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Foreign Exchange


Dirty float while exchange rates are determined by the financial markets, ... Other currencies have freely fluctuating exchange rates ... – PowerPoint PPT presentation

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Title: Foreign Exchange

Foreign Exchange
  • Chapter 17

  • About 170 different foreign currencies in the
  • Traded in a global currency market
  • Most trading occurs in only a few currencies
  • Euro, U.S. dollar
  • Currencies market is the largest financial market
    in the world
  • Decentralizedmost transactions occur via
  • Over 1 trillion U.S. dollars of transaction
    occur daily
  • Most of the trading occurs between larger
    international banks in London, New York City,
    Tokyo and Singapore

Common Markets and Economic Unions
  • For many years countries tried to maintain a gold
    exchange standard
  • The exchange rate between currencies determined
    by the ratio of the weights of gold defining the
  • However, since 1970 most national governments
    have abandoned the gold standard
  • Makes it easier for government to create money
  • If a countrys money supply expands too rapidly,
    inflation generally results

Foreign Exchange Rate Fluctuations
  • Exchange rate movements occur when
  • Economic relations between countries change
  • Market participants expectations change
  • Governments often intervene in foreign exchange
  • Attempt to affect their currency values
  • Dirty floatwhile exchange rates are determined
    by the financial markets, governments are free to
  • Happens in U.S., U.K., Japan, Germany, France,

Foreign Exchange Rate Fluctuations
  • In long run, currencies interaction is shaped by
    political and economic conditions
  • Germany and U.S. have had stable political
    systems for the last several decades
  • Thus, these currencies are viewed as safe
  • Some countries (Brazil, Israel, Mexico) have
    experienced hyperinflation
  • Thus, their currencies lost purchasing power

Economic Unions
  • Economic unions occur when countries band
    together and adopt a common currency
  • Attempt to foster cross-border trade
  • Expected benefits of forming an economic union
  • Will reduce the number of foreign exchange
  • Increase competition by making price comparisons
  • Form a bond between the countries in the union

European Monetary Union (EMU)
  • European Monetary Union composed of
  • Austria
  • Belgium
  • Finland
  • France
  • Germany
  • Ireland
  • Italy
  • Luxembourg
  • Netherlands
  • Portugal
  • Spain

Adopted the euro on 1/1/1999. Euro and original
countries currencies are still acceptable.
However, after 7/1/2002 only the euro will be
European Monetary Union (EMU)
  • Will the EMU work?
  • It is easy to argue that a common currency will
    facilitate cross border trade
  • Economic unions prior to EMU did not fare well
  • Latin Monetary Union, Scandinavian Monetary Union
    and East African Community all fell apart
  • Cultural differences between nations will remain
  • Administrative costs may exceed benefits of a
    common currency

European Monetary Union (EMU)
  • Member nations created the European Central Bank
    ( to replace member countries
    separate central banks
  • Reason for failure of other unions was different
    monetary policies pursued by separate member
    countries banks
  • ECB has power over inflation, deficit spending
    and currency stability

Spot and Forward Markets
  • Some nations currency trades at a fixed rate
    relative to a popular currency
  • Other currencies have freely fluctuating exchange
  • The spot market is the current exchange rate for
    immediate delivery

Spot and Forward Markets
  • A transaction of foreign currency with a future
    delivery date occurs in the forward market
  • Only a few currencies are traded in the forward
  • Unprofitable to make a forward market in a
    currency that does not have an active market

Spot and Forward Markets
  • An example of spot prices for different
    currencies are listed below

Expected Foreign Exchange Rate
  • The expected spot rate during the next time
    period is equal to the value of todays forward
    rate for delivery during that time period, or
  • Currencies can sell at a premium or a discount in
    the forward market

If value ) 0, currency is selling at a
forward discount (premium).
Analysis of Foreign Exchange Risk
  • Two people simultaneously invest in an Indian
  • Domestic investor in Indiadomestic currency to
    purchase domestic security
  • Foreign investor in U.S.uses U.S. dollars to buy
    an equivalent amount (500 rupees) of the same
    Indian security
  • Must purchase the rupee with U.S. dollars to make
    the investment
  • If the exchange rate fluctuates, the two
    investors can earn different rates of return
  • Even though they owned the same security over the
    same holding period

The Domestic Investor
  • If the Indian investment returned 550 rupees
    after a one-year period (with no cash income
    during the period), the domestic investor has
    earned 10

The Foreign Investor
  • The return to the foreign investor hinges on the
    exchange rate fluctuation
  • Suppose at the beginning of the investment
    period, the spot rate was 40 rupees for 1 or
  • SPt-1 1/Rs40 0.025
  • Thus, the American paid 12.50 for the Indian
  • 0.025 x 500 rupees 12.50
  • If the exchange rate remains at 0.025, the
    American earns the same return as the Indian

The Foreign Investor
  • However, most governments allow exchange rates to
  • American investor has actually made two risky
  • In the risky Indian security
  • In the risky rupee
  • If the exchange rate has fluctuated to 0.0275 (a
    10 gain) per rupee by the end of the investment
    period, the American investors return is

Components of Investors Total Return
  • The return to the foreign investor can be
    simplified as
  • rforeign rdomestic rforeign exchange gain
    rforeign exchange gainrdomestic
  • This can be approximated by
  • rforeign ? rdomestic rforeign exchange gain
  • Any investor undertaking a foreign investment
    faces three risk factors
  • Total risk foreign currency risk foreign
    security risk covariance risk
  • Covariance risk can be negative or positive

Risks Undertaken by International Investors
  • Estimates of the risks undertaken by U.S. and
    domestic investors, 1993-1999 inclusive

