Chapter 2

Chapter Two Foreign Exchange Markets and Exchange Rates
Chapter Two
Foreign Exchange Markets and Foreign Exchange Rates
Chapter objective
 To define the meaning of foreign exchange market and foreign exchange rate
 To explain why citizens with in a nation demand foreign currency, and other
supply foreign currency
 To show how exchange rate is determined in case of flexible exchange regimes
 To enrich you about the relationship between exchange rate and balance of
payment
 To differentiate the concepts of arbitrage, foreign exchange risks, hedging, and
speculation.
 To give a hint for you about the uncovered and covered interest arbitrage, and
 Finally, you we will be in position to evaluate the efficiency of foreign exchange
market.
2.1 Introduction
The foreign exchange market is the market in which individuals, firms, and banks buy and
sell foreign currencies or foreign exchange. The price of one currency in terms of another is
called an exchange rate. Because of their strong influence on the current account and other
macroeconomic variables, exchange rates are among the most important prices in an open
economy.
Activity 2.1 Why do individuals, firms and banks want to exchange one nation’s
currency for another?
This question addresses the need for demand and supply of foreign currency.
Arba Minch University Department of Economics Page 35

The demand for foreign currencies arises when…..

 tourists visit another country,
 a domestic firm wants to import from other nations,
 an individual wants to invest abroad…
The supply of a nation’s foreign currency arises from….

 foreign tourist expenditures in the nation,
 export earnings,
 foreign investments…
Dear distance learners! Before engaging ourselves to the depth analysis of foreign
exchange rate markets, let us first see the structure and functions of foreign exchange
markets.
2.2 Structure and functions of foreign exchange market

A. Structure of foreign exchange market
There are four levels of participants in foreign exchange markets:
At the first level, are traditional users as tourists, importers, exporters, investors and so on.
These are the immediate users and suppliers of foreign currencies.
At the second level are the commercial banks, which act as clearing houses between users
and earners of foreign exchange.
At the third level are foreign exchange brokers, through whom the nation’s commercial
banks even out their foreign exchange inflows and outflows among themselves (the so
called Interbank or wholesale market) .
Finally, at the highest level is the nation’s central bank, which acts as the seller or buyer of
last resort when the nation’s total foreign exchange earnings and expenditures are unequal.
The central bank either draws from its foreign reserves or adds to them.
The complete structure of foreign exchange market can be outlined as follows.

Interbank
Market
FX
Broker
Local
Financial Banks:
Customers Central Retail Customers
Local banks:
Buy Market Sell
FX with Banks: FX Exchange FX for dollars
Retail markets
Dollars
Market
FX
Futures/
Options
Market
Diagram 2.1 the complete structure of foreign exchange markets
B. Functions of the Foreign Exchange Markets

The following are the major function of foreign exchange markets:
The principal function of foreign exchange market is the TRANSFER OF FUNDS
from one nation and currency to another. This is usually accomplished by Reuters
electronic trading system, where all markets around the world are connected
through a network.
The role of commercial banks as CLEARING HOUSES for the foreign exchange
demand and supply in the course of foreign transactions by the nation’s residents.

In the absence of this function, a U.S importer needing British pounds, for instance,
need have to locate a U.S exporter with pounds to sell. This would be time
consuming and inefficient and would essentially be equivalent to reverting to barter
trade.
Another function of foreign exchange markets is the CREDIT FUNCTION. Credit is
usually needed when goods are in transit and also to allow the buyer time to resell
the goods and make payment. Most commonly, exporters allow 90 days for
importer to pay. However, the exporter usually discounts the importer’s obligation
to pay at the foreign department of his commercial bank. As a result, the exporter
receives payment right away, and the bank will eventually collect the payment from
the importer when due.
The last and most important function of foreign exchange market is to provide the
facilities for HEDGING (exchange risk avoidance) and SPECULATION (exchange risk
taking). These concepts will be discussed on the topics ahead.
Activity 2.2
State the different participants and function of foreign exchange markets.
2.3 Foreign exchange rates

Dear distance learners! In this section we first show you how exchange rates are
determined under a flexible exchange rate system. Then we explain how exchange
rates between currencies are equalized by arbitrage among different monetary centers
and finally, we show the relationship between the nation’s balance of payments and the
exchange rate.
I. Equilibrium foreign Exchange Rates
For simplicity let’s assume there are only two nations, United States (considered as home
country) and United Kingdome (considered as foreign country) , US dollar ($) and UK
Pound Sterling (£) as respective currencies. The exchange rate between the dollar and the
pound (R) is equal to the number of dollars needed to purchase one pound.

For example, R = $/£ = 2, this means that two dollars are required to purchase one pound.
On the same line, If the exchange rate between Birr and Dollar is equal to 13.5Br/1$, this is
to mean that 13.5 Br is required to get 1$.
Under the flexible exchange rate system the dollar price of the pound is determined, just
like the price of any commodity, by the intersection of the market demand and supply
curves for pounds. This is shown in the following figure.
The vertical axis measures the dollar price of the pound (R=$/£) and the horizontal axis
measures the quantity of pounds. With a flexible exchange rate system, the equilibrium
exchange rate is R = 2, at which the quantity of pounds demanded and the quantity
supplied are equal at £40 million per day. This is given by the intersection at point E of the
US demand and supply curves for pounds.
At a higher exchange rate, a surplus of pounds would result that would tend to lower the
exchange rate toward the equilibrium rate. At an exchange rate lower than R = 2, a
shortage of pounds would result that would drive the exchange rate up toward the
equilibrium level.
R=$/£
S£
A . F
4 -
. A
3 - . B . G
3 . E
2
1 -
. H
. C
D£
10 20 30 40 50 60 70 Mil. £/day

