The Foreign Exchange Market

Pilbeam, chapter 1

Prof. F. Klaassen
 What you will learn
• Exchange rate definition
• Types of exchange rates: spot, forward, nominal, real, effective
 Better understand texts on exchange rates and avoid confusion.

• Covered interest parity (CIP):

combines spot & forward exch. rates and home & foreign interest rates
 Better understand arbitrage.

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The Market
 Why is forex market needed?
Transactions between home (H) and foreign (F) countries:
• Export of goods
• Buying foreign bonds / equity.

Involve different currencies, so need to trade them

Foreign exchange (forex, or FX) market needed.

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 Main participants
• Retail clients:
E.g., Dutch importer who needs dollars.

• (Commercial) banks:
Sell dollars to importer
Buy dollars from another bank.

• FOREX (FX) brokers:

Intermediary for banks: gains from economies of scale.

• Central banks (ECB, Fed, …):

Intervene (i.e., buy/sell H currency) to influence value of H currency
(e.g., Swiss National Bank sells Swiss francs to weaken it compared to euro).

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 Importance of forex market
• International trade is important part of GDP:
export/GDP is 10% for US, 60% for NL.
• International financial flows nowadays exceed trade flows
 Forex market is important.

Turnover nowadays:
• Absolute: $7,000 billion …….. per day!
• Relative:
– Official reserves aggregated over all CBs are about $12,000 billion
– Annual GDPs in EU and US are about $20,000 billion each
Daily forex turnover is of the same order of magnitude.

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Its price: the exchange rate
If the euro appreciates, then

8
A) If euro (=H curr.) appreciates, then

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 Confusions
Draghi at press conference after ECB Governing Council meeting 8-5-2014:
• “ECB has worries about the high exchange rate”
 What does he mean: is euro cheap or expensive?
• “The exchange rate, both nominal and effective, has appreciated”
 What does he mean by: * effective exchange rate?
* exchange rate appreciates?

Exchange rate quotations at the forex market:

• EUR/USD there denotes the number of dollars per euro
 Quote differs from mathematical dimension, which is $/€.

 Confusing.

To avoid confusions: be very clear about exchange rate definitions.

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 Exchange rate definitions
Exchange rate is a relative price  two definitions possible:

1: Price of foreign currency in domestic currency (continental definition)

– Example:0.9 euro per dollar; “H per F”
– Dimension and notation: €/$
– Used by: Pilbeam, research literature, Dutch media before euro
(e.g., 2 guilders per dollar).

2: Price of domestic currency in foreign currency (English definition)

– Example:1.1 dollar per euro; “F per H”
– Dimension and notation: $/€
– Used by: Mankiw, Draghi, Dutch media nowadays.
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 Definition throughout this course
Definition 1: Euro per dollar exchange rate Definition 2: Dollar per euro exchange rate

1.3 1.6
1.2 1.5
1.1 1.4
1 1.3
0.9 1.2
0.8 1.1
0.7 1
0.6 0.9
0.5 0.8
01-1999 01-2001 01-2003 01-2005 01-2007 01-2009 01-2011 01-1999 01-2001 01-2003 01-2005 01-2007 01-2009 01-2011

This course: ALWAYS definition 1: exchange rate is just as price of a good


exchange rate increase = higher price of F curr= loss of value of H money,
just as
price increase = higher price of good = loss of value of H money.
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Data source: Datastream.
B) If euro (=H curr.) appreciates, then

13
Depreciation of H curr.: exchange rate
But one sometimes hears: “Depreciation of the exchange rate”
 Strictly speaking this is wrong,
as an exchange rate can only increase (or decrease), not lose value.

Still, we have to know what people mean by the statement.

Answer: depreciation of the H currency (so no decrease in exchange rate).

So, focus on the word depreciation.

Nice, because that does not depend on how one defines the exchange rate.

Depreciation of H currency
= H currency loses value (independent of exchange rate definition)
= Exchange rate increases given our exchange rate definition.
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Exchange rate regimes
 Main regimes
All regimes:
• Rate determined by market (in market economies).

Difference between regimes concerns central bank (CB) interference:

• Fixed
Central bank acts to keep rate at official level; see example in tutorial
(instruments: forex interventions, interest rate, capital controls).

• Floating
Central bank (CB) does not interfere.

• Intermediate regimes:
Central bank acts to influence rate.

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 Fixed and floating are extremes
In reality, few rates are perfectly fixed or floating
 Extremes are convenient for theory (and this course).