When correlation 0 the American investors risk
is greater than the domestic investors
riskcausing the last column to exceed 1.0.
Worldwide Currency Trading
  • A large international bank may make a market in
    50 currencies
  • Responsibility for the banks electronic trading
    book may pass daily from New York to London to
    Tokyo and back to New York
  • Allows the currency market to operate around the

Three Foreign Exchange Parity Relationships
  • In long run exchange rates are determined by
    fundamental economic relationships
  • Relative purchasing power parity
  • Inflation-based theories
  • Interest rate parity

Relative Purchasing Power Parity (PPP)
  • Law of one priceidentical goods should sell for
    the same price
  • Tends to equalize prices around the world
  • More applicable to financial goods because there
    are essentially no transportation costs
  • Relative PPP generalizes law of one price
  • A basket of identical goods should sell at the
    same price around the world
  • If goods are priced in a common currency and no
    barriers to trade exist
  • Adjusts for different countries inflation rates

Relative Purchasing Power Parity (PPP)
  • Implies that if countries have different
    inflation rates, the exchange rate should
    fluctuate to compensate
  • Example If inflationUS 4 and
    inflationU.K.8, the U.S dollar should
    appreciate by 1.08/1.04 1 3.8 relative to
    the British pound
  • If this doesnt happen, U.K. exports to the U.S.
    will become overpriced and U.S. exports to U.K.
    will become underpriced
  • Demand for pounds would decrease
  • Demand for U.S. dollar would increase
  • Until new equilibrium is reached

Relative Purchasing Power Parity (PPP)
  • Thus, the relationship between inflation and
    exchange rates is
  • In a world without restrictions, foreign exchange
    rates would reflect inflation differentials
    between countries

Critique of PPP
  • PPP lacks the ability to explain day-to-day (or
    even month-to-month) changes in foreign exchange
  • One of the main problems is our inability to
    measure inflation
  • Consumers baskets of goods change continuously
  • Difficult to alter the basket of goods used in
    calculating a CPI
  • Different baskets of goods apply for different
  • Most inflation measures are based on historical
    data, not on expected future price changes

Fishers Inflation-Based Theories
  • During 1930s Irving Fisher states that nominal
    interest rates could be divided into
  • Constant real rate
  • Fluctuating expected rate of inflation
  • (1 nominal rate) (1 real rate) x ( 1
    expected inflation)
  • Can be approximated by
  • Nominal rate ? real rate expected inflation
  • Critics argue Fishers model is too simple
  • Assumes the real rate remains constant

Fishers Inflation-Based Theories
  • Fisher extended his model to an open economy
  • Allows trading between countries and multiple
  • Differences between countries nominal interest
    rates can be explained by
  • Differences in real rates
  • Differences in inflation rates
  • Known as the Fisher open model

Fisher Open Model
  • If two countries have the same real rate, the
    differences in their nominal rates can be
    explained by differences in their expected
    inflation rates
  • More useful for analyzing long-run than short-run
  • Also, differences in countries real rates causes

Interest Rate Parity
  • Occurs when market returns in two countries are
    equal when they are denominated in the same
  • Applies law of one price to nominal interest
  • Adjusts to remove exchange rate effects
  • Uncovered interest rate parity involves no
    offsetting cover to hedge the position

Uncovered Interest Rate Parity
  • Not useful for predicting because
  • Comparison must be made across countries on
    assets of equal risk
  • Can be troublesome if different levels of
    sovereign risk exist
  • The expected spot price1 is difficult to measure
  • Foreign exchange adjustments needed to derive the
    model make the model cumbersome
  • The covered interest rate parity model is easier
    to use

Covered Interest Rate Parity
  • Forward contracts can be used to earn arbitrage
    profits if the relationships do not hold

Example Covered Arbitrage
  • Given information
  • FP1 C/US 1.17
  • SP0 C/US 1.16
  • Nominal rateU.S. (domestic) 10
  • Nominal rateCanada (foreign) 13
  • Substituting these values into the covered
    interest rate parity equation yields the
    following inequality

Example Covered Arbitrage
  • Arbitrage profits could be earned by
  • Borrowing U.S. dollars for 10
  • Converting the U.S. to Canadian at the current
    spot price of 1.16
  • Investing the Canadian in an investment
    returning 13
  • Buying a foreign exchange forward contract
    guaranteeing the exchange rate in 1 year of
    C1.17 per U.S.

Example Covered Arbitrage
  • If this were done with 100,000 U.S., the result
    would be
  • If this inequality existed arbitrage would lead
  • Increase in demand for Canadian dollars
  • Lead to a reduction in the C/US exchange rate
  • Increase in supply of Canadian dollars in the
    forward market
  • Lead to an increase in the C/US foreign
    exchange rate

Simplified Summary of Equilibrium Conditions
  • Profit seekers can use the covered interest rate
    parity equation to determine if profitable
    currency trading opportunities exist
  • However, profitable trading opportunities will
    not exist for long
  • Arbitrageurs must be prepared to transact quickly
  • In less liquid markets, covered interest rate
    parity is more likely to be violated

The Bottom Line
  • When buying a foreign currency-denominated asset
    an investor faces foreign exchange risk and
    foreign investment risk
  • Several European nations are trying to reduce
    international trade barriers by executing
    transactions in a single currency (the euro)
  • While similar unions have been unsuccessful,
    supporters hope it will lead to trade stimulation

The Bottom Line
  • Parity relationship exist to explain foreign
    exchange rates
  • Purchasing power parity
  • Identical goods should sell for the same price,
    regardless of the currency
  • Interest rate parityapplies law of one price to
    nominal interest rates
  • Covered interest rate parity