Foreign Exchange Market

Meaning
 The foreign exchange market (Forex,
FX, or currency market) is a global
decentralized or over-the-counter
(OTC) market for the trading of
currencies.
 This market determines foreign
exchange rates for every currency. It
includes all aspects of buying, selling
and exchanging currencies at current
or determined prices.
Continue
 The foreign exchange market is an
over-the-counter (OTC) marketplace
that determines the exchange rate for
global currencies.
 Participants are able to buy, sell,
exchange and speculate on
currencies.
 Foreign exchange markets are made
up of banks, forex dealers,
commercial companies, central banks,
investment management firms, and
investors.
Purpose of the foreign exchange
market
 The purpose of the foreign exchange
market is to help international trade
and investment.
 A foreign exchange market helps
businesses convert one currency to
another.
 For example, it permits a U.S.
business to import Rwandan goods
and pay RWF, even though the
business's income is in U.S. dollars.
PARTICIPANTS IN THE
FOREIGN EXCHANGE
MARKET
 All Scheduled Commercial Banks
(Authorized Dealers only).
 National Bank of Rwanda(NBR).
 Public Sector/Government.
 Resident Rwandans
 Exchange Companies
 Money Changers
Continue
 Level 1: Tourists, importers, exporters,
investors- immediate users & suppliers
of foreign currencies.
 Level 2: Commercial banks- they act
as clearing houses between users and
earners, do not actually buy & sell- Retail
market
 Level 3: Forex brokers- They deal with
commercial banks.
 Level 4: Nation’s central bank: Act as
Lender/ Buyer of last resort- Interbank
market/ wholesale market
Meaning of Foreign Exchange
Transaction
 Any financial transaction that involves
more than one currency is a foreign
exchange transaction.
 Most important characteristic of a
foreign exchange transaction is that it
involves Foreign Exchange Risk.
Components of a Standard FX
Transaction
 Base Currency (USD/RWF)
 Dealt’ or ‘Variable’ Currency
 Exchange Rate
 Amount
 Deal Date
 Value Date
 Settlement Instructions
Value Date Conventions
Currencies are traded both in Ready and
forward value dates.
 1) Ready: Settlement on the deal date. e.g.
Rwanda
 2) Value Tom : Settlement on next day. e.g.
Canada
 3) Spot Transaction : Settlement usually in two
working days. In International FX transactions,
Spot is the Standard value date.

Why Spot Date ?

Time Zone Difference

 4) Forward Transaction: Settlement at some

future date ahead of the spot.
FORWARD
TRANSACTIONS
 Out right sale/purchase of a currency against
the other for settlement at a future date at the
predetermined exchange rate
 Forward rates are quoted as premium or
discount over spot rate.
 Forward rates depend upon interest rate
differential between the two currencies.
 Currency with higher interest rates is at
discount w.r.t currency having lower interest
rate.
 Currency with lower interest rates is at
premium w.r.t currency having higher interest
rate.
continue
Forward Premium-
when, Forward rate > Spot Rate
 Forward Discount-
when, Forward rate < Spot Rate
Meaning of Arbitrage
Simultaneous purchase and sale of
the same assets / commodities on
different markets to profit from price
discrepancies.
 Eg. If the dollar price of pounds were
$1.98 in New York and $ 2.01 in
London, an arbitrageur would
purchase pounds at $1.98 in New York
and immediately resell them in London
for $2.01, thus realizing a profit of
$0.03 per pound.
Appreciation and Depreciation of
Currency
 When a currency becomes more
valuable in terms of other currencies,
economists say the currency
appreciates.
 When a currency becomes less
valuable in terms of other currencies,
it depreciates.
 Movements in exchange rates, ceteris
paribus, affect the relative prices of
goods, services, and assets in
Example of depreciation of
currency
 If US demand for Rwandan goods
increased, more RWF would be
needed to pay for the goods, and so
the demand for RWF would increase.
This change increases the dollar price
of RWF, which means there has been
a depreciation of the US dollar relative
to the RWF.
Example of appreciation of
currency
 Conversely, if Rwanda demand for US
goods increased, more dollars would
be needed to pay for the goods, and
the supply of RWF would increase.
This change will decrease the dollar
price of RWF, which means there has
been an appreciation of the US dollar
relative to the RWF.
Meaning of Exchange rate
 Exchange Rate is the price of one
country's currency expressed in another
country's currency.
 In other words, the rate at which one
currency can be exchanged for another.
e.g. 1 USD = 912 RWF
Major currencies of the world
 USD
 EURO
 YEN
 POUND STERLING
Example of Exchange Rate
FOREIGN EXCHANGE
REGIMES
 FIXED EXCHANGE RATE
 FLOATING EXCHANGE RATE
1. FIXED EXCHANGE RATE SYSTEM

