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The Foreign Exchange Market
Currency variability
Currencies vary widely in value over time.The US dollar has shown weakness from time
to time, but has so far maintained its position as the world reserve currency.
The dependence of countries on export-driven growth policies help the US dollar.
Investment into the US both supports the dollar and attests to world confidence in its future growth
The Exchange Rate
The exchange rate is the price of one currency in terms of another currency.
Example : US/€ measures how many US $ it takes to buy one Euro.
The value of the exchange rate may be fixed (like any fixed price), but in many countries it is determined by the demand and supply of currency
The market“The worldwide network of markets and
institutions that handle the exchange of foreign currencies is known as the foreign exchange market .
There are two main components to the market.– the spot market is where current transactions for
immediate delivery of currency take place– the forward and futures markets are where
transactions for future delivery of currency take place.
The Basic Foreign Exchange Market
Like any market, there is a demand side and a supply side to foreign exchange
Demand for Foreign Currency (3 types)
1. Demand for goods, services or immediate purchases, gifts– goods and services from another country– demand for currency to send a gift to another
country– demand for currency to pay foreign factors
• pay investors
• pay international workers
Demand for Foreign Currency (foreign exchange)
2. Demand for financial assets– buy stocks from another country– buy bonds from another country– open a bank account in another country– buy a business in another country
Demand for Foreign Exchange (3 types)
3. Hedging and speculation– If you need to pay a foreign seller in the near
future, you may buy foreign currency now if you are worried that its value will rise by the time the payment is due. (hedging)
– If you want to make a profit off the change in value, you may buy the currency today to sell the currency tomorrow at a higher value (speculation)
The Demand for Foreign currency
The sum of the three demands constitute the demand for foreign currency
These demands correspond to debit items in the balance of payments
The Supply of Foreign currency
The sum of the three demands constitute the demand for foreign currency
These demands correspond to debit items in the balance of payments
Supply of Foreign Currency (3 types)
1. Sale of goods, services or immediate purchases, gifts– goods and services from OUR country– demand for OUR currency to send a gift to OUR
country– supply of currency when foreign companies need
to pay domestic factors • pay investors
• pay workers working abroad
Supply of Foreign Currency (foreign exchange)
2. Purchases of OUR financial assets
People from other countries– buy stocks from OUR country– buy bonds from OUR country– open a bank account in OUR country– buy a business in OUR country
Supply of Foreign Exchange
3. Hedging and speculation– If a foreign seller needs to pay in Canadian dollars in the
near future, they may buy OUR currency now (selling theirs) if they are worried that its value will rise by the time the payment is due. (hedging)
– If speculators want to make a profit off the change in value, they may buy OUR currency today (selling foreign currency) to sell OUR currency tomorrow at a higher value (speculation)
The market for Foreign Exchange
The foreign currency market defines demand an supply of a foreign currency.
Therefore, when the demand for foreign currency increases, the price of foreign currency rises, this means
the value of our currency falls!
The following slide shows the demand and supply of foreign currency
The Basic Foreign Exchange Market
e
$/€
S€
S’€
D€
D’€
Euros (€)Qeq
eeq
Movement in the market
An increase in demand for the foreign currency results in a rightward shift of the demand curve.
It now takes more domestic currency to buy the foreign currency.
Therefore, when e rises, the value of the foreign currency rises and the value of OUR currency falls. We call this an appreciation of the foreign currency or a depreciation of OUR currency in relation to the foreign currency
The Basic Foreign Exchange Market
e
$/€
S€
D€
D’€
Euros (€)Qeq Q’
eeq
e’
Increase in supply of foreign currency
When foreign currency supply increases, the supply curve shifts right
the price of the foreign currency falls
This means the value of our own currency rises, (our currency appreciates and the foreign currency depreciates)
The Basic Foreign Exchange Market
e
$/€
S€
S’€
D€
Euros (€)Q”Qeq
eeq
e”
Demand and supply and the current account
The demand and supply of foreign exchange can be broken into 2 components– Goods & services (current account)– financial transactionsThese sum to total demand and supply
The equilibrium exchange rate is determined by the total demand and supply
Demand and supply and the current account
In the following slide, the equilibrium exchange rate is lower than the rate needed for a current account balance (our exchange rate would be more valuable than
would be the case if there were only current account transactions)
Therefore, there is a current account deficit (shown as Q2 – Q1)
this deficit is also the surplus in financial transactions. (Qeq-Q1) – (Qeq-Q2)=Q2-Q1
Demand and supply and the current account
eSG&S
STotal
DTotal
Foreign ExQ2Qeq
eeq
DG&S
Q1
Concept checks
The market for international currency is called the…
Concept checks
The market for current transactions of foreign exchange to be delivered immediately is called..…
Concept checks
The two markets for future transactions in foreign exchange are called…
Concept checks
The three sources of demand for foreign exchange are…
Concept checks
An increase in demand for foreign currency results in __________ of our currency and ___________________ of the foreign currency
Concept checks
If the foreign exchange rate is too high for our current account transaction, this means we will have a current account __________ (surplus/deficit) and a capital account ______________ (surplus/deficit)
Meaning of Exchange Rate and Measuring Changes in Exchange Rates
Value of one currency in units of another currencyA decline in a currency’s value is referred to as
depreciation and an increase in currency’s value is called appreciation.