The US demand for pounds is negatively inclined, indicating that the lower the exchange
rate (R), the greater quantity of pounds demanded by the US.
The reason is that the lower the exchange rate (few dollars required to purchase one
pound), the cheaper it is for US to import from and to invest in the UK, and thus the
greater the quantity of pounds demanded by US residents.
US supply of pounds usually positively inclined, indicating that the higher the exchange
rate (R), the greater the quantity of pounds earned by or supplied to the US.
The reason is that the higher exchange rate, UK residents receive more dollars for each of
their pounds. As a result UK will find US, thus supplying more pounds to US.
If the exchange rate (R), increases from $2 to $3 per each pound. It refers to DEPRECIATION
(increase) in the domestic currency price of foreign currency. On the contrary, if (R),
becomes less than $2 for each pound, then it refers to APPRECIATION or decline in the
domestic price of foreign currency.
An appreciation of the domestic currency means depreciation in the foreign
currency and a depreciation of the domestic currency means an appreciation in the
foreign currency.
The exchange rate could also be defined as the foreign currency price of unit of the
domestic currency, i.e., pound price of the dollar is 1/R = ½, or it takes half a pound to
purchase one dollar.
Activity 2.4
A. How is the exchange rate between Dollar (foreign currency) and Br (domestic currency)
determined?
B. Define what depreciation and appreciation of the domestic currency mean.

Finally, in reality there are numerous exchange rates, one between any pair of currencies.
Once the exchange rate between each pair of currencies with respect to dollar is
established, the exchange rate between any two currencies can easily be determined. It is
called cross exchange rate. In other words, exchange rate between currency A and
currency B, given the exchange rate of A & B with respect to C.
For example, if R between $ and £ is 2 and between $ and DM (German Mark) is 2, then the
exchange rate between the pound and German Mark is
Dollar Value of £
R = DM/£ = = 2/0.5 = 4 (i.e., 4 DM require to purchase 1£).
Dollar Value of DM
II. Arbitrage
The exchange rate between any two currencies is kept the same in different monetary
centers by arbitrage. The purchase of a currency in the monetary center where it is cheaper,
for immediate resale in the monetary center where it is more expensive, in order to make a
profit is called Arbitrage.
Effect: when arbitrage takes place, the exchange rate between the two currencies tends to
be equalized in the two monetary centers.
Example:
If dollar price of pound is cheap ($1.99/1£) in New York, arbitrage will increase the
demand for pounds by applying an upward pressure on the dollar price of pounds (this is
true with the assumption that the dollar price of pounds is 2).
At the same time, if dollar price of pound is expensive ($2.10/1£1) in London, the sale of
dollars will increase pressure on downward movement of exchange rate. Eventually, there
will be elimination of the profitability of further arbitrage.

Types of arbitrage
a) Two – point Arbitrage: When two currencies and two monetary centers are involved in
arbitrage,
b) Three-point (triangular) Arbitrage: when three currencies and three monetary centers
are involved. It operates in the same manner to ensure consistent indirect, or cross
exchange rates between three currencies and three monetary centers. For example,
suppose exchange rates are as follows:
$2 = £1 in New York
£0.2 = DM 1 in London
DM 2.5 = $1 in Frankfurt
These cross rates are consistent because, $2 = £1 = DM 5, and there is no possibility of
profitable arbitrage.
Case I: If dollar is appreciated to $1.96 in New York against £1. And at the rest of the
centers there is no change in exchange rates. Then the triangular arbitrage as follows
NEW YORK LONDON FRANKURT

SELL $1.96 SELL £1 SELL DMs 5
Buy £1 Buy DMs 5 Buy $2
 Thus profit realized $0.04 on each pound transferred.
Case II: If dollar is depreciated to $2.04 against pound in New York, and in the rest of the
centers there is no change in exchange rates. The triangular arbitrage is a s follows
FRANKURT LONDON NEW YORK

SELL $2 SELL DMs 5 SELL£1
Buy DMs 5 Buy £1 Buy $2.04
 Thus profit realized is $0.04 on each pound transferred.

Activity 2.5
suppose exchange rates between dollar, Germen mark and Birr are as follows
$1 = 12 Br. in Addis Ababa
$ 0.5 = DM 2 in New York
DM 1 = 3 Br. in Frankfort
Given the above consistent cross exchange rate, if the birr value of dollar is
reduced to 11 (i.e 11Br/$) in Addis, what will be the complete activity of
arbitrageurs in different markets and what is their level of profit per Dollar?
Usefulness of Arbitrage
Two point arbitrage or triangular arbitrage increases the demand for the currency in the
monetary center where the currency is cheaper, increases the supply of the currency in the
monetary center where the currency is more expensive, and quickly eliminates inconsistent
cross rates and the profitability of further arbitrage. As a result, arbitrage quickly equalizes
exchange rates for each pair of currencies and results in consistent cross rates among all
pairs of currencies, thus unifying all international monetary centers in to a single market.
2.4 The Exchange Rate and the Balance of Payments

The relationship between exchange rates and balance of payments can be understood form
taking a look at the demand and supply factors of foreign currency. As in our earlier
examples, the US demand (D£) for pounds arises from:
(1) US demand for imports of UK’s goods and services,
(2) US unilateral transfers (gifts and grants) to the UK,
(3) US investments in the UK (capital outflow from US).
On the other hand, the supply (S£) of pounds in to the US arises from
(1) US exports of goods and services to the UK,
(2) The unilateral transfers received from the UK, and
(3) The UK investments in the US (Capital inflow into UK).

