1. 11 Chapter 8 The Foreign Exchange Market © Thomson/South-Western 2006

2. 22 International Trade  Foreign Exchange  Nations engage in international trade for the same reason that individuals engage in domestic trade Comparative Advantage  Specialization & Int. Trade Improve productivity  More Consumption, Income Increase standard of living  International trade requires the exchange of currencies  Currency exchange is often regulated by government.

3. 33 The Foreign Exchange Market  The foreign exchange (ForEx) market is the market in which parties exchange national currencies  It is not a public outcry auction market, but rather operates as a computer driven over-the-counter market  The volume of activity has escalated dramatically in response to the growth in world trade volume in goods & services.

4. 44 The Foreign Exchange Market  International capital flows The acquisition of financial & real assets across national borders 90% of foreign exchange volume is associated with capital flows (investment markets)  The direct or immediate participants (Dealers)  U.S. & foreign commercial banks with international deposits & foreign branches  The ultimate participants  import & export firms, tourists & other travelers, & financial entities seeking to invest internationally.

5. 55 The Foreign Exchange Rate  The price at which one nation’s currency is exchanged for another’s is the foreign exchange rate  An exchange rate exists between each pair of nations that engage in trade using different currencies  A currency appreciates against other currencies when a single unit of that currency buys more units of these foreign currency Last month: THB 34.50 / $ This month: THB 32.25 / $

6. 66 The Foreign Exchange Rate  The price at which one nation’s currency is exchanged for another’s is the foreign exchange rate  An exchange rate exists between each pair of nations that engage in trade using different currencies  It depreciates against other currencies when when a single unit of that currency buys less units of these foreign currency Last month: $ 1.54 / £ This month: $ 1.33 / £

7. 77 Table 8-1

8. 88 Figure 8-1

9. 99 Fixed & Floating Exchange Rates  Fixed exchange rates : exchange rates do not change & countries must act to maintain some predetermined level of value  Bretton Woods exchange rate system (adjustable-peg) required countries get IMF approval to change their exchange rates The system collapsed in the early 1970s  Major industrial states’ currencies currently float according to supply & demand for each currency  Floating exchange rates : exchange rates continuously change according to supply & demand in the world marketplace.

10. 10 Spot & Forward Exchange Markets  Spot transactions involve the exchange of currencies for immediate or “on the spot” delivery & payment  The exchange rate at which such transactions take place is called the spot exchange rate.

11. 11 Spot & Forward Exchange Markets  Forward transactions involve the purchase and sale of foreign currencies for delivery & payment at some specific future date, at a price specified in advance The exchange rate at which these forward transactions take place is the forward exchange rate Forward exchange markets provide hedging for investors to avoid possible large losses due to changes in the spot exchange rate.

12. 12 Forward Transaction Forward Contract Agreement to exchange Thai Baht for USD Price: At 33 Baht/USD Time: In the next 3 months Amount: 100,000 Baht Sign ______ (today)

13. 13 Spot Transaction U.S. Importer Swiss Exporter Pay S Fr 100,000 in 30 days Watches Today Spot rate = S Fr 1.25 / USD Expected cost = USD 80,000 If that day’s Spot rate = S Fr 1.20 /USD (next 30 days)Then the Actual cost = USD 83,333 On the delivery day

14. 14 Forward Transaction U.S. Importer Swiss Exporter Pay S Fr 100,000 in 30 days Watches Today Spot rate = S Fr 1.25 / USD Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver in 30 days Forward rate = S Fr 1.2489 / USD Actual cost = USD 80,070 On the delivery day Actual cost = USD 80,070

15. 15 The Importance of the Exchange Rate  A country’s exchange rate level is important because, together with domestic prices, the exchange rate determines the cost of the nation’s products in foreign nations  influencing the nation’s exports the cost of foreign products sold in the country  influencing imports  Currency Appre  products look more expensive Export less Import more Trade Deficit  Currency Depre  products look cheaper Export more Import less Trade Surplus

16. 16 The Importance of the Exchange Rate  Exchange rate influences Trade deficits/surplus  Because of the large influence of currency values upon trade, disputes among nations have arisen over one governments’ decisions to intervene in the foreign exchange market  Managed float system..