If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated
If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated
Appreciation/Depreciation
Percentage change in value US $New Value of Foreign Currency per unit of $ - Old value of foreign currency per $
-------------------------------------------------- X 100
Old value of Foreign Currency per $
Percentage change in value of Foreign Currency
New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency
-------------------------------------------------- X 100
Old value of $ per unit of Foreign Currency
Exchange Rate Equilibrium
Forces of Demand and SupplyDemand for foreign currency negatively
related to the price of foreign currencySupply of foreign currency positively
related to the price of foreign currencyForces of demand and supply together
determine the exchange rate
Demand for Foreign Currency
Price for Foreign Currency
Units of Foreign Currency (£)
$1.50
$2.00
D
D
50m 75 m
Supply of Foreign Currency
Supply for Foreign Currency
Units of Foreign Currency (£)
$1.50
$2.00
50 m 75 m
S
S
Equilibrium Exchange Rate
Exchange Rate
Units of ForeignCurrency(£)
S
SD
D
$1.6775
Factors that influence the Exchange Rate
Expectations of the MarketPolitical Events Relative Inflation RatesRelative Interest RatesRelative Income Levels
Exchange rate is the results of an interaction of these factors
Market Expectations
Expectations about future exchange rate changes on the basis of current and future political and economic conditions
1960s Strong $Between 1960s and 1970s: weak $Strong $ in 1999 – 2001Weak Dollar today 20051995 European Exchange Rate MechanismDevaluation of Asian Currencies
Political Events
Fall of Berlin Wall and unification of East and West Germany
Rumors about resignation of Mikhail Gorbachov
Tiannanmon SquarePersian Gulf WarSeptember 11, 2001
Relative Inflation
High inflation relative to a foreign country, decline in value of currency—Why?
Low inflation relative to a foreign country, increase in value of currency—Why?
Relative Interest Rates
High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?
Relative Income Levels
Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?
Exchange Rate Determination
An interaction of factorsIs it possible for a country with high real
returns to have a low currency value?Is it possible for a country with low real
returns to have a high currency value?
Definitions of Exchange Rates
Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
– How much can be exchanged for one dollar? ¥102/$1
– How much can be exchanged for one yen? $0.0098/¥1
• Exchange rate allow us to denominate the cost or price of a good or service in a common currency.
– How much does a Honda cost? ¥3,000,000
– Or, ¥3,000,000 x $0.0098/¥1 = $29,400
Depreciation and Appreciation
Depreciation is a decrease in the value of a currency relative to another currency.
– A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.
– $1/€1 ! $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.
– The euro has appreciated relative to the dollar: it is now more valuable.
Depreciation and Appreciation (cont.)
Appreciation is an increase in the value of a currency relative to another currency.
– An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.
– $1/€1 ! $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.
– The euro has depreciated relative to the dollar: it is now less valuable.
Depreciation and Appreciation (cont.)
A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.– How much does a Honda cost? ¥3,000,000– ¥3,000,000 x $0.0098/¥1 = $29,400– ¥3,000,000 x $0.0100/¥1 = $30,000
A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.
A depreciated currency lowers the price of exports relative to the price of imports.
Depreciation and Appreciation (cont.)
An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.– How much does a Honda cost? ¥3,000,000– ¥3,000,000 x $0.0098/¥1 = $29,400– ¥3,000,000 x $0.0090/¥1 = $27,000
An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.
An appreciated currency raises the price of exports relative to the price of imports.
The Effects of Changes in Exchange Rates
How do changes in exchange rates affect a country's net exports since currency appreciations or depreciations change international relative prices?
(Remember: the basic role of an exchange rate is to convert one country’s prices into another country’s currency.)
