1. The Foreign Exchange Market
Chapter 9
The Foreign Exchange Market

2. The rate at which one currency is converted into another is the
Exchange rate
Cross rate
Conversion rate
Foreign exchange market

3. 1. Foreign Exchange http://www.fxweek.com http://www.xe.com
2/22/10
10/4/09

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5. The Foreign Exchange Market
Currency conversion in the foreign exchange market
complete commercial transactions across borders
pay expenses on the road in local currency
A firm
Buys/sells goods and services in the other country’s local currency
Uses the foreign exchange market to invest excess funds
Is used to speculate on currency movements

6. The Foreign Exchange Market
Min foreign exchange risk (unpredictable rate swings)
-Spot exchange rates: the day’s rate offered by a dealer/bank
-Forward exchange rates:
Agreed in advance rates to buy/sell a currency on a future date
Usually quoted 30, 90, 120 days in advance
-Currency swap (simultaneous purchase&sale foreign exchange for 2 different value dates)
-Lead vs. Lag strategy
Arbitrage is the process of buying low and selling high … given slightly different exchange rate quotes in one location vs another (e.g., London vs Tokyo)

7. I. Determinants of Exchange Rates
Parity Conditions
a) Relative inflation rates (purchasing power parity)
b) Relative interest rates (Fisher effect and real interest difference)
Forward exchange rates
c) Exchange rate regimes (fixed vs floating rates)
Official monetary reserves
Infrastructure
Strengths of banking system
Strength of securities markets
Outlook for growth and profitability
Spot Exchange Rate
Political Risk
Capital controls
Black market in currencies
Exchange rate spreads
Risk premium on securities and FDI
Cross-Border Investment
Foreign direct investment
Portfolio investment
Speculation
d) Currencies
Securities
Uncovered interest arbitrage
Real estate
Commodities

8. a) Country’s Inflation: Money Supply and Currency Value
=# money in circulation rises faster than the stock of goods and services
predict relative exchange rate movements
When changes in relative prices in two countries change their currencies’ exchange rate, then the currency of the country with the highest inflation should decline in value

9. Purchasing Power Parity (PPP)
The law of one price:
Identical products sold in different countries must sell for one price if their price is expressed in one currency
Assumptions:
Competitive markets
No transportation costs; no trade barriers
Purchasing Power Parity (PPP) exchange rate:
If the law of one price holds for all goods / services, the PPP exchange rate is found by comparing prices of identical products in different countries

10. =[( )/120]*100
=262/2.71
=262/120
PPP is measured by the price of the same goods in different countries, translated by the FX rate (or exchange rate) of that country's currency against a "base currency".

11. Prices and Exchange Rates
Question: How well does PPP theory work?
Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run

12. b) Interest Rates and Exchange Rates
Interest rates reflect expectations of inflation rates;
high interest rates reflect high inflation expectation
Fisher Effect: i = r + I
i: “nominal” interest rate in a country
r: “real” interest rate
I: inflation over the period the funds are to be lent
International Fisher Effect: (S1-S2)/S2 X 100 = i$ - i¥
For any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries
S1: spot rate at time 1, S2 : spot rate at time 1; i$, i¥: nominal interest rates in the US and Japan

13. c) International Monetary System
Currency exchange rates depend on the structure of the international monetary system
In 2003 of all IMF members currencies
Only 19% were free floating
25% were managed float
8% were adjustable peg
22% were fixed peg
4% were fixed by a currency board
22% were not currency of their own (use Euro, US Dollar)

14. d) Investor Psychology and Bandwagon Effects
Short run
Self fulfilling propheciestraders joint the bandwagon and move exchange rate
George Soros 1992  down value of the pound
Government intervention
Southeast Asia during 1997

15. II. Exchange Rate Forecasting
The efficient market school
Prices reflect all available public information
The inefficient market school
Prices do not reflect all available public information
Approaches to forecasting
Fundamental analysis
Econometric models draw on economic theory to forecast future movements
Technical analysis
Extrapolation/interpretation of past trends assuming they predict future movements

16. Convertibility Convertibility and government policy
Slide 8-8
Convertibility
Convertibility and government policy
freely convertible: residents/non-residents can buy foreign currency with the local currency
externally convertible: non-residents can buy foreign currency with the local currency
not freely convertible: residents/non-residents not allowed
Countertrade
Barter-like agreements by which goods and services can be traded for other goods and services
Used to get around the non-convertibility of currencies

17. Exercises
The interest rate on South Korean government securities with one-year maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The US interest rate on government securities with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot exchange rate for Korea won is $1 = W Forecast the spot exchange rate one year from today. Explain the logic of your answer.