Chapter 13

The Foreign
Exchange
Market
 Foreign Exchange Market

• Most countries of the world have their own

currencies: the U.S dollar., the euro in
Europe, the Brazilian real, and the Chinese
yuan, just to name a few.
• The trading of currencies and banks
deposits is what makes up the foreign
exchange market.

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 What are Foreign Exchange Rates?

Two kinds of exchange rate transactions

make up the foreign exchange market:
– Spot transactions involve the near-immediate
exchange of bank deposits, completed at the
spot rate.
– Forward transactions involve exchanges at
some future date, completed at the forward
rate.

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 Foreign Exchange Market

• The next slide shows exchange rates for

four currencies from 1990-2006.
• Note the difference in rate fluctuations
during the period. Which appears most
volatile? The least?

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 Why Are Exchange Rates Important?

• When the currency of your country

appreciates relative to another country,
your country's goods prices  abroad and
foreign goods prices  in your country.
1. Makes domestic businesses less competitive
2. Benefits domestic consumers (you)

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 Why Are Exchange Rates Important?

• For example, in 1999, the euro was valued

at $1.18. On April 26, 2006, it was valued
at $1.36.
– Euro appreciated 15% (1.36-1.18) / 1.18
– Dollar depreciated 13% (0.75-0.85) / 0.85
Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18

We can see exchange rates in the WSJ.

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 Currency Symbol Buying Selling

Australian Dollar AUD 92.3 92.55

Bahrain Dinar BHD 256.6 256.85

Canadian Dollar CAD 90.1 90.35

China Yuan CNY 15.15 15.3

Danish Krone DKK 17.5 17.65

Euro EUR 136.1 136.35

Hong Kong Dollar HKD 12.3 12.45

Indian Rupee INR 1.6 1.65

Japanese Yen JPY 0.97 0.98

U.A.E Dirham AED 27.15 27.4

UK Pound Sterling GBP 166.2 166.45

US Dollar USD 99.6 99.85

13-8
 How is Foreign Exchange Traded?

• FX traded in over-the-counter market

1. Most trades involve buying and selling bank
deposits denominated in different currencies.
2. Trades in the foreign exchange market
involve transactions in excess of $1 million.
3. Typical consumers buy foreign currencies
from retail dealers, such as American
Express.

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 Exchange Rates in the Long Run

• Exchange rates are determined in markets

by the interaction of supply and demand.
• An important concept that drives the
forces of supply and demand is the Law
of One Price.

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 Exchange Rates in the Long Run: Law of
One Price

• The Law of One Price states that the price

of an identical good will be the same
throughout the world, regardless of which
country produces it.
• Example: American steel costs $100 per
ton, while Japanese steel costs 10,000 yen
per ton.

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 Exchange Rates in the Long Run: Law of
One Price
If E = 50 yen/$ then price are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen

If E = 100 yen/$ then price are:

American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen

• Law of one price  E = 100 yen/$

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 Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)

• The theory of PPP states that exchange

rates between two currencies will adjust to
reflect changes in price levels.
• PPP  Domestic price level  10%,
domestic currency  10%
– Application of law of one price to price levels
– Works in long run, not short run

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 Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)

• Problems with PPP

1. All goods are not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded
(e.g., haircuts, land, etc.)

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 Exchange Rates in the Long Run: PPP

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 Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

• Basic Principle: If a factor increases

demand for domestic goods relative to
foreign goods, the exchange rate 
• The four major factors are relative price
levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.

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 Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

• Relative price levels: a rise in relative

price levels cause a country’s currency
to depreciate.
• Tariffs and quotas: increasing trade barriers
causes a country’s currency to appreciate.

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 Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

• Preferences for domestic v. foreign goods:

increased demand for a country’s good
causes its currency to appreciate;
increased demand for imports causes the
domestic currency to depreciate.
• Productivity: if a country is more productive
relative to another, its currency
appreciates.

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 Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

• The following table summarizes these

relationships. By convention, we are
quoting, for example, the exchange rate, E,
as units of foreign currency / 1 US dollar.

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 Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run

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 Exchange Rates in the Short Run

• In the short run, it is key to recognize that

an exchange rate is nothing more than the
price of domestic bank deposits in terms of
foreign bank deposits.
• Because of this, we will rely on the tools
developed in Chapter 4 for the
determinants of asset demand.