Exchange Rates and Home Currency Prices
30,000 Yen
TV Set $1,000 US
Home PC
Exchange
Rate
Price in
Japan
Price in
The US
Price in
The US
Price in
Japan
$1 = 120 yen $/Y=.0083
30,000 Y $250 $1,000 120,000 Y
$1 = 100 yen $/Y=.01
30,000 Y $300 $1,000 100,000 Y
From the American consumer’s viewpoint, a television set that costs 30,000 yen in Japan goes up in price from $250 (that is, 30,000/120) to $300 (that is, 30,000/100).
To Americans, it is just as if Japanese manufacturers had raised TV prices by 20 percent.
The Dollar price of the yen went from $0.0083 to $0.01 – an appreciation of the yen.
What about the implications for Japanese consumers interested in buying American personal computers that cost $1,000?
When the dollar falls from 120 yen to 100 yen, they see the price of these computers falling from 120,000 yen to 100,000 yen.
To them it is just as if American producers had offered a 16.7 percent drop in the price of PCs.
A currency depreciation should raise net exports and increase aggregate demand.
A currency appreciation should reduce net exports and therefore decrease aggregate demand.
In this case the U.S. dollar has depreciated. Thus, U.S. exports should rise.
AS1
AD1
Depreciation
Q1
P1
P
GDP
A
AD2
B
AS1
AD1
Appreciation
Q1
P1
P
GDP
A
AD2
Conclusions to date:
currency depreciations increase AD. currency appreciations decrease AD.
Evaluation of exchange rate systems
Fixed Exchange Rates: Advantages
1. Favour business investmentsNo uncertainty → easy to plan future investmentsNo exch rate movements that alter relative prices
2. Favour international trade by making it possible to accurately compare prices among countries.
3. No room for speculation → more currency stability. Exception: when people believe that a country may devalue or revalue its currency.
4. Firms and gov more disciplined to keep inflation under control:a. Firms: keep costs down so that domestic
goods do not lose competitiveness
b. Government: if allows inflation to increase: ↓X and ↑M → AD↓ → possible recession and UE and BoP deficit
1. Possibility of insufficient reserves to maintain the fixed exchange rate.
2. Difficult to handle external shocks (eg ↑oil price → deficit ). If reserves to correct deficit are not readily available, country must resort to protectionist measures, contractionary policies or exchange controls, with negative effects.
a. Policies to correct deficits conflict with domestic priorities and can cause a recession. Contractionary policy → ↓AD → ↓Y (↑UE) → ↓M
Fixed Exchange Rates: Disadvantages
b. Increased protectionism reduces world trade and worsens global allocation of resources.
c. Exchange controls worsen global allocation of resources. The control by the gov of currency transactions:
a. Distorts trade patterns
b. Restricts consumer choice
c. Causes development of black market for foreign exchange
3. Speculation. If devaluation is anticipated (because of a large and persistent deficit), speculators may sell the currency, which worsens deficit and forces devaluation.
Floating Exchange Rates
Floating exchange rate: exchange rate between two currencies can move in price each day– Value of currencies is determined by supply
and demand in marketplace.
Floating Exchange RatesUnder the floating exchange rate regime,
international businesses must account for currency translation risk.– Currency translation risk: risk that value of
foreign currency changes in a way which makes business less profitable, absent an exchange rate “devaluation”
Floating Exchange RatesExchange rate of a particular currency with
U.S. dollar is either:1. How many dollars it takes to buy one unit of
foreign currency2. How many units of foreign currency it takes
to buy one dollarCross rate (American perspective): exchange
rate between two foreign currencies because it can be calculated by multiplying their rates relative to the U.S. dollar
Floating exchange rates: Advantages
1. Automatic adjustment. Correction of deficits and surpluses in an automatic way.
2. No need to hold official reserves to intervene in foreign exchange markets.
3. No conflict between BoP objectives and domestic objectives.
4. Easy adjustment to external schocks. If oil price ↑ → value of currency↓, eliminating the deficit.
1. Speculation can be destabilizing: when currency is expected to depreciate, it does it further than otherwise.
2. Excessive exchange rate volatility. Large and abrupt changes cause problems for countries depending on X → risk of financial crises (MX, Thailand, Russia) → intervention by IMF.
3. Exchange rate fluctuations cause uncertainty for traders and investors → inability to plan for the future → negative effects on trade and investment flows.