We can examine the relationship between exchange rates and balance of payments with
figure 2.2, which is identical to figure 2.1, except for the addition of the new demand curve
for pounds labeled D£’.
R=$/£
S£
4 -
. . .
3 - . E’
2.5 W . Z
2 .E .T
1 -
.
D£’
D£
'
10 20 30 40 50 60 70 90 Mil. £/day
Fig.2.2 disequilibrium under fixed and flexible exchange rate system
Disequilibrium under a fixed and Flexible Exchange Rate System

 Under fixed Exchange Rate System: If D£ is shifted up to D’£, the US could
maintain the exchange rate at R = 2 by satisfying (out of its official pound
reserves) the excess demand of £50 million per day (TE in the figure). If the
US wanted to maintain the exchange rate fixed at R = 2, US monetary
authorities would have to satisfy the excess demand for pounds (TE) out of
their official reserve holdings of pounds. Alternatively, UK monetary
authorities would have to purchase dollars and supply pounds to the foreign
exchange market to prevent appreciation of pound (a depreciation of the
dollar). In either case, the US official settlements balance would show a
deficit of £50 million. (£100 million at the official exchange rate R = 2) per
day, or £18.25 billion (£36.5 billion) per year.

 With a Freely flexible Exchange Rate System, the dollar would depreciate
until R = 3 (point E’ in the figure). At which the quantity of pounds (£60
million per day) exactly equals the quantity supplied. In this case the US
would not lose any of its official pound reserves. The tendency for an excess
demand for pounds on autonomous transactions would be completely
eliminated by a sufficient depreciation of the dollar with respect to the
pound.
 If, on the other hand, the US wanted to limit the depreciation of the dollar to
R = 2.50 under a managed float, it would have to satisfy the excess demand
of £20 million per day (WZ in the figure) out of its official pound reserves.
Under such system, part of the potential deficit in the US balance of payments
is covered by the loss of official reserve assets of the US, and part is reflected
in the form of depreciation of the dollar. Thus under the implementation of
managed floating system, it is not possible to measure the deficit in the US
balance of payments by simply measuring the loss of US international
reserves or by amount of the net credit balance in the official reserve account
of the US. Under Managed float system, the loss of official reserves only
indicates the degree of official intervention in foreign exchange markets to
influence the level and movement of exchange rates, and not the balance of
payments deficit.
Activity 2.6
If nation 1, 2 & 3 faced with a BOP deficit of 120 Mil. $, what exchange rate policy do you
recommend to overcome the problem if they are using fixed, managed and floating
(flexible) exchange rate regimes respectively?
The concept and measurement of international transactions and the balance of payments
are still very important and useful because of the following reasons.

1. The flow of trade provides the link between international transactions and the
national income.
2. Most developing countries still operate under a fixed exchange rate system and peg
their currency to a major currency, such as the US dollar, the French franc, etc…
3. The international monetary fund requires all member nations to report their balance
of payments statement annually to it.
4. Finally, while not measuring the deficit or surplus in the balance of payments, the
balance of the official reserve account gives an indication of the degree of
intervention by the nation’s monetary authorities in the foreign exchange market to
reduce exchange rate volatility and to influence exchange rate levels.
2.5 Spot and forward rates, Currency swap, futures and options
Dear distance learners! In this section we will define and distinguish between the concepts
of spot and forward exchange rates and examine their significance. Then we will discuss
foreign exchange swaps, futures, and options and their uses.
 Spot Rate: The exchange rate in foreign exchange transactions that calls for the
payment and receipt of the foreign exchange within two business days from the date
when the transaction is agreed upon. The two day period gives adequate time for
the parties to send instructions to debit and credit the appropriate bank accounts at
home and abroad. The exchange rate R = $/£ = 2 in the figure above is a spot rate.
 Forward Rate: The exchange rate in foreign exchange transactions involves an
agreement today to buy or sell a specified amount of foreign currency at a specified
future date at a rate agreed upon today.
For example:
An importer could enter into an agreement today to purchase £100 pounds from today at
$2.02 = £1. Note that at the time of the contact no currencies are paid (except 10% security
margin). After 3 months, importer gets £100 for $202, regardless of the day’s spot rate.

Typical forward contract is for 1 month, 3 month and 6 months. Among these, 3 months is
most common. Equilibrium forward rate is determined at the intersection of the market
demand and supply curves of foreign exchange for future delivery. The demand for and
supply of forward exchange arises in the course of hedging, from foreign exchange
speculation, and form covered interest arbitrage.
Activity 2.6
What is the difference between spot and forward rates?
Forward discount and Forward Premium

 If the forward rate is below the spot rate, the foreign currency is said to be at a
forward discount with respect to the domestic currency.
 If the forward rate is below the spot rate, the foreign currency is said to be at a
forward premium with respect to the domestic currency.
Forward discounts (FD) and forward premium (FP) are usually expressed as percentages
per year from the corresponding spot rate and can be calculated formally with the
following formula.
FR-SR
FD/FP = x 4 x 100
SR
 Currency Swaps: A currency swap refers to a spot sale of a currency combined with
a forward repurchase of the same currency – as part of single transaction. For
example, suppose that Commercial Bank of Ethiopia receives a $1 million payment
today that it will need in three months but in the meantime it wants to invest this
sum in British pounds. CBE would incur lower brokerage fees by swapping the $1
million into British pounds with London’s Barclays Bank as part of a single
transaction or deal instead of selling dollars for ponds in the spot market today and
at the same time repurchasing dollars for pounds in the forward market for

delivery in three months – in two separate transactions. The swap rate (usually
expressed on a yearly basis) is the difference between the spot and forward rates in
the currency swap.
Most interbank trading involving the purchase or sale of currencies for future delivery is
done not by forward exchange contacts alone but combined with spot transactions in the
form of currency swaps.
 Forward exchange futures and options: An individual firm or bank can also
purchase or sell foreign exchange futures and options. Trading in foreign exchange
futures was initiated in 1972 by the international Monetary Market (IMM) of the
Chicago Mercantile Exchange (CME). A foreign exchange future is a forward
contract for standardized currency amounts and selected calendar dates traded in an
organized exchange rate markets.
The futures market differ from a forward market in that in the futures market only a few
currencies are traded; trades occur in standardized contracts only, for a few specific
delivery dates, and are subject to daily limits on exchange rate fluctuations; and trading
takes place only in a few geographical locations, such as Chicago, New York, London, and
Singapore. Futures contracts are usually smaller than forward contracts and thus are more
useful to small firms than to large ones but are somewhat more expensive. Futures
contracts can also be sold any time up until maturity on an organized futures market while
forward contracts cannot.
A foreign exchange option is a contract giving the purchaser the right, but not the
obligation, to buy (a call option) or to sell (a put option) a standard amount of a traded
currency on a stated date (the European option) or at any time before a stated date (the
American option) and at a stated Price (the strike or exercise Price).

