Money, Banking, and Financial Markets about the foreign exchange market

1. Chapter 8 International Trade Foreign Exchange
Nations engage in international trade for the same reason that
individuals engage in domestic trade
Comparative Advantage Specialization & Int. Trade
The Foreign Exchange Market Improve productivity More Consumption, Income
Increase standard of living
International trade requires the exchange of currencies
Currency exchange is often regulated by government.
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The Foreign Exchange Market The Foreign Exchange Market
The foreign exchange (ForEx) market is the market in which parties International capital flows
exchange national currencies The acquisition of financial & real assets across national borders
90% of foreign exchange volume is associated with capital flows
It is not a public outcry auction market, but rather operates as a computer (investment markets)
driven over-the-counter market
The direct or immediate participants (Dealers) U.S. & foreign
The volume of activity has escalated dramatically in response to the growth commercial banks with international deposits & foreign branches
in world trade volume in goods & services.
The ultimate participants import & export firms, tourists & other
travelers, & financial entities seeking to invest internationally.
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The Foreign Exchange Rate The Foreign Exchange Rate
The price at which one nation’s currency is exchanged for another’s is the The price at which one nation’s currency is exchanged for another’s is the
foreign exchange rate foreign exchange rate
An exchange rate exists between each pair of nations that engage in trade An exchange rate exists between each pair of nations that engage in trade
using different currencies using different currencies
A currency appreciates against other currencies when a single unit of that It depreciates against other currencies when when a single unit of that
currency buys more units of these foreign currency currency buys less units of these foreign currency
Last month: THB 34.50 / $ Last month: $ 1.54 / £
This month: THB 32.25 / $ This month: $ 1.33 / £
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2. Table 8-1 Figure 8-1
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Fixed & Floating Exchange Rates Spot & Forward Exchange Markets
Fixed exchange rates : exchange rates do not change & countries must
act to maintain some predetermined level of value Spot transactions involve the exchange of currencies for immediate or
(adjustable-
Bretton Woods exchange rate system (adjustable-peg) “on the spot” delivery & payment
required countries get IMF approval to change their exchange rates
The system collapsed in the early 1970s The exchange rate at which such transactions take place is called the
spot exchange rate.
Major industrial states’ currencies currently float according to supply &
demand for each currency
Floating exchange rates : exchange rates continuously change
according to supply & demand in the world marketplace.
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Spot & Forward Exchange Markets Forward Transaction
Forward transactions involve the purchase and sale of foreign currencies
Forward Contract
for delivery & payment at some specific future date, at a price specified in Agreement to exchange
advance Thai Baht for USD
The exchange rate at which these forward transactions take place is
the forward exchange rate
Price: At 33 Baht/USD
Forward exchange markets provide hedging for investors to avoid Time: In the next 3 months
possible large losses due to changes in the spot exchange rate.
Amount: 100,000 Baht
Sign ______ (today)
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3. Spot Transaction Forward Transaction
Watches Watches
U.S. Swiss U.S. Swiss
Importer 100,
Pay S Fr 100,000 Exporter Importer 100,
Pay S Fr 100,000 Exporter
in 30 days in 30 days
Today Spot rate = S Fr 1.25 / USD Today Spot rate = S Fr 1.25 / USD
Expected cost = Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver in 30 days
Actual cost =
On the delivery day If that day’s Spot rate = S Fr 1.20 / USD
(next 30 days) Then the Actual cost = On the delivery day Forward rate = S Fr 1.2489 / USD
Actual cost =
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The Importance of the Exchange Rate The Importance of the Exchange Rate
A country’s exchange rate level is important because, together with domestic prices, the Exchange rate influences Trade deficits/surplus
exchange rate determines
the cost of the nation’s products in foreign nations
influencing the nation’s exports
Because of the large influence of currency values upon trade,
the cost of foreign products sold in the country
influencing imports
disputes among nations have arisen over one governments’
Currency Appre products look more expensive decisions to intervene in the foreign exchange market
Export less Managed float system..