 A fixed, or pegged, rate is a rate the

government (central bank) sets and
maintains as the official exchange rate. A
set price will be determined against a
major world currency (usually the U.S.
dollar, but also other major currencies
such as the euro, the yen, or a basket of
currencies).
 In order to maintain the local exchange
rate, the central bank buys and sells its
own currency on the foreign exchange
market in return for the currency to which
it is pegged.
Continue
 If, for example, it is determined that the value
of a single unit of local currency is equal to
USD 3.00, the central bank will have to
ensure that it can supply the market with
those dollars.
 In order to maintain the rate, the central bank
must keep a high level of foreign reserves.
This is a reserved amount of foreign currency
held by the central bank which it can use to
release (or absorb) extra funds into (or out of)
the market. This ensures an appropriate
money supply, appropriate fluctuations in the
market (inflation/deflation), and ultimately, the
exchange rate.
Continue
 The central Bank can also adjust the
official exchange rate when necessary.
The purpose of a fixed rate system is to
maintain a country’s currency value
within a very narrow band.
 The Central Bank holds foreign currency
reserves in order to intervene in the
foreign exchange market, when the
demand and supply of foreign exchange
(say pound) are note equal at the fixed
rate. This is explained in figure 1.
Continue : Excess demand for
pound
 D and S are the demand and supply curves
of Pound. They determine the exchange rate
E which is the authority maintains.
 Suppose the demand for pound is more than
supply of pound, as shown by P,P1 in the
figure given the supply (S curve). This lead to
rise in the exchange rate to E2,when the new
demand curves D1 intersects the supply
curve S. To maintain the exchange rate at the
level E, the Central bank will continue to
supply additional pounds to the market from
its reserves till the exchange rate E is
reached.
Graph
Continue: Excess supply of
Pound
 In the opposite case, If there is excess
supply of pounds equal to P,P2 in the
market given the demand (D curve),
the exchange rate falls to E2 , as
shown by the rightward shift of the
supply curve to S1 and it is
intersecting the D curve at P2. The
monetary authority will start buying
these excess pounds from the market
till the exchange rate E is reached.
Graph
ADVANTAGES OF FIXED EXCHANGE RATE
SYSTEM

