purchasing Power Parity (PPP)
 Problems with PPP
 All goods are not identical in both countries (i.e., Toyota Vs Chevy)
 Many goods and services are not traded (ex. haircuts, land, etc.)

Inflation Rate
(Jan 2017)
USA 2.50%
India 3.17%
Russia 5.00%
China 2.50%
Brazil 5.35%
Singapore 0.20% (Dec)
Thailand 1.55%
Malaysia 1.80%
Sri Lanka 5.60%
Source: http://www.tradingeconomics.com/country-list/inflation-rate
Exchange Rates in the Long Run
Factors Affecting Exchange Rates in the Long Run
 Basic Principle: If a factor increases demand for domestic
goods relative to foreign goods, the exchange rate 

 The four major factors are:

 Relative price levels
 A rise in relative price levels cause a country’s currency to depreciate
 Tariffs and quotas
 Increasing trade barriers causes a country’s currency to appreciate
 Preferences for domestic v. foreign goods
 Increased demand for a country’s good causes its currency to appreciate
 increased demand for imports causes domestic currency to depreciate
 Productivity
 If a country is more productive relative to another, its currency
appreciates
Factors Affecting Exchange Rates in Long
Run

**By convention the exchange rate is quoted as as units of foreign currency / 1 USD
 Exchange Rates in the Short Run
A Supply and Demand Analysis
 Factors driving exchange rate changes long run move slowly over time
 To understand why exchange rates exhibit large changes day to day, we
develop a supply-and-demand analysis of how current exchange rates
(spot exchange rates) are determined in the short run
 Exchange rate is the price of domestic assets (bank deposits, bonds, equities,
etc., denominated in the domestic currency) in terms of foreign assets
(similar assets denominated in the foreign currency)
 Investigate the short run determination of exchange rates is to use an asset
market approach - analysis of the determinants of asset demand

 Ex: A US investor decides to invest USD 1.0 mn in a 1 year LKR Bill at 11.00%.
At the time of initial investment the exchange rate is Rs. 150.00 / USD. Calculate
the return to the investor in USD terms if the exchange rate at the end of the
year is as follows:
1. Rs. 155.00 / USD
2. Rs. 150.00 / USD
3. Rs. 145.00 / USD
 Exchange Rates in the Short Run
A Supply and Demand Analysis
 In the past, supply-and-demand approaches to exchange rate
determination emphasized the role of import and export demand
 The asset market approach emphasizes stocks of assets Vs flows of
exports and imports over short periods
 because export and import transactions are small relative to the amount of
domestic and foreign assets at any given time
 For ex., forex transactions in the US each year are over 25 times greater U.S.
exports / imports

 Thus, over short periods, decisions to hold domestic or foreign assets play a
greater role in exchange rate determination vs demand for exports & imports
 Exchange Rates in the Short Run:
Deriving RF and RD Curves
 To determine equilibrium conditions,
 First determine the expected return in terms of dollars on foreign deposits, R F
 Next, determine the expected return in terms of dollars on dollar deposits, R D
 Finally determine the relative return in terms of Dollars
 Relative RD = iD – iF + appreciation of Dollar

 Deriving the Demand Curve

 Demand curve traces the quantity demanded at each current exchange rate
(Et) holding everything else constant, particularly the expected future value of
the exchange rate (Et+1)
 A lower value of the exchange rate implies that the dollar (domestic currency)
is more likely to rise in value (appreciate)
 The greater expected rise (appreciation) of the dollar, the higher the relative expected
return on dollar (domestic) assets
 From the theory of asset demand dollar assets are now more desirable to hold, the
quantity of dollar assets demanded will rise
 The demand curve connects the points and is downward sloping
 Deriving the Supply Curve
 There is nothing to derive – Dollar assets supplied is primarily the quantity of
bank deposits, bonds, and equities in the home country. This is fairly fixed in
the short-run with respect to exchange rates
 Exchange Rates in the Short Run: Equilibrium
 Equilibrium
 Supply = Demand at E*
 If Et > E*,
 Demand < Supply
 buy $, Et 
 If Et < E*,
 Demand > Supply
 sell $, Et 

 To understand how exchange rates

shift in time, the factors that shift
expected returns for domestic and
foreign deposits need to be understood
Explaining Changes in Exchange Rates:
Increase in iD

1. Demand curve shifts

right when
 iD : because people
want to hold more
dollars
2. This causes domestic
currency to appreciate
Explaining Changes in Exchange Rates:
Increase in iF

1. Demand curve
shifts left when
 iF : because people
want to hold fewer
dollars
2. This causes
domestic currency
to depreciate
Explaining Changes in Exchange Rates:
Increase in Expected Future FX Rates
1. Demand curve
shifts left when
 Ete1 : because
people want to hold
more dollars
2. This causes
domestic currency
to appreciate
Explaining Changes in Exchanges Rates
Explaining Changes in Exchanges Rates
Explaining Changes in Exchanges Rates
 Similar to determinants of exchange rates in the long-run, the
following changes increase the demand for foreign goods
(shifting the demand curve to the right), increasing Eet+1
 Expected fall in relative U.S. price levels
 Expected increase in relative U.S. trade barriers
 Expected lower U.S. import demand
 Expected higher foreign demand for U.S. exports
 Expected higher relative U.S. productivity
 Explaining Changes in Exchange Rates:
Interest Rate Changes
 Impact of changes in interest rates
 Interest rates change because
 (a) the real rate or (b) the
expected inflation is changing
 The effect of each differs
 When the domestic real interest
rate increases,
 the domestic currency appreciates
 When the domestic expected
inflation increases,
 the domestic currency depreciates