Foreign Exchange

1
Foreign Exchange
2
Introduction

• The volume of international exchange has grown
  tremendously since World War II
• Whenever an exchange takes place between
  residents of different countries, one kind of
  money has to be exchanged for another
• Foreign exchange rate between two currencies is
  determined by supply and demand established in
  the foreign exchange market consisting of a
  network of foreign exchange dealers

3
The Equilibrium Exchange Rate

• The rate at which the quantity of a currency
  demanded is equal to the quantity supplied.
• At the equilibrium exchange rate, the foreign
  exchange market clears, meaning that the quantity
  of the currency demanded is exactly equal to the
  quantity supplied.

4

What Determines Foreign Exchange Rates?

• Imports of a country give rise to a demand for
  foreign exchange and a supply of U.S. dollars
• Exports result in a supply of foreign exchange
  and a demand for U.S. dollars
• Therefore, trade of the U.S. will be a primary
  contributor to the demand and supply of dollars
  and foreign currency

5
Balance of Payments

• The record of transactions between the United
  States and its trading partners in the rest of
  the world over a period of time.

6
Trade Deficit

• Imports are greater than exports.
• Demand for foreign currency is greater than
  supply
• Result in a depreciation of the U.S. dollar
• Encourages exports and discourages imports
• Eventually the trade balance is in equilibrium at
  the new exchange rate.

7
Trade Surplus

• Exports are greater than imports.
• This will result in an appreciation of the U.S.
  dollar and a depreciation of the foreign currency
• Discourages exports and encourages imports
• The trade will be balanced at the new exchange
  rate

8
Factors that Effect Supply and Demand

• Relative prices of U.S. vs. foreign goods
• Differential inflation rates
• Differential interest rates
• Productivity
• Tastes for U.S. vs. foreign goods
• Government intervention.

9
Relative Prices of U.S. Versus Foreign Goods

• Relative increase in price of U.S. goods will
  encourage more imports
• increase demand for foreign currency
• tends to depreciate the value of the U.S. dollar
  or an appreciation of the foreign currency
• Relative decrease in price of U.S. goods will
  result in an appreciation of the U.S. dollar

10
Productivity

• Increased productivity in U.S. will lower price
  of American goods
• Increased demand for U.S. goods internationally
• Increased supply of foreign currency will
  appreciate the value of the dollar while foreign
  currency depreciates

11
Tastes for U.S. Versus Foreign Goods

• Increased tastes for U.S. goods
• Increased demand for U.S. goods and increased
  supply of foreign currency
• Dollar appreciates relative to foreign currency

12
How Global Investors Cause Exchange Rate
Volatility

• Changes in the factors described above occur
  slowly over time, so they cannot explain the
  often violent short-term movement in exchange
  rates
• There is considerable day-to-day movement of U.S.
  dollar exchange rates versus major foreign
  currencies

13
International Capital Mobility

• Funds flow freely across international borders
  and investors can purchase U.S. or foreign
  securities
• U.S. investors compare the expected return on
  domestic securities versus foreign securities to
  determine which are the most attractive
• Therefore, changes in preferences of U.S. versus
  foreign securities will result in a change in
  demand and supply of foreign currency and a
  change in the exchange rate

14
International Capital Mobility

• In this case, expectations of future exchange
  rates play a central role in the decision process
• When considering investing in foreign securities
  to take advantage of a higher yield, must
  consider the expected movement of future exchange
  rates
• In order to invest in foreign securities, must
  first purchase foreign currency and eventually
  re-purchase U.S. dollars to bring currency back
  to U.S.

15
International Capital Mobility

• It is possible that a change in the future
  exchange rate will offset any increased yield by
  holding foreign securities
• In fact, the international mobility of capital
  will often cause the change in future exchange
  rates that was anticipatedself-fulfilling
  prophesy

16
How Global Investors Cause Exchange Rate
Volatility

• This suggests that the equilibrium foreign
  exchange rate is sensitive to investor
  expectations of future movement in exchange rates
  
• Since these expectations might be quite unstable
  and susceptible to change, this may cause
  considerable short-term volatility in the actual
  exchange rates

17
Fixed Versus Floating Exchange Rates

• Volatility in foreign exchange rates represents a
  cost of doing business internationally and
  imposes considerable risk on investments overseas
• Historically governments tried to avoid this cost
  by fixing exchange rates at some predetermined
  level

18
Foreign Exchange Trading Regimes

• 1944 to 1973
• Major industrial countries maintained a system of
  fixed exchange rates.
• Currency values rarely changed.
• 1973-present
• Exchange rates fluctuate daily in response to
  changes in supply and demand.

