Chapter 2

Exchange rate and

foreign exchange
market: an asset-
market based
approach Lê Minh Tuấn, Msc
Faculty of International Economics
and Business, UEB-VNU
 2
 This chapter reviews the concepts and
the role of the exchange rate in
international trade
Objective
 This chapter discusses the
determination of the exchange rate in
the asset market
 3
 The concepts of the exchange rate
 The foreign exchange market
The demand for assets
Content


 The asset-based determination of the exchange

rate
 4
What is the exchange rate?
1. The  Exchange rate is the price of one currency in
exchange terms of another currency
rate and  Ex. 1: E(VND/USD): 1 USD = 22500 VND
international  Ex. 2: E(USD/EUR): 1 EUR = 1.1788 USD
transactions
 5
The exchange rate quotation
1. The  Direct quotation shows the value of the foreign
exchange currency in terms of the domestic currency
rate and  1 foreign currency = x (domestic currency)
international  Ex. 1 USD = 22.500 VND (VND is DC)
transactions
 Indirect quotation shows the value of domestic
currency in terms of foreign currencies
 1 domestic currency = x (foreign currency)
 Ex. 1 VND = 0.000044 USD (VND is DC)
 6
The exchange rate quotation
1. The  In order to determine an exchange rate that is
exchange directly or indirectly quoted, it is necessary to
rate and associate it with the foreign exchange market
international  For example, the rate E($/£) is the direct quote
with the US market but is the indirect quote with
transactions the UK market because the British pound is the
foreign currency to the US but is the domestic
currency in the UK
 Unless clearly stated, we always use direct
quotations in our course
 Vietnamese dong is always directly quoted against other
currencies
 7
Bid and Ask Rates
1. The  Bid rates are the rates that the trader of foreign
exchange exchange (a bank) is willing to pay for a
rate and particular currency
international  Ask rates are the rates that the trader of foreign
transactions exchange (a bank) is willing to sell a particular
currency
 Bid-Ask spread: The different between the ask
rate and the bid rate
 The spread is influenced by several factors including
trading volume, the liquidity of the currency, the
competition among banks.
 8
Measuring changes in the exchange rate
1. The  The movement in the exchange rate is often
exchange expressed in terms of the percentage
rate and change from a benchmark value
international  Appreciation/revaluation: means an
transactions increase in the value of a currency in terms
of another currency
 Depreciation/devaluation refers to a fall in
the value of a currency in terms of another
currency
 The exchange rate and international9
transactions
1. The  Exchange rates make it possible to compare the
exchange price of goods and services produced in different
rate and countries.
international  The price of a goods produced in one country
transactions can be translated into the price of the same
good in terms of another country’s currency
using the exchange rate
 Example: T-shirt (produced in Vietnam): 225.000
VND/ 1 T-shirt (price in Vietnam)
=> 10 USD / 1 T-shirt (the price in the U.S. dollar).
E(vnd/usd) = 22.500vnd
 The exchange rate and international
10

transactions
1. The  A devaluation (or depreciation) of the
exchange domestic currency reduces the price of domestic
rate and goods in terms of the foreign currency
international  Ex. Given a 10% devaluation of VND, the dollar
transactions price of T-shirt becomes: 225.000/24.750 = 9.1
USD
 A revaluation (or appreciation) of the domestic
currency increases the price of domestic goods
in terms of the foreign currency
 Ex. Given a 10% revaluation of VND, the dollar
price of T-shirt becomes: 225.000/20.250 = 11.1
USD
 Definition of foreign exchange market 11

2. The  Foreign exchange market is the market

where foreign currencies or foreign
Foreign exchange are bought or sold.
Exchange  Foreign currencies can be traded in
Market different locations
 Monetary centers are connected via internet and
electronic means, thus forming a single international
foreign exchange market
 Currency transactions can take place 24 hours a day,
and it takes only few seconds to execute a
transactions
 12

