International Economics

FOREIGN EXCHANGE MARKETS

AND FOREIGN EXCHANGE RATES

Nguyen Thi Minh Phuong

(University of Economics and Business, VNU)
3 FACTORS THAT IMPACT
ON EXCHANGE RATES
 Changes in the exchange rate

• Depreciation: The value of one currency falls relative to another currency.

• Appreciation: The value of one currency rises relative to another currency.

E.g. A depreciation of VND against USD/ An appreciation of USD against VND

refers to a decrease in the dollar price of VND/an increase in the VND price of USD
The USD exchanges for 20.000 VND and then exchanges for 21.000 VND

• Devaluation: the increase in the fixed value of one currency due to its
government acts
E.g. To devaluate the USD against Yen, FED will sell USD and buy JPY from the
market

• Revaluation: the decrease in the fixed value of one currency due to its
government acts
E.g. To revaluate the USD against Yen, FED will sell JPY to the market
 Changes in the exchange rate

At the most basic level, exchange rate are determined by the demand and supply
of one currency relative to the demand and supply of another
R = CD/CF  Vertical axis: presents the price of foreign
currency in terms of domestic currency
SF -> An increase in the exchange rate (R) refers to
depreciation of domestic currency and
appreciation of foreign currency
-> A decrease in the exchange rate (R) refers to
appreciation of domestic currency and
depreciation of foreign currency

 Horizontal axis: presents the quantity of

foreign currency in domestic market

 The lower the rate is,, the greater the

DF quantity of foreign currency demanded and
the lower the quantity of foreign currency
0 QCF supplied.
 Changes in the exchange rate

At the most basic level, exchange rate are determined by the demand and supply
of one currency relative to the demand and supply of another
R = CD/CF
S2
 Trade in goods and services:
SF
• Exports  S -> S1
S1 • Exports  S -> S2
• Imports  D -> D1
• Imports  D -> D2

Nation’s exports create a supply of

foreign currency and a demand for
domestic currency
Nation’s imports create a demand for
foreign currency and a supply of
D1 domestic currency
DF
D2
0 QCF
 Changes in the exchange rate

At the most basic level, exchange rate are determined by the demand and supply
of one currency relative to the demand and supply of another
R = CD/CF
S2
SF  Investment:
S1 • Foreign inv. in the nation  S -> S1
• Foreign inv. in the nation  S -> S2
• Nation’s inv. abroad  D -> D1
• Nation’s inv. abroad  D -> D2

Nation’s capital outflows create a demand for

foreign currencies and a supply of domestic
currency.
Nation’s capital inflows create a supply of
D1 foreign currencies and a demand for
DF domestic currency.
D2
0 QCF
Factors that impact on exchange rate

Economic variables
Real income
Real interest rate
Inflation rate
Other economic variables

The market’s expectation

 1. Real income and the exchange rate

E.g. 1. The real income in the U.S 

The real income in the U.K 
R = $/£
-> U.S demand for U.K goods & services; U.S S
investment in U.K (demand for £) 
1
-> U.K demand for U.S goods & services; U.K 2
investment in U.S (supply of £) 

D -> D1; S stay the same R1

R = $/£ -> Depreciation of $ R
R2
E.g. 2. The real income in the U.S  D1
The real income in the U.K 
D
D2
D -> D2; S stay the same 0 Million of £
R = $/£ -> Appreciation of $
1. Real income and the exchange rate

R = $/£
E.g. 3. The real income in the U.S  S
The real income in the U.K  S1

-> U.S demand for U.K goods & services; U.S

investment in U.K (demand for £) 

-> U.K demand for U.S goods & services; U.K

investment in U.S (supply of £)  R

D -> D1; S -> S1 D1

Change in R = $/£ is ambiguous
D

0 Million of £
 2. Real interest rate and the exchange rate

E.g. 4. Short-term real interest rate in Japan = R = $/¥

3% S2
S
Short-term real interest rate in U.S = 2%

-> U.S investment in Japan (demand for JPY) 

-> Japan investment in U.S (supply of JPY) 

R1
D -> D1; S -> S2
R
R = $/¥  -> Depreciation of $

D1
Differential in real interest rates is D
the main factor for the change in the
exchange rate in the short term. 0 Million of ¥
2. Real interest rate and the exchange rate

Nominal interest rate and real interest rate

in the short term, 2006 (%)

Source: International Financial Statistics, Ạugust 2007

3. Inflation and the exchange rate
• Law of one price: A good must sell for the same price in all locations

• PPP – Purchasing Power Parity: Global exchange rates should

eventually adjust to make the price of identical baskets of tradable
goods the same in each country.

