Chapter 10

Foreign Exchange

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 Introduction
• Global business includes goods, services,
stocks, bonds, etc. around the globe.
• To understand the nature of these transactions,
we must become familiar with exchange rates.
• All cross-border transactions have a buyer and
a seller that want to use their own currency.
• The exchange rate, at it most basic level, is the
tool we use to measure the price of one
currency in terms of another.

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 Introduction
• In this chapter we will discuss:
– How foreign exchange rates are determined,
– What accounts for their fluctuations over days,
months, years, and decade, and
– The connection of foreign exchange rates and
exchange markets.

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 Foreign Exchange Basics
• When you travel to other countries, the
providers of the goods and services you buy
usually want to be paid in their own currency.
• In Europe that is easier because most
European countries, at least members of the
European Monetary Union, all use euros.
• The price of one euro in dollars is called the
dollar-euro exchange rate.

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The Nominal Exchange Rate
• Exchanging dollars for euros is like any other
economic transaction: you are using your
money to buy something, but in another
country.
• The price you pay for this currency is called
the nominal exchange rate, or simply the
exchange rate.
• The nominal exchange rate is the rate at
which one can exchange the currency of one
country for the currency of another country.
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The Nominal Exchange Rate
• Exchange rates change every day.
• Figure 10.3 shows the dollar-euro exchange
rate from January 1999 to January 2010.
• The figure plots the number of dollars per
euro (€), which is conventional way to
quote the dollar-euro exchange rate.

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The Nominal Exchange Rate

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 The Nominal Exchange Rate
• A decline in the value of one currency relative
to another is called a depreciation of the
currency that is falling in value.
• The rise in the value of one currency relative
to another is called an appreciation of the
currency that is rising in value.
• When one currency goes up in value relative
to another, the other currency must go down.

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 The Nominal Exchange Rate
• The price of the British pound is quoted in the
same ways the euro - the number of dollars
that can be exchanged for one pound (£).
• The price of Japanese yen (¥) is quoted as the
number of yen that can be purchased with
one dollar.
• Most rates tend to be quoted in the way that
yields a number larger than one.

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 The Real Exchange Rate
• When you visit a foreign country you want to
know how much you can buy with that
currency.
• The real exchange rate is the rate at which
one can exchange the goods and services
from one country for the goods and services
from another country.
– It is the cost of a basket of goods in one country
relative to the cost of the same basket of goods
in another country.
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 The Real Exchange Rate
• There is a simple relationship between the
real exchange rate and the nominal exchange
rate.
• For an espresso in the U.S. and in Italy the real
exchange rate:

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 The Real Exchange Rate
• This tells us that one cup of Starbucks
espresso buys 1.1 cups of Italian espresso.
• The real exchange rate has no units of
measurement.
Dollar price of domestic goods
Real Exchange Rate =
Dollar price of foreign goods

• Whenever the ratio in this equation is more

 than one, foreign products will seem cheap.

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 The Real Exchange Rate
• The competitiveness of U.S. exports
depends on the real exchange rate.
• Appreciation of the real exchange rate
makes U.S. exports more expensive to
foreigners, reducing their competitiveness.
• Depreciation of the real exchange rate
makes U.S. exports seem cheaper to
foreigners, improving their
competitiveness.
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• The Wall Street Journal carries daily Foreign
Exchange column that describes events in the
markets, as well as a table reporting the most
recent nominal exchange rates between the
U.S. dollar and various foreign currencies.
• Spot rates are the rates for an immediate
exchange (subject to a two-day settlement
period).
• Forward rates are the rates at which foreign
currency dealers are willing to commit to
buying or selling a currency in the future.
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Foreign Exchange Markets
• Because of its liquidity, the U.S, dollar is one
side of roughly 85 percent of the currency
transactions.
• If you want to exchange Thai baht for
Japanese Yen, you likely have to perform two
transactions:
– Thai baht for U.S. dollars and then
– U.S. dollars for Japanese yen.
• The United Kingdom is home to more than
one-third of foreign exchange trades.
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Exchange Rates in the Long Run
• How are exchange rates determined?
• This section will look at the determination of
the long-run exchange rate and the forces that
drive its movement over an extended period,
such as a year or more.

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 The Law of One Price
• The law of one price is based on the concept
of arbitrage -- the identical products should
sell for the same price.
• We can conclude that identical goods and
services should sell for the same price
regardless of where they are sold.
– If they don’t, someone can make a profit.