2. The
Foreign
Exchange
Market
 The growth of foreign exchange market 13

2. The  The global foreign exchange market has

rapidly expanded, reflecting the expansion
Foreign of world trade and investment.
Exchange  The total foreign exchange trading increased from
Market 1.2 trillion per day in 2001 to 4.0 trillion in 2010 to
6.6 trillion in 2019 (Bank for International
Settlements)
 Most foreign exchange transactions take
place by crediting and debiting bank
accounts rather than actual currency
exchange
 Participants in the foreign exchange market 14
 Immediate users and suppliers: Individuals and
2. The firms can sell or buy foreign exchange in the foreign
Foreign exchange market
 Earners of foreign exchange can sell foreign
Exchange currencies in the foreign exchange market
Market  User (demander) of foreign exchange can purchase
foreign exchange
 Commercial banks: banks operate as a clearing
house for the earners and users of foreign
exchange
 Without commercial banks, it would be time-
consuming and inefficiently for sellers and buyers to
find each other
 Participants in the foreign exchange market 15
 Foreign exchange brokers: brokers act as
2. The intermediaries between commercial banks (the
Foreign interbank or whole sale market)
 Non-bank financial institution: insurance
Exchange companies or investment funds can trade foreign
Market currencies
 Central banks: central banks act as sellers or
buyers of last resorts when there is an excess
supply or excess demand in the foreign exchange
market.
 Central banks sell foreign currencies if there is a
shortage of foreign exchange and they buy in the case of
surplus.
 Characteristics of the foreign exchange market16
 Most of foreign exchange transactions between

2. The two currencies go through US dollars

Foreign  US dollar serves as a vehicle currency and is

Exchange widely used in international trade and investment

Market  Exchange rates quotes at different banks and

location tend to converge.

 Any significant difference between the exchange

rates quoted at different locations will trigger

arbitrage activities.
 17
Arbitrage
2. The  Exchange rates for a given pair of currencies are

Foreign kept consistently in different monetary centers

Exchange  If there is any difference in the exchange rates for

a given pair of currencies, arbitrage will take place
Market to make profits from the inconsistency.
 Investors will purchase the currency in the
monetary center where it is cheap and sell the
currency in the monetary center where the currency
is expensive.
 18
Arbitrage
2. The  Example:

Foreign E(JPY/USD)= 90 in New York

Exchange E(JPY/USD) = 91 in London
Market  Is there any opportunity for arbitrage to take
place? What is the impacts of the arbitrage on
the exchange rate between JPY and USD?
 Foreign exchange transactions 19

 Spot transactions
2. The  Forward transactions
Foreign
Exchange  Foreign exchange swaps
Market  Futures, and
 Options
 Spot transactions 20

 Spot transactions are executed immediately

2. The after the agreement is reached.
Foreign  Spot exchange rate: Spot trading employs the
Exchange current exchange rate, which is called the spot
Market exchange rate.
 Value date: The value date is the date that the
parties involved in the spot transaction actually
receive funds they have purchased.
 In practice the spot trading are often executed two
days after the agreement is reached.
 Forward transactions 21

2. The  The forward transactions involve trading of

foreign currencies at some date in the future
Foreign at the rate agreed on today.
Exchange  The agreement is reached today, but it is carried

Market
out at a specified future date
 The duration of forward contracts is typically
less than one year, but sometimes these
contracts can last longer.
 A deposit of 10% of the contract value is usually
required when the contract is signed.
 Forward transactions 22

2. The  Example: A firm needs one million

dollars to pay for imported goods three
Foreign months from today. What the firm can
Exchange do?
Market  The firm signs a three-month forward
contract with a bank to purchase dollars,
and after three months, when they need
dollars to pay for the foreign exporter, they
will implement the contract and exchange
dong for dollar. .
 Forward Transactions – Forward Rates 23

 Forward trading uses a forward exchange rate,

2. The which is determined when the transactions is
Foreign agreed on, and can be different from the current
Exchange spot rate.
Market  The forward contract is executed in the specified
date using the forward rate regardless of the spot
rate at that time
 In the above example, suppose the forward rate
is 22000 dong/dollar. On the specified date, the
firm must pay 22 billion dong for one million
dollars
 Forward Transactions 24

