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The Spot Market for Foreign Exchange

The Spot Market for Foreign Exchange. Market Characteristics: An Interbank Market. The spot market is a market for immediate delivery 92 to 3 days). Primarily an interbank market, which is the trading of foreign-currency-denominated deposits between large banks.

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The Spot Market for Foreign Exchange

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  1. The Spot Market forForeign Exchange

  2. Market Characteristics:An Interbank Market • The spot market is a market for immediate delivery 92 to 3 days). • Primarily an interbank market, which is the trading of foreign-currency-denominated deposits between large banks. • Approximately $US2 trillion daily in global transactions.

  3. Market Quotes: The WSJ Currency Trading Table • Provides spot and forward rates. Forward rates are for forward contracts, or the future delivery of a currency. • US $ equivalent is the dollar price of a foreign currency (home currency price of a foreign currency). • Currency per US $ is the foreign currency price of one US dollar (foreign currency price of the home currency)

  4. Market Quotes:Direct - Indirect Quotes • The home currency price of a foreign currency is called ? • The foreign currency price of the home currency is called?

  5. Market Quotes:Direct - Indirect Quotes • The home currency price of a foreign currency is called a direct quote. • The foreign currency price of the home currency is called?

  6. Market Quotes:Direct - Indirect Quotes • The home currency price of a foreign currency is called a direct quote. • The foreign currency price of the home currency is an indirect quote. • Dollars & Yen? Dollars & pounds?

  7. Appreciating and Depreciating Currencies • A currency that has lost value relative to another currency is said to have ? • A currency that has gained value relative to another currency is said to have ?

  8. Appreciating and Depreciating Currencies • A currency that has lost value relative to another currency is said to have depreciated. • A currency that has gained value relative to another currency is said to have appreciated. • These terms relate to the market process and are different from devaluation and revaluation.

  9. Appreciating and Depreciating Currencies • We use the percentage change formula to calculate the amount of depreciation/appreciation. • Example, on Monday, the peso traded at 0.1021 $/P. On Tuesday the market closed at 0.1025 $/P. • The peso has appreciated, as it now takes more $ to purchase each peso.

  10. Appreciating and Depreciating Currencies • Example, on Monday, the peso traded at 0.1021 $/P. On Tuesday the market closed at 0.1025 $/P. • The amount of appreciation is: [(0.1025 - 0.1021)/0.1021] * 100 = 0.39%

  11. Bid - Ask Spreads:Example from Financial Times • The bid is the price the bank is willing to pay for the currency, e.g., 1.2002 $/€ is the bid on the euro in terms of the dollar. • The ask is what the bank is willing to sell the currency for, e.g. 1.2010 $/€, is the ask on the euro in terms of the dollar.

  12. Bid - Ask Spread:Cost of Transacting • The bid - ask spread of a currency reflects, in general, the cost of transacting in that currency. • It is calculated as the difference between the ask and the bid. • Example, 1.2020 - 1.2002 = 0.0018.

  13. Bid - Ask Margin:Percent Cost of Transacting • The bid - ask spread can be converted into a percent to compare the cost of transacting among a number of currencies. • The margin is calculated as the spread as a percent of the ask. • (Ask - Bid)/Ask * 100 • Example, (1.2020 - 1.2002)/1.2020 * 100 = 0.15%.

  14. Cross-Rates: Unobserved Rates • A cross-rate is an unobserved rate that is calculated from two observed rates. • For example, the spot rate for the Canadian dollar is 0.70 $/C$, and the spot rate on the euro is 1.02 $/€. What is the Canadian dollar price of the euro (C$/€)?

  15. Cross-Rates: Unobserved Rates • A cross-rate is an unobserved rate that is calculated from two observed rates. • For example, the spot rate for the Canadian dollar is 0.70 $/C$, and the spot rate on the euro is 1.02 $/€. What is the Canadian dollar price of the euro (C$/€)? • Note that ($/€)/($/C$) = ($/€)*(C$/$)=C$/€. • In this example, 1.02/0.70 = 1.457 C$/€.

