THE FOREIGN EXCHANGE MARKET

It can be seen that, in the absence of intervention by the central bank in the foreign
exchange market, any deficit or surplus on the current account would be exactly offset by a
surplus or deficit on the capital account. For this to occur, a price quoted in each of the two
currencies must be found at which both parties to each transaction are willing to deal; this
price is the exchange rate. We now examine how the equilibrium exchange rate is
determined.

THE FOREIGN EXCHANGE RATE

The exchange rate is the price of one currency expressed in terms of another. With the
exception of the pound sterling, this is expressed as the number of units of the domestic
currency per unit of the foreign currency (for example, R/$). Once the domestic price of a
unit of the foreign currency is determined, the foreign price of a unit of the domestic currency
is given by the reciprocal of the domestic exchange rate; for example, R5/$ is equal to
$0.20/R.

The equilibrium exchange rate can be viewed as being the result of the interaction of forces
of supply and demand in the market for the foreign currency; indeed, as indicated above, if a
country is to avoid continual deficits and surpluses on the BOP, the exchange rate over time
must average that which would be determined in the foreign exchange market.

In the foreign exchange market, transactions for immediate delivery of the foreign currency
are carried out in the spot market, and contracts to buy or sell currencies for future delivery
are carried out in the forward market.

The Demand for Foreign Exchange

Demand for a foreign currency can arise from a number of sources:

• Imports of goods and services;

• Purchase of foreign financial or real assets;
• Speculation;
• Hedging.

Currency speculation involves the purchase of a currency now in the belief that it is going to
become more valuable in the future, so that the speculator would profit by the difference
between the low price at which the currency is bought and the (anticipated) high price at
which it is sold.

Hedging, by contrast, is an activity in which the risk of changes in the value of a currency is
avoided. For example, an importer typically acquires an obligation to make a foreign
currency payment in the future. In order to avoid the risk of the foreign currency becoming
more expensive by the time the payment falls due, the importer will hedge his obligation by
buying the currency now.

The Supply of Foreign Exchange

Supply of a foreign currency similarly arises from a number of sources:

• Exporters of goods and services;

• Foreign investment in the home country;
• Speculation;
• Hedging.
Speculation and hedging in this case are done for the same motives as described above.
For example, a belief that the rand will strengthen against the dollar would lead speculators
to buy rands in exchange for dollars, and then profit once the expected change in the
exchange rate has occurred. Similarly, foreign importers who wish to hedge their future rand
obligations would buy rand against dollars now.

The Foreign Exchange Market

The foreign exchange market is represented by the normal negatively sloped demand and
positively sloped supply curves. The exchange rate is measured on the vertical axis in the
number of units of the domestic currency for one unit of the foreign currency, and the
relevant foreign currency (say the U S dollar) on the horizontal axis. The equilibrium
exchange rate is, as usual, determined at the intersection of the two curves.

Increases in demand for the foreign currency (at all levels of the exchange rate) are
represented by a shift to the right of the demand curve, and decreases by a shift to the left.
Similarly, increases in the supply of the foreign currency (at all levels of the exchange rate)
are represented by shifts to the right of the supply curve, and decreases by shifts to the left.

A shift to the right of the demand curve (an increase in the demand for dollars) and/or a shift
to the left of the supply curve (a decrease in the supply of dollars) will result in an increase in
the R/$ exchange rate, which is called a depreciation of the rand against the dollar. Note
that a depreciation of the rand against the dollar means that the dollar has appreciated
against the rand.

A shift to the left of the demand curve (a decrease in the demand for dollars) and/or a shift to
the right of the supply curve (an increase in the supply of dollars) will result in a fall in the R/$
exchange rate, which is called an appreciation of the rand against the dollar. As above, this
means that the dollar has depreciated against the rand.

The Exchange Rate and the BOP

The demand and supply curves reflect the total demand and supply of foreign exchange,
including transactions arising from both the current and capital accounts.

Insert diagram showing current account and total D and S curves

The equilibrium exchange rate need not be that rate that balances the current account. For
example, at a rate below the equilibrium rate there is an excess demand for the foreign
currency and hence a current account deficit. This is matched by an excess supply of
foreign currency of an equal amount on the capital account, and hence a capital account
surplus. Under a system of freely floating exchange rates, the BOP would balance without
any need for intervention by the SARB. Note that this does not mean that the individual
components of the BOP will be in balance.

THE SPOT MARKET

The spot market, as mentioned above, is the market in which currency for immediate
delivery is traded.