Sometimes “fixed” and “floating” (i.e., less strict versions of fixed & floating)
denote broader categories:
• “Fixed” includes (order: decreasing fixity)
– No separate legal tender (e.g., countries with euro, Ecuador has US $)
– Currency board (e.g., Hong Kong $ vs. US $)
– Other fixed pegs
– Pegs within horizontal bands
– Crawling pegs.

• “Floating” includes
– Managed floating with no predetermined path
– Independently floating.
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 Guilder/dollar rate: various regimes
7

3 “fixed”
2
“fixed”
1
“floating”
0
1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
Data source: Macrohistory
Note: dividing by 2.20371 gives euro/dollar for 1999 onwards.
 Both “fixed” and “floating” matter

“ ”

“ ”

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Source: Feenstra and Taylor: International Economics, first edition
Spot and forward
exchange rates
Pilbeam §1.5, 1.7, 1.9
 Two types of exchange rates (1/2)
I. Spot exchange rate:
Price for immediate transaction
(actually: transaction effective two days after deal)
E.g., I pay €0.86 to get one dollar now.

Notation: St for rate at time t.

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 Future spot rate St+1 is risky
Consider 22-1-2015, 14:30; suppose I have to pay $100 next month (is t+1).
• Current exchange rate St is 0.86 €/$
• I expect St+1 to be the same: Et{St+1}=0.86, where Et is expectation at t
 Expected cost is €86.
€/$-rate on 22-1-2015
(5-minute frequency)
Now Draghi starts press conference
and announces QE.
• At 17:00 S is 0.88: 2% up
• Suppose St+1 is also 0.88
 Actual cost is €2 higher: bad luck.

 St+1 is risky at time t

(very risky: 2% up in 2.5 hours).
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Source: dukascopy.com/swiss/english/marketwatch/charts/
 Two types of exchange rates (2/2)
To avoid risk in St+1, get a forward contract.

II. Forward exchange rate:

Price for transaction later
E.g., I will pay €0.87 to get one dollar next month
 Price & transaction date are certain
 no risk.

Notation: Ft (or Ft,t+1 to make time period explicit).

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 Correspondence spot & forward rates

Is close correspondence surprising?

 Need deeper understanding to answer this
 To do.

Timers Source: Krugman, Obstfeld, and Melitz: International Economics, ninth edition
I. More on spot
 Two types of bilateral spot rates
Nominal (symbol S):
• The exchange rate; the central type in the course.
• Often “nominal” is left out.

Real (symbol Sr):

• Corrects for price differences
• Sr=SP*/P, where P is domestic price of domestic goods bundle
P* is foreign price of foreign goods bundle
 dimension is number of H bundles per F bundle
 measures bilateral (between two countries) competitiveness.
• More discussion on Sr: see Chapter 4 and tutorial.

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 Two types of multilateral spot rates
(Nominal) effective:
• Trade-weighted average of indices of nominal rates
• Index.

Real effective:
• Trade-weighted average of indices of real rates
• Index
• Measures overall competitiveness.

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 Spot rate determination

€/$ Supply
rate

Demand

Q Quantity of $

Graph will be analyzed at tutorial.

 Open questions
What determines supply and demand?
• Goods prices
• Money supply
• Interest rates
• Exchange rate expectations
• Risk premia
• Central bank interventions
• ....

See chapters 6-8.

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II. More on forward
 Participants at forward market
• Hedgers [trade to get rid of a risky position]:
– E.g. importer needs $ next month: avoids risk in St+1 by buying forward $ now
– Main reason for emergence of forward markets.

• Arbitrageurs [trade in riskless assets]:

– Try to exploit differences between St & Ft,t+1  ensure CIP (see below).

• Speculators [trade to create a risky position]:

– They are willing to take risk.
– In this chapter, speculators just compare Ft,t+1 & Et{St+1} to take positions,
where Et is the speculators’ expectation at t.
– They want to exploit Ft,t+1≠ Et{St+1}.
E.g., if they expect cheap $ (i.e., Ft,t+1>Et{St+1})
 sell expensive $ forward and expect to buy cheap $ at spot market at t+1.

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Forward rate determination (floating)
Potential elements relevant for forward rate (F):
• F should be strongly related to S:
both are prices of same currency; only difference is the time component

• F involves time, so interest rates may be relevant.

 Concept that formalizes this: Covered Interest Parity (CIP).

