International Economics

An Overview
Foreign exchange

Foreign exchange market

 Largest and most liquid market in the world __ total world turnover in a
single day in 2006 was USD 1400 billion (approx).
 No central market - key markets in several cities around the world
 Participating banks and brokers are in constant contact via phone and
computer

 Three general types of transaction

 Between banks and their customers
 Domestic interbank market conducted through brokers
 Trading with overseas banks____

Foreign Exchange___ SN (edited) 2

The Major Players

 The major players are____

 Individuals: tourists, migrants
 Firms: importers and exporters
 Banks: short position, long position, square position
 Governments/ monetary authorities: market intervention
 International agencies: lending
 Two tier market: First tier: ultimate customer and banker
 Second tier: between banks

 Classifications of participants__
 Non-banking entities: business transactions and hedging
 Banks: foreign exchange dealers
 Arbitrageurs: profit seeking from variations in rates in
different markets
 Speculators: profit seeking from movements in exchange
rates
Foreign Exchange___ SN (edited) 3
Foreign exchange

Types of FX transactions
 Spot transactions - executed nearly immediately

 Forward transactions - agreement to buy or sell a currency

at a date in the future, at a rate agreed in advance

 Currency swaps - agreement to trade one currency for

another now, and to trade currencies back again later, both
at prices agreed at the beginning

Foreign Exchange___ SN (edited) 4

Foreign exchange

Foreign exchange quotations

 Exchange rate is the price of one currency in terms of another
 One country’s currency has depreciated when more of it is
needed to buy a unit of a foreign currency (is worth less relative
to the other currency) [ direct quote like $ 1 = Rs. 39.75]

 A currency has appreciated when less of it is needed to buy a

foreign currency (is worth more relative to the other currency)

 Two –way quote: $ 1 = INR 39.72 / 77

 With a spread of .05

Foreign Exchange___ SN (edited) 5

Foreign exchange
Foreign exchange quotations

 Cross exchange rate between two currencies is

calculated from their exchange rates with a third,
benchmark currency - frequently the US dollar

 Since USD is the anchor currency, any INR / CAD

rate will be given by dealer in India with the help of
cross rates___ through INR / USD and CAD / USD
rates

Foreign Exchange___ SN (edited) 6

Foreign exchange markets
Forward markets, futures & options

 Forward contracts obligate buyer to buy or sell a certain amount

of foreign currency at a future date_ margin money deposited
with the seller bank

 Usually made between banks and firms who expect to

receive or make payments in foreign currency; the amount of
currency and the date are set by the agreement

Foreign Exchange___ SN (edited) 7

Some concepts

 Appreciation
 Depreciation
 Cross rates
 Anchor currency
 Arbitrage
 Speculation
 Open position
 Close position

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Foreign exchange markets
Forward markets, futures & options

 Futures, traded on special exchanges, are contracts

to trade given amounts of currencies at a specified
date
 Only a small number of major currencies can
be so traded, and only in fixed lots with fixed
trade dates

Foreign Exchange___ SN (edited) 9

Foreign exchange markets
Forward markets, futures & options

 Options provide the holder with the right (but not the obligation)
to buy or sell foreign currencies at an agreed rate within a
period of time, in return for a fee paid to the seller of the option

 Options to buy are called call options, and those to sell are
called put options
 Options are frequently used to reduce risk from exchange
rate changes
 Other concepts__ Option : In-the-money: Out-of-the money:
At –the- money
 Asset price, strike price

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Foreign exchange markets

Exchange rate determination

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Theory #1: Purchasing power parity [ Cassel, 1927]

Law of One Price

Versions of
PURCHASING Absolute PPP
POWER
PARITY

Relative PPP

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 The Law of One Price

 A commodity will have the same price in terms of common

currency in every country
 In the absence of frictions (e.g. shipping costs, tariffs,..)

 Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate

P€ = s€/$ • P$

Foreign Exchange___ SN (edited) 13

Absolute PPP

 Extension of law of one price to a basket of goods

 Absolute PPP examines price levels

 Apply the law of one price to a basket of goods with
price P€ and PUS (use upper-case P for the price of the
basket):

where P€ = Σi (wFR,i • p€,i )

PUS = Σi (wUS,i • pUS,i )
S€/$ = P€ / PUS

Foreign Exchange___ SN (edited) 14

Relative PPP

Absolute PPP:
P€ = s€/$ • P$

For PPP to hold in one year:

P€ (1 + i€) = E(s€/$) • P$ (1 + i$),

or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] • P$ (1 + i$)

Using absolute PPP to cancel terms and rearranging:

1 + i€ = E(s€/$)
1 + i$ s€/$
Foreign Exchange___ SN (edited) 15
Relative PPP:
Relative PPP
 Main idea – The difference between (expected) inflation
rates equals the (expected) rate of change in exchange
rates:

1 + i€ = E(s€/$)
1 + i$ s€/$

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 Interest Rate Parity
START (today) END (in one
year) r$=2.24%
$117,228 $117,228 • 1.0224 = $119,854
(Invest in $)

s€/$=0.83215 One year f€/$=0.83435

(Invest in €)
$117,228 • 0.83215 = 97,551€ 97,551€ • 1.0251 = 100,000€
r€=2.51%
Foreign Exchange___ SN (edited) 17
Summary of theories #1 and #2:
.
Difference in Exp. difference in
interest rates inflation rates
1 + r€ 1 + i€
1 + r$ 1 + i$
Interest
Rate Relative PPP
parity
Difference between Expected change
forward & spot rates in spot rate
f€r/$ E(s€/$)
s€/$ s€/$
Foreign Exchange___ SN (edited) 18
Theory #3: The Fisher condition

 Main idea: Market forces tend to allocate resources to their

most productive uses

 So all countries should have equal real rates of interest

 Relation between real and nominal interest rates:

(1 + rNominal) = (1 + rReal)(1 + i )

(1 + rReal) = (1 + rNominal) / (1 + i )

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Theory #4: Expectations theory of forward rates

 Main idea:
 The forward rate equals expected spot
exchange rate f€/$ = E(s€/$)

f€/$ = E(s€/$ )
Expectations theory s€/$ s€/$

of forward rates:
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Important Relations

 1. i = R + п [ nominal interest = real interest + inflation rate]

 Fisher Equation

 2. F = S + S [ ( i – i* )/ 1+i* ] , or
 (F – S )/ S = ( i – i* ) [ approx.]  Covered interest parity

 3. i = r + x
 [ nominal rate = real rate + expected rate of depreciation of
exchange rate] ==, uncovered interest parity

 4. Forward rate is the unbiased expected value of future

spot rate
 These four relations can be related like the next slide==. 

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Summary of all four theories

.
Fisher
Difference in Exp. difference in
Theory
interest rates inflation rates
1 + r€ 1 + i€
1 + r$ 1 + i$
Interest
Rate Relative PPP
parity
Difference between Expected change
forward & spot rates in spot rate
f€/$ Exp. Theory E(s€/$)
s€/$ of forward s€/$
rates
Foreign Exchange___ SN (edited) 22
Foreign exchange
Impact of an appreciating Indian Rupee

 Pros  Cons
 Lower prices on  Exporters’ products
foreign goods become more
 Keeps inflation down expensive abroad
 Foreign travel is  Imports-competing

cheaper firms face price

 Less expensive to competition
 Travel more expensive
invest abroad
for foreign tourists
 Slows inflow of foreign
investment

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Foreign exchange
Impact of a depreciating Indian Rupee

 Pros  Cons
 Exporters can sell  Higher prices on
abroad more easily imports
 Less competition for  Upward pressure on
Indian firms from inflation
imports  Travel abroad more
 Foreign tourism is expensive
encouraged  Harder for Indian firms
 Indian capital markets to expand into foreign
more attractive markets

Foreign Exchange___ SN (edited) 24

Foreign exchange markets
Arbitrage and hedging

 Exchange arbitrage involves taking advantage of exchange rate

differences in different markets to make a profit
 Helps equalize exchange rates globally

 Three point Arbitrage__ Pound, Dollar and Euro__ example

 Three point arbitrage___ let GBP 1 = $ 1.50,

GBP 1 = franc 4, and franc 1 = $ 0.50
 arbitrage facility can make a profit by buy and sell of currency through
3-point arbitrage

 Interest arbitrage involves taking advantage of differences in

international interest rates to get a higher return__
 Subject to exchange rate risk

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Foreign exchange markets

Arbitrage and hedging

 Hedging involves making use of forward contracts or options to
minimize exchange rate risk in international transactions

 Firms which expect to need to make or receive payments in

the future can use forward contracts or options to “lock in”
rates and avoid the disruptive effects of sudden exchange
rate swings

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Foreign exchange markets

Speculation

 Speculation differs from arbitrage, in that it involves the

purchase or sale of a currency in the expectation that its value
will change in the future__ basically a position is created in the
expectation of positive gain

 Speculation can either reduce or increase volatility in foreign exchange

rates

 If speculators expect a current trend in rates to change, then their

purchase or sale moderates the price movements
 If they expect a current trend in rates to continue, their transactions
can accelerate the rise or fall of the target currency

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What about Indian rupee ?

 How rupee’s exchange rate is determined ?

 Present scenario___ INR has appreciated about 12 % in the
last one year…..

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Big Mac Index

 Index

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