Import more
Trade Deficit
Currency Depre products look cheaper
Export more
Import less
Trade Surplus
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Exchange Rate Determination Figure 8-2
The foreign exchange market is highly competitive
many small buyers & small sellers relative to the total market
homogenous product--a national currency
In Freely Floating Exchange Rates, governments rarely intervene exchange
rates are driven entirely by supply & demand
In a Managed Float (the system in place today), governments sometimes
intervene in an effort to prevent exchange rate movements perceived to be
excessive or strongly at odds with national interests.
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4. The Supply & Demand Model The Supply & Demand Model
Demand
Supply
The demand curve for dollars stems from foreign buyers of American The supply curve for dollars stems from Americans seeking to purchase
goods & services, U.S. financial & real assets foreign goods & services, financial & real assets
The demand curve is downward sloping because, ceteris paribus, a The supply curve slopes upward because, given other factors, an
decline in the price of $ makes everything from the United States increase in the dollar’s value reduces the price of foreign items in the
United States.
cheaper for foreign buyers.
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Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants
1. Relative Price Level Behavior (Inflation) 1. Relative Price Level Behavior (Inflation)
Nations with chronically high inflation are likely to be weak-currency
Non-inflation factors nations—i.e., they are likely to see their currencies depreciate over the
2. preferences & product development (innovation) years against currencies of nations that experience lower inflation.
3. productivity behavior (growth)
4. tariffs & quotas (trade restrictions)
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Figure 8-3 Increase in Japanese Prices Purchasing Power Parity Theory
The purchasing power parity (PPP) theory says that exchange rates adjust
Exchange Rate
completely to offset the effects of different inflation rates in two countries
S1$
Under highly restrictive & unrealistic conditions, PPP theory would
always be valid
The law of one price states that the cost of a single homogeneous good
must be the same to an American or a foreigner, whether purchased at
home or abroad
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D 1$
Q$
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5. Purchasing Power Parity Theory Purchasing Power Parity Theory
Original exchange rate = 40 THB/USD Why PPP doesn’t always work in the real world
In Thailand, 1 hamburger = 80 THB In the real world, many products are not homogeneous in nature, some goods are non-
In U.S., 1 hamburger = 2 USD tradable, some goods enjoy brand loyalty that keeps their prices artificially high, and
Thailand experiences inflation of 10% some goods sell at higher prices simply because of consumers’ forces of habit.
In Thailand, 1 hamburger = 88 THB
1 hamburger in Thailand = 1 hamburger in the U.S. PPP theory works:
88 THB = 2 USD
well in accounting for major exchange rate movements
The new exchange rate = 44 THB/USD
poorly in explaining short-to-intermediate term changes
10% Inflation in Thailand 10% ________in THB
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Figure 8-4 Long-Run Exchange Rate Determinants
Non-inflation factors
2. preferences & product development (innovation)
3. productivity behavior (growth)
4. tariffs & quotas (trade restrictions)
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Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants
2. Preferences & Product Development 3. Productivity
Japan produces new bread toaster improve in productivity production costs fall
Foreigners start importing this new product Thai products have lower prices
Foreigners demand ______Yen products look more attractive in world market
Yen _________ more ________for THB
THB ________
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6. Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants
4. Tariffs and Quotas 4. Tariffs and Quotas
U.S. puts more tariffs more tax on imported U.S. puts more quotas
products less quantity of imported products
Imported products have higher prices U.S. people import _____
U.S. people import _______ supply _____USD
supply _____USD USD _____________
USD ____________
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Spot - Forward
In your new business venture, you expect a shipment of Swiss watches in 90 days. Upon
delivery 90 days from now, you must pay the Swiss company 142,000 Swiss francs.
What risk are you taking if you wait 90 days and then buy the needed francs in the
spot market?
What is the expected cost in $ if the current spot rate = 6.3 S Fr/$
What is the actual cost in $ if the future spot rate = 5.8 S Fr/$
If you enter 90 days Forward Contract and lock-in the forward rate at 6.15 S Fr/$,
what is the expected cost? What is the actual cost?
What is the benefit you get from entering Forward Contract?
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