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International FinanceLecture 7

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Learning Outcomes1. What is the foreign exchange market

and its characteristics.

2. What determines the exchange rates in the long run.

3. What determines the exchange rates in the short run.

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What is the Foreign Exchange Market (FX)?

The Foreign Exchange Market is the financial market in which currencies are bought and sold: is a transaction where a given amount of currency

is exchanged for an amount of another currency. The need for the Foreign Exchange Market is to facilitate International trade and the currency

conversion: • currencies were required to be settled from the country of both the

importer and the exporter. It therefore plays an extremely important role in facilitating cross-border trade, financial transactions and investment. Companies investing spare cash for short terms in money market accounts

• More recently, it allows borrowers to have access to the International capital markets in order to meet their financing needs in the currency which is most helpful to their requirements.

An exchange rate is the price of one money in terms of another.

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Characteristics of the Foreign Exchange Market

• The Forex Market does not exist physically – there is no location. It is a framework in which participants banks, brokers and foreign exchange dealers (mostly banks) are connected by computers, telephones and telex (SWIFT) and operates in most financial centers globally. Because the Forex Market is so highly integrated globally, it can operate 24 hours a day – when one major market is closed, another major market is open to facilitate trade occurring 24 hours a day moving from one major market to another. Most exchanges of currency are made through bank deposits that is transferred electronically from one account to another.

• The Forex Market is an over-the-counter market (no location no building) that is trading in financial instruments that are not listed or available on an officially recognized exchange (such as the NYSE – New York Stock Exchange), but traded in direct negotiation between buyers and sellers. Trading takes place telephonically or electronically.

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•Example: When we say that a bank is buying dollars in the foreign exchange market what we actually mean is that the bank is buying deposits denominated in dollars. And the individual citizens are buying currency in the retail market from dealers such as American Express or from banks. Because retail prices are higher than wholesale when we buy foreign exchange we are getting fewer units of foreign currency per dollar than exchange rates in the box indicate.

American Express Corporation in Manhattan also known as the Three World Financial Centre.

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The examination of foreign exchange market is an important subject in International Finance

• The exchange rate affects the economy and our daily lives because for example when the U.S dollar becomes more valuable relative to foreign currencies , foreign goods become cheaper for Americans and American goods become more expensive for foreigners. When the U.S dollar falls in value foreign goods become more expensive for Americans and American goods become cheaper for foreigners.

• Fluctuation in the exchange rate also affect both inflation and output and are an important concern to monetary policymakers. When the US dollar falls in value the higher prices of imported goods feed directly into a higher price level and inflation. A declining US dollar which makes US goods cheaper for foreigners increases the demand for US goods and leads to higher production and output.

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Economic theories of exchange rate determination

• Exchange rates, like the price of any good or asset in a free market, are determined by the demand and supply of one currency relative to the demand and supply of another.

• The analysis of the factors that determine Exchange rates is divided into two parts: the long-run and the short-run determinants.

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Exchange Rates in the Long-run• The long-run analysis is based on the scheme that there is

predictable relationship between product price levels and exchange rates. The relationship is based on the fact that people choose to buy goods and services from one country or another according to the prices they must pay.

• Therefore we use the following two versions of this relationship for better understanding of the factors that determine exchange rates in the long run. (The relationship between Price and exchange rates can be explained by)

– Law of One Price– Purchasing Power Parity (PPP)

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Law of one priceIf two countries produce an identical good, and

transportation costs and trade barriers are very low or free, the price of the good should be the same throughout the world no matter which country produce it.

Example: A jacket selling for $50 in New York is identical to a French jacket retail for 39.24Eur in Paris. For the law of one price to hold the exchange rate between the $ and the € must be $1 = 0.78Eur (39.24/50). If not this mean that the jacket will be expensive in one of the two cities either in N.Y or in Paris (the city of which its currency has been appreciated) and the demand in the expensive country will go to zero and only if the exch.rate falls will start selling again.

In reality the law of one price does not hold closely for most products traded internationally because transport costs are not low and governments do not practice free trade. Also firms apply discrimination on price in different national markets.

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Purchasing power parity (PPP) A basket of tradable products will have the same cost in

different countries if the cost is stated in the same currency. The theory of PPP is simply an application of the law of one price to national price levels rather than to individual prices.

Based on the evidence the theory of PPP does not hold as well and thus can not fully explained exchange rates. The reason is that the basket many times does not include the same products and sometimes nontraded goods are incorporated. But there is evidence that large differences from PPP tend to shrink over time for traded products.

