Financial Markets and Institutions, 9e: Chapter 15 The Foreign Exchange Market

Financial
Markets and
Institutions, 9e
Chapter 15 The Foreign
Exchange Market
Outlines
1. Foreign Exchange Market
2. Exchange Rate Overview
3. Exchange Rates in the Long Run
4. Exchange Rates in the Short Run
5. Exchange Rates – applications
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Foreign exchange market
• Definition: a market where the currencies of
different countries are bought and sold.
• Characteristics: OTC market, no physical location,
operates 24 hours a day, using telecommunications
technology to facilitate fx transactions
• Participants:
– Tier 1: interbank market including central bank,
commercial banks: trading for liquidity, exchange
rate interventions, exchange rate adjustments
– Tier 2: commercial banks vs their clients such as
other financial institutions (excluding banks),
corporations (ex-im co., debtors,…) individuals.
Composition of derivatives in the two markets -
FX market in Vietnam 2019 - Daily turnover Vietnamese market daily average data 2019
and composition 100%
5 90%
4
67/33 (%) 80%
70%
3 60%
50%
2 90/10 (%) 40%
30%
1
20%
0 10%
Interbank bank-clients 0%
Interbank bank-clients
spot derivatives
swap forward
Growth of the two markets during 2015-2019

450%
400%
350%
300%
250%
200%
150%
100%
50%
0%
Total spot derivatives
Interbank bank-clients
• Aims of transactions:
– For the demand of foreign currencies for international
trade settlements, travel, external debt service
payments, (with underlying transactions)…
– For risk management (hedging),
– Arbitrage + speculations (no underlying transactions)
– Interventions to manage exchange rates fluctuations
and exchange rate policies
– Foreign currency liquidity in banking system
• Types of markets:
– Spot market (the immediate delivery market) vs
forward market (the deal is close at a definite future
date) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Foreign Exchange Market
• Types of FX transactions:
buyer and seller enter into an
agreement of sale and purchase of
currency after a definite period of A standardize forward
time and at a fixed exchange rate contract traded in
on a definite date in the future. organized market
Buyer and seller settle

within the two days of
the deal.
gives an investor the right,

but not the obligation to
simultaneous borrowing
exchange the currency in and lending of two
one denomination to another different currencies
at an agreed exchange rate between two investors.
on a pre-defined date
Outlines
Exchange Rate overview
• Exchange rates:
– An exchange rate is the price of one currency
expressed in terms of another currency or group of
currencies
– The spot exchange rate (in spot transactions) vs the
forward exchange rate (in the forward transactions)
– Direct quotes (EUR/USD: 1 EUR = x USD) vs Indirect
quotes (USD/VND: 1 USD = x VND)
– Currency depreciation (fall in value/weaken) vs
appreciation (increase in value/strengthen). How about
devaluation???
• The importance of exchange rates: the movement
of exchange rate affect the economy
Direct effects Indirect effects

• Direct effects
– They affect the relative price of domestic and
foreign goods.
– When home currency appreciates relative to foreign
currency, the country’s goods abroad (exports)
become more expensive and foreign goods in that
country (imports) become cheaper (holding
domestic prices constant in the two countries).
 Makes domestic businesses less competitive
 Benefits domestic consumers
– They also affect debt services of external debts
when they are converted in to home currency
– And the reverse - home currency depreciates!
Foreign Exchange Market
• Indirect effects
Support aggregate demand
Inflation and interest rate

and employment
increase
Outlines

Exchange Rates in the Long Run
• Exchange rates are determined in markets by the
interaction of supply and demand of foreign currency.
• Important concepts that drive the forces of supply and
demand are
– The Law of One Price.
– Purchasing Power Parity (PPP)
• The Law of One Price: the price of the good should
be the same throughout the world no matter which
country produces it, provided that the two countries:
– produce an identical good
– transportation costs and trade barriers are very low
Exchange Rates in the Long Run: Theory
of Purchasing Power Parity (PPP)
• The theory of PPP: exchange rates between two
currencies will adjust to reflect changes in price levels
• Foreign price = Domestic price x Exchange rate
• PPP  when foreign price unchanged, domestic
Domestic price level  10=> currency  10% (home
currency depreciation)
─ Application of law of one price to price levels
─ Works in long run, not short run
• Problems with PPP

─ All goods are not identical in both countries
─ Many goods and services are not traded
(e.g., haircuts, land, etc.) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Figure 15.2 Purchasing Power Parity, United States/United
Kingdom, 1973–2016 (Index: March 1973 = 100)
Source: Federal Reserve Bank of St. Louis FRED database:

https://fred.stlouisfed.org/series/CP0000GBM086NEST;
https://fred.stlouisfed.org/series/CPIAUCNS; https://fred.stlouisfed.org/series/EXUSUK.
Factors Affecting Exchange Rates in Long Run
• Basic Principle:
– If a factor increases/decreases demand for
domestic goods relative to foreign goods =>
increases/decreases demand for home
currency to service the payment => home
currency appreciated/depreciated
• The four major factors affecting demand for
domestic goods relative to foreign goods:
– relative price levels
– tariffs and quotas
– preferences for domestic vs. foreign goods
– productivity
Factors Affecting Exchange Rates in Long Run
• Relative price levels: a rise in relative price
levels cause a country’s currency to depreciate.
• Tariffs and quotas: increasing trade barriers
(import falls and domestic good demand rises)
causes a country’s currency to appreciate.
• Preferences for domestic vs. foreign goods:
increased demand for a country’s good (export)
causes its currency to appreciate; increased
demand for imports causes the domestic currency
to depreciate.
• Productivity: if a country is more productive
relative to another, its currency appreciates.
Table 15.1 Summary Factors That Affect Exchange Rates in
the Long Run
Factor Change Change in Change in Domestic
in Factor Domestic Domestic (home)
demand for demand for currency
goods home
currency
Domestic price Rise Fall Fall Depreciation

level
Trade barriers Rise Rise Rise Appreciation
Import demand Rise Fall Fall Depreciation
Export demand Rise Rise Rise Appreciation
Productivity Rise Rise Rise Appreciation
Outlines