Forward discount and premium

2. The
Forward discount: if the forward rate is
Foreign


lower than the current spot rate, foreign

Exchange currency is at a forward discount with
Market respect to domestic currency
 Forward Premium: if the forward rate is
above the current spot rate, foreign currency
is at a forward premium with respect to
domestic currency
 Hedging – Hedging through the Forward
 Importers: An U.S. importer will make25 a
payment of 1 million euros to the foreign
2. The partner in three months.
Foreign  The U.S. importer will purchase one million
Exchange euros forward in three months. At the due
Market date, he will implement the contract and pay
one million euros for the foreign exporter.
 If the three-month forward rate is $1.01/€1,
the importer has to pay 1.01 million dollars.
 Hedging – Hedging through the Forward
 Exporters: An U.S. exporter has a future 26

receipt of one million euros in three months.

2. The
The exporter will sell one million euros forward
Foreign


for delivery in three months. At the due date,

Exchange he receives one million euros from the foreign
Market importer and implements the contract.
 If the three-month forward rate is $1.01/€1.,

the exporter would receive 1.01 million dollars.

 Swap Transactions
 Currency swap: the swap transaction is a spot 27

sale of a currency combined with a forward

2. The repurchase of the currency.
Foreign  An exporter has just received one million dollars,
Exchange but will have to pay one million dollars for imported
inputs in three months. The exporter may join a
Market swap transaction which allow it to sell one million
dollars and repurchase it three months later.
 Swaps often result in lower fees or transaction
costs because they combine two transactions, and
they allow parties to meet each others needs for a
temporary amount of time.
 Foreign exchange futures
 Foreign exchange futures are a forward contract for28 a
standardized volume of a specific currency and selected
2. The calendar date traded on an organized market.
Currency futures mostly involve major currencies such as
Foreign

dollars, Canadian dollars, Australian dollars, Yen, Euro, Swiss
Exchange Franc or Mexican pesos.

Market
 The size of future contracts are standardized such as 12.5
million yen for yen contracts, 100000 dollars for Canadian
dollar contracts, 125 euro for euro contract....
In the IMM, four dates are available: the third Wednesday in
March, June, September and December.
 A daily limit is imposed on the exchange rate fluctuation to
reduce risk of default
 Investors are required to pay a brokerage commissions and
deposits a certain amount of money (4% of the contract value)
 Different between futures and forward contracts
 In the futures market, only few currencies are 29

traded for standardized amount and at few

2. The selected dates.
Foreign  The trade of futures takes place in an organized

Exchange market with few geographical locations.

Market  Future contracts can be sold at any time up until

maturity, but the forward contract cannot.

 Futures contracts are usually for smaller amounts

than forward contracts and is more useful for small

firms than large firms.
 The market for futures is smaller than that for the

forward contracts, but has been growing rapidly.

 Foreign Exchange Options
 Currency option: the option contract gives the buyer the right, but
30 not
obligation, to sell or purchase a particular currency at a specified
exchange rate and date.
2. The  The seller of the option must fulfill the contract if the buyer so
Foreign desires, but the buyer of the option can forgo the contract if it turns out
unprofitable.
Exchange  The buyer of a option pays the seller a premium (the option price),

Market 
which ranges from 1% to 5% of the contract value
Put and call options: a call option specifies the right to buy a
currency, while the put option specifies the right to sell a currency.
 European and American options: An European option must be
implemented on the specified date, but the American option can e
implemented at any time before the stated date.
 The exchange rate used in the option contract is called the exercise
price or strike price.
 The amount of the option contract is standardized for the trading that
takes place in the organized market.
 Foreign Exchange Options
 The option contract can be useful in some cases31

such as when there is uncertainty about the receipt

2. The or payment of foreign exchange in the future.
Foreign  Example: A company makes a bid for a construction
Exchange project in a foreign country. If the bid is successful, the
company will need to purchase foreign currencies to
Market implement the project. But this is not certain. How the
company would do.
 In this case the company can purchase a call option.
If the bid succeeds, the company will implement the option
and has the amount of foreign exchange needed for the
project. Otherwise, it will forgo the option
 Assets
 People can hold their wealth in various forms
32

or assets, such as bonds, stocks, bank

3.The deposits, gold and precious metals, cash, real
demand for estate, ...
foreign  The demand for assets depends on the
currency following:
 The return to assets: the expected return
to assets
 Risks
 Liquidity
 Rate of return to assets 33