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 Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets

• We will illustrate this with a simple example

• François the Foreigner can deposit excess
euros locally, or he can convert them to
U.S. dollars and deposit them in a U.S.
bank. The difference in expected returns
depends on two things: local interest rates
and expected future exchange rates.

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 Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets

• Al the American has a similar problem. He

can deposit excess dollars locally, or he
can convert them to euros and deposit
them in a foreign bank. The difference in
expected returns depends on two things:
local interest rates and expected future
exchange rates.

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 Exchange Rates in the Short Run:
Expected Returns and Interest Parity

Re for François Re for Al

D

E e
t 1  Et 
$ Deposits i iD
Et

F i F

E e
 Et
t 1 
F Deposits i Et

e D
i i F

E e
t 1  Et  D
i i F

E e
t 1  Et 
Relative R
Et Et

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 Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets

• What this shows is simple. As the relative

expected return on dollar assets increases
(decreases), both François and Al respond
by holding more (fewer) dollar assets and
fewer (more) foreign assets.
• This leads us to our formal title for what is
going on here: Interest Parity

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 Exchange Rates in the Short Run:
Expected Returns and Interest Parity

• Interest Parity Condition

– $ and F deposits perfect substitutes
t 1  Et
e
D F E
i i  (2)
Et
Example: if iD = 6% (US interest rate) and iF = 3%
(foreign currency interest rate), what is the expected
appreciation of the foreign currency?
Ete1  Et
 6%  3%  3%
Et

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 Exchange Rates in the Short Run:
Expected Returns and Interest Parity

Several things to recognize about the

interest rate parity condition:
•Expected returns are the same in both dollars
and foreign assets
•Equilibrium condition for the foreign exchange
market

Next, we will develop supply/demand curves to

explain how the exchange rate is determined.

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 Exchange Rates in the Short Run:
Expected Returns and Interest Parity

• To determine the equilibrium condition, we

must first determine the expected return in
terms of dollars on foreign deposits, RF.
• Next, we must determine the expected
return in terms of dollars on dollar
deposits, RD.

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 Deriving the Demand Curve

Assume iF = 5%, Eet+1 = 1 euro/$

Point
A: Et = 1.05 (1.00 – 1.05)/1.05 = -4.8%
B: Et = 1.00 (1.00 – 1.00)/1.00 = 0.0%
C: Et+1 = 0.95 (1.00 – 0.95)/0.95 = 5.2%

• The demand curve connects these points and is

downward sloping because when Et is higher,
expected appreciation of the dollar is higher.
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 Deriving the Supply Curve

• Deriving the Supply Curve

– There isn’t really anything to derive. We
will take the quantity of bank deposits,
bonds, and equities as fixed with respect
to exchange rates.

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 Exchange Rates in the Short Run:
Equilibrium

• Equilibrium
– Supply = Demand at E*
– If Et > E*, Demand < Supply, buy $, Et 
– If Et < E*, Demand > Supply, sell $, Et 

• The following figure illustrates this.

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 Exchange Rates in the Short Run:
Equilibrium

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 Explaining Changes
in Exchange Rates

• To understand how exchange rates shift in

time, we need to understand the factors
that shift expected returns for domestic and
foreign deposits.
• We will examine these separately, as well
as changes in the money supply and
exchange rate overshooting.

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 Explaining Changes in Exchange Rates:
Increase in iD

1. Demand curve
shifts right when
– iD : because
people want to
hold more dollars
2. This causes
domestic currency
to appreciate.

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 Explaining Changes in Exchange Rates:
Increase in iF

1. Demand curve
shifts left when
– iF : because
people want to
hold fewer dollars
2. This causes
domestic currency
to depreciate.

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 Explaining Changes in Exchange Rates:
Increase in Expected Future FX Rates

1. Demand curve
shifts left when
– Ete1 : because
people want to
hold more dollars
2. This causes
domestic currency
to appreciate.

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 Explaining Changes in Exchanges Rates

• Similar to determinants of exchange rates in the long-run,

the following changes increase the demand for foreign
goods (shifting the demand curve to the right), increasing Ete1
– Expected fall in relative U.S. price levels
– Expected increase in relative U.S. trade barriers
– Expected lower U.S. import demand
– Expected higher foreign demand for U.S. exports
– Expected higher relative U.S. productivity
• These are summarized in the following slides.

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Explaining Changes in Exchanges Rates
 Explaining Changes
in Exchanges Rates (cont.)