BRUNEL UNIVERSITY LONDON

 
Department of Economics and Finance
 
EC1030 LECTURE 10

Foreign Exchange (FX) Markets

Dr. Woo-Young Kang

 Contents
1. Foreign Exchange Markets
2. Exchange Rates in the Long-Run
: The Law of One Price, PPP
3. Exchange Rates in the Short-
Run : Expected Returns on
Deposits, Interest Parity Condition
4. Lecture 10 Summary
Foreign Exchange Markets
 The Foreign Exchange Markets
• Most countries of the world have their own currencies: The U.S. has its dollar; France, its
Franc; The U.K. has the £ sterling; Japan, the Yen etc.
• Trade between countries involves the mutual exchange of different currencies (or, more
usually, bank deposits denominated in different currencies).
• When a U.K. firm buys foreign goods, services, or financial assets, for e.g., £ sterling
(typically, bank deposits denominated in £ sterling) must be exchanged for foreign currency
(bank deposits denominated in the foreign currency).
• The trading of currency and bank deposits denominated in particular currencies takes place
in the foreign exchange (FX) market.
• Transactions conducted in the FX market determine the rates at which currencies are
exchanged, which in turn determine the cost of purchasing foreign goods and financial
assets.
The Foreign Exchange Markets (cont.)
• Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency.
• How much can be exchanged for one pound? $1.34/£1
• How much can be exchanged for one dollar? £0.74/$1
• Exchange rate allow us to express the cost or price of a good or
service in a common currency.
• How much does a product cost? $100
• Or, $100 x £0.74/$1= £74
 What are Foreign Exchange Rates?
• The price of one currency in terms of another currency is called the
exchange rate.
• Exchange rates are regularly quoted between all major currencies,
but frequently, one major currency (usually the dollar) is used as a
standard in which to express and compare all rates.
• The exchange rate of all fully convertible currencies is determined,
like any price, by supply and demand conditions in the market in
which it is traded (i.e. the Foreign Exchange market).
The Foreign Exchange Markets
(cont.)
• Depreciation is a decrease in the value of a currency relative to
another currency.
A depreciated currency is less valuable (less expensive) and
therefore can be exchanged for (can buy) a smaller amount of
foreign currency.

• Appreciation is an increase in the value of a currency relative to

another currency.
An appreciated currency is more valuable (more expensive)
and therefore can be exchanged for (can buy) a larger amount
of foreign currency.
The Foreign Exchange Markets
(cont.)
• Spot rates are exchange rates for currency exchanges “on the
spot”, or when trading is executed in the present.
• Forward rates are exchange rates for currency exchanges that
will occur at a future (“forward”) date.
Why are Foreign Exchange Rates
Important?
• Exchange rates are important because they affect the relative
price of domestic and foreign goods.
• For instance, the dollar price of French goods to an American is
determined by the interaction of two factors:
(a) the price of French goods in francs and
(b) the franc/dollar exchange rates.
Why are Foreign Exchange Rates
Important? (cont.)
• Such reasoning leads to the following conclusion:
• When a country’s currency appreciates (rises in value
relative to other currencies), the exports become expensive
and imports become cheaper (holding domestic prices
constant in the two countries).
• Conversely, when a country’s currency depreciates, its
exports become cheaper and imports become expensive.
Why are Foreign Exchange Rates
Important? (cont.)
• In the 1980’s, American businesses became less competitive
with their foreign counterparts.
• Question: Was this fall in competitiveness due to American
management falling down?
• Answer: ?
How is Foreign Exchange Traded?
• Unlike Stock markets, you cannot go to a centralised location to
watch exchange rates being determined; currencies are not
traded on exchanges. Instead, the FX market is organised as an
over-the-counter market in which several hundred dealers
(usually banks) stand ready to buy and sell deposits
denominated in foreign currencies. Because these dealers are in
constant telephone and computer contact, the market is very
competitive; in effect, it functions no differently from a
centralised market.
How is Foreign Exchange Traded?
(cont.)
• Like the price of any good or asset in a free market, exchange
rates are determined by the interaction of supply an demand. To
simplify our analysis of exchange rates in a free market, we shall
divide it into two parts:
(a) How exchange rates are determined in the long-run and,
(b) How exchange rates are determined in the short-run.
Exchange Rates in the Long-Run
: The Law of One Price, PPP
Exchange Rates in the Long-Run
The Law of One Price
The Law of One Price states that,
• If two countries produce the same good, the price of the good should be the
same throughout the world no matter which country produces it.
• The forces of demand and supply ensure that this is so.
e.g. If American steel costs $100 per ton and identical Japanese steel costs
10,000 yen per ton, then the law of one price  the exchange rate between yen
and the dollar must be 100 yen per dollar ($0.01 per yen). If this were not the
case then arbitrage would occur until any excess demand or supply were
eliminated.
 Exchange Rates in the Long-Run
(cont.)
The Theory of Purchasing Power Parity (PPP)
• PPP states that exchange rates between any two countries will adjust to
reflect changes in the price levels of the two countries.
• The theory of PPP is simply an application of the law of one price to
national price levels rather than to individual prices.