17. 17 Exchange Rate Determination  The foreign exchange market is highly competitive many small buyers & small sellers relative to the total market homogenous product--a national currency  In Freely Floating Exchange Rates, governments rarely intervene  exchange rates are driven entirely by supply & demand  In a Managed Float (the system in place today), governments sometimes intervene in an effort to prevent exchange rate movements perceived to be excessive or strongly at odds with national interests.

18. 18 Figure 8-2

19. 19 The Supply & Demand Model  Demand The demand curve for dollars stems from foreign buyers of American goods & services, U.S. financial & real assets The demand curve is downward sloping because, ceteris paribus, a decline in the price of $ makes everything from the United States cheaper for foreign buyers.

20. 20 The Supply & Demand Model  Supply The supply curve for dollars stems from Americans seeking to purchase foreign goods & services, financial & real assets The supply curve slopes upward because, given other factors, an increase in the dollar’s value reduces the price of foreign items in the United States.

21. 21 Long-Run Exchange Rate Determinants 1. Relative Price Level Behavior (Inflation) Non-inflation factors 2. preferences & product development (innovation) 3. productivity behavior (growth) 4. tariffs & quotas (trade restrictions)

22. 22 Long-Run Exchange Rate Determinants 1. Relative Price Level Behavior (Inflation) Nations with chronically high inflation are likely to be weak-currency nations—i.e., they are likely to see their currencies depreciate over the years against currencies of nations that experience lower inflation.

23. 23 Figure 8-3 Increase in Japanese Prices S1$S1$ D1$D1$ 120 Exchange Rate Q$Q$ D2$D2$ S2$S2$ 132

24. 24 Long-Run Exchange Rate Determinants Non-inflation factors 2. preferences & product development (innovation) 3. productivity behavior (growth) 4. tariffs & quotas (trade restrictions)

25. 25 Long-Run Exchange Rate Determinants 2. Preferences & Product Development Japan produces new bread toaster Foreigners start importing this new product Foreigners demand more Yen Yen appreciates

26. 26 Long-Run Exchange Rate Determinants 3. Productivity improve in productivity  production costs fall Thai products have lower prices products look more attractive in world market more demand for THB THB appreciates

27. 27 Long-Run Exchange Rate Determinants 4. Tariffs and Quotas U.S. puts more tariffs  more tax on imported products Imported products have higher prices U.S. people import less supply less USD USD appreciates

28. 28 Long-Run Exchange Rate Determinants 4. Tariffs and Quotas U.S. puts more quotas  less quantity of imported products U.S. people import less supply less USD USD appreciates

29. 29 Spot - Forward  In your new business venture, you expect a shipment of Swiss watches in 90 days. Upon delivery 90 days from now, you must pay the Swiss company 142,000 Swiss francs. What risk are you taking if you wait 90 days and then buy the needed francs in the spot market? Answer : I will face the foreign exchange rate risk. If Swiss francs is appreciated in next 90 days, I need to use more USD, to buy 142,000 Swiss francs. What is the expected cost in $ if the current spot rate = 6.3 S Fr/$ Answer : Expected Cost = 142,000/6.3 = 22,539.97 Swiss francs

30. 30 Spot - Forward What is the actual cost in $ if the future spot rate = 5.8 S Fr/$ Answer : Actual Cost = 142,000 / 5.8 = 24,482.76 USD. If you enter 90 days Forward Contract and lock-in the forward rate at 6.15 S Fr/$, what is the expected cost? What is the actual cost? Answer : Expected Cost = 142,000 / 6.15 = 23,089.43 USD. Actual Cost = 142,000 / 6.15 = 23,089.43 USD. What is the benefit you get from entering Forward Contract? Answer : Forward exchange markets provide hedging for me to avoid possible large losses due to Swiss Francs appreciated in the spot exchange rate

31. 31 More Exercise Suppose you are importer, you expect a shipment of computers from United State of America in 60 days. Upon delivery 60 days from now, you must pay the US. company 200,000 USD. 1.What is the expected cost in THB if the current spot rate = 33.40 THB./$? Answer: The expected cost = 200,000 * 33.4 = 6,680,000 THB 2.What is the actual cost in THB if the future spot rate = 34.30 THB./$ ?86 Answer : The actual cost = 200,000 * 34.3 = 6,860,000 THB 3.If you enter 60 days Forward Contract and lock-in the forward rate at 33.86 THB./$ what is the expected cost? What is the actual cost? Answer: The expected cost = 200,000 * 33.86 = 6,772,000 THB