• Exchange rate tends to change at an equal rate of differential in

inflation rate between domestic and foreign countries.
E.g. if the inflation rate in Vietnam is 4% higher than China, then the
purchasing power of VND will decrease 4% in compared with CNY.
-> VND will depreciate against CNY 4%
4. Other economic variables

 Bilateral trade relation

• Currency of the nation that has deficit in trade balance tends to
depreciate against foreign currency.
 Consumer’s tastes
• Consumer’s tastes in favor of domestic or imported goods
 Investment profitability
 Product’s availability
 Changes in productivity
 Trade policy
5. Expectation and the exchange rate

• Expectation of the market changes in the future vs. current

situation of the market changes at the present time.

Factors Changes Effects on exchange Relationship

value of $
Expected price in U.S Increase Depreciate Negative
Decrease Appreciate
Expected interest rate in U.S Increase Appreciate Positive
Decrease Depreciate
Expected trade restrictions of Increase Appreciate Positive
U.S Decrease Depreciate
Expected demand for import Increase Depreciate Negative
in U.S Decrease Appreciate
Expected demand for U.S Increase Appreciate Positive
export Decrease Depreciate
Expected productivity Increase Appreciate Positive
Decrease Depreciate
5. Expectation and the exchange rate

E.g.
• The lower the current exchange rate between VND and USD, the
larger the expected profit from holding USD, all other things
remaining the same.
• The higher the expected exchange rate between VND and USD,
the larger the expected profit form holding USD, all other things
remaining the same.
4 FOREIGN EXCHANGE
TRANSACTIONS
 Spot exchange vs. Forward exchange transactions

• Spot exchange transaction:

 An agreement to exchange currencies at a specific rate (spot rate) and
execute the deal immediately or within two business days.
 Spot rates are reported on a real-time basis on many financial websites.

• Forward exchange transaction:

 An agreement today to buy or sell a specified amount of a foreign
currency at a specified future date at a rate agreed upon today (forward
rate) -> the deal will be executed at some specific date in the future.
 Forward rates are often quoted for 1 month, 3 months, 6 months in the
future. 3 months are the most common.
 Forward premium or discount refers to the difference between current
forward rate and current spot rate

In practice, the forward and spot exchange rates are not necessarily equal, but
they move closely together.
Exercise
Thượng Đình exports sport shoes to a US
firm and will receive payment of 10.000
USD in three months. On March 1, the spot
rate of the USD and VND was 1 USD =
20.000 VND, and the 3-month forward rate
was 1USD = 19.500VND. On March 1,
Thượng Định negotiated a forward contract
with a bank to sell 10.000USD forward in
three months. The spot rate of USD and
VND on June 1 is 1USD=20.500VND.
Thương Đình will receive -------- VND for the
USD?
a.200 million VND
b.195 million VND
c.205 million VND
d.210 million VND
Foreign exchange Swaps

 Foreign exchange swaps refers to a spot sale of a currency

combined with a forward repurchase of the currency
E.g. Citibank receives 1 million USD of payment today. It will need this
sum of USD in 3 months, but in the meantime it wants to invest in EUR.
Instead of selling dollars for EUR in spot market today and at the same
time repurchasing dollars for euro in the forward market for delivery in 3
months (involve two separate transactions), Citibank would make a
foreign exchange swap (Involve only one single transaction) with
Deutscher Bank.

 Most interbank trading are foreign exchange swap and spot

transactions
Foreign exchange Futures

 Foreign exchange futures is a forward contract for

standardized currency amounts and selected calendar dates
traded on an organized market
o Currencies traded on the IMM: JPY, CND, GBP, CHF, AUD, MXN, EUR
o Standardized amount: e.g. JPY 12.5 million, CND100.000,
GBP62.500, EUR125.000
o Only four dates per year: 3rd Wednesday in March, June, September,
December.
o Organized market: Chicago, New York, London, Frankfurt and
Singapore
 Futures contracts are usually for smaller amounts than
forward contracts -> more useful to small firms than to large
ones but more expensive.
-> has grown very rapidly recently
Foreign exchange Options

 Foreign exchange option is a forward contract in which an

investor can, but does not have to, exchange currency at a
specific rate at a specific future date.
 Call option: a contract giving the option buyer the right, but
not the obligation, to buy foreign currency at a known price at
a specific future date (the European option) or at any time
during the period of the option (the American option).
 Put option: a contract giving the option buyer the right, but
not the obligation, to sell foreign currency at a known price at
a specific future date (the European option) or at any time
during the period of the option (the American option)
Foreign exchange Options

