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R.López-Monti -1
Exchange Rates and the
Foreign Exchange Market*
SURVEY OF INTERNATIONAL
ECONOMICS
Rafael López-MontiDepartment of Economics
George Washington University
Summer 2015(Econ 6280.20)
Required Reading:
Feenstra, R. and Taylor, A., International Economics (3e). Worth Publishers, Chap 13
OR Feenstra, R. and Taylor, A., Essential of International Economics (3e). Worth Publishers, Chap. 10
* Material for teaching only. I thank Professor Pablo Vega-Garcia for sharing his Lectures with me.
2
THE FOREIGN EXCHANGE MARKET
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage
3
Exchange Rate Essentials: Defining the Exchange Rate
An exchange rate is the price of some foreign currency expressed in
terms of a home (or domestic) currency.
Because an exchange rate is the relative price of two currencies, it may
be quoted in either of two ways:
The number of home currency units that can be exchanged for one unit of
foreign currency (e.g. US$/€)
The number of foreign currency units that can be exchanged for one unit of
home currency (e.g. €/US$)
We will mostly use the domestic currency/foreign currency convention.
We will use e to refer to exchange rate [Note: in the book the exchange
rate is denoted with E]
e = units of domestic currency per unit of foreign currency
4
Exchange Rate Essentials: Appreciation/Depreciation
A depreciation of the domestic currency occurs when e
increases. The domestic currency is loosing value. You need
more domestic currency to get 1 unit of foreign currency.
For example, if the US$/€ exchange rate moves from 1.31 US$/€ to
1.5 US$/€ then the US$ depreciates (or the € appreciates).
An appreciation of the domestic currency occurs when e
decreases. The domestic currency is gaining value. You need less
domestic currency to get 1 unit of foreign currency.
For example, if the US$/€ exchange rate moves from 1.31 US$/€ to
1.20 US$/€ the US$ appreciates (or the € depreciates).
Note: The previous terminology is mostly used under floating exchange rate
regimes. The equivalent terminology under a fixed exchange regime is
revaluation / devaluation, although sometimes they are used interchangeably
5
Exchange Rate Essentials: Example
Suppose that a bottle of good Argentine Malbec wine cost about 100 Argentinean
pesos (AR$). Argentina used to have a fixed exchange rate with respect to the US
dollar during the nineties.
In 1999, the exchange rate was fixed at 1 US$/AR$, but after the Argentinean
devaluation (2002) the US$/AR$ exchange rate dropped to 0.30 (i.e., the AR$
devaluated with respect to the US$).
Similarly, the €/AR$ exchange rate was about 0.9 in 1999, but 0.21 €/AR$ in
2005. (i.e., the AR$ devaluated with respect to the euro too).
After the devaluation, the same bottle of wine was relatively cheaper from the
American and European perspective. Thus, Argentinean exports of wine
increased in that period.
Cost of buying an Argentine Malbec wine (in domestic currency)
American % Change European % Change
1999 US$ 100.- € 90.-
2005 US$ 30.- -70% € 21.- -77%
6
Exchange Rate Essentials: Appreciation/Depreciation
A depreciation (appreciation) of the domestic currency makes
domestic exports cheaper (more expensive) and domestic imports
more expensive (cheaper).
Important Result:
7
Exchange Rate Essentials: Fixed Versus Floating
There are two major types of exchange rate regimes
Fixed (or pegged) exchange rates fluctuate in a narrow range (or
not at all) against some base currency over a sustained period. A
country’s exchange rate can remain rigidly fixed for long periods
only if the government intervenes in the foreign exchange market
in one or both countries.
Floating (or flexible) exchange rates fluctuate in a wider range,
and the government makes no attempt to fix it against any base
currency. Appreciations and depreciations may occur from year to
year, each month, by the day, or every minute.
8
Exchange Rate Essentials: Examples
This figure shows the exchange rates of three currencies against the U.S. dollar.
The U.S. dollar is in a floating relationship with the yen, the pound, and the
Canadian dollar (or loonie). The U.S. dollar is subject to a great deal of volatility
because it is in a floating regime, or free float.
Exchange Rate Behavior: Selected Developed Countries, 1996-2012
9
Exchange Rate Essentials: Examples
This figure shows exchange rates of three currencies against the euro, introduced
in 1999. The pound and the yen float against the euro. The Danish krone provides
an example of a fixed exchange rate. There is only a tiny variation around this
rate, no more than plus or minus 2%. This type of fixed regime is known as a
band.
Exchange Rate Behavior: Selected Developed Countries, 1996-2012 (continued)
10
Exchange Rate Essentials: Examples
Argentina is an example of a middle ground, somewhere between a fixed rate and
a free float, called a managed float. Colombia is an example of a crawling peg.
The Colombian peso is allowed to crawl gradually, it steadily depreciates at an
almost constant rate for several years from 1996 to 2002. Dollarization occurred
in Ecuador in 2000, which is when a country unilaterally adopts the currency of
another country.
