Chapter One

Exchange Rate and the Foreign

Exchange Market
 Exchange Rate
• It is the price of one currency in terms of another currency.

• Exchange rate can be quoted in two ways:

• Domestic currency per unit of foreign currency, i.e. the price of

the foreign currency in terms of birr called direct (“Ethiopian")
terms
– E.g. 30 birr per USD

• Foreign currency per units of the domestic currency, i.e. the

price of birr in terms of the foreign currency called indirect
(“American") terms
– E.g. 0.034 USD per birr
 Exchange Rate
• Foreign exchange rates are usually quoted by dealers.

• The rate at which the foreign currency is offered for sale is called
the bid price.

• The rate at which the foreign currency will be purchased is called

the ask price.

• The difference between the bid price and the ask price is known
as the spread and is the gross profit margin of the dealer.

• The spread will vary from dealer to dealer, from bank to bank,
from currency to currency, and according to market conditions.
 Exchange Rate

21/02/2020

Buying Selling
USD 32.2632 32.9085
GBP 39.8453 40.6422
EUR 35.0798 35.7814

Source: Commercial Bank of Ethiopia (CBE),

https://www.combanketh.et/More/CurrencyRate.as
px#top1
 Exchange Rate
• Care should be taken as to which exchange rate
definition is being used, particularly when we discuss
about changes in the rate.

• E.g.1: Let 1 birr=$0.034 be the old rate, and let 1birr = $0.028
be the new rate. In this case, birr has depreciated against the
dollar because at the new rate one needs less units of dollars to
purchase the same amount of birr.

• E.g.2: Let $1 = 30 birr be the old rate, and let $1 = 28 birr be the
new rate. Here, at the new rate, we need less units of birr to
purchase the same amount of dollar. Therefore, the birr has
appreciated against the dollar.
 The Foreign Exchange Market
• The market in which international currency trades take
place is called the foreign exchange market.

• Foreign exchange trading takes place in many financial

centers around the world and is made up primarily of
commercial banks, foreign exchange brokers and
other authorized agents.

• The most heavily traded currency is the US dollar which

is known as a vehicle currency because the currency is
widely used to denominate international
transactions.
 The Foreign Exchange Market
World’s top five financial centers as of September, 2019, Global
Financial Centers Index (GFCI) 26

Source:
https://www.zyen.com/media/documents/GFCI_26_Report_v1.0.pdf
The Functions of Foreign Exchange Markets
• The principal function of foreign exchange markets is the
transfer of funds or purchasing power from one nation to
another or from one currency to another.

• Current transactions for immediate delivery are carried out in

the spot market.

• Contracts to buy or sell for future delivery are carried out in the
forward and future markets (these are to be discussed later).

• Other functions include the provision of short term credits to

finance trade and the facilities in order to avoid foreign
exchange risks.
 Actors in the Foreign Exchange Market

 Retail Clients

• These are made up of business, international

investors, multinational corporations and the
like who need foreign exchange for the purpose
of operating their business.

• Usually, they do not directly purchase or sell

foreign currencies themselves, rather they
operate by placing buy/sell orders with the
commercial banks.
 Actors in the Foreign Exchange Market

 Commercial banks
• Every sizable international transaction involves the debiting and
crediting of accounts at commercial banks in various financial
centers.

• Carry out buy/sell orders from their retail clients and buy/sell
currencies on their own account (known as proprietary trading).

• The banks deal either directly with other banks (interbank trading)
or through foreign exchange brokers.

• The rates available to retail customers, called "retail" rates, are

usually less favorable than the "wholesale“ interbank rates.
 Actors in the Foreign Exchange Market

 Foreign exchange brokers

• Banks often buy and sell currencies via foreign exchange
brokers.

• Operating through such brokers is advantageous because

they collect buy and sell quotations for most currencies
from many banks, so that the most favorable quotation is
obtained quickly and at very low cost.