  16. Arbitrage:Consistency of Cross Rates • Arbitrage is the simultaneous buying and selling to profit (as opposed to speculation). • The ability of market participants to arbitrage guarantees that cross rates will be, in general, consistent. • If a cross rate is not consistent, the actions of currency traders (arbitrage) will bring the respective currencies in line.

  17. Spatial Arbitrage • Spatial Arbitrage refers to buying a currency in one market and selling it in another. • Price differences arise from geographical (spatial) dispersed markets. • Due to the low-cost rapid-information nature of the foreign exchange market, these prices differences are arbitraged away quickly.

  18. Triangular Arbitrage • Triangular arbitrage involves a third currency and/or market. • Arbitrage opportunities exist if an observed rate in another market is not consistent with a cross-rate (ignoring transaction costs).

  19. The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London. Does an arbitrage opportunity exist? Triangular Arbitrage: An Example

  20. The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London. The cross-rate in New York is: 0.024/1.455 = 0.016 (£/b) Hence, an arbitrage opportunity exists. Triangular Arbitrage: An Example

  21. The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London. The cross-rate in New York is: 0.024/1.455 = 0.016 (£/b) Hence, an arbitrage opportunity exists. How do you exploit it? Triangular Arbitrage: An Example

  22. Example Continued • “Buy low, sell high.” • A trader with $1, could buy £0.687 in New York. • The £0.687 would purchase b57.274 in London. • The b57.274 purchases $1.375 in New York, or 37.5% profit on the transaction.

  23. Real Exchange Rates: Measuring Relative Purchasing Power

  24. Real Exchange RatesReal Measures • Nominal variables, such as exchange rates, do not consider changes in prices over time. • Real variables, on the other hand, include price changes. • A real exchange rate, therefore, accounts for relative price changes.

  25. Real Exchange Rates • A nominal exchange rate indicates the purchasing power of one nation’s currency over the currency of another nation. • Real exchange rates indicate the purchasing power of a nation’s residents for foreign goods and services relative to their purchasing power for domestic goods and services. • A real exchange rate is an index. Hence, we compare its value for one period against its value in another period.

  26. Real Exchange RatesAn Example • In 2000 the spot rate between the dollar and the pound was 1 USD = 0.6873 GSB (£/$). • Yesterday the rate was 1 USD = 0.5100 GBP. • Hence, the pound appreciated relative to the dollar by 26 percent {[(0.5100-0.6873)/0.6873]*100}. • Based on this alone, the purchasing power of US residents for British goods and services (relative to US goods and services) fell by 26 percent.

  27. Example: Continued • Suppose in 2000 the British CPI was 156.4 and the US CPI was 154.7. In early 2006, the CPI’s were 170.5 and 172.7 respectively. • Based on this, British prices rose 9.0 percent while US prices rose 11.6 percent, a 2.6 difference. • Since the prices of British goods and services rose slower than the prices of US goods and services, there was an increase in purchasing power of British goods and services relative to the purchasing power of US goods and services.

  28. Combining the Two Effects • A real exchange rate combines these two effects - the fall in purchasing power of US residents due to the nominal appreciation of the pound and the gain in relative purchasing power due to British prices rising at a slower rate than US prices. • To construct a real exchange rate, the spot rate, as it is quoted here, is multiplied by the ratio of the US CPI to the UK CPI. (£/$) x (US CPI/UK CPI)

  29. Combining the Two Effects • 2000 Real Rate = 0.6873 x (154.7/156.4) = 0.6798 • 2007 Real Rate = 0.51 x (172.7/170.5) = 0.52. • The real appreciation of the pound was only 24 percent.

  30. Conclusion • The nominal exchange rate change resulted in a 26 percent fall in the purchasing power of US residents for UK goods and services. • The difference in price changes resulted in a 2.6 percent gain in purchasing power of UK goods and services relative to US goods and services for US residents. • Consequently, the 26 percent rise was offset by the 2.6 gain, resulting in an overall 24 percent loss in purchasing power.

