Foreign Exchange
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Introduction Exchange rates are important because they enable us
to translate different counties’ prices into comparable terms. Exchange rates are determined in the same way as other asset prices. The general goal of this chapter is to show:
• How exchange rates are determined • The role of exchange rates in international trade
Copyright © 2003 Pearson Education, Inc.
Slide 13-1
Exchange Rates and International Transactions Domestic and Foreign Prices • If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money. – Example: The dollar price of a £50 sweater with a dollar exchange rate of $1.50 per pound is (1.50 $/£) x (£50) = $75.
Copyright © 2003 Pearson Education, Inc.
Slide 13-2
Exchange Rates and International Transactions • Two types of changes in exchange rates: – Depreciation of home country’s currency – A rise in the home currency prices of a foreign currency – It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents.
– Appreciation of home country’s currency – A fall in the home price of a foreign currency – It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents.
Copyright © 2003 Pearson Education, Inc.
Slide 13-3
Exchange Rates and International Transactions Exchange Rates and Relative Prices • Import and export demands are influenced by relative prices. • Appreciation of a country’s currency: – Raises the relative price of its exports – Lowers the relative price of its imports
• Depreciation of a country’s currency: – Lowers the relative price of its exports – Raises the relative price of its imports
Copyright © 2003 Pearson Education, Inc.
Slide 13-4
The Foreign Exchange Market Exchange rates are determined in the foreign exchange market.
• The market in which international currency trades take place
The Actors • The major participants in the foreign exchange market are:
– Commercial banks – International corporations – Nonbank financial institutions – Central banks Copyright © 2003 Pearson Education, Inc.
Slide 13-5
Exchange Rates and International Transactions • Interbank trading – Foreign currency trading among banks – It accounts for most of the activity in the foreign exchange market.
Copyright © 2003 Pearson Education, Inc.
Slide 13-6
Exchange Rates and International Transactions Spot Rates and Forward Rates • Spot exchange rates – Apply to exchange currencies “on the spot”
• Forward exchange rates – Apply to exchange currencies on some future date at a prenegotiated exchange rate
• Forward and spot exchange rates, while not necessarily equal, do move closely together.
Copyright © 2003 Pearson Education, Inc.
Slide 13-7
Exchange Rates and International Transactions Foreign Exchange Swaps • Spot sales of a currency combined with a forward repurchase of the currency. • They make up a significant proportion of all foreign exchange trading.
Copyright © 2003 Pearson Education, Inc.
Slide 13-8
Exchange Rates and International Transactions Futures and Options • Futures contract – The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.
• Foreign exchange option – The owner has the right but not obligation to buy or sell a specified amount of foreign currency at a specified price.
Copyright © 2003 Pearson Education, Inc.
Slide 13-9
Exchange Rate Equilibrium An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.
$$
Copyright © 2003 Pearson Education, Inc.
$
Exchange Rate Equilibrium Value of £ $1.60 $1.55 $1.50
S: Supply of £ Equilibrium exchange rate D: Demand for £ Quantity of £
Copyright © 2003 Pearson Education, Inc.
Factors that Influence Exchange Rates e = f ( ∆INF , ∆INT , ∆INC , ∆GC , ∆EXP ) e =percentage change in the spot rate ∆ INF =change in the relative inflation rate ∆ INT= change in the relative interest rate ∆ INC= change in the relative income level ∆ GC=change in government controls ∆ EXP= change in expectations of future
Copyright © 2003 Pearson Education, Inc.
exchange rates
Factors that Influence Exchange Rates Relative Inflation Rates
$/£ r1 r0
S1 S0 D1 D0 Quantity of £
Copyright © 2003 Pearson Education, Inc.
U.S. inflation ↑ ⇒
↑ U.S. demand for British goods, and hence £.
⇒
↓ British desire for U.S. goods, and hence the supply of £.
Factors that Influence Exchange Rates Relative Interest Rates
$/£ r0 r1
S0 S1 D0 D1 Quantity of £
Copyright © 2003 Pearson Education, Inc.
U.S. interest rates ↑ ⇒
↓ U.S. demand for British bank deposits, and hence demand for £.
⇒
↑ British desire for U.S. bank deposits, and hence the supply of £. Slide 13-14
Factors that Influence Exchange Rates Expectations Foreign exchange markets react to any news that may have a future effect.
• News of a potential surge in U.S. inflation may cause currency traders to sell dollars.
Many institutional investors take currency positions based on anticipated interest rate movements in various countries.
