The Spot Market for Foreign Exchange

1
The Spot Market forForeign Exchange
2
Market 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.

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.
• Currency per US is the foreign currency price
  of one US dollar.

4
Market 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.

5
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.
• This terms relate to the market process and are
  different from devaluation and revaluation
  (Chapter 3).

6
Appreciating 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.

7
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

8
Bid - 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.

9
Bid - 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.

10
Bid - 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.

11
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 0.6770 /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/.

12
ArbitrageConsistency 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.

13
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.

14
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).
• Again, profit opportunities are likely to be
  arbitraged away quickly, meaning that cross-rates
  are, for the most part, consistent with observed
  rates.

15
Triangular 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.

16
Example 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.

17
Real Exchange Rates Measuring Relative
Purchasing Power
18
Real 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.

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Real 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.

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Real 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.

21
Example 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.

22
Combining 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)

23
Combining 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.

24
Conclusion

• 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.

25
More 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.

26
Effective Exchange Rate

• A measure of the general value of a currency.

27
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.

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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 countrys importance as a
  trading partner.

29
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.

30
Exchange Rate Data
31
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.

32
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.

33
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)0.20100
• 100.
• As with any index measure, the base year value is
  100.

34
Example

• 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.

35
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.

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37
The Demand for and Supply of Currencies

• A Derived Demand

38
The 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.

39
The 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.

40
The Demand Curve
S (/)
S0
S1
Demand
Quantity
Q0
Q1
41
Important 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.

42
An 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.

43
An Increase in Demand for the Euro
S (/)
S0
D
Demand
Quantity
Q0
Q1
44
The 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.

45
The Supply of a Currency
S (/)
S
Dollar depreciation
B
S1
A
S0
Q0
Q1
Quantity
46
Equilibrium

• 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.

47
Equilibrium
S (/)
S
A
S0
D
Q0
Quantity
48
Increase in the Demand for the Euro
S (/)
S
S1
S0
D
D
Q0
Quantity
Q1
49
Over 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.

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Over and Under-Valued Currencies
S (/)
The euro is undervalued
S
S
S0
D
Q0
Quantity
51
Undervalued

• 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.

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Purchasing Power Parity
53
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).

54
Absolute 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.

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Absolute 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.

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Relative 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.

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Example

• 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).

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Another 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.