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GENERAL RULE: If the demand for domestic goods increases (for any

reason) Appreciation of the currency If the demand for domestic goods falls (for any

reason) Depreciation of the currency

Long-run: 4 factors affecting exchange rates

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1.Money Supply, Prices and Inflation

In line with PPP theory when prices of American goods

Increases (holding prices of foreign goods stable) the

demand for American goods falls and the dollar tends to

depreciate so that American goods can be sold and vice versa.

So in the long run a rise in a country’s price level causes its currency to depreciate and a fall in the country’s price level causes its currency to appreciate.

A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate.Inflation occurs when the money supply increases faster than output increases.

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2. Trade BarriersBarriers to free trade such as tariffs (taxes on imported goods)

and quotas (restrictions on the quantity of foreign goods that

can be imported) can affect the exchange rate. This is because

when a country increases trade barriers the imported goods are

becoming more expensive and thus the demand for domestic

products increases. Consequently the currency of the country is

appreciating and vice versa.

So in the long run a rise in trade barriers cause a country’s currency to appreciate and a fall cause its currency to depreciate.

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3. Preferences for domestic versus foreign goodsSupposed that the home country is US.

If the Japanese develop an appetite for American goods (e.g.

Florida oranges, American movies) the increased demand for

American goods (exports) tends to appreciate the dollar,

because the American products will continue to sell well even

at a higher value of dollar. Likewise if there is a high demand

for the imports in US instead for the domestic goods the dollar

will depreciate.

Increased demand for a country’s exports causes its currency to appreciate in the long run, and conversely increased demand for imports causes the domestic currency to deprecate in the long run.

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4. ProductivityIf productivity in domestic sectors that produce traded goods

rises in a country the prices are declining, relative to imported

goods, and therefore the demand for domestic products

increases and thus currency is appreciating finally in the long

run.

In the long run as a country becomes more productive relative to other countries its currency appreciates and vice versa.

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Exchange Rates in the Short-run• How current exchange rates (spot exchange rates) are

determined in the short run?

Economists believe that pressures on exchange rates in the short run can be best understood in terms of the demands and supplies of assets such as government bonds denominated in different currencies.

The investors determine the expected return in an investment in a bond expressed in a foreign currency by using:

1.The basic return on the bond: the interest rate or yield. There is an important relationship between the return on home currency bonds and the return on foreign currency bonds. Investors will change their portfolios if there are differences between these two returns.

2.The expected gain or loss on currency exchanges: the expected appreciation or depreciation of the foreign currency.

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Sort-run: 2 factors affecting exchange rates1. Interest rates and exchange rates

• Foreign exchange markets do seem sensitive to movements in interest rates and jumps of exchange rates often follow changes in interest rates. If our interest rate (i) increases ,while the foreign interest rate (if) and the spot exchange rate expected in the future (eex) remain constant, the return comparison is in favor of investments in bonds denominated in our currency. If international financial investors want to shift toward domestic-currency assets , they first need to buy our domestic currency before they can buy the domestic currency bonds. This increase in demand for domestic currency increases the current value of domestic currency (so e decreases).

Domestic currency appreciates The change in the spot exchange rate can happen very quickly even within a few

minutes.

• If our interest instead decreases, while the foreign interest rate (if) and the spot exchange rate expected in the future (eex) remain unchanged, the value of our currency is decreased (so e increases).

Domestic currency depreciates

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• If the foreign interest rate (if) increases, the story is similar. Assuming that the domestic interest rate and the expected future spot exchange rate are constant, the return comparison is in favor of investments in bonds denominated in foreign currency. A shift by international financial investors toward foreign currency bonds would require them first to buy foreign currency in the foreign exchange market. This increase in demand for the foreign currency increases the current value of the foreign currency (foreign currency appreciates) and the domestic

currency depreciates. (so e increases).

• If instead the foreign interest decreases, the spot rate e decreases: the foreign currency depreciates and the domestic currency appreciates.

(so e decreases).

Investment funds follow the higher rates. As they change countries, they bid up currency values.

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Exchange Rates

$ per £

Quantity of £ currency in ForEx Markets

D£

S£

1.85

Q1

1. Assume an initial exchange rate of £1 = $1.85. (home country is US) There are rumours that the UK is going to increase interest rates.