3.The  The return to an asset measures the change in

the value of the investment in the asset
demand for between two dates.
foreign  The change in the value of an assets is
currency brought about by the change in
 Its price and
 The interest earned during a period of time.
 Rate of return to assets 34

3.The  Example 1: An investor bought 1000 USD in

early 2008 at the exchange rate was 1 USD =
demand for 16000 VND. In 2010, the exchange rate was
foreign 1 USD = 19200 VND. What is the return to the
currency investment in US dollars.
 The rate of return = (19200 - 16000)/16000 *100 = 20%
 Rate of return to assets 35

3.The  Example 2: An investor bought 1 share of the

stock issued by a commercial bank at the price
demand for of 50000 VND per share. The investor
foreign received a dividend of 2000 VND per share at
currency the year end, and the price of the stock also
rose to 58000 VND at the year end. What is
the return to the stock.
 The rate of return = (60000 - 50000)/50000
*100 = 20%
 Rate of return to assets 36

3.The  Expected return to assets

demand for  Since people do not know the return to an
asset before they buy the asset, the demand
foreign for an asset largely depends on the expected
currency return to the asset.
 The expected return to an asset measures
the change in the expected value of the asset
using its expected prices and interest over a
given period
 Rate of return to assets 37

3.The  The real return to an asset

demand for  Because the value of assets measured in terms
of money, the change to the value of money has
foreign an impact on the value of asset.
currency  The demand for an asset depends not only on
the nominal return to the asset, but also on its real
rate of return.
 The expected real rate of return to an asset is
the expected nominal rate of return minus the
(expected inflation during a given period.
 Rate of return to assets 38

3.The  The real return to an asset

demand for  Example 1: A saver deposits 1 million VND at a
bank. The one-year interest rate is 8%, and the
foreign expected inflation over the next year is 6%. What
currency is the real rate of return to the bank deposit
 Example 2: A saver deposits 1 million VND at a
bank. The one-year interest rate is 10%, and the
expected inflation over the next year is 12%. What
is the real rate of return to the bank deposit
 Risk and liquidity
 The risk of an asset refers to the uncertainty of39 its
expected return.
3.The  Given all other things equal, the more risky an asset is, the
demand for lower the demand for it.

foreign
 The liquidity of an asset refers to the speed and cost of
disposing an asset. All else equal, the more liquid an
currency asset is, the higher the demand for it.
 In this chapter, we consider the case of perfect asset
substitutability (khả năng thay thế tài sản hoàn hảo), i.e.
we assume that domestic and foreign assets have the
same degree of risks and liquidity.
 Under this assumption, the rate of return is the only
factor that influences the demand for assets.
 Domestic and foreign deposits
Domestic currency deposits 40

The interest rate is the rate of return to the deposit

3.The


at the bank. When you deposit money, you are

demand for buying the asset ‘deposit’
foreign  The rate of return to domestic currency
currency deposits is the interest rate offered on the
deposits.
 Example: A saver deposits 10 millions VND at a
commercial bank with annual interest rate of 7%.
After one year, he will receive 700000 VND in
interest. The rate of return is 7%
 Domestic and foreign deposits
The exchange rate and foreign assets 41

The return to the foreign currency deposit

3.The


consists of not only the interest rate, but also

demand for the expected change in the exchange rate.
foreign  Example: Suppose the annual interest rate
currency offered on the dollar deposit is 2%.
Vietnamese dong is expected to depreciate by
3% against US dollar over next year. What is
the expected rate of return on the dollar
deposit?
 Domestic and foreign deposits
The rate of return to foreign assets 42