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 The Law of One Price
• If a specific model of TV is cheaper in
Windsor, Ontario than Detroit, someone will
buy in Windsor and sell in Detroit for a profit.
• This continues until the prices are the same.
• Ignoring transportation costs and considering
foreign exchange rate, the law of one price
tells us that:

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 The Law of One Price
• However, the law of one price fails
almost all of the time. Why?
1. Transportation costs can be significant,
especially for heavy items;
2. Tariffs, the taxes countries charge at their
borders, can be high;
3. Technical specifications can differ;
4. Tastes differ across countries, leading to
different pricing; and
5. Some things simply cannot be traded.
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• One justification for investing abroad is that
more diversification is always better.
• It makes sense to hold a portion of your
equity portfolio in foreign stocks, as long as
the stocks in the other country do not move
in lock step with U.S. stocks.
• Evidence shows that holding foreign stocks
reduces risk without sacrificing returns,
despite the risk of exchange rate fluctuations.

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 Purchasing Power Parity
• The law of one price is extremely useful in
explaining the behavior of exchange rates over
long periods.
• To understand this, we can extend the law
from a single commodity to a basket of goods
and services.
• The result is the theory of purchasing power
parity (PPP), which means that one unit of U.S.
domestic currency will buy the same basket of
good and services anywhere in the world.
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 Purchasing Power Parity
• According to the theory of purchasing power
parity:
Dollar price of basket = Dollar price of basket
of goods in U.S. of goods in U.K.
Dollar price of basket of goods in U.S.
1
Dollar price of basket of goods in U.K.

• Thus, purchasing power parity implies that

 the real exchange rate is always equal to one.

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 Purchasing Power Parity
• If we just showed that a dollar does not buy
the same amount of coffee in Italy and the
U.S., then how can this be true?
• On a given day, it is not.
• But over the long term, exchange rates do
tend to move, so this concept helps us to
understand changes that happen over years or
decades.

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 Purchasing Power Parity
• If we quote the price of a basket of goods in the
U.K in pounds instead of dollars, then:

• Purchasing power parity implies that when

prices change in one country but not in another,
the exchange rate should change as well.

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 Purchasing Power Parity
• If inflation occurs in one country but not in
another, the change in prices creates an
international inflation differential.
– The currency of a country with high inflation will
depreciate.
• We can confirm this by looking at a plot of:
– The historical difference between inflation in other
countries and inflation in the U.S., and
– The percentage change in the number of units of
other countries’ currencies required to purchase
one dollar.
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 Purchasing Power Parity
• Figure 10.4 presents data for 71 countries
drawn from files maintained by the
International Monetary Fund.
• The solid 45-degree line is a line consistent
with the theoretical prediction of purchasing
power parity.
• On the 45-degree line, exchange rate
movements exactly equal differences in
inflation.

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Purchasing Power Parity

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 Purchasing Power Parity
• The data in Figure 10.4 tell us that purchasing
power parity held true over the 25-year
period.
• Over weeks, months, and even years, nominal
exchange rates can deviate substantially from
the levels implied by purchasing power parity.
– This means PPP does not help us explain short-
term movements.

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 Purchasing Power Parity
• We often hear of currencies being
undervalued or overvalued.
• When people use these terms, they have in
mind a current market rate that deviates
from what they consider to be purchasing
power parity.
– If we think one dollar should purchase one
euro, the “correct” long run exchange rate, and
one dollar purchases only 0.90 euro, it is
undervalued relative to the euro.
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• By the end of the 20th century, the Big Mac
was available in 11 countries and was always
defined the same way.
• The Economist magazine saw this as an
opportunity.
• Using Big Mac prices as a basis for
comparison, the Big Mac index shows the
extent to which each country’s currency was
undervalued or overvalued relative to the
U.S. dollar.
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An excerpt from
Table 10.5

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Exchange Rates in the Short Run
• To explain short-run exchange rates, we turn to
an analysis of supply and demand for
currencies.
• Because, in the short-run, prices don’t move
much, these nominal exchange rate movements
represent changes in the real exchange rate.
• A one or two percent change in the nominal
dollar-euro exchange rate over a day or week
creates a roughly equivalent change in the real
dollar-euro exchange rate.

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 The Supply of Dollars
• We will use the U.S. dollar as the domestic
currency.
– This means we will discuss the number of units of
foreign currency that it takes to purchase one
dollar.
• The supply of dollars slopes upward.
– The higher the price a dollar commands in the
market, the more dollars are supplied.
– The more valuable the dollar, the cheaper are
foreign-produced goods and foreign assets
relative to domestic ones in the U.S. Markets.
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 The Demand for Dollars
• Foreigners who want to purchase American-
made goods, assets, or services need dollars
to do so.
• The demand curve for dollars slopes
downward.
– The cheaper the dollar--the lower the dollar-
euro exchange rate--the more attractive are U.S.
investments and the higher is the demand for
dollars with which to buy them.