Neither forward contracts nor futures are options. Though forward contracts can be
reversed (e.g., a party can sell a currency forward to neutralize a previous purchase) and
futures contracts can be sold back to the futures exchange, both must be exercised (i.e., both
contracts must be honored by both parties on the delivery date) Thus, options are less
flexible than forward contracts, but in some cases they may be more useful. For example,
an American firm making a bid to take over a British firm may be required to promise to
pay a specified amount in pounds. Since the American firm does not know if its bid will be
successful, it will purchase an option to buy the pounds that it would need and will
exercise the option if bid is successful.
Activity 2.7
Explain how the currency swaps and forward exchange futures operate in the exchange
markets.
2.6 Foreign exchange risks, hedging and speculation

Dear distance learners! In this section, we will examine the meaning of foreign exchange
risks and how they can be avoided or covered by individuals and firms whose main
business is not speculation. Then we attempt to understand how speculators endeavor to
earn a profit by trying to anticipate future foreign exchange rates.
A. Foreign exchange risks
In the course of time, a nation’s demand and supply curves for foreign exchange shift
causing the spot and the forward rate to fluctuate frequently. A nation demand and supply
curves for foreign exchange shift over time as a result of changes in tastes for domestic and
foreign products in a nation and abroad, different growth and inflation rates in different
nations, change in relative interest rates, changing expectation and so on.

For example
If US taste for British products increases, the US demand for pounds increases (the demand
curve shifts up), leading to a rise in exchange rate (a depreciation of dollar).
On the other hand, a lower rate of inflation in the US than in the UK leads to US products
becoming cheaper for UK residents. This tend to increase US supply of pounds the US
supply of pounds (the supply curve shift to the right) and causing a decline in exchange
rate (an appreciation of dollar).
The expectation of a strong dollar may lead to an appreciation of dollar. In brief, in

dynamic and changing world, exchange rates frequently vary, reflecting the constant
change in the numerous economic forces simultaneously working.
For instance, foreign exchange risk faced by an importer, an exporter and an investor could
be explained as follow:
The case of an importer:

A US importer imports £1000,000 worth UK goods and has to pay in three months in
pounds. If the present spot rate is $2/£1, the current dollar value payment that he must
make in three months is $200,000. But in three months the spot rate changes to $2.01/£1
then the importer has to pay $210,000 or $10,000 more. If the SR after three months changes
to $1.90/£1, then the importer has to pay $190,000 or $10,000 less than the anticipated.
The case of exporter:

The US exporter who expects to receive a payment of £100,000 in three months will receive
only $190,000 in the case of appreciation of dollar spot rate to $1.90/£1. And the spot rate
could be higher too in three months than it is today so that the exporter would receive
more than anticipated.
A case of an investor:

A US investor who buys pounds in today’s spot rate in order to invest in the British
treasury bills paying a higher interest rate than US treasury bills. After three months when
he converts back in to dollars, the spot rate may have fallen sufficiently to wipe out most of
the extra interest earned on the British bills or even produce a loss.
The three cases clearly show that whenever a future payment must be made or received in
the foreign currency, a foreign exchange risk, or open position is involved because of the
fluctuation in spot exchange rates over time.
Activity 2.8
In what circumstance that importer, exporters, and investors face foreign exchange risk
or open position?
Foreign exchange risk arises out of three types of exposures:

 The transaction exposure: risk from a transaction involves future payments and
receipts in foreign currency
 The translation or accounting exposure: it is created when a need arises to value
inventories and assets held abroad in terms of domestic currency for inclusion in
the firms consolidated balance sheet.
 The economic exposure: it arises when estimating domestic currency value of future
profitability of the firm.
Dear distance learners! In the following sub sections, we will discuss the concept of
hedging and speculation based on the transaction exposure or risk.
B. Hedging
Hedging refers to the avoidance of foreign exchange risk, or the covering of an open
position. Let us make clear the concept of hedging using different cases.
Case 1: Importer to avoid risk

He could borrow £100, 000 at the SR= $2/£1 and leave this money in the three month
deposits (to earn interest) in a bank. By doing so the importer avoids the risk of future
depreciation of the dollar, in which case he would have to pay more than $200, 000. The
cost of insuring against the foreign exchange in this way is the positive difference between
the interest rate the importer has to pay on the loan of £100,000 and the interest rate he
earns on the term deposit of £100,000.
Case II: Exporter to avoid risk

Also acts in the similar fashion by borrowing $200,000 at today’s spot rate and deposit the
money in the bank to earn interest. After three months, the exporter would repay the loan
of £100,000 he receives.
The cost of avoiding the foreign exchange risk in this manner is equal to the positive
difference between the borrowing and deposit rate of interest. This kind of covering has a
very serious disadvantage. The importer/exporter must borrow and tie up his/her funds
for three months. To avoid this, hedging usually takes place in the forward markets, where
tying up of funds is not required.
Hedging in the forward markets

The importer could buy pound forward for payment in three months at today’s three
month forward rate. If the pound is at three month forwards premium of 4% per year, the
importer will have to pay $202,000 in three months for the £100,000 needed to pay for the
imports; therefore the hedging cost will be $2,000 (i.e 1% of $200,000 for the three months).
Similarly, the exporter could sell pounds forward for payment in three months at today’s
three month forward rate, in the anticipation of receiving the payment of £100,000 for the
exports. If the pound is at 4% three month discount per year, the exporter would get only
$198,000 for £100,000 he sells in three months. On the other hand, if the pound is at a 4%
forward premium, the exporter will receive $202,000 in three months with certainty by
hedging.

