Economics of International Finance Econ. 315

Economics of International FinanceEcon. 315 Chapter 4: Foreign Exchange Markets and Exchange Rates

I. Overview • The exchange rate ( also known as the foreign exchange rate, forex rate or FX rate) between two countries specify how much one currency is worth in terms of the other . • A fixed exchange rate (pegged exchange rate) is a type of exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value such as gold. • A floating exchange rate ( flexible exchange rate) is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to foreign exchange market.

II. The Foreign Exchange Market The market in which individuals, firms, and banks buy and sell foreign currencies (foreign exchange). • Examples: London, Paris, Zurich, Frankfurt, Singapore, Hong Kong, Tokyo and New York. • These centers form a single international foreign exchange market. They are connected electronically and are in constant contact with each other • What are the major world currencies?. • The world have what is called a vehicle currency, i.e., the US Dollar which is used to pay for the transactions that do not involve USA. • Note that the Euro is also growing as a world vehicle currency. China and Russia are asking now for a new vehicle currency.

Major foreign exchange centers (by size) are: • London (about 40% of daily transactions) • New York • Tokyo • Singapore

III. Functions of the Foreign Exchange Markets: • The principle function is to transfer funds or purchasing power from one nation or currency into another. How it is done: • If we need foreign exchange we usually go to a bank. A domestic bank will instruct its correspondent in a foreign monetary center to pay the specified amount of its local currency (foreign exchange) to a person, firm or an account. • This is usually accomplished by electronic transfers (the internet).

Foreign Exchange (Demand): Source of demand for foreign exchange: • Imports of goods from abroad • Imports of services, e.g., travel abroad • Invest abroad Note: these items are all recorded in the country’s BOP

Foreign Exchange (Supply): Source of Supply for foreign exchange: • Exports of goods to abroad • Exports of services, e.g., insurance • Investments at home Note: these items are all recorded in the country’s BOP

Important Notes: • All these transactions are mainly made through commercial banks which function as a clearinghouse for the foreign exchange. • Banks may end up having: - Oversupply of foreign exchange (will sell it to other banks) through a broker. - Excess demand of foreign exchange (will buy it from other banks) through a broker. • In general: - A country pays for its imports, investments ..etc. with its foreign exchange earnings from exports, services..etc. - What happens if the nation’s demand for foreign exchange exceeds the supply, or if the supply of foreign exchange exceeds demand?

If exchange rate is flexible; the exchange rate will have to changeto equilibrate supply and demand. • What if changes in exchange rates are not allowed? (exchange rate is fixed), there will either be: (1) Excess demand - Banks will borrow foreign exchange from the central bank (lender of the last resort). -The central bank will draw down its foreign reserves (a BOP deficit) (2) Excess Supply -Banks will sell foreign exchange to the central bank(exchange the surplus into domestic currency) -Foreign reserves in the CB will accumulate (a BOP surplus).

There are four levels of participants in the foreign exchange market that can be identified: 4th level the central bank: seller or buyer of the last resort when the nations earnings and expenditures of foreign exchange are unequal, draw down its foreign reserves or adds to them 3rd level foreign exchange brokers (wholesale market) 2nd level commercial banks (clearing house between users & earners) 1st level traditional users: tourists, importers,exporters (immediate users of foreign exchange)

2. Another function is the credit function. International transactions involve credit facilities, e.g., • An importer is usually given time to resell his imports and make the payments. • What the exporter do is to discount the “importer’s obligations to pay” at his bank, i.e., the exporter receives payments. • The bank eventually collects the payments from the importer when due. 3. A third function is to provide facilities for hedging and speculation(explained later)

IV. Foreign exchange rates • Equilibrium foreign exchange rates: Flexible exchange rates: Consider the following case (the Dollar and the Euro)

FIGURE 1: The Equilibrium Exchange Rate

According to the table: Under Flexible Exchange Rate Regime • The exchange rate is determined just like the price of any other good. • If the rate of the Euro is $ 0.5, the quantity of euros demanded will exceed the quantity supplied the rate will bid up towards the equilibrium rate • If the rate of the Euro is $ 1.5, the quantity of euros supplied will exceed the quantity demanded  the rate will fall towards the equilibrium rate

FIGURE 2: The Exchange Rate Under a Flexible Exchange Rate System.