 Avoid Currency Fluctuations. If the value of

currencies fluctuate significantly this can
cause problems for firms engaged in trade.
For example : If a firm relied on imported raw
materials a devaluation would increase the
costs of imports and would reduce
profitability.
 Stability encourages investment. The
uncertainty of exchange rate fluctuations can
reduce the incentive for firms to invest in
export capacity. Some Japanese firms have
said that the UK’s reluctance to join the Euro
and provide a stable exchange rates market
the UK a less desirable place to invest.
Continue
 Keep inflation Low. Governments who
allow their exchange rate to devalue may
cause inflationary pressures to occur.
This is because AD increases, import
prices increase and firms have less
incentive to cut costs.
 A rapid appreciation in the exchange rate
will badly effect manufacturing firms who
export, this may also cause a worsening
of the current account.
 Joining a fixed exchange rate may cause
inflationary expectations to be lower.
Continue
 Helpful for Small Nations.
 It promotes international trade.
 No adverse effect of speculation.
There is no fear of any adverse effect
of speculation on the exchange rate,
as speculative activities are controlled
and prevented by the monetary
authorities under a regime of fixed
exchange rates.
DISADVANTAGES OF FIXED
EXCHANGE RATE SYSTEM
1. Conflict with other objectives. To maintain a
fixed level of the exchange rate may conflict
with other macroeconomic objectives.
 If a currency is falling below its band the
government will have to intervene. It can do this
by buying sterling but this is only a short term
measure.
 The most effective way to increase the value of a
currency is to raise interest rates. This will
increase hot money flows and also reduce
inflationary pressures.
 However higher interest rates will cause lower
AD and economic growth, if the economy is
growing slowly this may cause a recession and
rising unemployment.
Continue
 2. Less Flexibility. It is difficult to respond to
temporary shocks. For example an oil
importer may face a balance of payments
deficit if oil price increases, but in a fixed
exchange rate there is little chance to
devalue.
 3. Join at the Wrong Rate. It is difficult to
know the right rate to join at. If the rate is too
high, it will make exports uncompetitive. If it is
too low, it could cause inflation.
 4. Current Account Imbalances. Fixed
exchange rates can lead to current account
imbalances. For example, an overvalued
exchange rate could cause a current account
deficit.
Continue
 5. It does not reflect the true value of the
currency
 6. It may lead to the Black markets
emerge
 7. It can be expensive or even
impossible to hold
 8. Dependence on International
Institutions: Under this system, a
country mostly depends upon
international institutions for borrowing
and lending foreign currencies.
FLEXIBLE / FLOATING EXCHANGE
RATE

 Flexible, floating or fluctuating exchange

rates are determined by market force.
The monetary authority (Central Bank)
does not intervene for the purpose of
influencing the exchange rate.
 Under a regime of freely fluctuating
exchange rates, if there is an excess
supply of currencies, the value of that
currency in foreign exchange markets
will fall. It will lead to depreciation of the
exchange rate.
Continue
 Consequently, equilibrium will be
restored in the exchange market. On
the other hand, shortage of a currency
will lead to appreciation of a exchange
rate, thereby leading to restoration of
equilibrium in the exchange market.
 Theses market forces operate
automatically without any intervention
on the part of monetary authority.
For example
 This is illustrated in Figure 2, where D
and S are the demand and supply curves
of pound which interest at a point P and
the equilibrium exchange rate E is
determined. Suppose the exchange rate
rises to E2. The quantity of pounds
supplied OQ3 is more than the quantity
demanded OQ2. When pounds are in
excess supply, the price of pounds will
fall in the foreign exchange market. The
value of pounds in term of dollars will
depreciates. Now less
Continue
 pound will be supplied and more will be
demanded. Ultimately, equilibrium will be
reestablished at the exchange rate E. on the
other hand, if the exchange rate falls to E1,
the quantity of pounds demanded OQ4 is
more than quantity supplied OQ1.
 When there is a shortage of pound in the
foreign exchange market, the price of pounds
will rise the value of pound in terms of dollar
will appreciate. The rise in the price of
pounds will reduce the demand for them and
increase their supply.
 This process will continue till equilibrium
exchange rate E is reestablished at point P.
Graph
ADVANTAGES OF FLEXIBLE
EXCHANGE RATE SYSTEM