 The buyer of the option has the choice to buy/sell or forgo

the deal if it turns out to be unprofitable -> Greater
flexibility
 The seller of the option must fulfill the contract if the
buyers so desires
 Option price: the buyer has to pay the seller a premium for
the privilege (often 1-5% of the contract’s value)
 Arbitrage: the process by which an investor buys a currency in
one market at a specific exchange rate and then almost
immediately sells that currency in another market where the
exchange rate is more advantageous to earn profits

• Two-point arbitrage: only two currencies and two

monetary centers are involved in arbitrage.

• Three-point arbitrage/ triangle arbitrage: three

currencies and three monetary centers are involved.
ARBITRAGE

- Arbitrage eventually equalize exchange rates for all pairs of

currencies, unifying all centers into a single market.
• Increases the demand for the currency in the monetary
center where the currency is cheaper
• Increase the supply of the currency in the monetary
center where the currency is more expensive
 Exercise
Suppose you have 1000 USD to invest.
a. Explain how you can capitalize on the exchange rate
inconsistency. Calculate the profit.
b. Explain how this arbitrage activity would finally
eliminate the exchange rate inconsistency.

$1 = €1 in New York
$1.05 = €1 in Frankfurt

Answer:
a. I will use 1000 USD to buy 1000 EUR in NY. Then I sell
1000 EUR and get 1050 USD in FF. The total profit is 50
USD.
b. In NY, the demand for EUR increases -> the USD price
of EUR increase (1EUR>1USD). In FF, the supply of EUR
increases -> the USD price of EUR decrease
(1EUR<1.05USD). The process continues until the USD
price of EUR are equal in both markets
 Exercise
The dollar exchange rates quoted at Bank A and Bank B
are as follows:
Bank A: 20,030 VND per USD – 20,070 VND per USD
Bank B: 21,000 VND per USD – 21,040 VND per USD
What would be your profit if you use 2,000,000 VND
and conduct an arbitrage?

Answer: 92,675.64 VND

 Exercise
Suppose you have 2,000,000 JPY to invest.
a. Explain how you can capitalize on the exchange rate
inconsistency. Calculate the profit.
b. Explain how this arbitrage activity would finally eliminate the
exchange rate inconsistency.
€1 = $1.28 in New York
$1 = ¥100 in Tokyo
€1 = ¥133 in London

Answer:
a. - The cross rate between EUR and JPY in NY and TK is 1EUR =
128JPY. This suggests that EUR is expensive in LD. One should
sell EUR in LD to make profits.
- Buying USD in TK: 2,000,000/100=20,000USD
- Buying EUR in NY: 20,000/1.28=15,625EUR
- Selling EUR in LD: 15,625*133=2,078,125JPY
- The profit is 78,125JYP
b. The buying of USD raises the JPY price of USD in TK. At the
same time, the buying of EUR in NY raise the USD price of EUR.
Thus, the cross rate between EUR and JPY increases. Meanwhile,
selling EUR lowers the exchange rate of EUR in LD. The exchange
rate difference between monetary centers declines and final
eliminates.
 Foreign exchange risk :
- Occurs when a person’s or firm’s financial welfare can be
affected by changes in the exchange rate
FOREIGN EXCHANGE RISK

E.g.
+ A U.S importer buys 100,000EUR of goods from EU,
and will pay in three months
+ The current spot rate $1 = €1
-> the current USD value of the payment is $100.000
+ Three month later, the spot rate $1.10 = €1
-> U.S importer has to pay $110.000 ($10.000 higher)
 Hedging : the action to avoid foreign exchange risk

1. In spot market

• The exporters with future receipts denominated in foreign

currencies can borrow the amount they will receive and
exchange it for domestic currency. Later they repay the loan
with the payment they receive.

• The importers with future payments denominated in the

foreign currency can borrow in the domestic currency,
exchange it for the foreign currency, and deposit the
HEDGING

amount of the foreign currency for future payment.

• Advantage: Traders are certain about his future receipts or

payment.
• Disadvantage: Traders must borrow or tie up his/her own
funds for three month
 1.In spot market

E.g. A U.S exporter will receive €100.000 in 3 month.

The spot rate is $1 = €1 How can he hedge against the
foreign exchange risk in the spot market?

