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Foreign Exchange

Foreign Exchange

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09/17/2010

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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.
place

• The market in which international currency trades take

 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

exchange rates

Copyright © 2003 Pearson Education, Inc.

Factors that Influence Exchange Rates
Relative Inflation Rates U.S. inflation ↑

$/£ r1 r0

S1 S0 D1 D0 Quantity of £

↑ U.S. demand for British goods, and hence £. ↓ British desire for U.S. goods, and hence the supply of £.

Copyright © 2003 Pearson Education, Inc.

Factors that Influence Exchange Rates
Relative Interest Rates U.S. interest rates ↑

$/£ r0 r1

S0 S1 D0 D1 Quantity of £

↓ 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

Copyright © 2003 Pearson Education, Inc.

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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