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International Economics By Robert J. Carbaugh 10th Edition

International Economics By Robert J. Carbaugh 10th Edition. Chapter 11: Foreign Exchange. Foreign exchange. Foreign exchange market. Largest and most liquid market in the world No central market - key markets in several cities around the world (London, New York & Tokyo are the largest)

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International Economics By Robert J. Carbaugh 10th Edition

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  1. International EconomicsBy Robert J. Carbaugh10th Edition Chapter 11: Foreign Exchange

  2. Foreign exchange Foreign exchange market • Largest and most liquid market in the world • No central market - key markets in several cities around the world (London, New York & Tokyo are the largest) • Most transactions involve transfers of bank deposits, not currency • Participating banks and brokers are in constant contact via phone and computer • Three general types of transaction • Between banks and their customers • Domestic interbank market conducted through brokers • Trading with overseas banks Carbaugh, Chap. 11

  3. Foreign exchange Types of FX transactions • Spot transactions - executed nearly immediately • purchase and sale of foreign currency for cash settlement not more than 2 business days after the date the transaction • Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance • Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning • It provides an efficient mechanism through which banks can meet their FX needs over a period of time. • Banks are able to use a currency for a period in exchange for another currency that is not needed during that time Carbaugh, Chap. 11

  4. Foreign exchange Distribution of FX transactions by US banks Carbaugh, Chap. 11

  5. Foreign exchange Foreign exchange • Exchange rate is the price of one currency in terms of another • One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) • A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency) Carbaugh, Chap. 11

  6. Foreign exchange markets Forward markets, futures & options • Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date • Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement Carbaugh, Chap. 11

  7. Foreign exchange markets Forward markets, futures & options • Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date • Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates Carbaugh, Chap. 11

  8. Foreign exchange markets Forward markets, futures & options • Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option • Options to buy are called call options, and those to sell are called put options • Strike price – the price at which the option can be exercised. • Options are frequently used to reduce risk from exchange rate changes Carbaugh, Chap. 11

  9. Exchange-Rate Determination Exchange rate determination • Like other prices, the exchange rate in a free market is determined by both supply and demand conditions (see Figure 11.2). • A nation’s demand for FX is derived from, or corresponds to, the debit items on its BOP. • A nation’s supply of FX is derived from, or corresponds to, the credit items on its BOP. • The equilibrium exchange rate is established at the point of intersection of the supply and demand schedules of FX. Carbaugh, Chap. 11

  10. Figure 11.2: Exchange rate determination • If the demand for pounds shift rightward (leftward), the dollar will depreciate (appreciate) against the pound. • Conversely, a rightward (leftward) shift in the supply of pounds causes the dollar to appreciate (depreciate). Carbaugh, Chap. 11

  11. Pros Lower prices on foreign goods Keeps inflation down Foreign travel is cheaper Cons Exporters’ products become more expensive abroad Imports-competing firms face price competition Travel more expensive for foreign tourists Foreign exchange Impact of an appreciating US dollar Carbaugh, Chap. 11

  12. Pros Exporters can sell abroad more easily Less competition for US firms from imports Foreign tourism is encouraged Cons Higher prices on imports Upward pressure on inflation Travel abroad more expensive Foreign exchange Impact of a depreciating US dollar Carbaugh, Chap. 11

  13. Foreign exchange Exchange rate indexes • To judge the overall value of a currency versus many others, an index is used • A common index for the US dollar is the “trade weighted” index with respect to the currencies of the US’s most important trading partners (in proportion to their share of trade) • To take into account price changes (inflation or deflation), a “real exchange rate” is used • The real exchange rate is the nominal rate multiplied by the ratio of the foreign to domestic price levels Carbaugh, Chap. 11

  14. Nominal and Real Exchange Rates • Real Exchange Rate Index: • The real exchange rate is the nominal exchange rate adjusted for relative price levels. • For example: • In 2002, the nominal exchange rate for the US and Europe is 90 cents per euro; in 2004, it is 80 cents per euro  it leads to an 11% appreciation of the US dollar against euro. • If CPI = 100 in 2002; then it becomes 108 in US and 102 in Europe in 2004  the real exchange rate becomes 75.6 cents per euro (80 cents x 102/108)  an 16% appreciation! • A rise (fall) in the real exchange rate tends to reduce (increase) the international competitiveness. Carbaugh, Chap. 11

  15. Foreign exchange markets Arbitrage and hedging • Exchange arbitrage involves taking advantage of simultaneous exchange rate differences in different markets to make a profit • Helps equalize exchange rates globally • Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return • Subject to exchange rate risk Carbaugh, Chap. 11

  16. Foreign exchange markets Arbitrage and hedging • Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions • Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings Carbaugh, Chap. 11

  17. Foreign exchange markets Speculation • Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future Carbaugh, Chap. 11

  18. Foreign exchange markets Speculation • Speculation can either reduce or increase volatility in foreign exchange rates • If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements • If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency Carbaugh, Chap. 11

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