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• Should you try to turn a profit on changes in
the exchange rate?
• No.
– Having a good sense of what should happen in
the long run doesn’t help much in the short run.
– Looking at forward markets for major currencies
show that forward rates are virtually always
within one or two percent of current spot rates.
– The best forecast of the future exchange rate is
usually today’s exchange rate.
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 Equilibrium in the Market for Dollars

• The equilibrium exchange rate is the rate that

equates supply and demand for dollars.
• Because the values of all the major currencies
in the world float freely, they are determined
by market forces.
– Fluctuation in their value are the consequences of
shifts in supply or demand.

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Equilibrium in the Market for Dollars

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 Shifts in the Supply of and Demand for
Dollars
• What shifts the supply of dollars?
– Americans wanting to purchase products from
abroad to buy foreign assets will supply dollars to
the foreign exchange market.
– Anything that increases their desire to import
goods and services from abroad, or their
preference for foreign stocks and bonds, will
increase the supply of dollars.

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Shifts in the Supply of and Demand for
Dollars
A rise in the supply of dollars can be caused by:
1. An increase in Americans’ preference for
foreign goods.
2. An increase in the real interest rate on
foreign bonds (relative to U.S. bonds).
3. An increase in American wealth.
4. A decrease in the riskiness of foreign
investments relative to U.S. investments.
5. An expected depreciation of the dollar.

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Shifts in the Supply of and Demand for
Dollars

• An increase in supply
leads to a depreciation
of the dollar.
– The number of euros per
dollar fall.

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Shifts in the Supply of and Demand for
Dollars
To understand shifts in the demand for dollars, we can
look at the previous list from the point of view of a
foreigner:
1. Foreigners prefer more American-made goods.
2. The real yield on U.S. bonds rises (relative to foreign bonds).
3. When foreigner wealth increases.
4. When the riskiness of American investments falls.
5. When the dollar is expected to appreciate.

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Exchange Rate in the Short-run:
Shifts in Demand
• An increase in demand
leads to an appreciation
of the dollar.
– The number of euros per
dollar fall.

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Exchange Rate in the Short-run:
Shifts in Demand

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• During the crisis of 2007-2009, some non-U.S.
banks faced a sudden threat to their survival:
– When the interbank market dried up, they found
it difficult to borrow the U.S. dollars needed to
fund their dollar loans and securities.
• Banks face currency risk if they borrow in one
currency and lend in another.
• The U.S. central bank arranged a series of
extraordinary dollar swaps with 10 other
central banks.
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 Explaining Exchange Rate Movements

• There was a 30 percent appreciation of the

dollar relative to the euro that occurred
between January 1999 and October 2000.
• Our model allows us to conclude that the
cause was either a decrease in the dollars
supplied by Americans or an increase in the
dollars demanded by foreigners.

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Explaining Exchange Rate Movements
• During this period, Americans increased
their purchases of foreign goods, increasing
the supply of dollars.
• At the same time, investment funds were
pouring into the U.S. from abroad,
increasing the demand for dollars.
• The increase in demand was greater than
the increase in supply, leading to an
increase in the exchange rate.

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Explaining Exchange Rate Movements

S0
Number of Euros per Dollar

S1

E0

E1

D1
D0

Quantity of Dollars Traded

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Government Policy and Foreign Exchange
Intervention
• Currency appreciation drives up the price
foreigners pay for a country’s exports and
reduces the price residents of the country pay
for imports.
• This shift in foreign versus domestic prices
hurts domestic businesses.
• Government officials can intervene in foreign
exchange markets in several ways.

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Government Policy and Foreign Exchange
Intervention
• Some countries adopt a fixed exchange
rate and act to maintain it at a level of
their choosing.
• Here we will just discuss the fact that
exchange rates can be controlled if
policymakers have the resources available
and are willing to take the necessary
actions.

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Government Policy and Foreign Exchange
Intervention
• Policymakers will buy or sell currency in an
attempt to affect demand or supply.
– This is called foreign exchange intervention.
• Some countries hardly ever do this and some
regularly do this.
• Between 1997 and 2009, the U.S. intervened
only twice, both because of pressure from
allies.
• The Japanese are the most frequent
participants in the foreign exchange market.
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• In 2009, most analysts viewed the Chinese
Yuan as undervalued.
– Many firms complained that an overly cheap
Yuan was putting Chinese producers at an
unfair advantage.
• Other governments sought to convince
China to allow their currency to appreciate.
• However, Chinese exporters preferred the
weak Yuan, which prevailed.

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• As a by-product of this policy, China
accumulated a record volume of currency
reserves and became the largest holder of U.S.
Treasury debt.
• We do not know just how long China can delay
a rise of the Yuan.

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