The Spot Market for

Foreign Exchange

Market Characteristics:
An Interbank Market
• The spot market is a market for immediate
delivery (2 to 3 days).
• Primarily an interbank market, which is the
trading of foreign-currency-denominated
deposits between large banks.
• Approximately $US1.4 - 1.6 trillion daily in
global transactions.
Spot Market

Daniels and VanHoos

2

Market Quotes: The WSJ
Currency Trading Table
• Provides spot and forward rates. Forward
rates are for forward contracts, or the future
delivery of a currency.
• US $ equivalent is the dollar price of a
foreign currency.
• Currency per US $ is the foreign currency
price of one US dollar.
Spot Market

Daniels and VanHoos

3

Market Quotes:
Direct - Indirect Quotes
• Direct quote is the home currency price of a
foreign currency.
• Indirect quote is the foreign currency price
of the home currency.

Spot Market

Daniels and VanHoos

4

Appreciating and
Depreciating Currencies
• A currency that has lost value relative to
another currency is said to have depreciated.
• A currency that has gained value relative to
another currency is said to have appreciated.
• This terms relate to the market process and are
different from devaluation and revaluation
(Chapter 3).
Spot Market

Daniels and VanHoos

5

• Example. • The peso has appreciated. Spot Market Daniels and VanHoos 6 .1021 $/P. as it now takes more $ to purchase each peso. the peso traded at 0. On Tuesday the market closed at 0.Appreciating and Depreciating Currencies • We use the percentage change formula to calculate the amount of depreciation. on Monday.1025 $/P.

on Monday.1021 $/P. • The amount of appreciation is: [(0.1021)/0. the peso traded at 0.1025 $/P.1025 . On Tuesday the market closed at 0.0.39% Spot Market Daniels and VanHoos 7 .1021] * 100 = 0.Appreciating and Depreciating Currencies • Example.

• The ask is what the bank is willing to sell the currency for.g.g. 0.Ask Spreads: Example from Financial Times • The bid is the price the bank is willing to pay for the currency.9002 $/€ is the bid on the euro in terms of the dollar. Spot Market Daniels and VanHoos 8 . e. is the ask on the euro in terms of the dollar. 0.Bid .9010 $/€. e..

the cost of transacting in that currency.Bid . • Example. Spot Market Daniels and VanHoos 9 .0.0018. • It is calculated as the difference between the ask and the bid.ask spread of a currency reflects.9002 = 0.Ask Spread: Cost of Transacting • The bid .9020 . 0. in general.

Bid)/Ask * 100 • Example. (0.Bid .9020 .20%. • (Ask .0.ask spread can be converted into a percent to compare the cost of transacting among a number of currencies.Ask Margin: Percent Cost of Transacting • The bid . • The margin is calculated as the spread as a percent of the ask.020 * 100 = 0. Spot Market Daniels and VanHoos 10 .9002)/9.

What is the Canadian dollar price of the euro (C$/€)? • Note that ($/€)/($/C$) = ($/€)*(C$/$)=C$/€. and the spot rate on the euro is 0.6770 $/C$. the spot rate for the Canadian dollar is 0. • For example. 0.Cross-Rates: Unobserved Rates • A cross-rate is an unobserved rate that is calculated from two observed rates.6770 = 1.3297 C$/€.9002 $/€. • In this example. Spot Market Daniels and VanHoos 11 .9002/0.

the actions of currency traders (arbitrage) will bring the respective currencies in line. in general. consistent.Arbitrage: Consistency of Cross Rates • Arbitrage is the simultaneous buying and selling to profit (as opposed to speculation). • The ability of market participants to arbitrage guarantees that cross rates will be. • If a cross rate is not consistent. Spot Market Daniels and VanHoos 12 .

these prices differences are arbitraged away quickly. • Price differences arise from geographical (spatial) dispersed markets.Spatial Arbitrage • Spatial Arbitrage refers to buying a currency in one market and selling it in another. Spot Market Daniels and VanHoos 13 . • Due to the low-cost rapid-information nature of the foreign exchange market.