According to the table: Under Fixed Exchange Rate Regime • What if the rate is fixed (fixed exchange rate system). • In case of excess demand the central bank (Fed) will either: - fill the gap between demand and supply out of its international reserves, or - set restrictions on the demand for euro (2) In case of excess supply the central bank (Fed) will either: individuals are not willing to hold the existing supply of euro. In such case Central Bank must absorb the excess supply of euro.

FIGURE 3 The Exchange Rate Under a Fixed Exchange Rate System.

According to the graphs: Why the demand is negatively slopped? (note that the demand for foreign exchange is a derived demand) - At lower rates the demand for the euro increases: why? The lower the rate, the lower is the quantity of dollars required to buy one euro  the cheaper it is for Americans to import and to invest in Europe  the greater is the demand for euros. Why the supply is positively slopped? • At higher rates, European residents will receive more dollar for each euro  they will find American goods and investments cheaper and more attractive  they will spend more in USA and the supply of euro will increase

Changes in demand and supply of foreign exchange (1) Demand Changes ( shifting up) • If the American demand for euros shifted up, e.g., as a result of increased US tastesfor European goods and the US quantity supplied for euros increased at point G in figure 4, the euro rate will be 1.5 and the equilibrium daily quantity will be € 300 mn. • It requires now $ 1.5 (instead of $ 1) to buy one euro. This is a depreciation of the US $, which is an increase in the domesticprice (US) of the foreign currency (euro).

FIGURE 4 depreciation D€1

(2) Demand Changes ( shifting down) • If the American demand for euros shifted down to so as to intersect the US supply at point H in figure 5, the equilibrium exchange rate of the euro would fall to $ 0.5 and the daily equilibrium quantity would be € 50 mn. • It requires now fewer dollars to buy one euro,  this is an appreciation of the $ US, which is a decline in the domestic price (US) of the euro. • Note that changes in supply of euros would similarly affect the equilibrium exchange rate and quantity of euros.

FIGURE 5 appreciation D€2

Another Definitions of the Exchange Rates (1) Foreign Currency Price • The exchange rate can be defined as the foreign currency price of a unit of domestic currency. If the Dollar price of the euro is $1.5 = € 1 then the euro price of the dollar is (1/1.5) = .667, i.e., it takes 0.667 euros to buy one dollar. • note: the conventional definition (number of domestic currency units to buy one unit of foreign currency) is (R), hence the other definition is (1/R)).

Another Definitions of the Exchange Rates (2) Cross Exchange rates: There are rates between the dollar and other currencies, i.e., between the dollar and the euro, the dollar and the Sterling…etc. once the rate between the dollar and other two currencies is determined, the exchange rate between them (cross) can easily be calculated. Example: if the rate between the dollar and the Sterling is $ 2 = £ 1 and the rate between the dollar and the euro is $ 1.25 = € 1, then the cross exchange rate between the sterling and the euro is 1.60. R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6 i.e., it takes € 1.6 to purchase £ 1.

Another Definitions of the Exchange Rates (3) Effective Exchange Rate: • A weighted average of the rate between the domestic currency and the nations most important trade partners, with weights given by the relative importance of the nation’s trade with each of these partners. (4) Nominal and Real Exchange Rates: • Nominal exchange rate is the domestic price of the foreign currency (direct or indirect rate). • The real exchange rate is the nominal exchange rate divided by the ratio of the consumer price indices in the two countries. e.g., the real exchange rate between the dollar and the Sterling is: ($/£)/(PUSA/PUK) = ( $/£ )( PUK / PUSA )

Arbitrage • The purchase of a currency from the monetary center where it is cheaper for immediate resale in the monetary center where it is more expensive in order to make a profit. • Arbitrage keeps the exchange rate between two currencies the same in different monetary centers. Two point arbitrage New York London $ 1.99 = £ 1 $ 2.01 = £ 1 * Buy here* sell here Therefore, Arbitrageur profit = 2.01-1.99 = $ .02 per £ 1 (minus transactions cost) Note: As arbitrage continues, the exchange rate between the two currencies equalizes. e.g., $ 2.00 = £ 1 $ 2.00 = £ 1 • Eliminating thus the profitability of further arbitrage.

