Title: The Spot Market for Foreign Exchange
1The Spot Market forForeign Exchange
2Market CharacteristicsAn Interbank Market
- The spot market is a market for immediate
delivery (2 to 3 days). - Primarily an interbank market, which is the
trading of foreign-currency-denominated deposits
between large banks. - Approximately US1.4 - 1.6 trillion daily in
global transactions.
3Market 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. - Currency per US is the foreign currency price
of one US dollar.
4Market QuotesDirect - Indirect Quotes
- Direct quote is the home currency price of a
foreign currency. - Indirect quote is the foreign currency price of
the home currency.
5Appreciating 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. - This terms relate to the market process and are
different from devaluation and revaluation
(Chapter 3).
6Appreciating and Depreciating Currencies
- We use the percentage change formula to calculate
the amount of depreciation. - 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.
7Appreciating 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
8Bid - Ask SpreadsExample from Financial Times
- The bid is the price the bank is willing to pay
for the currency, e.g., 0.9002 / 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. 0.9010 /, is the ask on the
euro in terms of the dollar.
9Bid - Ask SpreadCost 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, 0.9020 - 0.9002 0.0018.
10Bid - Ask MarginPercent 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, (0.9020 - 0.9002)/9.020 100 0.20.
11Cross-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 0.6770 /C, and the spot rate on the
euro is 0.9002 /. What is the Canadian dollar
price of the euro (C/)? - Note that (/)/(/C) (/)(C/)C/.
- In this example, 0.9002/0.6770 1.3297 C/.
12ArbitrageConsistency 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.
13Spatial 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.
14Triangular 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). - Again, profit opportunities are likely to be
arbitraged away quickly, meaning that cross-rates
are, for the most part, consistent with observed
rates.
15Triangular Arbitrage An Example
- 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.
16Example Continued
- 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. - To understand the arbitrage opportunity, remember
buy low, sell high.
17Real Exchange Rates Measuring Relative
Purchasing Power
18Real Exchange RatesReal Measures
- Nominal variables, such as an exchange rate, 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.
19Real Exchange Rates
- A nominal exchange rate indicates the purchasing
power of one nations currency over the currency
of another nation. - Real exchange rates indicate the purchasing power
of a nations 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.
20Real Exchange RatesAn Example
- In 1996 the spot rate between the dollar and the
pound was 0.6536 (/). - In 2000 the rate was 0.6873.
- Hence, the pound depreciated relative to the
dollar by 5.16 percent (0.6873-0.6536)/0.65361
00. - Based on this alone, the purchasing power of US
residents for British goods and services
(relative to US goods and services) rose by 5.16
percent.
21Example Continued
- Suppose in 1996 the British CPI was 156.4 and the
US CPI was 154.7. In 2000, the CPIs 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.
22Combining the Two Effects
- A real exchange rate combines these two effects -
the gain in purchasing power of US residents due
to the nominal depreciation 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)
23Combining the Two Effects
- 1996 Real Rate 0.6536 x (154.7/156.4) 0.6465.
- 2000 Real Rate 0.6873 x (172.7/170.5) 0.6962.
- The real depreciation of the pound was 7.69
percent.
24Conclusion
- The nominal exchange rate change resulted in a
5.2 percent gain in the purchasing power of UK
goods and services for US residents. - 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. - Note how the 5.2 percent decline was augmented by
the 2.6 gain, resulting in an overall 7.7 percent
gain in purchasing power.
25More on Prices and the Exchange Rate
- A Hitchhikers Guide to Understanding Exchange
Rates by Owen Humpage, an economic advisor at the
Federal Reserve bank of Cleveland, is a very
helpful article on prices and real exchange
values.
26Effective Exchange Rate
- A measure of the general value of a currency.
27Effective 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.
28Weighted 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 countrys importance as a
trading partner.
29Weights
- 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.
30Exchange Rate Data
31Calculating 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.
32Calculating 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.
33Example
- 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)0.20100
- 100.
- As with any index measure, the base year value is
100.
34Example
- Todays 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.
35Effective 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.