Spot Market Daniels and VanHoos 14 . for the most part. meaning that crossrates are. • Arbitrage opportunities exist if an observed rate in another market is not consistent with a crossrate (ignoring transaction costs). • Again. profit opportunities are likely to be arbitraged away quickly. consistent with observed rates.Triangular Arbitrage • Triangular arbitrage involves a third currency and/or market.

455 = 0.012 (£/b) in London.Triangular Arbitrage: An Example • The British pound is trading for 1. • The cross-rate in New York is: 0. while the Thai baht is trading for 0.024 ($/b) in New York.455 ($/£) and the Thai baht for 0.024/1.016 (£/b) • Hence. Spot Market Daniels and VanHoos 15 . an arbitrage opportunity exists.

• The b57.274 purchases $1. sell high.” Spot Market Daniels and VanHoos 16 . • The £0.274 in London. remember “buy low. • To understand the arbitrage opportunity.5% profit on the transaction.687 would purchase b57.375 in New York.Example Continued • A trader with $1. or 37.687 in New York. could buy £0.

Real Exchange Rates: Measuring Relative Purchasing Power .

Real Exchange Rates Real Measures • Nominal variables. • A real exchange rate. • Real variables. Spot Market Daniels and VanHoos 18 . include price changes. such as an exchange rate. accounts for relative price changes. do not consider changes in prices over time. on the other hand. therefore.

Real Exchange Rates • A nominal exchange rate indicates the purchasing power of one nation’s currency over the currency of another nation. we compare its value for one period against its value in another period. Hence. • Real exchange rates indicate the purchasing power of a nation’s residents for foreign goods and services relative to their purchasing power for domestic goods and services. Spot Market Daniels and VanHoos 19 . • A real exchange rate is an index.

• In 2000 the rate was 0.16 percent.6536 (£/$).6873.6873-0. Spot Market Daniels and VanHoos 20 .16 percent {[(0. • Based on this alone.6536)/0. • Hence.6536]*100}. the purchasing power of US residents for British goods and services (relative to US goods and services) rose by 5. the pound depreciated relative to the dollar by 5.Real Exchange Rates An Example • In 1996 the spot rate between the dollar and the pound was 0.

7.6 difference.6 percent.0 percent while US prices rose 11.Example: Continued • Suppose in 1996 the British CPI was 156.7 respectively. Spot Market Daniels and VanHoos 21 . In 2000. British prices rose 9.4 and the US CPI was 154. the CPI’s were 170. there was an increase in purchasing power of British goods and services relative to the purchasing power of US goods and services. • Since the prices of British goods and services rose slower than the prices of US goods and services. a 2.5 and 172. • Based on this.

• To construct a real exchange rate.Combining the Two Effects • A real exchange rate combines these two effects the gain in purchasing power of US residents due to the nominal depreciation of the pound and the gain in relative purchasing power due to British prices rising at a slower rate than US prices. the spot rate. as it is quoted here. is multiplied by the ratio of the US CPI to the UK CPI. (£/$) x (US CPI/UK CPI) Spot Market Daniels and VanHoos 22 .

69 percent.6536 x (154.Combining the Two Effects • 1996 Real Rate = 0. • 2000 Real Rate = 0.6962.6465.7/170. Spot Market Daniels and VanHoos 23 .5) = 0.4) = 0.6873 x (172.7/156. • The real depreciation of the pound was 7.

Spot Market Daniels and VanHoos 24 .7 percent gain in purchasing power.2 percent decline was augmented by the 2.6 percent gain in purchasing power of UK goods and services relative to US goods and services for US residents.6 gain. • The difference in price changes resulted in a 2.2 percent gain in the purchasing power of UK goods and services for US residents. • Note how the 5. resulting in an overall 7.Conclusion • The nominal exchange rate change resulted in a 5.

an economic advisor at the Federal Reserve bank of Cleveland. is a very helpful article on prices and real exchange values. Spot Market Daniels and VanHoos 25 .More on Prices and the Exchange Rate • A Hitchhiker’s Guide to Understanding Exchange Rates by Owen Humpage.