19
1944 Bretton Woods Accord

• Established the fixed exchange rate system.
• The U.S. dollar was the official reserve
  currency.
• A government was obligated to intervene in the
  foreign exchange markets to keep the value of its
  currency within a narrow range.
• Reserve asset balances such as gold or foreign
  currency holdings were key indicators of a
  governments ability to keep its exchange rate
  stable.

20
Floating Exchange Rates

• Bretton Woods System collapsed in 1971 when the
  U. S. suspended the international conversion of
  dollars to gold.
• Since 1973, major industrialized countries have
  participated in a managed float exchange rate
  system.
• If currency fluctuations become too severe and
  disruptive to the economy, countries may borrow
  funds from the International Monetary Fund (IMF)
  to stabilize their currency.

21
Fixed Exchange Rate System

• This was the system maintained globally from 1944
  until the early 1970s.
• It came under the supervision of the
  International Monetary Fund (IMF)
• After the collapse of the fixed exchange rate
  system, it was resurrected with a more limited
  scope in 1979 for the major European countries

22
Fixed Exchange Rate System

• The most recent example of a fixed exchange rate
  is the introduction of the Euro as the common
  currency of the 12 members of the European
  Monetary Union
• This new monetary union sets the exchange rate
  between the Euro and the member countries
  national currencies at a fixed rate
• Individual member countries are expected to
  maintain domestic economic conditions that will
  not cause these agreed upon exchange rates to
  change

23
International Financial Crises

• Major problem with a fixed rate system is that it
  contains no self-correcting exchange rate
  mechanism to eliminate a countrys persistent
  balance-of-payment deficit
• A continual balance-of-payment deficit suggests
  domestic economic structural problems relative to
  the rest of the world
• Eventually the country will run out of
  international reserves and be forced to devalue
  which will eliminate the deficit

24
International Financial Crises

• The expectation of a devaluation will cause the
  international financial community to take actions
  that will increase the likelihood of the
  anticipated devaluation
• Individuals will sell the threatened currency in
  the international market
• This increases the supply of the currency which
  increases the downward pressure on the value
• This capital flight will further deplete the
  countrys international reserve and speed up the
  devaluation

25
Managed Float System

• Currently industrialized countries practice a
  managed float system
• The exchange rate is permitted to vary within a
  predetermined band
• If foreign exchange markets attempt to push the
  value of the currency outside the band (both
  above or below), central bank will intervene
• However, if the central bank is intervening an
  excessive amount, it is likely that country will
  be forced to devalue or revalue its currency to
  recognize structural changes in local economy

26
Central Bank Intervention

• Direct Intervention
• Occurs when a countrys central bank sells some
  of its currency reserves for a different
  currency.
• If the Federal Reserve desired to weaken the
  dollar, it could sell some of its dollar reserves
  in exchange for foreign currencies those
  currencies would appreciate against the dollar.

27
Direct Intervention - Example

• On July 17, 1998, the Federal Reserve and Japans
  central bank directly intervened in the foreign
  exchange market by using more than 3 billion to
  purchase Japanese yen. The Fed was concerned
  that the continued depreciation of the yen would
  place more downward pressure on the currencies of
  China and Hong Kong, two currencies that had
  remained stable during the Asian crisis.
• The yens value increased by 5 percent on the day
  of the intervention.
• Over the next several months, the yens value
  strengthened, and in January 1999, the Fed and
  the Bank of Japan attempted to weaken the yens
  value by selling yen in the foreign exchange
  market.

28
WSJ January 30, 2003

• Japan No Plan To Guide Yen To Specific Rate
• TOKYO -- Japan has no intention to guide the yen
  to specific level, a top Finance Ministry
  official said Thursday, repeating that
  authorities only intervene when it's necessary to
  calm volatile markets.
• Hiroshi Watanabe, the head of the International
  Bureau, said purchasing power parity between
  different countries was only one measure for
  currency levels.
• "Intervention , fundamentally, is for smoothing
  (volatile markets) or countering sudden moves,"
  Watanabe said.