The major participants in the foreign exchange market are the large commercial banks, who
trade both for their customers and in their own right to alter their portfolios of asset holdings.
These transactions occur mainly between the banks themselves in what is called the
interbank market, and commonly consist of the debiting and crediting of bank accounts (both
at home and abroad) without any physical delivery of the currencies taking place.
Large corporations, non-bank financial institutions and various government agencies,
including the central banks, also operate in the market.

The Role of Arbitrage

The foreign exchange market consists of many institutions that are widely dispersed across
the globe but, at any given point in time, these different institutions tend to generate the
same exchange rate for a currency.

This occurs because of arbitrage, which is the action of buying in a low-priced market and
selling in a high-priced market for the purpose of making a profit. This causes the price in
the low-priced market to be driven up and that in the high-priced market to be driven down,
and the arbitrage will continue until prices in the two markets are equalized. With the
relevant currencies being bought and sold at the same time, there is no risk attached to the
transaction and there are thus many potential arbitrageurs in the market. With the speed of
communications in the foreign market any profitable spread in exchange rates in different
locations will quickly be arbitraged away.

Arbitrage is also possible when exchange rates are not consistent between currencies. For
example, at R6/$ and $1.50/£, consistency demands that the R/£ rate must be equal to
R9/£. This arises because there are two ways in which sterling can be acquired; either
directly in return for rands, or by first buying dollars for rands and then using the dollars to
buy sterling.

A current R/£ rate of R10/£ would mean that profits can be made by simultaneously buying
and selling all three currencies in an operation referred to as triangular arbitrage which would
ensure cross-rate equality. Arbitrageurs would buy dollars at R6/$, use these dollars to buy
sterling at $1.50/£ and then use the sterling to buy rands at R10/£; for each unit of sterling
bought in this way, a profit of R1 would be made (to acquire the necessary $1.50 to by a unit
of sterling would cost R9, and the unit of sterling is then sold for R10). These operations
would have the effect of causing a depreciation in the R/$ rate and an appreciation in the R/£
rate, and they would continue until the cross-rates were consistent with one another.

Measures of the Spot Rate

The nominal spot rate for any one currency (which is the rate usually given in the financial
press and that at which actual trades occur), while it is useful, does not provide much
information.

Given the nature and structure of the two countries, it does not provide information about
what the spot rate should be; it does not provide information about changes in the strength
of the home currency relative to those of all of the country’s trading partners; and it does not
give any indication of the real cost of acquiring foreign goods and services in a world of
continually changing prices.

The effective exchange rate addresses the problem of assessing the relative strength or
weakness of a currency against those of a number of trading partners. Taking a simple
mean (or average) is not sufficient, and it is necessary to construct an index in the same way
that various price indices are constructed.

Each exchange rate is indexed to a given base year, with the index computed by:

eIi = ei / ei-base
where eIi = exchange rate index for currency i
ei = actual exchange rate for currency i
ei-base = exchange rate for currency i in the base year

it can be seen that the value of the index for the base year will be equal to 1, and all other
values for the exchange rate for any given year are valued relative to the base year. The
aggregate of the indices for each of the i currencies provides a measure against which it can
be seen if the domestic currency has appreciated or depreciated against the other
currencies as a group.

One further refinement is necessary; since all currencies are not equally important, a
weighting has to be applied to the index to reflect the relative importance of individual
currencies. The most commonly employed method of weighting is to assign importance to
currency i in line with the relative importance of country i’s trade with the home country:

wi = (Mi + Xi) / (Mtotal + Xtotal)

where

Σi w i = 1

The effective exchange rate (EER) is thus given by:

EER = Σi ei wi

Recent substantial depreciation in the nominal R/$ exchange rate has been accompanied by
the EER remaining relatively constant, as a result of the fact that all currencies have been
depreciating against the dollar, and not just the rand.

The real exchange rate (RER) addresses the problem of prices not remaining constant.
With prices changing in either or both of the home and foreign countries, changes in spot
rates will not reflect changes in the relative prices of foreign goods and services.
For this reason the RER is calculated which embodies the price changes in both countries:

USA
PI 1999
RER R / $1999  e1999 SA
PI 1999

Relatively higher inflation in South Africa accompanied by a depreciation in the nominal R/$
exchange rate in equal proportion to the inflation differential would leave the RER
unchanged. Whether or not the RER appreciates or depreciates would thus depend on
whether the nominal depreciation is smaller or greater (respectively) than the inflation
differential.

With price changes being the rule rather than the exception, it is important to analyze the
RER as well as the nominal exchange rate when analyzing the foreign exchange market.

Related to both of the above is the real effective exchange rate (REER) which calculates
the effective exchange rate based on real rather than nominal exchange rates. The EER is
calculated as above, but using real rates rather than nominal rates:

REER = Σi (RER index)i wi