Convenience of hedging: the ability of traders and investors to hedge greatly facilitates the
international flow of trade and investments. Without hedging there would be smaller
international capital flows, less trade and specialization in production, and smaller benefit
from trade. Most importantly, a multinational cooperation that has to make and receive a
large number of payments in the future need only hedge its net open position (risks).
Activity 2.9
Explain how importers and exporters hedge themselves from foreign exchange risk in
spot markets?
C. Speculation
It is the opposite of hedging. Where a hedger seeks to cover a foreign exchange risk, a
speculator accepts and even seeks out a foreign exchange risk, in the hope of making profit.
If the speculator correctly anticipates future changes in the spot rates, he makes profit;
otherwise incurs a loss. As in the case of hedging, speculation can takes place in the spot ,
forward, futures or option markets-most frequently in forward markets.
I. Speculation in spot markets: if a speculator believes that the spot rate of a particular
currency will rise, he could purchase the currency now and hold it in deposit in the
bank for resale later. If he is correct, spot rate raises and he makes profit on each unit
of foreign currency equal to the difference between the previous lower spot rate at
which he purchases it and its subsequent higher rate at which he resells. On the
contrary, if the speculator is wrong he incurs a loss.
If the speculator believes that the spot rate of a particular currency will fall, he acts
in the reverse way. In both cases the speculator who operates in the spot market has
to tie up his funds to speculate. To avoid his short coming, speculation usually takes
place in the forward market.
II. Speculation in the forward markets: If the speculator believes that the spot rate of a
certain foreign currency will be higher in three months than its present three month

forwards rate, the speculator purchases a specified amount of foreign currency for
delivery in three months. After three months if the speculator is correct, he receives
delivery of foreign currency at a lower agreed forward rate and immediately resells
it at the higher spot rate, realizing profit. If the speculator is wrong, and the spot rate
in three months is lower than the agreed forward rate, he incurs loss. In any event,
no currency changes hands until the three months are over (except normal 10%
security margin that speculator required paying at the time he signs the forward
contract).
Effects of speculators
A. Stabilization speculation: the purchase of foreign currency when the domestic
price of foreign currency ( exchange rate ) falls or is low, in the expectation that it
will soon rise, thus leading to a profit. Or it refers to the sale of foreign currency
when the exchange rate rises, in the expectation that it will soon fall. Stabilization
speculation moderates fluctuations in exchange rates over time and performs a
useful function.
Dear distance learners! Let us see the stabilization speculation using graphs for
falling and rising exchange rates.
Case 1: Stabilization speculation using falling exchange rates:
Suppose the foreign exchange rate (pound value) is falling on the foreign exchange market
on-account of growing balance of payments surpluses: and it is falling at the following
rapid rate
£1=$8
£1=$7
£1=$6
£1=$5
(and so forth)
It is possible that speculators may start buying more and more pounds, because the pounds
are becoming cheaper. This would mean that the speculative demand for pounds would go

on increasing. Speculators are buying more pounds in order to sell them later at a higher
price. In any case, this would shift the pound demand curve to the right and the effect of
speculative demand for pounds is stabilizing the value of pounds (or exchange rate).
R
S£ (1)
S£ (2)
S£ (3)
S£ (4)
£1=$8 7
£1= $7 1 3 5
£1= $6 6
£1=$5 2 4
£1=4$ D£ (4)
D£ (3)
D£ (2)
D£ (1)
£ s.d
Fig 2. 3. Stabilizing speculation with falling exchange rates
In fig 3, as the BOP Surpluses go on increasing, the pound supply curve goes on shifting
rightwards putting a downward pressure on the pound value or the exchange rate. If the
speculative demand for pounds did not increase, the movement would be (stating form
point 1 in fig. 3) towards all along the pound demand curve D£ (1,) resulting in progressive
and uninterrupted exchange rate decline. But the speculative action would keep raising the
level of demand curves as well D£ (1), D£ (2) to D£(3)….. etc the right ward shifts in the
pound supply curves, caused by Bop surplus pressures would be offset by shifts in pound
demand curves in the same direction keeping the exchange rate stable at £ 1= $6 (in fig. 3).
This is described as stabilizing speculation. The exchange rate, though fluctuating, is stable
around the original equilibrium rate of £1=$6.

Case 2: Raising foreign exchange rate situation

When the foreign exchange rate or the pound value is rising in the account of balance of
payment deficits, it is possible that the speculators would start selling the pounds in their
hand. This action on the part of the speculators would result in increased pound supplies
on the foreign exchange market precisely at the time when the demand for pound is rising
due to BOP deficit pressures. Such behavior on the part of the speculators will have
stabilization effect on exchange rate in the market.
S£ (1)
S£ (2)
S£ (3)
S£ (4)
4 6
£1=$8 2
£1= $7 3 5 7
1
£1= $6
£1=$5
£1=4$ D£ (4)
D£ (3)
D£ (2)
D£ (1)
£ s.d
Fig.2.4 stabilization speculation using rising exchange rates
In Fig. 4 the original equilibrium exchange rate is at point 1. As the BOP deficit situations
going on increasing, the pound demand curve goes on shifting right wards as shown in the
diagram. Unaided by speculators selling of pounds to the foreign exchange market, the
exchange rate (the pound value) will go on increasing along the original pound supply

curve. But, when the speculators start selling pound, because the pound value in terms of
dollars is rising, this trend will be revered contributing to the exchange rate stability at the
level represented by point 1. In other words the pound demand curve goes on shifting to
the right (under BOP deficit situation), the pound supply curve would also go on shifting
to the right (due to speculative selling of pounds). This would keep the equilibrium
exchange rate relatively stable at £1=$6 level, although the exchange rate tend to fluctuate
up and down from point 1 to 2 to 3 to 4…etc. the exchange rate fluctuations are ironed or
smoothened by speculators pound sales. This would keep the exchange rate stable at or
around the equilibrium level. This is stabilization speculation.
B. Destabilization speculation: the sale of foreign currency when the exchange rate
falls or is low, in the expectation that it will fall even lower in the future, or the
purchase of foreign currency when the exchange rate is rising or is high, in the
expectation that it will rise even higher in the future. This type of destabilization
speculation magnifies exchange rate fluctuation over time and can prove very
disruptive to the international flow of trade and investments. Let us see
destabilization speculation using rising and falling exchange rates
Case1: falling exchange rate situations:

It is also conceivable that, speculation could be of a destabilizing nature. In this case, as the
pound value goes on falling due to BOP surplus, the speculators may start selling (rather
than buying) pounds in the fear that the pound will fall even more in future. They want to
avoid further risks of holding foreign currency. In this event, the speculators’ action would
add to pound supplies which are already increasing due to BOP surpluses. The combined
result would be to aggravate the situation i.e. to accelerate the falling trend in exchange
rate. Such a situation can be graphically shown as below.

R
S£
S£ (1)
S£ (2)
S£ (3)
S£ (4)
(1)
£1=$6
(2)
(3)
(4)
(5)
D£
£ s.d
Fig.2.5 Destabilization speculation with falling exchange rates
The pound supply curve is shifting continuously to the right on the account of BOP surplus
pressure reinforced by increased pound supplies sold by speculators. Starting with the
initial equilibrium exchange rate at point 1, we go down along the pound demand curve
from point 1 to 2 to 3 to 4….etc. The trend is to take the situation further away from the
equilibrium exchange rate, point 1 (viz £1=6$). In this case speculation is said to be of
destabilization effect.
Case 2: raising exchange rate situations:

In this case, as the pound value goes on rising due to BOP deficit, the speculators may start
buying (rather than selling) pounds in the fear that the pound will fall even more in future.
They want to avoid further risks of holding foreign currency. In this event, the speculators’
action would add to pound demand which is already increasing due to BOP deficit. The

combined result would be to aggravate the situation i.e. to accelerate the rising trend in
exchange rate. Such a situation can be graphically shown as below.
S£
(4)
(3)
(2)
(1) D£ (4)
£1=$6
D£ (3)
D£ (2)
D£ (1)
£ s.d
Fig. 2.6 destabilization speculation with raising exchange rates
Starting with the initial equilibrium exchange rate at point 1, the demand for pound curve
is continuously pushed right ward owning, first, to BOP deficit pressure, and due to
speculative demand for pounds in a cumulative fashion. The movement in exchange rate
would be upward along the pound supply curve from point 1 to 2 to 3 to4 …etc. the result
is then, a continued exchange rate appreciation up along the vertical axis. In this case
speculation added fuel to the fire, so to speak, and caused destabilization effect on the
equilibrium exchange rate.
In a simple term, if speculation is of stabilization nature it would help in returning the

exchange rate back to the original equilibrium level. I.e. the movement in exchange rate is
towards equilibrium. If, however, speculation is destabilization nature, then it would take
the exchange rate away from the original equilibrium.

Activity 2.10
If Mr. X is a speculator in Ethiopian coffee market and if he purchase coffee when the
price of this commodity rises, his action is
A) Stabilization B) destabilization
Moreover, try to relate the above concept with speculators in the foreign exchange
market.
2.7 Interest rate arbitrage and efficiency of foreign exchange markets

Interest arbitrage refers to the international flow of short term liquid capital to earn high
returns abroad. Dear distance learners! We will discuss interest arbitrage as covered and
uncovered. Finally we try to understand the efficiency of foreign exchange markets.
A. Uncovered interest arbitrage
The transfers of funds abroad have to take advantage of higher interest rates in monetary
centers involves the conversion of domestic to foreign currency to make investment, and
the subsequent reconversion of the funds and interest earned abroad from foreign currency
to domestic currency at the time of maturity. In such transactions a foreign exchange risk is
involved due to the possible depreciation of the foreign currency during the period of
investment.
If such foreign exchange risk is covered, we have covered interest arbitrage; otherwise we
have uncovered interest arbitrage.
Example of simple uncovered interest arbitrage

Suppose that the interest rate on three month treasury bills is 6% on annual basis in
Newyork and 8% in London. It may then pay a U.S investor to exchange dollars for pounds
at current spot rate and purchase British treasury bills to earn extra 2% interest at annual
basis.

When the British Treasury bill matures, the U. S investor may want to exchange the pounds
invested plus the interest earned back in to dollars. But, by that time the pound may have
depreciated so that the investor would get back fewer dollars per pound than he paid.
 If the pound depreciate by 1% at annual basis during the three month of

investment, then the U.S investor nets only about 1% from this foreign
investment (the extra 2% interest earned minus the 1% lost from the
depreciation of pound) at annual basis (1/4 of the 1% for three months or the
quarter of investment).
 If the pound depreciates by 2% at annual basis during the three months, the
U.S investor gained nothing.
 If the pound depreciates by more than 2%, the U.S investor loses.
 If the pound appreciates, the U.S investor gains both from the extra interest
earned and from the appreciation of the pound.
B. covered interest arbitrage
Investors of short term abroad generally want to avoid the foreign exchange risk; therefore,
interest rate arbitrage is usually covered. Covered interest rate arbitrage refers to the spot
purchase of the foreign currency to make the investment and the balancing with
simultaneous forward sale (swap) of foreign currency to cover the foreign exchange risk.
When the treasury bill matures, the investor can then get the domestic currency equivalent
of the foreign investment plus the interest earned without a foreign exchange risk.
First, the investor exchanges the domestic for the foreign currency at the current spot rate
in order to purchase the foreign treasury bills, and at the same time the investor sells
forward the amount of foreign currency he is investing plus the interest he or she will earn
as to coincide with the maturity of the foreign investment.
Since the currency with the higher interest rate is usually at the forward discount, then the
net return on the investment is approximately equal to the interest differential in favor of