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37The Demand for and Supply of Currencies
38The Demand for a Currency
- The demand for a currency is a derived demand.
That is, the demand for the currency is derived
from the demand for the goods, services, and
financial assets the currency is used to
purchase. - If, for example, foreign demand for European
goods and services increases, the demand for the
euro increases.
39The Demand Curve is Downward Sloping
- If, for example, the euro depreciates, European
goods, services, and financial assets become less
expensive to foreign residents. Foreign
residents will increase their quantity demanded
of the euro to purchase more European goods,
services, and financial assets. - The downward slope of the demand curve shows the
negative relationship between the exchange rate
and the quantity demanded.
40The Demand Curve
S (/)
S0
S1
Demand
Quantity
Q0
Q1
41Important Note
- It is vital to construct and label supply and
demand diagrams properly. - Note here we are diagramming the market for the
euro. Hence, it is crucial to represent the
correct exchange rate on the vertical axis. - The correct exchange rate is one that reflects
the price of the euro. That is, it must be an
indirect quote.
42An Increase in Demand
- Consider an increase in the demand for the euro.
- Suppose, for example, that savers desire
euro-denominated financial assets relative to
dollar-denominated financial assets because of
a change in economic conditions. - The demand for the euro rises as savers desire
more euros to purchase greater amounts of
European financial assets.
43An Increase in Demand for the Euro
S (/)
S0
D
Demand
Quantity
Q0
Q1
44The Supply of a Currency
- The supply of a currency is also a derived
demand. - Consider the demand schedule for the dollar. If
the dollar depreciates relative to the euro,
there is an increase in the quantity demanded of
dollars. - As more dollars are purchased, the quantity of
euros supplied in the foreign exchange market
increases.
45The Supply of a Currency
S (/)
S
Dollar depreciation
B
S1
A
S0
Q0
Q1
Quantity
46Equilibrium
- The market is in equilibrium when the quantity
supplied of a currency is equal to the quantity
demanded. - This is the market clearing exchange rate because
there is no surplus or shortage of the currency.
47Equilibrium
S (/)
S
A
S0
D
Q0
Quantity
48Increase in the Demand for the Euro
S (/)
S
S1
S0
D
D
Q0
Quantity
Q1
49Over and Under-Valued Currencies
- If a currencys value is market determined, how
can it be over- or under-valued? - A currency is said to be over- or under-valued if
the market exchange rate is different from the
rate that a model or individual predicts to be
the correct rate. - In other words, the individual believes the
market has it wrong.
50Over and Under-Valued Currencies
S (/)
The euro is undervalued
S
S
S0
D
Q0
Quantity
51Undervalued
- In the previous slide, the euro is said to be
undervalued. - The predicted or expected spot rate, S, lies
above the market determined rate, S0. - Hence, it should take a greater amount of
dollars to buy each euro. The euro, therefore,
is underpriced, or undervalued.
52Purchasing Power Parity
53Purchasing 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).
54Absolute PPP
- Absolute PPP is expressed as P PS, 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.
55Absolute PPP as a Guide to Exchange Values
- Suppose the actual spot rate pertaining to the
previous example is 1.480 whereas PPP says the
rate should be 1.580. - Only a slight difference exists, but we can
conclude (for instructional purposes) that the
pound is undervalued relative to the dollar. - In percentage terms (1.580-1.480)/1.480 100
6.76 percent.
56Relative PPP - A Weaker Version
- Rearrange APPP to S P/P.
- Divide one period equation by another period,
e.g., S1/S0 (P1/P0)/(P1/P0) - Rearrange as S1 S0(P1/P0)/(P1/P0)
- 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.
57Example
- Suppose the exchange rate between the dollar and
the pound was 1.58 in 1999 and is 1.60 today.
Further, the UK CPI was 110 and is now 115, while
the US CPI was 108 and is now111. - Plugging this into the formula we have
- st (1.58)(111/108)/(115/110) 1.55
- Hence the is overvalued (3.125).
58Another Expression
- Often economists will take the log of the
previous expression of RPPP to obtain the
following. - ? - ? ?S
- 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.