• The disadvantage of dealing through a broker is that a

small brokerage fee is payable which is not incurred in a
straight bank-to-bank deal.
 Actors in the Foreign Exchange
Market
 Central Banks
• Central banks frequently intervene to buy and sell their currencies
to influence the rate at which their currency is traded (common in a
fixed exchange rate systems).

• Even when the volume of central bank transactions is typically not

large (in the case of managed floating exchange rate system), the
impact of such transactions may be great.

• Participants in the foreign exchange market watch central bank

actions closely for clues about future macroeconomic policies that
may affect exchange rates.
 The Demand for and the Supply of Foreign
Exchange
• Demand side: Why does one need a foreign currency?

• To purchase goods (tangibles) and services (intangibles, e.g., freight

charges, insurance premiums, commissions, and travel expenses) from
abroad, i.e., to pay for imports

• To purchase financial assets (such as stocks and bonds) abroad, i.e., to

invest abroad

• To send a gift or investment income payments abroad

• To visit another country as a tourist

• To avoid losses or make profits

 The demand for foreign exchange
• The demand for any currency (Birr or USD) in the
foreign exchange market is a derived demand.

• That is, Birr or dollar is not demanded because it has

an intrinsic value in itself but rather because of what
it can buy.

• E.g. If pound appreciates against the dollar, that is

moves from $1.60/£1 towards $2/£1, the price of the
UK export to US importers increases, which leads to a
lower quantity of exports and with it a reduced
demand for pounds.
The demand for foreign exchange

E.g. Demand Schedule for Pound

The demand for foreign exchange
• The demand curve (D) for pound
slopes down from left to right.

• A right- ward shift of the demand

schedule for pounds could be due
to:
– A rise in US income,
– A change in US tastes in favor of UK
goods,
– A rise in the price of US goods

• All these factors would result in an

increased demand for UK exports
and hence pounds, shifting the
demand schedule to the right.
 The Demand for and the Supply of Foreign
Exchange
• Supply side: How does foreign exchange arise?

• The proceeds from export of goods and services

• From the purchase financial assets in the home

country

• From unilateral transfers or investment income

payments made to the home country

• From foreign tourist expenditures in the home country.

 The supply of foreign exchange
• The supply of a currency is in essence the domestic
demand for foreign currency.
– E.g. the supply of birr is Ethiopians demand for dollars
– Similarly, the supply of pounds is the UK demand for dollars

• As the pound appreciates, the cost of US exports becomes

cheaper for UK residents.

• As such, they demand more US exports and this results in

an increased demand for dollars which are purchased by
increasing the amount of pounds supplied in the foreign
exchange market.
The supply of foreign exchange
E.g. Supply Schedule for Pound
The supply of foreign exchange
• The supply curve (S) for
pound is upward-sloping.

• Its position will shift to the

right if there is
– an increase in UK income,
– a change in British tastes in
favor of US goods or
– a rise in UK prices.

• All these factors imply an

increased demand for US
goods and dollars which is
reflected in an increased
supply of pounds.
 Determination of exchange rate
 A simple model of the determination of the
spot exchange rate

• The basic tenet of the model is that the exchange

rate (the price) of a currency can be analyzed
like any other price using the tools of supply
and demand.

• The exchange rate of the Birr will be determined

by the intersection of the supply and demand
for birr on the foreign exchange market.
Determination of the spot exchange rate
• The exchange market brings
together those people that
wish to buy a currency
(which represents the
demand) with those that
wish to sell the currency
(which represents the
supply)

• Then the spot exchange rate

is determined by the
interaction of the supply
and demand for the
currency.
 Chang in the exchange rate
• Appreciation/Revaluation both convey the same message: an
increase in the value of the currency.

• However, appreciation of a currency is an increase in the

value of the currency because of market forces (i.e., the
interaction of demand and supply), while revaluation is an
increase in the value of the currency as the result a
deliberate policy action by monetary authorities.