foreign monetary center minus the forward discount on the foreign currency. This
reduction in earnings can be viewed as the cost of insurance against the foreign exchange
risk.
Example of covered interest arbitrage
The interest rate on three-month treasury bills is 6% per year in New York and 8% in
London, and assumes that the pound is at forward discount of 1% per year.
To engage in covered interest arbitrage, the U.S. investor exchanges dollars for pounds at
the current exchange rate (to purchase the British treasury bills) and at the same time sells
forward a quantity of pounds equal to the amount invested plus the interest he will earn at
the prevailing forward rate. Since the pound is at a forward discount of 1% per year, the
U.S. investor loses 1% on an annual basis on the foreign exchange transaction to cover the
foreign exchange risk.
The net gain is thus the extra 2% interest earned minus the 1% lost on the foreign exchange
transaction, or 1% on an annual basis ( ¼ of 1% for the three months or quarter of the
investment). Note that we express both the interest differential and the forward discount at
an annual basis and then divided by four to get the net gain for the three months or quarter
of the investment.
C. Efficiency of foreign exchange markets
A market is said to be efficient if prices reflect all available information. The foreign
exchange market is said to be efficient if forward rates accurately predict future spot rates,
that is, if forward rates reflect all available information and quickly adjust to any new
information so that investors cannot earn consistent and unusual profits by utilizing any
available information.
Questions of market efficiency are important because only when markets are efficient do
prices correctly reflect the scarcity value of the various resources and result in allocation

efficiency. For example, if, for whatever reason, the price of commodity is higher than its
value to consumers, too many resources flow to the production of the commodity at the
expense of other commodities that consumers prefer.
Even if foreign exchange markets were efficient, we cannot expect the forward rate of a
currency to be identical to the future spot rate of the currency because the latter also
depends on unforeseen events. If the forward rate exceeds the future spot rate as often as it
falls below it, then we could say that the market if efficient in the sense that there is no
available information that investors could systematically use to ensure consistent and
unusual profits.
Thus, while most studies seem to indicate that foreign exchange markets are fairly efficient,
this conclusion is not unanimous. Exchange rates do seem to respond very quickly to news,
are very volatile, and have challenged all attempts at being accurately forecasted.
In recent years, as exchange rates have become more volatile, the volume of foreign
exchange transactions has grown much faster than the volume of world trade and faster
than even the much larger flows of investment capital. The risks associated with all kind of
foreign exchange trading have increases significantly.
Summary
 Foreign exchange markets are the markets where individuals, firms, and banks buy
and sell foreign currencies or foreign exchange.
 The principal function of foreign exchange markets is the transfer of purchasing
power from one nation and currency to another. The demand for foreign exchange
arises from the desire to import or purchase goods and services from other nations
and to make investments abroad. The supply of foreign exchange comes from
exporting or selling goods and services to another nation and from the inflow of
foreign investment.

 The exchange rate (R) is defined as the domestic currency price of the foreign
currency. Under a flexible exchange rate system of the type in existence since 1973,
the equilibrium exchange rate is determined at the intersection of the nation's
aggregate demand and supply curves for the foreign currency. If the domestic
currency price of the foreign currency rises, we say that the domestic currency
depreciated. In the opposite case, we say that the domestic currency appreciated.
Arbitrage refers to the purchase of a currency where it is cheaper for immediate
resale where it is more expensive in order to make a profit. This equalizes exchange
rates and ensures consistent cross rates in all monetary centers, unifying them into a
single market.
 A spot transaction involves the exchange of currencies for delivery within to
business days. A forward transaction is an agreement to purchase for delivery for at
a future date specified amount of a foreign currency at rate agreed upon today (the
forward rate). When the forward rate is lower than the spot rate, the foreign
currency is said to be at a forward discount of a certain percentage per year. In the
opposite case, the foreign currency is said to be at a forward premium.
 Because exchange rates usually change over time, they impose a foreign exchange
risk on anyone who expects to make or receive a payment in a foreign currency at a
future date. The covering of such an exchange risk is called hedging. Speculation is
the opposite of hedging. It refers to the taking of an open position in the expectation
of making a profit. Speculation can be stabilizing or destabilizing. Hedging and
speculation can take place in the spot, forward, futures, or options markets -usually
in the forward market.
 Interest arbitrage refers to the international flow of short term liquid funds to earn
higher returns abroad. Covered interest arbitrage refers to the spot purchase of the
foreign currency to make the investment and an offsetting simultaneous forward
sale of the foreign currency to cover the foreign exchange risk. Foreign exchange
markets are said to be efficient if forward rates accurately predict future spot rates

Review Questions
Part I: choose a single best answer for the following questions
1. The demand for foreign currency arises except from
A. When a tourist want to visit a place in a nation
B. When an investor what to invest in foreign country
C. To export goods towards the foreign country
D. To import goods from the foreign country
E. Both A and C
2. Which one of the following is not regarded as a participant in foreign exchange
rate market
A. Traditional users
B. Commercial banks
C. The nation’s apex bank
D. Foreign exchange brokers
E. None of the above
3. Which one of the following is the function of foreign exchange markets
A. Enable commercial banks to function as clearing house
B. Transfer funds
C. Credit function
D. Provide facility of hedging and speculation
E. All of the above
4. Flexible exchange rates are determined
A. By the government
B. Using supply of and demand for domestic currency
C. By parliament
D. Using demand for and supply of foreign exchange markets
5. The supply of dollar for Ethiopian citizens is upward sloping because
A. US citizens supply less at lower exchange rates