Selected Developing Countries, 1996-2012 (continued)
11
Foreign Exchange Market
The Foreign Exchange Market (forex or FX) is the set of markets
where foreign currencies and other assets are exchanged for
domestic ones
The participants:
1. Commercial banks and other depository institutions: transactions
involve buying/selling of deposits in different currencies for investment
purposes.
2. Non-bank financial institutions (mutual funds, hedge funds, securities
firms, insurance companies, pension funds) may buy/sell foreign
assets for investment.
3. Non-financial businesses conduct foreign currency transactions to
buy/sell goods, services and assets.
4. Central banks: conduct official international reserves transactions.
12
Foreign Exchange Market: Spot Rates and Forward Rates
Spot rates are exchange rates for currency exchanges “on the
spot,” or when trading is executed in the present.
Forward rates are exchange rates for currency exchanges that will
occur at a future (“forward”) date.
Forward dates are typically 30, 90, 180, or 360 days in the future.
Rates are negotiated between two parties in the present, but the
exchange occurs in the future
13
Foreign Exchange Market: appreciation/depreciation
Many factors:
Differences in prices.
Differences in interest rates.
Expectations about the performance of the domestic and the foreign
economies.
Political turmoil.
Financial turmoil.
….
Ultimately, it is all about the supply and demand of a currency.
Higher demand => the currency appreciates.
Higher supply => the currency depreciates.
What causes a currency to appreciate/depreciate?
14
Foreign Exchange Market: Supply and Demand Analysis
When people who are holding one currency want to exchange it for
U.S. dollars, they demand U.S. dollars and they supply that other
country’s currency.
So the factors that influence the demand for U.S. dollars also
influence the supply of Canadian dollars, E.U. euros, U.K. pounds,
and Japanese yen.
And the factors that influence the demand for another country’s
currency also influence the supply of U.S. dollars
The Demand for One Currency Is the Supply of Another Currency
15
Foreign Exchange Market: Supply and Demand Analysis
The quantity of U.S. dollars that traders plan to buy in the foreign
exchange market during a given period depends on
1. The exchange rate
2. World demand for U.S. exports
3. Interest rates in the United States and other countries
4. The expected future exchange rate
Demand in the Foreign Exchange Market
16
Foreign Exchange Market: Supply and Demand Analysis
The quantity of U.S. dollars supplied in the foreign exchange
market is the amount that traders plan to sell during a given time
period at a given exchange rate. This quantity depends on many
factors but the main ones are:
1. The exchange rate
2. U.S. demand for imports
3. Interest rates in the United States and other countries
4. The expected future exchange rate
Supply in the Foreign Exchange Market
17
Foreign Exchange Market: Supply and Demand Analysis
Equivalent Analysis: Recall that the Demand for one currency is
the Supply of another currency
€/US$
US$ (quantity)
D0US$
S1US$
S0US$
e0
e1
US$/€
€ (quantity)
D0Euro
D1Euro
S0Euro
e0
e1
Higher demand for the euro, D1> D0
Euro appreciates (US$ depreciates)
Higher supply of US$, S1> S0
US$ depreciates (euro appreciates)
(a) Euro’s Perspective (b) Dollar’s Perspective
18
Foreign Exchange Market: Supply and Demand Analysis
What causes the Demand of Foreign Currency (or the Supply of
Domestic Currency) to Shift? :
GDP changes
When a country’s income falls, the demand for imports falls.
Then demand for foreign currency to buy those imports falls.
Price level changes (inflation)
If the U.S. has more inflation than other countries, foreign goods will
become cheaper.
U.S. demand for foreign currencies will tend to increase, and foreign
demand for dollars will tend to decrease.
Interest rate changes
A rise in U.S. interest rates relative to those abroad will increase
demand for U.S. assets.
The demand for dollars will increase.
19
Foreign Exchange Market: Example 1 (Australia)
AUS$/US$
US$ (quantity)
S1US$
S0US$
Australia is a large exporter of
minerals.
Mineral prices in international markets
increased due to a larger international
demand during the 2000’s. This
increased the revenue of Australian
mineral companies abroad which
prompted a large inflow of US$ in
Australia. At the same time, the
Australian dollar appreciated with
respect to the US$.
The large inflow of US$ led to an
increase of the amount of US$ in
Australia (i.e., supply of US$ shifts to
the right). Thus, the AU$/US$
exchange rate decreased (i.e., an
appreciation of the Australian dollar
or US$ depreciation).D0
US$
1.0
1.2
1.4
1.6
1.8
2.0
100
150
200
250
300
350
400
450
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
AU
S$/U
S$
Min
eral
Pri
ce I
nd
ex 1
99
0=
10
0
Mineral Price Index Exchange rate (right axis)
e0
e1
20
Foreign Exchange Market: Central Bank Intervention
Central Bank Balance Sheet
Assets Liabilities
Foreign Assets Monetary base
Domestic Assets
Domestic Assets: Domestic government bonds, loans to domestic
commercial banks.