Limitations of PPP:
(1) Even though PPP theory provides some guidance to the long- run
movement of exchange rates, it is not perfect.
(2) In the short-run, the PPP is a particularly poor predictor.
Exchange Rates in the Short-Run
: Expected Returns on Deposits,
Interest Parity Condition
Exchange Rates in the Short-Run
• So far we have developed a theory of long-run behaviour of exchange
rates.
• However, if we are to understand why exchange rates exhibit such large
changes from day to day, we must develop a theory of how current
exchange rates (spot exchange rates) are determined in the short-run.
• The key to understanding the short-run behaviour of exchange rates is
to recognise that an exchange rate is the price of domestic bank
deposits (those denominated in the domestic currency) in terms of
foreign bank deposits (those denominated in the foreign currency).
 Comparing Expected Returns on
Domestic and Foreign Deposits
• The theory of portfolio choice suggests that the most important factor
affecting the demand for domestic deposits and foreign deposits is the
expected return on these assets relative to each other.
• In order to fully understand how the demands for domestic and foreign
deposits change, we need to compare the expected returns on domestic
deposits and foreign deposits.
Comparing Expected Returns on
Domestic and Foreign Deposits (cont.)
• For instance, let’s assume U.S. as the home country - so the
domestic bank deposits are denominated in dollars - and francs to
stand for any foreign country’s currency - so foreign bank deposits
are denominate in francs.
• Then consider the following two individuals: Francois, a Foreigner
and Eric, an American.
• Suppose that dollar deposits have an interest rate (expected return
payable in dollars) of r$, and foreign bank deposits have an interest
rate (expected return payable in the foreign currency, francs) of rF.
 Comparing Expected Returns on
Domestic and Foreign Deposits (cont.)
• In making his investment decision, Eric somehow needs to be able to compare the
returns on dollar deposits and foreign deposits in his own currency, the dollar.
• The expected return on franc deposits is simply
+  equation (1)
where
• is the interest rate on franc deposits
• is the currency exchange rate (spot rate),
• is the expected exchange rate in the future (“forward”) date (forward rate)
is the expected rate of appreciation/depreciation of the franc.
Comparing Expected Returns on
Domestic and Foreign Deposits (cont.)
i.e. when he considers the expected return on franc deposits, he
recognises that it does not equal rF; instead, the expected return
must be adjusted for any expected appreciation or depreciation of
the franc.
Thus, equation (1) is simply saying that the expected return on franc
deposits is the sum of the (i) interest rate on franc deposits plus the
(ii) expected appreciation/depreciation on franc.
 Comparing Expected Returns on
Domestic and Foreign Deposits (cont.)
• Eric’s expected return on dollar deposits is simply,
 equation (2)
• Since Eric is seeking to invest his money in whichever country offers him
the highest expected return, it follows that what he is really interested in is
the relative expected return between dollar and franc deposits i.e.
equation (2) - (1), or
+ ) equation (3)
i.e. as the relative expected return on franc deposits increases, people will
want to hold more franc deposits and fewer dollar deposits.
 Interest Parity Condition
• We currently live in a world in which there is capital mobility:
Because foreign bank deposits and domestic bank deposits have
similar risk and liquidity and because there are few impediments to
capital mobility, it is reasonable to assume that deposits are perfect
substitutes (that is, equally desirable).
• For existing supplies of both foreign and American deposits to be held,
it must be true that there is no difference in their expected returns;
that is, the relative expected return in equation (1) must be zero.
• This condition can be rewritten as:
+  equation (4)
 Interest Parity Condition (cont.)
• This equation (4) is called the interest parity condition, and it states
that the domestic interest rate equals the foreign interest rate plus the
expected appreciation/depreciation of the foreign currency.
= This is equivalent to say The domestic interest rate equals the
foreign interest rate minus the expected depreciation/appreciation
of the domestic currency.
• Only when the exchange rate is such that expected returns on domestic
and foreign deposits are equal - that is, when interest parity holds -
will the outstanding domestic and foreign deposits be willingly held
 Lecture 10 Summary
1. Foreign Exchange Markets
• Depreciation is a decrease in the value of a currency relative to another currency.
• Appreciation is an increase in the value of a currency relative to another currency.
• Spot rates are exchange rates for currency exchanges “on the spot”, or when trading is
executed in the present.
• Forward rates are exchange rates for currency exchanges that will occur at a future
(“forward”) date.
• When a country’s currency appreciates, the exports become expensive and imports
become cheaper.
• Conversely, when a country’s currency depreciates, its exports become cheaper and
imports become expensive.
 Lecture 10 Summary (cont.)
2. Exchange rates in the long-run
• The Law of One Price: If two countries produce the same good,
the price of the good should be the same throughout the world no
matter which country produces it.
• Purchasing Power Parity (PPP): exchange rates between any
two countries will adjust to reflect changes in the price levels of
the two countries.
• The theory of PPP is simply an application of the law of one price to
national price levels rather than to individual prices.
 Lecture 10 Summary (cont.)
3. Exchange rates in the short-run
• Because foreign bank deposits and domestic bank deposits have similar risk and
liquidity and because there are few impediments to capital mobility, it is
reasonable to assume that deposits are perfect substitutes
• Interest Parity Condition: the domestic interest rate equals the foreign
interest rate plus the expected appreciation/depreciation of the foreign
currency
+
• This is equivalent to say The domestic interest rate equals the foreign interest
rate minus the expected depreciation/appreciation of the domestic currency.