B. US citizens demand birr at higher exchange rates

C. There is no economic explanation for the situation
D. The Ethiopian demand more of dollar at higher exchange rates
6. If the exchange rate between Birr and dollar is 13.4/$ and between dollar and
Germen mark is 2 DM/$, then what is the amount of Birr that an Ethiopian
exporter receive if the he exports coffee worth of 2 million DM to Germany?
A. 5.5 million birr
B. 13.4 million
C. 17.28 million
D. 73.7 million
E. Impossible to determine
7. Credit transaction are the base for
A. Derivation of the supply curve for foreign currency
B. Derivation of the demand curve for foreign currency
C. Derivation of the supply for domestic currency
D. Derivation for the demand for domestic currency
8. ----------------- is rate in foreign exchange transactions that calls for the payment
and receipt of the foreign exchange within two business days from the date when
the transaction is agreed upon
A. Forward rate
B. Currency swap
C. Spot rate
D. Future rate
9. Speculation usually undertaken in the forward markets because
A. Speculation in the spot market involves tying up of finds
B. Speculation in the forward market doesn’t involve tying of funds

C. Forward markets are more certain than other markets

D. Speculation in the spot market doesn’t involve tying up of finds
E. Both A and B
10. Which one of the following results in stabilized exchange rate?
A. The sale of a foreign currency when it is cheaper
B. The purchase of foreign currency when it is expensive
C. The sale of foreign currency when it is expensive
D. The purchase of foreign currency when it is cheaper
E. Both A and B
F. Both C and D
11. A foreign exchange market is efficient when
A. The forward rare appropriately estimates the future spot rate
B. The forward rate is equal to the present spot rate
C. When the today’s spot rate appropriately estimates the future forward rate
D. Foreign exchange market cannot be efficient
Part II: say true if the statement is correct and false if incorrect
12. Supply of foreign currency arises from foreign investors who have a need to
invest in the home country
13. Total deficit in the case of managed exchange rate market is avoided only by the
government action
14. Hedging by no means put the hedger in to risk
15. Neither forward contracts nor futures are options
16. The purchase of foreign currency when the exchange rate falls is an example of
destabilization speculation
17. The transaction exposure risk comes from transactions that involve future
payments and receipts in foreign currency
18. Hedging is important to smoothen out the international flow of goods and
services.

19. Uncovered interest arbitrage refers to the spot purchase of the foreign currency
to make the investment and an offsetting simultaneous forward sale of the
foreign currency to cover the foreign exchange risk.
20. The demand for foreign exchange rate is derived from the credit transaction on
the balance of payment
21. Exchange rate is always determined by the interaction of the demand for and
supply of foreign currency
Part III: Essay questions

22. Define foreign exchange rate market and foreign exchange rates.
23. Explain how arbitrage secures consistency of exchange rates among different
currencies in different localities?
24. When is a foreign currency at forward discount/forward premium?
25. How exporters and importer hedge themselves from open positions (risks) in
forward markets?
26. Discuss the stabilization and destabilization effect of speculators verbally and
graphically using raising exchange rates
27. What is the criteria that will enable us to evaluate the efficiency of foreign
exchange markets?
Part IV: workout questions

28. Given the supply and demand for and supply of dollar (foreign currency) by
Qd$=3+2R
Qs$=42-R, where R is the exchange rate between birr and dollar, find the
equilibrium exchange rate and interpret the result.
29. Give that
SR=10Br/$ and FR=13Br/$, calculate the level of forward
Premium /discount?


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Chapter Two Foreign Exchange Markets and Exchange Rates

Arba Minch University Department of Economics Page 35

The demand for foreign currencies arises when…..

The supply of a nation’s foreign currency arises from….

2.2 Structure and functions of foreign exchange market

Arba Minch University Department of Economics Page 36

Diagram 2.1 the complete structure of foreign exchange markets

B. Functions of the Foreign Exchange Markets

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2.3 Foreign exchange rates

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Arba Minch University Department of Economics Page 39

Arba Minch University Department of Economics Page 40

Arba Minch University Department of Economics Page 41

NEW YORK LONDON FRANKURT

 Thus profit realized $0.04 on each pound transferred.

FRANKURT LONDON NEW YORK

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2.4 The Exchange Rate and the Balance of Payments

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Disequilibrium under a fixed and Flexible Exchange Rate System

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Arba Minch University Department of Economics Page 45

Arba Minch University Department of Economics Page 46

Forward discount and Forward Premium

Arba Minch University Department of Economics Page 47

Arba Minch University Department of Economics Page 48

2.6 Foreign exchange risks, hedging and speculation

A. Foreign exchange risks

Arba Minch University Department of Economics Page 49

The expectation of a strong dollar may lead to an appreciation of dollar. In brief, in

The case of an importer:

The case of exporter:

Arba Minch University Department of Economics Page 50

Foreign exchange risk arises out of three types of exposures:

Case 1: Importer to avoid risk

Arba Minch University Department of Economics Page 51

Case II: Exporter to avoid risk

Hedging in the forward markets

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Arba Minch University Department of Economics Page 53

Case 1: Stabilization speculation using falling exchange rates:

Arba Minch University Department of Economics Page 54

Fig 2. 3. Stabilizing speculation with falling exchange rates

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Case 2: Raising foreign exchange rate situation

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Case1: falling exchange rate situations:

Arba Minch University Department of Economics Page 57

Fig.2.5 Destabilization speculation with falling exchange rates

Case 2: raising exchange rate situations:

Arba Minch University Department of Economics Page 58

Fig. 2.6 destabilization speculation with raising exchange rates

In a simple term, if speculation is of stabilization nature it would help in returning the

Arba Minch University Department of Economics Page 59

2.7 Interest rate arbitrage and efficiency of foreign exchange markets

A. Uncovered interest arbitrage

Example of simple uncovered interest arbitrage

Arba Minch University Department of Economics Page 60

 If the pound depreciate by 1% at annual basis during the three month of

B. covered interest arbitrage

Arba Minch University Department of Economics Page 61