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 Combining spot and forward:
CIP

Timers
 Covered interest parity (CIP) (1/2)
Consider two risk-free investment possibilities: (r, r*: risk-free interest rates)
• €1 in EZ (euro zone) deposit:
 Gross return: 1+r euros.

• €1 in US deposit:
To do:
– convert into 1/S dollars
– US deposit yields 1/Sꞏ(1+r*) dollars
– convert on forward market into 1/Sꞏ(1+r*)ꞏF euros
 Gross return 1/Sꞏ(1+r*)ꞏF euros.

Arbitrage yields equality (to be explained below): 1+r = 1/Sꞏ(1+r*)ꞏF

known as Covered Interest Parity (CIP)
(“covered” as no risk involved).
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 CIP (2/2)
Crucial condition:
• Perfect capital mobility
(if not, then arbitrage cannot equalize returns).

Approximation (see tutorial):

r = r* + (F-S)/S (where (F-S)/S is forward discount on €)

Advantages of approximation:
• Interpretation is easier: r = r* + correction if € cheap on forward market:
(international) interest differential r-r* equals forward discount
• “Linearity” is easier to work with, particularly when we go to UIP in Ch.7.

Quality of approximation is discussed at tutorial.

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Terminology: investment & investment
Just to remind you, the word investment has two meanings:

• Build production capacity, physical capital

– Also called: physical investment
– This is what I means in Y=C+I+G+net exports
– If interest rate ↑, then cost of capital ↑, so this investment ↓

• Buying bonds, shares, …:

– Also called: portfolio investment
– This is what CIP is about
– If interest rate ↑, then return on deposit ↑, so this investment ↑.

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A) Assume perf. cap. mob. If r* up, then

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 r=r*+(F-S)/S is simple ... really?
Start from CIP: r=r*+(F-S)/S.
Question: what happens if r* increases?

Easy:
r*  r<r*+(F-S)/S  as we “know” in the end r=r*+(F-S)/S, we obtain S.

This seems plausible, but:

• Have you ever met an investor who reasons like this?
• Investors want to make a profit: how?
• Outcome (equilibrium) has been used to derive what happens: bad.
• Doesn’t F change?

 The above reasoning is mechanical; it misses the underlying economics

 Insufficient for this course!
Getting deeper understanding is one of the main goals of this course. 38
 How arbitrage ensures CIP
Start from CIP: r=r*+(F-S)/S.
Question: what happens if r* increases?

Equilibrating process:
r*  r<r*+(F-S)/S
 arbitrageurs invest abroad:
* spot demand of foreign currency to exploit higher return
* forward supply of foreign currency to avoid risk

 foreign currency appreciates on spot market (S) &

depreciates on forward market (F)

 (F-S)/S=F/S-1  until r=r*+(F-S)/S: CIP is restored.

This is an econ. instead of mechanical argument: gives much more insight.39

B) Assume perf. cap. mob. If r* up, then

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 Evidence on CIP
Can we earn profit through forward & spot contracts?
[Profit = Ft/St(1+r*t) – (1+rt) on German deposits using UK as home country]

 Integration lowers arbitrage profits & cap. markets are integrated now:
CIP holds.
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Source: Feenstra and Taylor: International Economics, first edition
 Correspondence S&F explained

Is close correspondence surprising?

No: for many industrial countries r ≈ r*  CIP shows F ≈ S.

This is an example of how theory helps to understand real life.

Timers Source: Krugman, Obstfeld, and Melitz: International Economics, ninth edition
Do you understand CIP?

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Joint determination of S & F
 CIP gives forward rate given S
If S is known,
then F= Sꞏ(1+r)/(1+r*) is known

 Banks use this to compute F.

Examples:
• In 2022: gas is expensive  need many $  supply many € to get $
 S high (about 1€/$)
 F high.

• See tutorial.

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 BUT: S & F are determined jointly
Previous slide: assumption that S is known before F
 Is this realistic?

No:
F  r>r*+(F-S)/S  arbitrageurs buy spot € (& sell forward € to avoid risk)
 S (and F drop is mitigated) (#)

 F affects S.

 Because S also affects F: F&S are determined jointly.

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 Conclusion
We now know basic ingredients:
• Foreign exchange market
• Price (=exchange rate)
• Relation spot – forward rate (CIP).

Use this to analyze:

• Relation with trade and financial flows
• Government policy
• Essays on international finance
• Real-life events
 To do in next chapters.

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