Effective Exchange Rate A measure of the general value of a currency. .

it is a guide to the general value of the currency. • Thus. Spot Market Daniels and VanHoos 27 .Effective Exchange Rate • On any given day. • An effective exchange rate is a measure of the weighted-average value of a currency relative to a select group of currencies. a currency may appreciate in value relative to some currencies while depreciating in value against others.

In the following example.Weighted Average Value • To construct an EER. • Next. we weight the currency according to the country’s importance as a trading partner. we must first pick a set of currencies we are most interested in. we must assign relative weights. Spot Market Daniels and VanHoos 28 .

and 0. and the UK for 20 percent.Weights • Suppose that of all the trade of the US with Canada.50. and the UK.20). Mexico for 30 percent. • Now consider the following exchange rate data.30. Canada accounts for 50 percent. Mexico. • These constitute our weights (0. 0. Spot Market Daniels and VanHoos 29 .

62 0.61 Spot Market Daniels and VanHoos 30 .19 £ 0.44 1.52 P 9.56 10.Exchange Rate Data Today Year Ago $C 1.

• The weighted-average value is calculated as: (weight i)(current exchange value i)/(base exchange value i) where i represents each individual country included in the weighted average. Spot Market Daniels and VanHoos 31 .Calculating the EER • The EER is calculating by summing the weighted values of the current period rate relative to the base year rate.

• The index. therefore.Calculating the EER • Commonly this sum is multiplied by 100 to express the EER on a 100 basis. Spot Market Daniels and VanHoos 32 . is useful is showing changes in the weighted average value from one period to another. the base-year value of the index is 100. • Hence. an EER is an index. • As we shall see next.

Example • Let last year be the base year.61/.52)*0.30 + (0.61)*0.19)*0.19/10.52/1.20]*100 = 100. • As with any index measure. • The effective exchange rate last year was: [(1. the base year value is 100. Spot Market Daniels and VanHoos 33 .50 + (10.

20 • or (0. Spot Market Daniels and VanHoos 34 .61)*0.50 + (9.44/1.2 percent depreciation in weighted value.62/0.56/10. therefore. has experienced a 4.19)*0.30 + (0.Example • Today’s value of the EER is: (1.8 • The dollar.52)*0.958) 95.

Morgan: The Wall Street Journal and the Financial Times.P. Spot Market Daniels and VanHoos 35 .Effective Exchange Measures • There are a number of effective exchange measures available in the popular press. Some common measures are: • Bank of England Index: The Economist. • J.

180 160 United States 140 120 100 United Kingdom 80 Japan 60 40 20 0 .

The Demand for and Supply of Currencies A Derived Demand .

services. and financial assets the currency is used to purchase. for example. the demand for the euro increases. That is. • If. foreign demand for European goods and services increases. the demand for the currency is derived from the demand for the goods. Spot Market Daniels and VanHoos 38 .The Demand for a Currency • The demand for a currency is a derived demand.

• The downward slope of the demand curve shows the negative relationship between the exchange rate and the quantity demanded.The Demand Curve is Downward Sloping • If. the euro depreciates. Spot Market Daniels and VanHoos 39 . and financial assets become less expensive to foreign residents. services. European goods. services. Foreign residents will increase their quantity demanded of the euro to purchase more European goods. for example. and financial assets.

The Demand Curve S ($/€) S0 S1 Demand Q0 Spot Market Q1 Quantity € Daniels and VanHoos 40 .

Important Note • It is vital to construct and label supply and demand diagrams properly. • Note here we are diagramming the market for the euro. Spot Market Daniels and VanHoos 41 . Hence. it is crucial to represent the correct exchange rate on the vertical axis. • The correct exchange rate is one that reflects the “price” of the euro. it must be an indirect quote. That is.

• The demand for the euro rises as savers desire more euros to purchase greater amounts of European financial assets. Spot Market Daniels and VanHoos 42 . • Suppose. that savers desire eurodenominated financial assets relative to dollar-denominated financial assets because of a change in economic conditions.An Increase in Demand • Consider an increase in the demand for the euro. for example.

An Increase in Demand for the Euro S ($/€) S0 D’ Demand Q0 Spot Market Q1 Quantity € Daniels and VanHoos 43 .