 1. Independent Monetary Policy. Under

flexible exchange rate system, a country is
free to adopt an independent policy to
conduct properly the domestic economic
affairs. The monetary policy of a country is
not limited or affected by the economic
conditions of other countries.
 2. Shock Absorber. A fluctuating exchange
rate system protects the domestic economy
from the shocks produced by the
disturbances generated in other countries.
Thus, it acts as a shock absorber and saves
the internal economy from the disturbing
effects from abroad.
Continue
 3. Promotes Economic Development. The
flexible exchange rate system promotes
economic development and helps to achieve full
employment in the country. The exchange rates
can be changed in accordance with the
requirements of the monetary policy of the
country to achieve the planned national
objectives.
 4. Solutions to Balance of Payment Problems.
The system of flexible exchange rates
automatically removes the disequilibrium in the
balance of payments. When, there is deficit in the
balance of payments, the external value of a
country's currency falls. As a result, exports are
encouraged, and imports are discouraged
thereby, establishing equilibrium in the balance of
payment.
Continue
 5. Promotes International Trade. The
system of flexible exchange rates does not
permit exchange control and promotes free
trade. Restrictions on international trade are
removed and there is free movement of
capital and money between countries.
 6. No need of Borrowings and lending
short-term funds : When foreign exchange
rates move freely , there is no need to have
international institutional arrangements like
IMF for borrowing and the lending short-term
funds to remove disequilibrium in the balance
of payments.
Continue
 7. Increase in International Liquidity. The
system of flexible exchange rates eliminates
the need for official foreign exchange
reserves, if the individual governments do not
employ stabilization funds to influence the
rate. Thus, the problem of international
liquidity is automatically solved. In fact, the
present shortage of international liquidity is
due to pegging the exchange rates and the
intervention of the IMF authorities to prevent
fluctuations in the rates beyond a narrow
limit.
DISADVANTAGES OF FLEXIBLE
EXCHANGE RATES

 1. Unstable conditions. Flexible exchange

rates create conditions of instability and
uncertainty which, in turn, tend to reduce the
volume of international trade and foreign
investment. Long term foreign investments
arc greatly reduced because of higher risks
involved.
 2. Adverse Effect on Economic Structure.
The system of flexible exchange rates has
serious consequence on the economic
structure of the economy. Fluctuating
exchange rates cause changes in the price of
imported and exported goods which, in turn,
destabilize the economy of the country.
Continue
 3. Inflationary Effect. Flexible exchange rate
system involves greater possibility of inflationary
effect of exchange depreciation on domestic
price level of a country. Inflationary rise in prices
leads to further depreciation of the external value
of the currency.
 4. Low Elasticities. The elasticities in the
international markets are too low for exchange
rate, variations to operate successfully in
bringing about automatic equilibrating
adjustments. When import and export elasticities
are very low, the exchange market becomes
unstable. Hence, the depreciation of the weak
currency would simply tend to worsen the
balance of payments deficit further.
HOW DO COUNTRIES CHOOSE
EXCHANGE RATE REGIMES

 1. Financial depth indicators. Deeper the financial

markets prone to adopting Floating Exchange rates
 2. Openness, size, trade concentration and
economic volatility indicators. A country is less likely
to adopt a fixed exchange rate if it is relatively large and
closed, if its external trade is concentrated, and if the
business cycle is more volatile. This suggests that what
matters for the choice of the exchange rate regime is
the exposure to external shocks.
 3. Political variables. Fragmented policymaking calls
for a Float probably because greater discretion makes it
easier to settle conflicts among agents involved in the
decision-making process. The use of monetary policy to
raise consensus in the elections.
 4. Inflation
DETERMINANTS OF FOREIGN EXCHANGE
RATE

 1. Interest Rate : Whenever there is an

increase interest rates in domestic
market there will be increase investment
funds causing a decrease in demand for
foreign currency and an increase in
supply of foreign currency.
 2. Inflation Rate : when inflation
increases there will be less demand for
local goods (decreased supply of foreign
currency) and more demand for foreign
goods (increased demand for foreign
currency).
Continue
 3. Government budget deficit or surplus :
The market usually react negatively to
widening govt. budget deficits and positively
to narrowing budget deficits. This will result in
change in the value of countries currency.
 4. Political conditions Internal, regional and
international political conditions and events
can have a profound effect on currency
market.
 5. Economic growth: Stronger economic
growth attracts investment funds causing a
decrease in demand for foreign currency and
an increase in supply of foreign currency.
IMPORTANCE OF EXCHANGE RATE
REGIMES