The U.S exporter will:

o Borrow €100.000
HEDGING

o Exchange € to $, at spot rate $1 = €1

-> certainly $100.000 in hand
o After 3m, receive the payment of €100.000 -> use it to
repay the loans
 1.In spot market

E.g. A U.S importer needs to pay €100.000 in 3 months.

The spot rate $1 = €1. How can he hedge against the
foreign exchange risk in the spot market?

The U.S importer will:

o Borrow/put aside $100.000
HEDGING

o Exchange $ to € -> €100.000 in hand

o Put €100.000 into deposit account for 3 months
o After 3m, withdraw € in deposit account to make the
payment.
 2. In forward market

• The exporters with future receipts in x months denominated

in foreign currencies could sell forward the amount they
would receive for delivery in x months. After x months, he
would implement the forward contract to sell this amount of
foreign currency.

• The importers with future payments in x months

denominated in the foreign currency could buy forward of
foreign currency for delivery in x months. After x months, he
HEDGING

would implement the forward contract to purchase foreign

currency.

• Advantage: Traders are certain about his future receipts or

payment; don’t need to borrow or tie up his own funds
 2. In forward market

E.g. A U.S exporter will receive 1 million euro in 3

months. How can he hedge against the foreign exchange
risk in the forward market?

The U.S exporter will:

HEDGING

o Sell forward 1 million euro for delivery in three

month.
o After 3 months, implement the forward
contract to sell one million euro
 2. In forward market

E.g. A U.S importer needs to pay 1 million euro in 3

months. How can he hedge against the foreign exchange
risk in the forward market?

The U.S importer will:

o Buy forward 1 million euro for delivery in three
HEDGING

month.
o After 3 months, implement the forward
contract to purchase one million euro
 3. In options market

• The exporters could buy a put option to sell the future receipt
denominated in foreign currencies. When he receives the
payment, he may choose either exercise the option or forgo the
option and sell the received foreign currency to the market at
spot rate at that time, depending on which is more beneficial.
• The importers could buy a call option to buy foreign currencies
for future payment. When he has to make the payment, he can
choose either exercise the option or or forgo the option and
buy the needed foreign currency from the market at spot rate
at that time, depending on which is more beneficial.
HEDGING

• Advantage: The option transaction gives the buyer a greater

flexibility. The buyer of an option don’t need to implement the
option if it turns out unprofitable.
• Disadvantage: However, the buyer has to pay a premium for
this privilege.
 3. In options market

E.g. A U.S importer has to pay €100,000 in 3 months. How can

he hedge against the foreign exchange risk in the option
market? Calculate the cost of purchasing EUR. Assume the
exercise rate is 1.2 USD per EUR and the premium (option
price) is 1% of the contract value.

o The U.S importer will buy a call option to purchase

HEDGING

€100,000 in 3 months
o After 3 months, he will implement the contract and pay
$120.000 to purchase €100,000
o At the same time, he has to pay the premium of $1200
($120.000*1%)
o So the total cost = 120,000+1,200=121,200 USD
 3. In options market

E.g. A U.S exporter will receive €100,000 in 3 months. How

can he hedge against the foreign exchange risk in the options
market?
The exercise rate is $1.2= €1. The premium (option price) is
1% of the contract value. Calculate how much the exporter
will receive.

The U.S exporter will:

HEDGING

o Buy a put option to sell €100,000 in 3 month

o After 3 months, implement the contract and receive
$120,000 (=€100,000 *1.2$/€)
o At the same time, he has to pay the premium of $1.200
(=$120,000 *1%)
o So the net receipt is $118,800
 3. In options market

E.g. An importer buys a call option to buy €100,000 in three

months at $1 = €1, and pay the premium of 1% ($1000)
3 months later, the spot rate is $0.98=€1. What should the
importer do?

o If importer buy €100,000 at the spot market

HEDGING

-> total cost = $98,000 + $1,000 = $99,000

o If importer buy €100,000 from option seller
-> total cost = $100,000 + $1,000 = $101,000
-> Importer should let the option unexercised and buy € at
the spot market
 3. In options market

E.g. An importer buys a call option to buy €100,000 in three

months at $1 = €1, and pay the premium of 1% ($1000)
3 months later, the spot rate is $1.02=€1. What should the
importer do?

o If importer buy €100,000 at the spot market

HEDGING

-> total cost = $102,000 + $1,000 = $103,000

o If importer buy €100,000 from option seller
-> total cost = $100,000 + $1,000 = $101,000
-> The Importer exercise the option
 Speculation: typically involves the short-term
movement of funds from one currency to another in the
hopes of profiting from shifts in exchange rates.