V. Exchange rates and the BOP Figure 6: Disequilibrium under a fixed and flexible exchange rate

According to the graph 6: • D€ is reached by imports of goods and services from and investment in Europe. • S€ is reached by exports of goods and services to Europe and European investments in US • Both are autonomous (BOP = 0) • Equilibrium exchange rate is $1 = €1. and the equilibrium quantity is 200 million. If demand for € increases to D€’ the effect will depend on the exchange rate system

According to the graph 6: Under Fixed Exchange Rate Regime • If US wants to keep the euro rate at $1, it would have to satisfy the excess demand TE (€ 250), out of official reserves, i.e. purchase $ and sell €. Under Flexible Exchange Rate Regime • The rate would rise to $1.5 to equilibrate demand and supply for €. • Use of reserves is unnecessary because the depreciation of the $ would eliminate excess demand for €. Under Managed – Floating Exchange Rate Regime • Monetary authorities intervene in the market to moderate depreciation of the $ to only $1.25 = €1. This can be done by supplying the market by WZ • Part of the deficit is financed by loss of official reserves, • The other part is eliminated by the depreciation of the $. • Loss of reserves indicates the degree of intervention

VI. Spot, Forward, Future, and Option Rates • Spot Exchange Rate: A spot transaction involves the payment and receipt of foreign exchange within two days after the day of transaction is agreed upon. The rate is called spot rate. • Forward Exchange Rate: - A forward transaction involves an agreement to buy or sell a specified amount of foreign exchange at a specified future date, at a rate agreed upon today (forward rate). - The contract is for one, three or six months. Three months is the most common.

-Equilibrium Forward rateis determined at the intersection of the market demand and supply of foreign exchange for future delivery. -This demand is derived in the course of hedging from foreign exchange speculation and from covered interest arbitrage (will explained later). • If the forward rate < the present spot rate, the foreign currency is said to be at a forward discount. - If the forward rate > the present spot rate, foreign currency is said to be at a forward premium.

For Example: If R is $2 = £1, and the threemonthforward rate $1.98 = £1, The £ is at a forward discount of 2 cents (or 1% (2/200), or the annual forward discount is 4% (8/200)). Same forward premium if the three month forward rate is $ 2.02. Hence, the forward discount or premium is calculated (for a three month contract) as: FD or FP = ((FR – SR)/SR)×4(quarters within one year)×100( to express percentage) FD = ((1.98-2)/2) × 4 × 100 = -4% FP = ((2.02-2)/2) × 4 × 100 = 4%

Currency Swaps (combination of spot and forward) -A currency swap refers to the spot sale of a currency combined with a forward purchase of the same currency - as part of a single transaction. -The swap rate is the difference between the spotand forward rate in the currency swap. -The foreign exchange market is currently dominated by swaps, about 50% of foreignexchange contracts.

Options -A foreign exchange option is a contract giving the purchaser the right, but not the obligation, to buy (a calloption) or to sell (a putoption) a standard amount of traded currency on a stated date (the European option) or at any time (the American option), and at a stated price (the strike or exercise price). -Restricted standard sizes for amount traded. -The buyer of the option has the right to purchase or forego the purchase if it turns out to be unprofitable. -The seller of the option, however, must fulfill the contract if the buyer desires so. -For this privilege, the buyer must pay the seller a premium (option price) ranging from 1 to 5% of the value of the contract.

VII. Foreign Exchange Risk, Hedging and Speculation (1) Foreign Exchange Risk Over time demand and supply for foreign exchange shifts due to changes in tastes, differences in inflation, changes in relative interest rates, changing expectations ..etc • Increasing demand (tastes) by Kuwaitis for American goods raises the US $ rate (depreciation of KD) • If domestic inflation in Kuwait decreases relative to US inflation the US $ depreciates relative to the KD. • If interest rates on domestic currency (KD) deposits are greater than the rate on US $ deposits, the KD will appreciate. • If expectations of a stronger KD increases, the KD appreciates relative to US $. Fluctuations in exchange rates impose risks on individuals, firms, and banks that have to make or receive payments in the future denominated in foreign exchange.