 1. Stock market trading

 2. Symbolizes growth
 3. Indicates Demand of currency
 4. Position of currency in world
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.
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.
Exchange Rates in the Long
Run: Law of One Price
PURCHASING POWER PARITY

 The purchasing power parity between

two countries’ is the nominal
exchange rate at which a given basket
of goods and services would cost the
same amount in each country.
Exchange Rates in the Long Run:
Theory of Purchasing Power Parity
(PPP)
Continue
 For example, if the same basket of
goods and services costs 800 pesos
in Mexico and $100 in the U.S. the
PPP would be:
800 pesos = $100
8 pesos per $1
Continue
 Nominal exchange rates almost
always differ from purchasing power
parities.
 Some of the differences are
systematic: in general, aggregate
price levels are lower in poor countries
than in rich countries because
services tend to be cheaper in poor
countries.
Continue
 But even among countries with
roughly the same amount of economic
development, nominal exchange rates
vary quite a lot from the purchasing
power parity.
 Over the long run, however,
purchasing power parities are quite
good at predicting actual changes in
nominal exchange rates.
Continue
 In particular, nominal exchange rates
between countries at similar levels of
economic development tend to
fluctuate around levels that lead to
similar costs for a given market
basket.
Exchange Rates in the Long Run:
Theory of Purchasing Power Parity
(PPP)
 Problems with PPP
 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.)
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 :
a. relative price levels,
b. tariffs and quotas,
c. preferences for domestic v. foreign
goods, and
d. productivity.
Continue
 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.
 Productivity: if a country is more
productive relative to another, its
currency appreciates.
Continue
 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.
 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.
Factors Affecting Exchange
Rates in Long Run
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.
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.
Continue
 What this shows is simple.
 As the relative expected return on
dollar assets increases, both François
and Mike respond by holding more
dollar assets and fewer foreign assets.
 Conversely, as the relative expected
return on dollar assets decreases,
both François and Mike respond by
holding fewer dollar assets and more
foreign assets.
Continue
 Mike 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.
Exchange Rates in the Short Run:
Equilibrium
Exchange Rates in the Short
Run: Equilibrium
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.
Explaining Changes in Exchange
Rates: Increase in iD (interest
rate)
Explaining Changes in Exchange Rates:
Increase in iF (Foreign Interest Rate)
Explaining Changes in Exchange Rates:
Increase in Expected Future Exchange Rate
(FX) Rates
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 :
 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
Explaining Changes in
Exchanges Rates
Continue
THE ROLE OF THE
EXCHANGE RATE
 The exchange rate, which is
determined in the foreign exchange
market ensures that the balance of
payments really does balance.
 Exchange rates are the equilibrium
prices for national currencies.
 An exchange rate shows how much of
a nation’s currency is needed to
purchase a unit of another’s currency.
THE EQUILIBRIUM EXCHANGE
RATE
 The equilibrium exchange rate is the
exchange rate at which the quantity of
currency demanded in the foreign
exchange market is equal to the
quantity of currency supplied.
 Movements in the exchange rate
ensure that changes in the financial
account and the current account offset
each other.
Factors that affect the
Equilibrium Exchange Rate
1. Relative inflation rates- Eg. R= 2$
/ £, If inflation in US in higher than in
UK, then US goods will be costlier
than that of UK goods and therefore,
UK will export more goods to US and
US will export less goods to UK.
 This means that value of Dollar has
Depreciated w.r.t. Pounds, or
 Value of Pounds has Appreciated
w.r.t. US dollars.
2. Relative interest rates
 If real interest rates of US are higher
than that of UK, then the dollar is said
to have appreciated as compared to
pound.
 Real interest rate = Nominal interest
rate - Inflation
 Therefore, real interest rate should
be considered
Continue
 3. Relative economic growth rates:
Strong economic growth- attract
investment
 4. Political & Economic risk: High
risk currency- more valuable