29
WSJ January 31, 2003

• Japan's Hush-Hush Intervention Sparks USD Rally,
  For Now
• Of DOW JONES NEWSWIRES NEW YORK -- Sometimes
  softly, softly does it, as the yen's decline on
  Friday shows.
• The announcement by Japan's Ministry of Finance
  overnight that it undertook covert currency
  market intervention this month to weaken the yen
  drove the Japanese currency to its biggest drop
  against the dollar in three weeks on Friday. It
  has left the greenback dancing around the
  important psychological Y120 mark, up from a
  session low of Y118.88 and helped fire a
  broad-based dollar rebound.
• As the world's second-biggest economy hovers on
  the brink of a renewed economic downturn,
  currency market intervention is one of the few
  recourses Japan's policy makers have at their
  disposal to encourage growth.
• But in the past, the Ministry of Finance - the
  guardian of Japan's currency policy - has been
  much more open with its market forays. This time,
  the confirmation that it has been quietly
  stepping into the market marks a clear - and
  intelligent - shift that has already nervous
  currency traders closely second-guessing any
  rapid slips in the yen. For a short while at
  least, this new deft strategy may continue to
  bear fruit, U.S.-based analysts say.

30
WSJ February 3, 2003

• Dollar Gains Against YenAs Intervention Fears
  Loom
• NEW YORK -- The dollar gave a split performance,
  rising against the yen on anticipation that Japan
  may intervene again to weaken its currency, but
  falling against the Swiss franc on worries about
  prospects for a U.S.-led war with Iraq.
• The dollar ended the New York day lower against
  the euro and the Swiss franc -- a classic refuge
  currency in times of war -- but higher against
  the yen and the pound.
• Early in the New York session, some
  stronger-than-expected U.S. economic reports
  helped improve dollar sentiment, but jitters
  ahead of Secretary of State Colin Powell's
  appearance at the U.N. Wednesday wiped out many
  of its gains.

31
Indirect Intervention

• The Fed can attempt to lower interest rates by
  increasing the U.S. money supply.
• Lower U.S. interest rates tend to discourage
  foreign investors from investing in U.S.
  securities, thereby putting downward pressure on
  the dollar.

32
Indirect Intervention during the Peso Crisis

• 1994 Mexico experienced a large balance of
  trade deficit.
• The peso was stronger than it should have been
  and that encouraged Mexican firms and consumers
  to buy an excessive amount of imports.
• On December 20, 1994, Mexicos central bank
  devalued the peso by about 13.
• Stock prices plummeted as many foreign investors
  sold their shares and withdrew their funds from
  Mexico in anticipation of further devaluation in
  the peso.
• On December 22, the central bank allowed the peso
  to float freely, and it declined by 15.
• The central bank increased interest rates as a
  form of indirect intervention to discourage
  foreign investors from withdrawing their
  investments in Mexicos debt securities.

33
Speculating with Exchange Rates

• The risk associated with fluctuations in the
  exchange rate.
• You have 1 million to invest. Interest rates in
  Germany are
• much higher than in the U.S., so you decide to
  invest in a one-
• year German T-bill with a market yield of 9.
  What is your
• holding-period yield for the year?
• Today Exchange dollars for marks 1.6 DM/
• Invest in German T-bills at 9.
• In one year Exchange marks for dollars. Suppose
  the dollar strengthened relative to marks 2
  DM/.
• DM 1,744,000/(2 DM/) 872,000
• Your return is not 9 but 12.8.

34
International Money and Capital Markets

• Capital mobility
• The extent to which savers can move funds across
  national borders for the purpose of buying
  financial instruments issued in other countries.
• International money markets
• Markets for cross-border exchange of financial
  instruments with maturities of less than one
  year.
• International capital markets
• Markets for cross-border exchange of financial
  instruments that have maturities of a year or
  more.

35
International Financial Integration

• International financial integration
• A process through which financial markets of
  various nations become more alike and more
  interconnected.
• Arbitrage
• Purchasing an asset at the current price in one
  market and profiting by selling it at a higher
  price in another market.