• An appreciation of the Birr is a rise in the price of birr against

foreign currency .
– E.g. change in exchanger rate from 25 birr/$1 to 20 birr /$1
or from $0.03/1birr to $0.05/1birr.
 Chang in the exchange rate
• Depreciation/Devaluation both convey the same message:
a decrease in the value of the currency.

• However, depreciation of a currency is due to market

forces, while devaluation of a currency is a deliberate
policy measure by monetary authorities.

• A depreciation of the birr is a fall in the price of birr

against foreign currency.
– E.g. change in the exchange rate from 16 birr/ $1 to
30 birr/$1 or from $0.05/1birr to $0.03/1birr
 The Rate of Appreciation/Depreciation
• It is the percentage change in the value of a currency over some
period of time.

• Example 1: let ¥/$ = 100 in 2006 and let ¥/$ = 110 in 2007.

• Rate of appreciation of the dollar against the yen is equal to:

new value – old value divided by old value.

• That is, 110 - 100 / 100 = 0.10 or 10 percent.

• Example 2: let €/$ = 0.80 in 2000 and let €/$ = 0.60 in 2002.
• Calculate the rate of depreciation of dollar?
 Spot Rates and Forward Rates
 Spot Exchange Rate

• The foreign exchange transactions take place on the spot: two

parties agree to an exchange of bank deposits and execute the
deal immediately.

• Exchange rates governing such "on-the-spot" trading are called

spot exchange rates, and the deal is called a spot transaction.

• In practice, there is a two-day lag between a spot purchase or

sale, and the actual exchange of currencies to allow for
verification, paperwork and clearing of payments.
• E.g. £100 could be obtained immediately by paying $2.00 per
pound for a total of $200.
 Spot Rates and Forward Rates
Forward Exchange Rate

• Foreign exchange deals which specify a value date* farther

away than two days— often 30 days, 90 days, 180 days,
270 days or one years are called forward exchange rates.

– *Value date is the date on which the parties actually receive the
funds they have purchased

• E.g.: One could enter into an agreement today to purchase

£100 three months from today at $2.02 = £1 (forward rate).
After three months, s/he gets £100 for $202, regardless of
what the spot rate is at the time.
The concepts of premium and discount
 The concepts of premium and discount

• E.g. 1: Let the spot rate be $2 = £1, and let the

forward rate be $2.03 = £1.
• In this example, there is 1.5% premium on the
pound sterling.
• That is, 2.03 – 2.00/2.00 = 0.015 or 1.5%.

• E.g. 2: Let the spot rate be $2 = £1 and let the

forward rate be $1.96 = £1, calculate forward
discount on pound?
Nominal, Real and Effective Exchange Rates

 Nominal exchange rate

• The exchange rate that prevails at a given date

• It is the amount of foreign currency that will be obtained for

one birr in the foreign exchange market with no reference made
to what this means in terms of purchasing power of
goods/services.

• Change in the nominal exchange rate does not necessarily imply

that the country has become more or less competitive on
international markets, for such a measure we have to look at the
real exchange rate.
Nominal, Real and Effective Exchange Rates
Construction of NER and RER indices for the Pound

Note: The real exchange rate index is constructed by multiplying the

nominal exchange rate index by the UK price index and dividing this by
the US price index.
Nominal, Real and Effective Exchange Rates
 Construction of NEER index for Pound

• Assume that UK is conducting 30% of its foreign trade with the US and
70% of its trade with Germany.

Note: The effective exchange rate index is constructed by multiplying the

$/£ index by 0.3 and the DM/£ index by 0.7.
 Exchange rate regimes
• It is the system that a country’s monetary authority, generally
the central bank, adopts to establish the exchange rate of its
own currency against other currencies.

• Each country is free to adopt the exchange-rate regime that it

considers optimal, and will do so using mostly monetary policies.