5. Exchange Rates – interesting notes
Table 15.2 Summary Factors That Affect Exchange Rates in
the Short Run
Factor Change Change in Change in Domestic
in demand for demand for (home)
Factor domestic foreign currency
currency currency
assets assets
Domestic interest Rise Rise Fall Appreciation

rate relatively to Fall Fall Rise Depreciation
foreign interest rate
Foreign Interest rate Rise Fall Rise Depreciation
relatively to… Fall Rise Fall Appreciation
Expected future spot Rise Fall Rise Depreciation

exchange rate => Fall Rise Fall Appreciation
speculation
Outlines

5. Exchange Rates – Applications
Application: Interest Rate Changes –
Nominal vs Real
• Changes in domestic interest rates are often cited in
the press as affecting exchange rates.
• Interest rates change because either (a) the real rate
or (b) the expected inflation is changing. The effect of
each differs.
• When the domestic real interest rate increases,
domestic currency is more attractive =>the domestic
currency appreciates.
• When the domestic nominal interest rate increases
=> domestic expected inflation increases =>
domestic good prices increase => demand for
domestic good falls => the domestic currency reacts
in the opposite direction—it depreciates.
Figure 15.8 Value of the Dollar and Interest Rates, 1973–2016
In 2007, the Fed lowered the fed

funds rate by 325 bps, while ECBs
did not do this. Relative return on
the dollar fell
=> In August 2007, the dollar
began an accelerated decline in
value, falling by 9% against the
euro through July 2008
By mid-2008, ECBs starting cutting

their domestic rates, increasing the
relative expected return of the US.
A “flight to quality” in T-bonds also
increased the demand for dollars.
=> The dollar suddenly shot
upward, by over 20% against the
euro by the end of October 2008
Source: Federal Reserve Bank of St. Louis FRED database:
https://fred.stlouisfed.org/series/TWEXMMTH;
https://fred.stlouisfed.org/series/TB3MS; real interest rate
from Figure 3.1 in Chapter 3.
Application: Exchange rate volatility
• Exchange rate overshooting is important because it
helps explain why exchange rates are so volatile.
• Dornbusch Overshooting Model (1976) argues that:
– Exchange rate volatility was not the result of speculators and
inefficiencies in the foreign exchange market
– It was more fundamental to the market:
 in the short-run, equilibrium is reached in the financial
markets, the exchange rate will temporarily overreact to
changes in monetary policy to compensate for sticky
prices of goods in the economy and then
 in the long run, the price of goods unsticks and responds to
these changes in the financial markets. The financial
market, including the foreign exchange market, adjusts to
this financial reality
The Practicing Manger: Profiting from
FX Forecasts
• Forecasters look at factors discussed here
• FX forecasts affect financial institutions
managers' decisions
• If forecast euro appreciate, yen depreciate,
─ Buy/Sell yen assets, buy/sell euro assets
─ Make more/less Euros loans, more/less yen loans
─ FX traders buy/sell yen, buy/sell euros
─ Borrow more/less Euro, more/less yen
Chapter Summary
• Foreign Exchange Market: the market for deposits
in one currency versus deposits in another.
• Exchange Rates in the Long Run: driven primarily
by the law of one price as it affects the four factors
discussed.
• Exchange Rates in the Short Run: short-run rates
are determined by the demand for assets
denominated in both domestic and foreign currencies.
• Explaining Changes in Exchange Rates: some key
notes to make clear the effect of nominal vs real
interest rate movement on exchange rates and
Exchange rate overshooting situation.

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Financial Markets and Institutions, 9e: Chapter 15 The Foreign Exchange Market

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Financial

Growth of the two markets during 2015-2019

Buyer and seller settle

gives an investor the right,

1. Foreign Exchange Market

2. Exchange Rate Overview

3. Exchange Rates in the Long Run

4. Exchange Rates in the Short Run

5. Exchange Rates – applications

Direct effects Indirect effects

Support aggregate demand

Inflation and interest rate

1. Foreign Exchange Market

2. Exchange Rate Overview

3. Exchange Rates in the Long Run

4. Exchange Rates in the Short Run

• Problems with PPP

Source: Federal Reserve Bank of St. Louis FRED database:

Domestic price Rise Fall Fall Depreciation

Trade barriers Rise Rise Rise Appreciation

Import demand Rise Fall Fall Depreciation

Export demand Rise Rise Rise Appreciation

Productivity Rise Rise Rise Appreciation

1. Foreign Exchange Market

2. Exchange Rate Overview

3. Exchange Rates in the Long Run

4. Exchange Rates in the Short Run

Domestic interest Rise Rise Fall Appreciation

Expected future spot Rise Fall Rise Depreciation

1. Foreign Exchange Market

2. Exchange Rate Overview

3. Exchange Rates in the Long Run

4. Exchange Rates in the Short Run

In 2007, the Fed lowered the fed

By mid-2008, ECBs starting cutting

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