Examples: • A local importer purchases $ 100,000 of goods to be paid in 3 month time. If the KD/$ rate is 0.300, He will have to pay KD 30,000 in three month time. -In 3 month time the rate could be 0.330, He will pay 33,000 (extra KD 3000). -The rate could also be 0.270 , then he will only pay KD 27,000 (KD 3000 less) • The exporter and investor may face the same situation Therefore; • Both the importer and exporter will have to insure against the increase in the rates in 3 months. • In general, whenever a future payment must be made in a foreign currency, a foreign currency risk, or the so called open position, occurs because the spot rate changes overtime. Most business people are risk averse.

(2) Hedging • Avoidance of “foreign exchange risk” or the covering of an “open position”. • How it is done? In the spot market • An importer purchases $100,000 goods. The importer could borrow domestic currency equals to the $100,000 ( loan with paying interest) and exchange it at the present spot rate, and leave the sum on deposit in a bank for 3 months and earn interest, when the payment is due. This way the importer avoids the risk. • The cost of insuring against the foreign exchange risk is the positive difference between the interest rate he pays on the loan and the interest rate he earns on his deposit.

An exporter exports $100,000 goods. The exporter who expects the rate to go down could also borrow the $100,000 in foreign exchange ( loan with paying interest) he expects to receive, exchange them into KDs, and deposit the sum in a bank for 3 month with interest. After 3 months, he will repay the loan using the payment he receives. • The cost of avoiding the risk is the difference between the borrowing and deposit interest rate. • The problem with coverage of exchange risk in the spot market is that the exporter (importer)has to tie his funds for three months.

(3) Speculation • Opposite of hedging. A speculator accepts and even seeks out a foreign exchange risk, or an open position in the hope of making a profit. • A speculator can make profit or incurs a loss. • Speculation can take place in spot, forward, futures and option markets. • How it is done?

In the spot market If a currency is believed to rise in three months, the speculator will : • buy the currency at the spot rate now. • deposit the currency in a bank • In the future if the rate is higher, he will sell it at the spot rate and earns profit. If a currency is believed to fall in three months, the speculator will: • borrow the currency and exchange it for domestic currency at the spot rate, • deposit the domestic currency in a bank for three months. • After three months, if the rate is lower, he will purchase the currency at the sport rate and repay the loan. Note: For a speculation to be profitable, the difference between the two spot rates should be higher than the difference between the interest rates on the domestic and foreign currency

VIII. Interest Arbitrage and Efficiency in the Foreign Exchange Market (1) Uncovered interest arbitrage • Suppose that interest rate on 3 month T.B is 6% in New York and 8% in Frankfurt. • The American investor may want to exchange $ for € and purchase EMU TBs, to earn an extra 2%. When the TBs matures the investor exchange back his euros plus interest into dollars. By that time the euro may have depreciated so that he would get fewer dollars than he paid. If the euro depreciates by more than 2% the investor loses. (if the euro appreciates he would get an extra gain from the appreciation of the euro) (this is an uncovered interest arbitrage)

(2) Covered interest arbitrage • Investors of short term funds abroad generally want to avoid the foreign exchange risk by covering interest arbitrage. • To do this the investor sells forward the amount of foreign exchange he invested plus interest with the maturity of the investment. • Covered interest arbitrage: refers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of it (swap) to cover the risk. • Since the currency with the higher interest rate is usually at a forward discount (why?), the net return on investment is roughly the interest differential minus the forward discount.

(3) Efficiency of foreign exchange markets • In general a market is efficient if it reflects all available information. • A foreign exchange market is efficient if forward rates accurately predict the future spot rates. • If forward rates reflect all available information and quickly adjust to any new information so that investors can not earn consistent and unusual profits by utilizing any available information, then the market is efficient. • Tests of efficiency are difficult to formulate and interpret.

Economics of International Finance Econ. 315