International trade requires the exchange of currencies in the foreign exchange market. There are three main types of exchange rate systems - fixed rates, floating rates, and managed floats. Under a floating rate system, exchange rates are determined by supply and demand. The purchasing power parity theory suggests that exchange rates should adjust to offset inflation differences between countries. However, several real-world factors prevent perfect purchasing power parity. Long-run exchange rates are influenced by relative inflation rates, productivity, preferences, and trade policies like tariffs. Forward markets allow traders to hedge against exchange rate risk.
2. Table 8-1 Figure 8-1
7 8
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 Spot transactions involve the exchange of currencies
value
for immediate or “on the spot” delivery & payment
Bretton Woods exchange rate system
(adjustable-peg) The exchange rate at which such transactions take place
required countries get IMF approval to change their
exchange rates is called the spot exchange rate.
The system collapsed in the early 1970s
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 9 10
marketplace.
Spot & Forward Exchange Markets Forward Transaction
Forward transactions involve the purchase and sale of Forward Contract
Agreement to
foreign currencies for delivery & payment at some specific
exchange Thai Baht
future date, at a price specified in advance
for USD
The exchange rate at which these forward transactions
take place is the forward exchange rate Price: At 33 Baht/USD
Time: In the next 3
Forward exchange markets provide hedging for
months
investors to avoid possible large losses due to changes
Amount: 100,000 Baht
in the spot exchange rate.
Sign ______ (today)
11 12
3. Spot Transaction Forward Transaction
Watches Watches
U.S. Swiss U.S. Swiss
Importer Pay S Fr 100,000 Exporter Importer 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 = USD 80,000 Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver
in 30 days
On the delivery day If that day’s Spot rate = S Fr 1.20 /USD Actual cost = USD 80,070
(next 30 days)Then the Actual cost = USD 83,333
On the delivery day Forward rate = S Fr 1.2489 / USD
Actual cost = USD 80,070
13 14
The Importance of the Exchange Rate The Importance of the Exchange Rate
A country’s exchange rate level is important because, together with Exchange rate influences Trade deficits/surplus
domestic prices, the 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
the cost of foreign products sold in the country
influencing imports
upon trade, disputes among nations have arisen
Currency Appre products look more expensive over one governments’ decisions to intervene in the
Export less foreign exchange market
Import more Managed float system..
Trade Deficit
Currency Depre products look cheaper
Export more
Import less
Trade Surplus
15 16
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.
17 18
4. The Supply & Demand Model The Supply & Demand Model
Demand
Supply
The demand curve for dollars stems from foreign buyers The supply curve for dollars stems from Americans
of American goods & services, U.S. financial & real seeking to purchase foreign goods & services, financial &
assets real assets
The demand curve is downward sloping because, ceteris The supply curve slopes upward because, given other
factors, an increase in the dollar’s value reduces the price
paribus, a decline in the price of $ makes everything from
of foreign items in the United States.
the United States cheaper for foreign buyers.
19 20
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
Non-inflation factors weak-currency nations—i.e., they are likely to see their
2. preferences & product development (innovation) currencies depreciate over the years against currencies of
3. productivity behavior (growth) nations that experience lower inflation.
4. tariffs & quotas (trade restrictions)
21 22
Figure 8-3 Increase in Japanese Prices Purchasing Power Parity Theory
S2$
The purchasing power parity (PPP) theory says that
Exchange Rate
exchange rates adjust completely to offset the effects of
S1 $
different inflation rates in two countries
Under highly restrictive & unrealistic conditions, PPP theory
132 would always be valid
The law of one price states that the cost of a single
D2$ homogeneous good must be the same to an American or a
120
foreigner, whether purchased at home or abroad
D 1$
Q$
23 24
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
In U.S., 1 hamburger = 2 USD goods are non-tradable, some goods enjoy brand loyalty that keeps
Thailand experiences inflation of 10% their prices artificially high, and some goods sell at higher prices simply
In Thailand, 1 hamburger = 88 THB because of consumers’ forces of habit.
1 hamburger in Thailand = 1 hamburger in the U.S.
88 THB = 2 USD PPP theory works:
The new exchange rate = 44 THB/USD
well in accounting for major exchange rate movements
10% Inflation in Thailand 10% depre in THB
poorly in explaining short-to-intermediate term changes
25 26
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)
27 28
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 more Yen products look more attractive in world market
Yen appreciates more demand for THB
THB appreciates
29 30
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 U.S. puts more quotas
imported products less quantity of imported products
Imported products have higher prices U.S. people import less
U.S. people import less supply less USD
supply less USD USD appreciates
USD appreciates
31 32
Spot - Forward Spot - Forward
In your new business venture, you expect a shipment of Swiss watches in What is the actual cost in $ if the future spot rate = 5.8 S Fr/$
90 days. Upon delivery 90 days from now, you must pay the Swiss
Answer : Actual Cost = 142,000 / 5.8 = 24,482.76 USD.
company 142,000 Swiss francs.
If you enter 90 days Forward Contract and lock-in the forward rate at
What risk are you taking if you wait 90 days and then buy the needed
6.15 S Fr/$, what is the expected cost? What is the actual cost?
francs in the spot market?
Answer : Expected Cost = 142,000 / 6.15 = 23,089.43 USD.
Answer : I will face the foreign exchange rate risk. If Swiss francs is
Actual Cost = 142,000 / 6.15 = 23,089.43 USD.
appreciated in next 90 days, I need to use more USD, to buy 142,000
What is the benefit you get from entering Forward Contract?
Swiss francs.
Answer : Forward exchange markets provide hedging for me to avoid
What is the expected cost in $ if the current spot rate = 6.3 S Fr/$
possible large losses due to Swiss Francs appreciated in the spot
Answer : Expected Cost = 142,000/6.3 = 22,539.97 Swiss francs
exchange rate
33 34
More Exercise
Suppose you are importer, you expect a shipment of computers
from United State of America in 60 days. Upon delivery 60 days
from now, you must pay the US. company 200,000 USD.
1. What is the expected cost in THB if the current spot rate = 33.40 THB./$?
Answer: The expected cost = 200,000 * 33.4 = 6,680,000 THB
2. What is the actual cost in THB if the future spot rate = 34.30 THB./$ ?86
Answer : The actual cost = 200,000 * 34.3 = 6,860,000 THB
3. If you enter 60 days Forward Contract and lock-in the forward rate at 33.86
THB./$ what is the expected cost? What is the actual cost?
Answer: The expected cost = 200,000 * 33.86 = 6,772,000 THB
35