Floating exchange rates: Disadvantages
Managed Float: the supporters’view
1. Allows countries some flexibility in carrying out domestic policies.
2. Allows economies to adjust more easily to shocks.
3. Offers governments the opportunity to prevent sudden and large exch. rate fluctuations.
4. Makes currency speculation more difficult as speculators ignore if and when a CB will intervene.
1. Cannot do enough to prevent large fluctuations, which especially damage countries dependent on X.
2. Not successful in eliminating large trade imbalances (US case)
3. Offers opportunity to cheat by undervaluing the currency and gaining unfair comparative advantage.
Managed Float: the critics’view
Changes inexchange rates
Different types of ER. Spot Exchange Rate
Forward Exchange Rate
Bi-lateral Exchange Rate
Effective Exchange Rate Index (EER)
Real Exchange Rate
What do you think
these mean?
Different types of ER. Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at current
market prices. This is determined by the FOREX market on a minute-by-minute basis on the basis of the flow of supply and demand for any one particular currency.
Forward Exchange Rate - a forward rate involves the delivery of currency at some time in the future at an agreed rate. Companies wanting to reduce the risk of exchange rate uncertainty by buying their currency ‘forward’ on the market often use this.
Bi-lateral Exchange Rate - this is simply the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
Effective Exchange Rate Index (EER) - the EER is a weighted index of sterling's value against a basket of international currencies the weights used is determined by the proportion of trade between the UK and each country.
Real Exchange Rate - this measure is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.
Different types of Exchange rate systems…
– Fully Fixed …. – Semi Fixed (peg)– Managed (dirty floating)– Free Floating….
…. need to know
Fixed Exchange Rate
Fully-fixed Exchange Rates
Central target for the exchange rate (currency peg)
No fluctuations permitted
Occasional revaluation or devaluation when economic fundamentals demand one
Central Bank intervention to maintain the currency
J curve effect…
The J curveDevaluation at ‘A’
initially pulls the BoP into further deficit (inelasticity of S)
After a time lag upto ‘B’ domestic firms can react to
the foreign demand and increase output & so
increase X (BoP moves into a surplus)
Issues of elasticity
J curve will only happen if there is an ‘elastic’ demand for the country’s exports
The devaluation should generate new interest in the country’s goods and services – ONLY if elastic PeD!
What would happen if the PeD was inelastic?
Mashall Lerner condition
The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments.
If elastic demand – devaluation will improve the BoP
If inelastic demand – devaluation will worsen the BoP.
Floating Exchange Rates
Floating Exchange Rates
– Rate determined purely by market demand and supply
– No government intervention
– Currency finds its own value
– Little need for central bank to hold or use foreign currency reserves
– Sterling has been a free-floating exchange rate since September 1992
Managed Exchange Rates
Government may seek to influence the market value of the currency
National Bank intervention
Uses stocks of gold and other foreign currencies
May decide to change short term interest rates to manage the external value of the currency
Increasingly difficult to manage the exchange rate given the size and power of the FOREX markets
FOREX = foreign exchange market
Semi Fixed Exchange Rates
– Exchange rate is given a central target (peg)
– Band of fluctuation allowed
– Day to day – currency finds its own market level
– Interest rates are set to meet the exchange rate target
– Central Bank intervention
Fixed Exchange rates analysis
Benefits Certainty & stability
Financial discipline for govts & global trade harmony…
Stabile macro economics, firms know the future value of currency
Problems
Continued over / under valuation of currency
Deflation with deficit BoP or inflation with surplus.
Opportunity cost of govt using finances to ‘support’ currency.
Floating Exchange rates analysis
Problems
International uncertainty
Speculation impact on currency & macro ec (think Black Wed!)
Cost push and Demand pull inflationary pressures.
Impact on PPP (long term impact over decades!)
Benefits
Market mechanism equilibrium
More robust – allows economies to adjust to exogenous shocks!
Independent monetary policy – no govt intervention needed!
The Asian Financial The Asian Financial CrisisCrisis
Hung-Gay FungHung-Gay Fung
University of Missouri-St. LouisUniversity of Missouri-St. Louis
Presentation OutlinePresentation Outline
Discuss briefly the behavior of the Discuss briefly the behavior of the Foreign Exchange (FX) of Southeast Foreign Exchange (FX) of Southeast Asian Countries.Asian Countries.
Assess different factors that lead to Assess different factors that lead to the currency crisis.the currency crisis.