2. Investing in the UK would now be more attractive and demand for £ would rise

D£1

Q2

Shortage

1.90

Q3

3. The rise in demand for £ creates a shortage in the relationship between demand for £ and supply – the price (exchange rate) would rise

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• What happens if both interest rates change at the same

time? • The answer is strait forward. What matters is the interest

rate differential : i - if . If the interest rate differential increases, the return differential shifts in favor of domestic currency bonds : e tends to decrease and domestic currency appreciates. In the opposite situation the domestic currency depreciates and the e increases.

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2. Investor psychology and the bandwagon effect

Lacking other information the role of expectations is extremely important in forecasting the future. The price of foreign exchange also rises when the expected future spot exchange rate rises. How come?

If you expect you will have to pay more for the Euros that you will need later because you expect the Euro/Dollar rate to rise, why not buy now before it does? Thus, the increased demand for Euros will bid the price up now.

• When financial investors decide that they now expect the future spot exchange rate to be higher than they previously expected relative to the current spot rate, this means that they expect the foreign currency to appreciate more or to depreciate less, or to appreciate rather than depreciate. For example if we assume that the interest rate differential is is unchanged, and the home country is US, and if we expect that the future spot exch.rate will increase from $5.05 per Sfr to about $5.15 per Sfr then the return differential is in favor of the foreign currency denominated bonds.

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• Result: International financial investors will want to buy foreign currency assets and their first step will be to buy foreign currency in the foreign exchange marker. This increase in demand for foreign currency increases the current spot exchange rate e : the foreign currency appreciates and the domestic currency depreciates. So what is happening at the end is exactly what the investors were expecting.

• If instead the investors are expecting that the future spot exchange rate will decrease, with the interest rate differential unchanged, the return differential changes in favor of domestic-currency investments and the value of our currency increases (e decreases).

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What factors can influence the direction of the expectations of the investors?

• Many things can influence investors some of them are:

1. The bandwagon effect: some investors predict/foresee that the recent trend of the exchange rate will continue in the future as well. Especially regarding the near future: the next minutes, hours, days, weeks.

For instance currencies that have been appreciating are expected to continue to do so. The recent actual increase in the exchange rate value of a country’s currency leads some investors to expect further increases.

2. Unexpected information-news: about government policies, about national and international economic data or performance and about political leaders and situations both domestic politics and international tensions.

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• For instance the foreign exchange market often react to news regarding the figures of trade of a country or the current account balances, that is measures which reflect the balance or imbalance between a country’s exports and imports of goods and service. For example an increase in a country’s trade deficit or its current account deficit especially shows that the country is in need for foreign financing. If the foreign financing that will cover the deficit is not assured to be forthcoming then the country’s currency will tend to fall in the foreign exchange market. The increasing demand for foreign currency as part of the process of paying for the excess of imports over exports tends to appreciate the foreign currency and depreciate the domestic currency.

Change in Variable Direction of International Financial Investors

Effects for the current spot exchange rate

e= Domestic Currency / foreign currency

Domestic Interest rate (i)

Increases Toward domestic-currency assets

e decreases - domestic currency appreciates

Decreases Toward foreign-currency assets

e increases - domestic currency depreciates

Foreign Interest rate (if)

Increases Toward foreign-currency assets

e increases - domestic currency depreciates

Decreases Toward domestic-currency assets

e decreases - domestic currency appreciates

Expected future Spot Exchange Rate (eex)

Increases Toward foreign-currency assets

e increases - domestic currency depreciates

Decreases Toward domestic-currency assets

e decreases - domestic currency appreciates

Determinants of e in the Short run

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Managerial implications• Exchange rates influence the profitability

of trade and investment deals

• International businesses must understand the forces that determine exchange rate:– Forward exchange rate is not a fair predictor– Inflation affects foreign exchange markets– International businesses need to take the

proper safety measures before trading or investing in a country

APPENDIX

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Exchange rate forecasting

• Efficient market school: ‘Prices reflect all available public information’

• Inefficient market school: ‘Prices do not reflect all available information’ – Use fundamental (economic theory) or technical

(price/volume data) analysis to predict the exchange rate

– Analysis suggest that professional forecasters are no better than forward exchange rates in predicting future spot rates

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Approaches to forecasting

• Fundamental analysis– Draws on economic theory to build

sophisticated econometric models for predicting exchange rate movements

• Technical analysis– Uses price and volume /quantity data to

determine trends