FOREIGN EXCHANGE

MARKET
• The foreign exchange market is the "place"
where currencies are traded.
• Currencies need to be exchanged for
conducting foreign trade and business.
• Most liquid financial market in world.
• No central marketplace for foreign exchange.
• Currency trading conducted electronically
over-the-counter (OTC).
• Open 24 hours a day
TYPES OF MARKETS
EXCHANGE RATE REGIMES
Demand Supply Curve
Purchasing power parity
TERMINOLOGIES
 The Law of One Price
• A commodity will have the same price in terms of
common currency in every country
– In the absence of frictions (e.g. shipping costs, tariffs,..)

– Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate

P€ = s€/$  P$
• Example:
Price of wheat in France per bushel (p€) = 3.45 €
Price of wheat in U.S. per bushel (p$) = $4.15
S€/$ = 0.83215 (s$/€ = 1.2017)

Dollar equivalent price

of wheat in France = s$/€ x p€
= 1.2017 $/€ x 3.45 € = $4.15

 When law of one price does not hold, supply

and demand forces help restore the equality
 Absolute PPP
• Extension of law of one price to a basket of goods
• Absolute PPP examines price levels
– Apply the law of one price to a basket of goods with
price P€ and PUS (use upper-case P for the price of the
basket):

S€/$ = P€ / PUS

where P€ = i (wFR,i  p€,i )

PUS = i (wUS,i  pUS,i )
 Absolute PPP
• If the price of the basket in the U.S. rises
relative to the price in Euros, the U.S. dollar
depreciates:
May 21 : s€/$ = P€ / PUS
= 1235.75 € / $1482.07 = 0.8338 €/$

May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$

 Relative PPP
Absolute PPP: P€ = s€/$  P$

For PPP to hold in one year:

P€ (1 + i€) = E(s€/$) P$ (1 + i$),



or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] P$ (1 + i$)



Relative PPP: 1 + i€ = E(s€/$)

1 + i$ s€/$

Main idea – The difference between (expected) inflation rates

equals the (expected)
rate of change in exchange rates.
 What is the evidence?
• The Law of One Price frequently does
not hold.
• Absolute PPP does not hold, at least in
the short run.
– See The Economist’s Big McCurrencies

• The data largely are consistent with

Relative PPP, at least over longer
periods.
Deviations from PPP
 Interest rate parity
• Main idea: There is no fundamental advantage to
borrowing or lending in one currency over another
• This establishes a relation between interest rates, spot
exchange rates, and forward exchange rates

FORWARD
MARKET
 Example of a forward market
transaction
• Suppose you will need 100,000€ in one year

• Through a forward contract, you can commit to lock in

the exchange rate

• f$/€ : forward rate of exchange

Currently, f$/€ = 1.19854  1 € buys $1.19854
 1 $ buys 0.83435 €

• At this forward rate, you need to provide $119,854 in 12

months.
 Interest rate parity
(1 + r€ )/ (1 + r$ ) = f€/$ / s€/$

In the above figure, Point G indicates a

situation of disequilibrium. Here, the
interest differential is -3% while
forward premium on home currency is
only 2%. The transfer of funds abroad
with exchange risks covered will yield
an additional 1% annually. At point H,
the interest differential remains at -3%
but forward premium increases to 4%.
Now it becomes profitable to reverse
the flow of funds. The 3% reduction in
interest rates is more than made up for
by the 4% gain on forward exchange
transaction, leading to a 1% increase in
This implies that the difference
the interest yield.
in interest rates must reflect the
difference between forward and
spot exchange rates
 Evidence on
interest rate parity

• Generally, it holds

• Why would interest rate parity hold better than

PPP?
 The Fisher condition
• Main idea: Market forces tend to allocate resources to their
most productive uses

• So all countries should have equal real rates of interest

• Relation between real and nominal interest rates:

(1 + rNominal) = (1 + rReal)(1 + i )

(1 + rReal) = (1 + rNominal) / (1 + i )
 Example of
capital market equilibrium
• Fisher condition in U.S. and France:
(1 + r$(Real)) = (1 + r$) / (1 + i$)
(1 + r€(Real)) = (1 + r€) / (1 + i€)

• If real rates are equal, then the Fisher condition implies:

• The difference in interest rates is equal to the expected

difference in inflation rates
International Fisher Effect
Expected change in
In the figure below, point E is home
currency value of
a point of equilibrium because
foreign currency(%)
it lies on the parity line with
3% interest differential in
favour of home country just
offset by the anticipated 3%
HC depreciation relative to
foreign currency. Point F,
however illustrates a situation
of disequilibrium. If a 3% HC
depreciation is anticipated
but the interest differential is
only 2% then funds would
flow from home country to
foreign country to take the
advantage of the higher
exchange adjusted return
there. This capital out flow
will continue until exchange
ECONOMIC FACTORS
 NATURE OF
FOREX MARKET
 LIMITATIONS OF CURRENCY
TRADING AS AN EXAMPLE OF A NEAR-
PERFECTLY COMPETITIVE MARKET
  
SHORT RUN EQUILIBRIUM FOR
PERFECT COMPETITION
LONG-RUN EQUILIBRIUM
EFFECTS OF A CHANGE IN
MARKET DEMAND