Speculators vs. hedgers:

- Speculators accept and seek out a foreign exchange
risk, in the hope of making a profit.
- A hedger seeks insurance against a foreign exchange
SPECULATION

risk
 1. In spot market
• Speculator expects that a currency will appreciate in the
future
-> he will buy the currency now, put into deposit to earn
interest, and resell when the currency actually appreciates.

E.g. Spot rate VND 20.000 = USD 1

Expectation: spot rate in 3 month VND 21.000 = USD 1
SPECULATION

(Appreciation of USD)

Speculators will:
o Buy USD now at the price of VND 20.000 per USD
o Put USD into deposit to earn interest
o After 3 month, sell USD at the price of VND 21.000 per USD
-> expected profit of VND 1.000 per USD
 1. In spot market
• Speculator expects that currency 1 will depreciate against
currency 2 (the price of currency 1 decreases) in the future
-> he will borrow the currency 1, exchange to the currency 2.
When the currency 1 depreciates, buy currency 1 and repay
the loans.

E.g. Spot rate VND 20.000= USD 1

SPECULATION

Expectation: spot rate in 3 month VND 19.000 = USD 1

(Depreciation of USD)

Speculators will:
o Borrow USD
o Exchange USD to VND at the price of VND 20.000 per USD
o After 3 months, buy USD at the price of VND19.000 per USD
and repay the loan
-> Expected profit of VND 1.000 per USD
 2. In forward market

• Speculator expects that the currency will appreciate

-> he signs a forward contract to buy the currency

• Speculator expects that the currency will depreciate

-> he signs a forward contract to sell the currency

• Right expectation: gain profits

SPECULATION

• Wrong expectation: incur losses

 2. In forward market

3m forward rate: $1.40 = €1

Expectation: spot rate in 3 month $1.50 = €1
(Appreciation of €)

Speculators will:
SPECULATION

o Sign a forward contract to buy € at exercise rate $1.40 =

€1
o After 3 months, sell the € received at $1.50 = €1

Results: 3 months later

+ Spot rate $1.50= €1 -> gain profit of $0.10 per euro
+ Spot rate $1.45= €1 -> gain profit of $0.05 per euro
+ Spot rate : $1.30= €1 -> incur loss
 2. In forward market

3m forward rate: $1.40 = €1

Expectation: spot rate in 3 month $1.35 = €1
(Depreciation of €)

Speculators will:
SPECULATION

o Sign a forward contract to sell € at exercise rate

$1.40 = €1
o After 3 months, buy € at $1.35 = €1 and sell it to the
partner in forward contract.

Results: 3 months later

+ Spot rate $1.35= €1 -> gain profit of $0.05 per euro
+ Spot rate $1.45= €1 -> incur loss
 3. In options market

• Speculator expects that a currency will appreciate

-> Buy a call option contract to buy the currency in x month.
After x month, he can exercise the options or not , depending
which is more profitable

• Speculator expects that currency 1 will depreciate against

currency 2 in the future
SPECULATION

-> Borrow in currency 2, exchange to currency 1, buy a put

option contract to sell the currency 1 in x month and then
repay the loans.
Exercise
A speculator expects EUR will appreciate.
He buys a call option to buy EUR 100.000
with the exercise rate of 1.2USD /EUR.
The option premium is USD0.1 per EUR.
Calculate his gain or loss in these two
cases:

a. On the expiration date, the spot rate

reaches 1.4 USD/EUR.
b. On the expiration date, the spot rate
reaches 1.1 USD/EUR.
Answer

a. The cost of purchasing 100,000 euro in

the option market is:
1.2×100,000 + 0.1×100,000 = USD 130,000
The revenue from selling 100,000 euro in
the spot market is:
1.4×100,000 = USD 140,000
If he exercises the deal, he gains USD
10,000. If he forgoes the deal, he loses
USD 10,000 (option fee)
-> He will exercise the deal.
 Answer
b. The cost of purchasing 100,000 euro in the
option market is:
1.2×100,000 + 0.1×100,000 = USD 130,000
The revenue from selling 100,000 euro in the
spot market is:
1.1×100,000 = USD 110,000
If he exercises the deal, he loses USD 20,000.
If he forgoes the deal, he loses USD 10,000
(option fee)
-> He will forgo the deal and only pays the
option premium of USD 10,000
Homework
Preparation for the next class

- Read D. Salvatore, chapter

21, p743-759
- Read K.T.T.Mai, chapter 7,
section 7.1, 7.2, 7.3.1
THANK YOU!