Opportunities and Implications for Opportunities and Implications for U.S. companiesU.S. companies
Foreign Exchange RatesForeign Exchange Rates Since June 1997, FX rates in many Since June 1997, FX rates in many
Southeast Asian countries have experienced Southeast Asian countries have experienced a substantial decline.a substantial decline.
These countries include the Philippines, These countries include the Philippines, Malaysia, Thailand, Indonesia, and Korea.Malaysia, Thailand, Indonesia, and Korea.
Many of these countries linked their Many of these countries linked their exchange rates to the U.S. dollar before the exchange rates to the U.S. dollar before the currency crisis.currency crisis.
Change in FX rates Change in FX rates (6/30/1998)(6/30/1998)
FX:1 $US FX:1 $US FX: 1 $USFX: 1 $US % %
6/30/986/30/98 6/30/976/30/97changechange
Chinese yuan 8.281 8.289 +0.09
HK dollar 7.745 7.747 +0.03
Indonesia rupiah 14568.89 1760 -87.92
Japanese yen 138.31 114.61 -17.58
Malaysian ringgit 4.1 1.827 -55.44
Korean won 1370 641.4 -53.18
Philippine peso 41.5 19.08 -54.02
Thai baht 42.16 17.9 -57.54
Immediate Results of CrisisImmediate Results of Crisis
In addition to currency devaluation:In addition to currency devaluation:Collapse of their Stock Markets Collapse of their Stock Markets
(all Southeast countries);(all Southeast countries);Call for an IMF rescue plan in theCall for an IMF rescue plan in the
Philippines, Thailand, Indonesia and Philippines, Thailand, Indonesia and Korea;Korea;
Bankruptcy and financial reformsBankruptcy and financial reforms(all Southeast countries).(all Southeast countries).
Reasons for the Currency Reasons for the Currency CrisisCrisis
Decline in Export EarningsDecline in Export EarningsExcessive and Risky InvestmentExcessive and Risky InvestmentCurrent Account DeficitCurrent Account DeficitOvervalued CurrencyOvervalued CurrencyUnderdevelopment of credit marketUnderdevelopment of credit marketProperty market bubbleProperty market bubble
What Really Causes A What Really Causes A Crisis?Crisis?
Corruption?Corruption?Korea, Indonesia, Thailand -corruptionKorea, Indonesia, Thailand -corruptionItaly and India have corruption, but no Italy and India have corruption, but no
crisiscrisis
Bank TransparencyBank Transparencyinadequate regulatory frameworkinadequate regulatory frameworkirrational lenders?irrational lenders?
Inflation RateInflation Rate
19931993 19941994 19951995 19961996
Indonesia 9.60 8.53 9.43 8.03
Korea 4.82 6.24 4.49 4.96
Malaysia 3.57 3.71 5.28 3.56
Philippines 7.58 9.06 8.11 8.41
Thailand 3.36 5.19 5.69 5.85
Source: Corsetti, Pesenti and Roubini (1998).
Savings Rates (% of GDP)Savings Rates (% of GDP)CountryCountry 19901990 19911991 19921992 19931993 19941994 19951995 19961996
China 38.1 38.3 37.7 40.6 42.6 41.0 42.9
Hong Kong 35.8 33.8 33.8 34.6 33.1 30.4 30.6
Indonesia 27.9 28.7 27.3 31.4 27.6 28.4 28.1
Japan 33.5 34.2 33.8 32.8 31.4 30.7 31.3
Korea 36.1 35.9 35.1 35.2 34.6 35.1 33.3
Malaysia 29.1 28.4 31.3 33.0 32.7 33.5 36.7
Philippines 18.7 18.0 19.5 18.4 19.4 17.8 19.7
Singapore 44.1 45.4 47.3 44.9 49.8 50.0 50.1
Taiwan 22.4 22.2 23.2 23.7 22.9 22.9 21.0
Thailand 32.6 35.2 34.3 34.9 34.9 34.3 33.1
Source: Statistical Appendix, IMF, 1997.
Human Development IndicatorsHuman Development Indicators
CountryCountry Life-ExpectancyLife-Expectancy Literacy RateLiteracy Rate Average Income Average Income ofof
(years)(years) (%) (%) Poorest 20% Poorest 20%
in ‘85 US$in ‘85 US$
19701970 19951995 19701970 19951995 19701970 19951995
Indonesia 48 64 54 84 392 908
Korea 60 72 88 98 303 2071
Malaysia 62 72 60 85 431 1070
Philippines 57 66 83 95 218 435
Thailand 58 69 79 94 361 726
Source: Radelet and Sachs (1998).