Spot Market Daniels and VanHoos 44 . If the dollar depreciates relative to the euro. • Consider the demand schedule for the dollar. there is an increase in the quantity demanded of dollars. • As more dollars are purchased. the quantity of euros supplied in the foreign exchange market increases.The Supply of a Currency • The supply of a currency is also a derived demand.

The Supply of a Currency S ($/€) S1 S0 Dollar depreciation B A Q0 Spot Market S€ Q1 Daniels and VanHoos Quantity€ 45 .

Equilibrium • The market is in equilibrium when the quantity supplied of a currency is equal to the quantity demanded. • This is the market clearing exchange rate because there is no surplus or shortage of the currency. Spot Market Daniels and VanHoos 46 .

Equilibrium S ($/€) S€ S0 A D€ Q0 Spot Market Daniels and VanHoos Quantity€ 47 .

Increase in the Demand for the Euro S ($/€) S€ S1 S0 D’€ D€ Q0 Spot Market Q1 Daniels and VanHoos Quantity€ 48 .

” Spot Market Daniels and VanHoos 49 .Over and Under-Valued Currencies • If a currency’s value is market determined.or undervalued if the market exchange rate is different from the rate that a model or individual predicts to be the “correct” rate. • In other words.or under-valued? • A currency is said to be over. how can it be over. the individual believes the market “has it wrong.

Over and Under-Valued Currencies S ($/€) The euro is undervalued S€ S* S0 D€ Q0 Spot Market Daniels and VanHoos Quantity€ 50 .

The euro.Undervalued • In the previous slide. it should take a greater amount of dollars to buy each euro. • The predicted or expected spot rate. the euro is said to be undervalued. therefore. S*. • Hence. is underpriced. or undervalued. lies above the market determined rate. S 0. Spot Market Daniels and VanHoos 51 .

Purchasing Power Parity .

should guarantee that the exchange rate between the dollar and the pound be s = 3.95/2. • Arbitrage. • In words. therefore. the dollar price of The Economist in the UK should equal the dollar price of the Economist in the US (ignoring transportation costs).50 in the UK and $3.Purchasing Power Parity Absolute or the Law of One Price • Suppose The Economist magazine sells for £2.95 in the US.580 ($/£).50 = 1. Spot Market Daniels and VanHoos 53 .

where P is the domestic price. Spot Market Daniels and VanHoos 54 . P* is the foreign price. • Often it is rearranged as: S = P/P*. and S is the spot rate.Absolute PPP • Absolute PPP is expressed as P = P*×S. expressed as domestic to foreign currency units.

• Only a slight difference exists.480)/1.480 whereas PPP says the rate should be 1. but we can conclude (for instructional purposes) that the pound is undervalued relative to the dollar.Absolute PPP as a Guide to Exchange Values • Suppose the actual spot rate pertaining to the previous example is 1. • In percentage terms (1.76 percent. Spot Market Daniels and VanHoos 55 .580.480 × 100 = 6.580-1.

A Weaker Version • Rearrange APPP to S = P/P*. • Note that the emphasis is on exchange rate movements.. • Divide one period equation by another period.Relative PPP .g. e. though it may appear otherwise. not levels. Spot Market Daniels and VanHoos 56 . S1/S0= (P1/P0)/(P*1/P*0) • Rearrange as: S1 = S0(P1/P0)/(P*1/P*0) • Can be used as a “model” of exchange rate movements.

60 today. the UK CPI was 110 and is now 115. • Plugging this into the formula we have • st = (1.Example • Suppose the exchange rate between the dollar and the pound was 1. Spot Market Daniels and VanHoos 57 .58)×[(111/108)/(115/110)] = 1. Further.58 in 1999 and is 1.125%).55 • Hence the £ is overvalued (3. while the US CPI was 108 and is now111.

* = S • In words.   . • Implies that the higher inflation country should see its currency depreciate. Spot Market Daniels and VanHoos 58 .Another Expression • Often economists will take the log of the previous expression of RPPP to obtain the following. domestic inflation less foreign inflation should equal the change in the spot rate.