Copyright © 2003 Pearson Education, Inc.
to translate different counties’ prices into comparable terms. Exchange rates are determined in the same way as other asset prices. The general goal of this chapter is to show:
• How exchange rates are determined • The role of exchange rates in international trade
Copyright © 2003 Pearson Education, Inc.
Slide 13-1
Exchange Rates and International Transactions Domestic and Foreign Prices • If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money. – Example: The dollar price of a £50 sweater with a dollar exchange rate of $1.50 per pound is (1.50 $/£) x (£50) = $75.
Copyright © 2003 Pearson Education, Inc.
Slide 13-2
Exchange Rates and International Transactions • Two types of changes in exchange rates: – Depreciation of home country’s currency – A rise in the home currency prices of a foreign currency – It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents.
– Appreciation of home country’s currency – A fall in the home price of a foreign currency – It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents.
Copyright © 2003 Pearson Education, Inc.
Slide 13-3
Exchange Rates and International Transactions Exchange Rates and Relative Prices • Import and export demands are influenced by relative prices. • Appreciation of a country’s currency: – Raises the relative price of its exports – Lowers the relative price of its imports
• Depreciation of a country’s currency: – Lowers the relative price of its exports – Raises the relative price of its imports
Copyright © 2003 Pearson Education, Inc.
Slide 13-4
The Foreign Exchange Market Exchange rates are determined in the foreign exchange market.
• The market in which international currency trades take place
The Actors • The major participants in the foreign exchange market are:
– Commercial banks – International corporations – Nonbank financial institutions – Central banks Copyright © 2003 Pearson Education, Inc.
Slide 13-5
Exchange Rates and International Transactions • Interbank trading – Foreign currency trading among banks – It accounts for most of the activity in the foreign exchange market.
Copyright © 2003 Pearson Education, Inc.
Slide 13-6
Exchange Rates and International Transactions Spot Rates and Forward Rates • Spot exchange rates – Apply to exchange currencies “on the spot”
• Forward exchange rates – Apply to exchange currencies on some future date at a prenegotiated exchange rate
• Forward and spot exchange rates, while not necessarily equal, do move closely together.
Copyright © 2003 Pearson Education, Inc.
Slide 13-7
Exchange Rates and International Transactions Foreign Exchange Swaps • Spot sales of a currency combined with a forward repurchase of the currency. • They make up a significant proportion of all foreign exchange trading.
Copyright © 2003 Pearson Education, Inc.
Slide 13-8
Exchange Rates and International Transactions Futures and Options • Futures contract – The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.
• Foreign exchange option – The owner has the right but not obligation to buy or sell a specified amount of foreign currency at a specified price.
Copyright © 2003 Pearson Education, Inc.
Slide 13-9
Exchange Rate Equilibrium An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.
$$
Copyright © 2003 Pearson Education, Inc.
$
Exchange Rate Equilibrium Value of £ $1.60 $1.55 $1.50
S: Supply of £ Equilibrium exchange rate D: Demand for £ Quantity of £
Copyright © 2003 Pearson Education, Inc.
Factors that Influence Exchange Rates e = f ( ∆INF , ∆INT , ∆INC , ∆GC , ∆EXP ) e =percentage change in the spot rate ∆ INF =change in the relative inflation rate ∆ INT= change in the relative interest rate ∆ INC= change in the relative income level ∆ GC=change in government controls ∆ EXP= change in expectations of future
Copyright © 2003 Pearson Education, Inc.
exchange rates
Factors that Influence Exchange Rates Relative Inflation Rates
$/£ r1 r0
S1 S0 D1 D0 Quantity of £
Copyright © 2003 Pearson Education, Inc.
U.S. inflation ↑ ⇒
↑ U.S. demand for British goods, and hence £.
⇒
↓ British desire for U.S. goods, and hence the supply of £.
Factors that Influence Exchange Rates Relative Interest Rates
$/£ r0 r1
S0 S1 D0 D1 Quantity of £
Copyright © 2003 Pearson Education, Inc.
U.S. interest rates ↑ ⇒
↓ U.S. demand for British bank deposits, and hence demand for £.
⇒
↑ British desire for U.S. bank deposits, and hence the supply of £. Slide 13-14
Factors that Influence Exchange Rates Expectations Foreign exchange markets react to any news that may have a future effect.
• News of a potential surge in U.S. inflation may cause currency traders to sell dollars.
Many institutional investors take currency positions based on anticipated interest rate movements in various countries.
Copyright © 2003 Pearson Education, Inc.
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