36
Putting a Lid on Open Financial Markets Capital
Controls

• Capital controls
• Legal restrictions on the ability of a nations
  residents to hold and trade assets denominated in
  foreign currencies.

37
Malaysia Softens on Ringgit Peg 1/12/04

• Malaysian Prime minister Abdullah Ahmad Badawi's
  new administration has wasted no time in floating
  a trial balloon about a potentially major
  economic-policy shift -- changing the currency's
  peg to the dollar.
• Mr. Abdullah has said there is no plan to alter
  the ringgit's value from 3.80 to the dollar,
  where it has remained for more than five years,
  But analysts say it is high time to consider
  letting the Malaysian currency strengthen against
  the wilting dollar and that 2004 would be a good
  year for a change in the fixed-rate system
• Enormous changes have taken place in Asia since
  then-Prime Minister Mahathir Mohamad clamp the
  ringgit to the dollar in September 1998.
• The peg was one of a series of measures,
  including controls to keep capital from pouring
  out of the country, that the government imposed
  during the regional financial crisis, when
  currencies regionwide plunged and economies were
  thrown into deep recession.
• Malaysia's drastic moves were criticized by
  Western governments and the International
  Monetary Fund at the time, but many critics now
  concede the peg and capital controls helped
  stabilize the Malaysian economy.

38
Mfg, Labor Grps Hire Law Firm On Case Vs China On
Forex Jan 30, 2004

• A group of 39 manufacturing, agriculture and
  labor trade associations and unions have hired a
  law firm to develop a case against China for
  manipulating its currency.
• "We believe that the Chinese practice of
  intervening heavily to control its currency at a
  significantly undervalued level - as much as 40
  - against the dollar conveys an artificial trade
  advantage that is affecting U.S. production and
  jobs," Mears said.
• China tightly manages its currency, both through
  intervention and capital controls , effectively
  pegging it at 8.3 yuan per U.S. dollar. U.S.
  manufacturers want China to revalue to a stronger
  rate, arguing the yuan is undervalued, giving
  Chinese producers an unfair competitive advantage.

39
Vehicle Currencies

• Vehicle currency
• A commonly accepted currency that is used to
  denominate a transaction that does not take place
  in the nation that issues the currency.
• Almost 70 percent of U.S. paper currency and
  coins circulate abroad.

40
Exchange Rate

• The number of units of foreign currency that can
  be acquired with one unit of domestic money.
• Appreciated when a currency has increased in
  value relative to another currency.
• Depreciated when a currency has decreased in
  value relative to another currency.

41
Foreign Exchange Markets and Spot Exchange Rates

• Spot market
• A market for contracts requiring the immediate
  sale or purchase of an asset.
• Spot exchange rate
• The spot-market price of a currency indicating
  how much of one countrys currency must be given
  up in immediate exchange for a unit of another
  nations currency.

42
Exchange Rate Quotations

• EXCHANGE RATES
• Wednesday, February 19, 2003
• The New York foreign exchange selling rates
  below apply to trading among banks in amounts of
  1 million and more, as quoted at 4 p.m. Eastern
  time by Bankers Trust Co., Dow Jones Telerate
  Inc., and other sources. Retail transactions
  provide fewer units of foreign currency per
  dollar.
• Currency U.S.
  equiv. per U.S. Country Wed. Wed.
• Australia (Dollar) .5942 1.6829

43
Foreign Exchange Rates

• Spot exchange rate vs. Forward exchange rate

44
Appreciation vs. Depreciation

• 1997 Britain (Pound) 1.6943 .5902
• 1999 Britain (Pound) 1.6517 .6054
• The pound has depreciated by 2.51
• (1.6517-1.6943)/1.6943-2.51
• The dollar has appreciated by 2.58
• (.6054-.5902)/.59022.58
• When a countrys currency appreciates, the
  countrys goods abroad become more expensive and
  foreign goods in that country become cheaper.
• Conversely, when a countrys currency
  depreciates, its goods abroad become cheaper and
  foreign goods in that country become more
  expensive.

45
Foreign Exchange Market

• Over-the-counter market
• Dealers (banks)
• Most trades involve the buying and selling of
  bank deposits denominated in different
  currencies.
• Transactions in excess of 1 million