3.The  The rate of return to a foreign-currency

denominated asset is equal to the interest
demand for offered by the asset plus the expected
foreign depreciation of domestic currency.
currency  Rate of return to foreign deposit
 Rate of Return= R* + (Ee – E)/E
 Where R* is the interest rate offered to
foreign currency deposits, E is the current
exchange rate, Ee is the expected exchange
rate
 Equilibrium in the foreign exchange market
 The foreign exchange market is in equilibrium 43

when bank deposits of all currencies offer the

4.Equilibrium same rate of return.
in the foreign  If the dollar deposit offers a higher rate of return as
exchange compared to the dong deposit, investors will move
market from dong deposit to dollar deposit, and thus
creating excess demand for dollar.
 If the dollar deposit offers a lower rate of return as
compared to the dong deposit, investors will move
toward dong deposit from dollar deposit, and thus
creating excess demand for dong.
 Interest parity condition (UIP)
 The interest parity condition establish an equality 44

between the rates of return on domestic-currency

4.Equilibrium deposits and foreign currency deposits (uncovered
interest parity – UIP)
in the foreign
R = R* + (Ee – E)/E
exchange


Here R is the interest rate on domestic-currency

market


deposits
 The UIP shows the difference in interest rates equals to
the expected rate of depreciation of domestic currency.
R – R* = (Ee – E)/E
 When the interest parity condition holds, the foreign
exchange market is in equilibrium
 Adjustment to equilibrium
Example: 45

R($) = 10%/yr
4.Equilibrium


R(€)=5%/năm;
in the foreign 

e = 0.38
exchange  E($/€) = 0.35. After 1 year E
market Should investor invest in US dollar or Euro?
 Adjustment to equilibrium
Example: 46

R($) = 10%/yr (US$ is Domestic currency)

4.Equilibrium


R(€)=5%/năm;
in the foreign 

e = 0.38
exchange  E($/€) = 0.35. After 1 year E
market Should investor invest in US dollar or Euro?

 Rate of return €
= R(€) + (Ee – E)/E = 5% + (0.38 – 0.35)/0.35 ≈ 14%

 Rate of return ($) – Rate of return (€) < 0 => should invest
in Euro
 Adjustment to equilibrium
47

4.Equilibrium
in the foreign
exchange
market
 Adjustment to equilibrium
48

4.Equilibrium
in the foreign
exchange
market
 Adjustment to equilibrium
 If the UIP condition does not hold, the exchange 49

rate will adjust to bring about the equilibrium in the

4.Equilibrium foreign exchange market
in the foreign  Question 1: what would happen if the rate of
exchange return on foreign currency deposits is higher
market than that of domestic currency deposits?
 R < R* + (Ee – E)/E
 Question 2: What would happen if the rate of
return on foreign currency deposits is lower
than that of domestic currency deposits
 R > R* + (Ee – E)/E
 Graph Presentation
50

4.Equilibrium
in the foreign
exchange
market
 Graph Presentation
 Adjustment to 51

equilibrium
4.Equilibrium  The exchange rate will
in the foreign adjust to maintain the
equilibrium in the
exchange foreign exchange
market market
 Graph Presentation
 Home interest rate 52

and the current

4.Equilibrium
exchange rate
in the foreign
 An increase in the
exchange
interest rate on
market
domestic currency
deposit raises the
rate of return on DC
deposits, causing an
appreciation of
domestic currency.
 Graph Presentation
 Foreign interest 53

rate and the

4.Equilibrium exchange rate
in the foreign  A higher foreign
exchange interest rate raises
market the rate of return
on foreign
currency deposits
(R* + (Ee – E)/E),
causing a
depreciation of
domestic currency.
 Graph Presentation
 The expected 54

exchange rate and

4.Equilibrium the current
in the foreign exchange rate
exchange  A rise in the
market expected exchange
rate raises the rate
of return on foreign
currency deposits
(R* + (Ee – E)/E),
causing the current
exchange rate to
rise.
 55

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