  31. Effective Exchange Rate A measure of the general value of a currency.

  32. Effective Exchange Rate • On any given day, a currency may appreciate in value relative to some currencies while depreciating in value against others. • An effective exchange rate is a measure of the weighted-average value of a currency relative to a select group of currencies. • Thus, it is a guide to the general value of the currency.

  33. Weighted Average Value • To construct an EER, we must first pick a set of currencies we are most interested in. • Next, we must assign relative weights. In the following example, we weight the currency according to the country’s importance as a trading partner.

  34. Weights • Suppose that of all the trade of the US with Canada, Mexico, and the UK, Canada accounts for 50 percent, Mexico for 30 percent, and the UK for 20 percent. • These constitute our weights (0.50, 0.30, and 0.20). • Now consider the following exchange rate data.

  35. Exchange Rate Data

  36. Calculating the EER • The EER is calculating by summing the weighted values of the current period rate relative to the base year rate. • The weighted-average value is calculated as: (weight i)(current exchange value i)/(base exchange value i) where i represents each individual country included in the weighted average.

  37. Calculating the EER • Commonly this sum is multiplied by 100 to express the EER on a 100 basis. • Hence, an EER is an index. • As we shall see next, the base-year value of the index is 100. • The index, therefore, is useful is showing changes in the weighted average value from one period to another.

  38. Example • Let last year be the base year. • The effective exchange rate last year was: [(1.52/1.52)*0.50 + (10.19/10.19)*0.30 + (0.61/.61)*0.20]*100 = 100. • As with any index measure, the base year value is 100.

  39. Example • Today’s value of the EER is: (1.44/1.52)*0.50 + (9.56/10.19)*0.30 + (0.62/0.61)*0.20 • or (0.958) 95.8 • The dollar, therefore, has experienced a 4.2 percent depreciation in weighted value.

  40. Effective Exchange Measures • There are a number of effective exchange measures available in the popular press. Some common measures are: • Bank of England Index: The Economist. • J.P. Morgan: The Wall Street Journal and the Financial Times.

  41. Purchasing Power Parity

  42. Purchasing Power ParityAbsolute or the Law of One Price • Suppose The Economist magazine sells for £2.50 in the UK and $3.95 in the US. • Arbitrage, therefore, should guarantee that the exchange rate between the dollar and the pound be s = 3.95/2.50 = 1.580 ($/£). • In words, the dollar price of The Economist in the UK should equal the dollar price of the Economist in the US (ignoring transportation costs).

  43. Absolute PPP • Absolute PPP is expressed as P = P*×S, where P is the domestic price, P* is the foreign price, and S is the spot rate, expressed as domestic to foreign currency units. • Often it is rearranged as: S = P/P*.

  44. Absolute PPP as a Guide to Exchange Values • Suppose the actual spot rate pertaining to the previous example is 1.7743 whereas PPP says the rate should be 1.580. • A difference exists so we can conclude (for instructional purposes) that the pound is overvalued relative to the dollar. • In percentage terms (1.580 - 1.7743) /1.7743 x 100 = -11 percent.

  45. Relative PPP - A Weaker Version • Rearrange APPP to S = P/P*. • Divide one period equation by another period, e.g., S1/S0= (P1/P0)/(P*1/P*0) • Rearrange as: S1 = S0(P1/P0)/(P*1/P*0) • Can be used as a “model” of exchange rate movements. • Note that the emphasis is on exchange rate movements, not levels, though it may appear otherwise.

  46. Example • Suppose the exchange rate between the dollar and the pound was 1.58 in 2000 and is 1.77 today. Further, the UK CPI was 110 and is now 115, while the US CPI was 108 and is now 111. • Plugging this into the formula we have • st = (1.58) [(111/108)/(115/110)] = 1.55 • Hence the £ is overvalued (14%).

  47. Another Expression In words, domestic inflation less foreign inflation should equal the change in the spot rate. Implies that the higher inflation country should see its currency depreciate.

  48. Interest Rates and Currency Markets

  49. Question of the day:Why does investment capital flow from some economies to others?

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