• Exchange regimes are broadly classified as fixed and flexible, but

there are many different regimes which are in between these
extreme cases.
 Exchange rate regimes
Flexible exchange rates

• Exchange rates determined by global supply and demand of

currency.

• They are prices of foreign exchange determined by the

market, that can rapidly change due to supply and demand,
and are not pegged nor controlled by central banks.

• Changes in exchange rates in a floating (flexible) regime are

described as depreciations or appreciations.
 Exchange rate regimes
• There are two types of flexible exchange rates: pure
floating regimes and managed floating regimes.

 Pure/clean floating exchange rate regime

• Under a floating exchange rate regime the authorities do

not intervene to buy or sell their currency in the foreign
exchange market.

• Rather, they allow the value of their currency to change

due to fluctuations in the supply and demand of the
currency (i.e. market forces).
Pure/clean floating exchange rate regime
 Exchange rate regimes
 Managed/dirty floating exchange rate

• A system in which governments or the country’s central

bank may attempt to moderate exchange rate movements
without keeping exchange rates rigidly fixed.

• The central bank may occasionally intervene in order to

direct the country’s currency value into a certain direction.

• This is generally done in order to act as a buffer against

economic shocks and hence soften its effect in the
economy.
 Advantages
of Flexible Exchange Rate Regime

• Advocates of flexible exchange rates argue that

such rates are more efficient than a system of
fixed exchange rates to correct balance of
payments disequilibria.

• By allowing to achieve external balance easily and

automatically, flexible exchange rates facilitate
the achievement of internal balance (for example,
full employment and price stability).
 Disadvantages of Flexible Exchange Rate
Regime
• Uncertainty and diminished trade: the risks and
uncertainties associated with this system
discourages the flow of trade

• Terms-of -trade changes: if, for example, because

of the fluctuations in exchange rate, there is a
decline in the value of a currency (i.e.,
depreciation), then that will worsen the nation’s
terms of trade (that is, the nation has to export
more to finance a specific level of imports).
 Disadvantages of Flexible Exchange Rate
Regime
• Instability: flexible exchange rates may
destabilize the domestic economy because wide
fluctuations stimulate and then depress
industries producing exported goods.
• For example, for an economy which is operating
at full employment, depreciation results in an
inflationary situation: demand for the goods will
rise – total spending increases – pushing prices
upwards.
• Conversely, appreciation will lower exports and
increase imports – causing unemployment.
 Exchange rate regimes
 Fixed exchange rate regime
• In fixed exchange rate, also referred to as pegged exchanged
rate, the currency of a country is fixed, either to another
country’s currency, a basket of currencies or another measure
of value, such as gold.

• A regime where the central banks intervene in the market

with purchases and sales of foreign and domestic currency in
order to keep the exchange rate within limits, also known as
bands.

• Changes in the value of a currency in a fixed exchange rate

regime are called devaluation or revaluation.
Fixed exchange rate regime
 Advantages of fixed rate regimes

• Lower uncertainty: a fixed exchange rate

avoids the uncertainty (because the rate is
maintained within a relatively narrow band by
the operations of the monetary authorities)

• Because of lower uncertainty, such rates

reduce the transaction costs facing importers,
exporters, international borrowers, and
lenders.
 Disadvantages of fixed rate regimes
• Preventing adjustments for currencies that become
under-or -overvalued
• If overvalued, it will make exports uncompetitive, if
undervalued , it will cause inflation
• Current account imbalance
• Less flexibility, difficult to respond to temporary shocks
• Requiring large pool of reserves to support the
currency if it comes under pressure
• Conflict with other macro-objectives such as requiring
higher interest rate
 Flexible Vs Fixed Regimes
• No clear – cut conclusion as to which system is
superior to the other

• However, as a result of the great volatility in

exchange rates experienced over the past
decades, the balance seems towards
managed floating rates.
 Interaction of hedgers, arbitrageurs
and speculators
• Economic agents involved in the forward
exchange market are divided into three groups,
distinguished by their motives for participation in
the foreign exchange market.

o Hedgers

o Arbitrageurs

o Speculators
 Hedgers
• Hedgers are agents (usually firms/corporations)
that enter the forward exchange market to
protect themselves against exchange rate
fluctuations which entail exchange rate risk.