Foreign Assets: Foreign currencies, foreign government bonds.
Monetary Base: is the sum of currency in circulation and depositary
institution deposits at the Central Bank.
Some Central Bank Interventions:
Purchase/Sale of Domestic Assets: Open Market Operations
Purchase/Sale of Foreign Assets: Foreign Exchange Intervention
21
Foreign Exchange Market: Foreign Exchange Interventions
When the Central Bank needs “to defend” a certain level of exchange
rate, it will intervene in the Foreign Exchange Market as another agent.
For example, If a developing country has a fixed exchange rate (or
relatively fixed) with respect to the USD, an increase in the demand of
dollars would depreciate the local currency with respect to the USD.
However, the Central Bank can increase the supply of USD in the Foreign
Exchange Market by selling USD (in exchange of local currency) to avoid
the depreciation. This is possible as long as the Central Bank has enough
International Reserves (Foreign Assets)
Alternatively, if there is an increase in the supply of USD, the Central
Bank will demand more USD, buying the excess supply of USD in order
to avoid the appreciation. In exchange, the monetary authority will have to
“print” local currency and increase the monetary base.
22
Foreign Exchange Market: Example 2 (Argentina)
Argentinean households started to
exchange pesos for US$ in 2001
in anticipation of the economic
crisis. The central bank used its
international reserves to satisfy
this increase in the demand for
US$ (see the decline of foreign
reserves held by the central bank
of Argentina in the upper graph).
During 2001, demand and supply
of US$ moved in such a way that
it kept the exchange rate at
1 peso/US$ (point 1 in the bottom
graph).
When the central bank ran out of
enough foreign reserves to meet
the increasing demand for US$,
the peso devaluated (point 2 in the
bottom graph).D0
US$
S0US$
Peso/US$
US$ (quantity)
D1US$
10 1
2
D2US$
S1US$
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
pes
os/
US
$
mil
lion
s of
US
$
international reserves Exchange rate (right axis)
23
Arbitrage
• Operation that consist of purchasing cheap in one market and selling at a
more expensive price in another market. It can be applied to any asset.
• Example 1: Suppose that the US$/Euro exchange rate in the NY Stock
Exchange is 1.5 US$/€ and that in the Frankfurt Stock Exchange is
1.3US$/€.
What would you do with your $1,000 savings from your summer work?
……………….
Buy euros in Frankfurt => US$1,000/1.3US$/€ = 769.23 euros.
And sell the euros in NY => 769.23 euros * 1.5 US$/€ = US$1,153.84
You made a US$153.84 profit!
24
Arbitrage
• Will this arbitrage opportunity last?
• No; If many investors exchange US$ for euros in Frankfurt, the higher
demand for euros will appreciate the euro (depreciate the US$) and the
arbitrage opportunity will disappear.
US$/€
€ (quantity)
D€
D €
S €
e0
e1
25
Arbitrage: More than two currencies
• Example 2: Suppose that the US$/Euro exchange rate in the NY Stock
Exchange is 1.5 US$/€ and that the Mexican peso is exchanged against the
US$ at 0.09 US$/peso. In Frankfurt the euro/peso exchange rate is 0.05
€/peso. Is there any arbitrage opportunity?
Given the exchange rates of the US$/€ and the US$/peso in NY, the €/peso
exchange rate (cross rate) should be
0.09US$/peso /1.5US$/€ = 0.06€/peso
• If the exchange rate of the peso in Frankfurt is 0.05 €/ peso, there is an
arbitrage opportunity.
Using your US$1,000 from you summer work:
- Change US$ for euros in NY: US$1,000/1.5US$/€ = 666.67 euros.
- Buy pesos in Frankfurt: 666.67euros/0.05 €/peso =13,333.33 pesos
- Sell them in NY for US$: 13,333.33 pesos * 0.09 US$/peso = US$1,200
- You made US$200 profit!
26
Arbitrage: More than two currencies
• If many investors exchange euros for pesos in Frankfurt, the higher
demand for pesos will appreciate the peso (depreciate the euro) and the
arbitrage opportunity will disappear.
€/peso
peso (quantity)
Dpeso
Dpeso
Speso
e0
e1
27
Black Market for Foreign Currency
• It arises when the government or the central bank imposes some type of exchange
rate control. This is, a limit on the amount of foreign currency (usually US$) that
domestic agents can buy or sell in the official market. This restriction creates a
distortion in the market price (i.e., difference between the official rate and the black
market rate).Example in Valenzuela: the
limit of US$ imposed by the
Central Bank (qcontrol) leads
to an excess of demand of
US$ at the official rate (i.e.,
qdemanded) which creates a
shortage of US$ at the
official rate. Domestic
agents are willing to pay a
higher price (e1) in the black
market to meet their
increasing demand for US$.
Bolivar/US$
US$
(quantity)
D US$
S US$
e0= official rate
e1
qcontrol qdemanded
Shortage
qBMkt