• By exchange risk we mean the risk of loss due to

adverse exchange rate movement.

• Hedgers avoid exchange risk by matching their

assets and liabilities in the foreign currency.
 Hedgers
• E.g. Consider an Ethiopian trader who has to pay
$15,000 for goods imported from USA in one year
time.
• Let, spot exchange rate = 30birr/$1 and the one year
forward exchange rate = 32birr/$1

• By buying dollar forward at this rate, the trader can be

sure that he only has to pay 480,000birr

• What might happen if the trader doesn’t involve in a

forward exchange contract?
 Hedgers
• If he doesn’t buy forward today, he runs the risk that in one
year’s time the spot exchange rate may be worse than
32birr/$1, such as 35birr/$1, which could mean that he has
to pay 525,000 birr

• Of course, the spot exchange rate in one year’s time may

be more favorable than 32birr/$1, such as 28birr/$1 in
which case he would only have had to pay 420,000birr

• But, by engaging in a forward exchange contract the trader

can be sure of the amount of dollar he will have to pay for
the imports, and as such protect himself against the risk
entailed by exchange rate fluctuation
 Arbitrageurs
• Arbitrage is the exploitation of price differentials of
identical or similar financial instruments on different
markets or in different forms for riskless guaranteed profits.

• An arbitrager simultaneously purchase and sale an asset to

profit from an imbalance in the price.

• Financial centre arbitrage: the act of exploiting exchange

rate differences among two currencies across financial
centers.
• Cross currency arbitrage: the act of exploiting a pricing
discrepancy among three different currencies in the
foreign exchange market.
 Arbitrageurs
• E.g.1: Financial center arbitrage
• The dollar-euro exchange rate is quoted at $1.89/₤1 in
New York and $1.87 /₤1 in London

• It would be profitable for banks to buy pounds in

London and simultaneously sell it in New York making a
2 cents guaranteed profit.

• Arbitrage continues until the dollar-euro exchange rate

quotation across financial centers is equalized.
 Arbitrageurs
• E.g. 2: Cross currency arbitrage
• Dollar-Pound = $1.88/ ₤1 , Dollar-Euro = $1.3/€1
 Euro-Pound = 1.88/1.3 = €1.4462/ ₤1

• What if €1.5/ ₤1?

• Then, a UK dealer wanting dollars would do better to first

obtain €1.5 and which would then buy $1.95 (1.5*1.3)
making 0.07 or 7 cent profit.

• The increased demand for euros would quickly appreciate

its rate against pound to the €1.4462/ ₤1 level.
 Speculators
• Speculators are agents that hope to make a profit
by accepting exchange rate risk.

• Speculators engage in the forward exchange

market because they believe that the future spot
rate corresponding to the date of the quoted
forward exchange rate will be different to the
quoted forward rate.

• Speculators attempt to predict price changes and

extract profit from the price moves in an asset.
 Speculators
• E.g. Let one-year dollar-euro forward rate is quoted at
$1.75/₤1, say the speculator feels that the spot will be
$1.6/₤1 in one year’s time.
• If the speculator have ₤1000 to invest, she may sell it
forward at $1.75/₤1 to obtain $1,750 and hope to change
the dollar back into pound in one year’s time at $1.6/₤1 to
get ₤1,093.75 making ₤ 93.75 profit.

• What if the speculator is wrong and the one-year spot

exchange rate is above $1.75/₤1, say $1.9 /₤1?

• Then, $1750 will worth only ₤921.05 making a loss of

₤78.95