CHAPTER 14
THE FOREIGN EXCHANGE MARKET
Introduction
- International trade is different from domestic trade because it requires buyers and sellers to transform their money into each other's currencies prior to buying or selling goods.
-When buying a German BMW (an import) we have to pay in Euros (€)
-When selling a Jumbo 747 (an export) we expect to be paid in US dollars (US$)
- International trade requires this "middle step" of buying or selling a currency before the actual transaction can take place. (note: most international transactions use US$)
- How do we buy other nation's currency? What price do we have to pay? Who or what determines that price?
The Basics of Currency Trading
- The exchange rate is the price of a foreign currency in terms of the domestic currency.
(or also: how many units of the domestic currency we need to have in order to buy one unit of the foreign currency)
-Exchange rate US$/€ = 1.20 (it takes 1.20US$ to buy 1 €)[American side]
-Exchange rate €/US$ = 0.83 (it takes 0.83€ to buy 1 US$)[European side]
- When the ER the domestic currency depreciates (loses value)
-That makes our goods cheaper for foreigners (exports increase): ERX
-That makes our imports more expensive to pay for (imports decrease): ERM
-Investment abroad is more expensive: ERKOUT
-Foreigners can cheaply invest in the US: ERKIN
- When the ER the domestic currency appreciates (gains value)
-That makes our goods more expensive for foreigners (exports decrease): ERX
-That makes our imports cheaper to pay for (imports increase): ERM
-Investment abroad becomes cheaper: ERKOUT
-Foreigners cannot cheaply invest in the US: ERKIN
- The exchange rate between currencies can be fixed (arbitrarily set by a government) or flexible (determined by the market forces of supply and demand), although there are multiple arrangements that combine features of both systems.
- Flexible exchange rates are determined in the foreign exchange market.
The Foreign Exchange Market
- Exchange rates, the relative values of national currencies, are set in the foreign exchange market. There is no single market, but a collection of financial centers around the world.
This marketdoes not have a physical location like the NYSE: it is an over-the-counter market. Trading is done almost non-stop over the phone and the internet.
It is the largest financial market in the world: it trades more than $1.5 trillion per day.
Its main function is to transfer funds and currency from one country to another; to pay for X or M, or to allow foreign investment, for speculation purposes or for hedging.
Most of the transactions are done among banks that trade bank (demand) deposits denominated in different currencies. Individuals are not allowed to trade.
- The dollar is the vehicle currency of the world -everybody uses it for international business because its value is very stable. The Euro is the second currency of choice.
- Asin every market, there is a supply of and a demand for foreign currency (e.g. euro):
Demand for Foreign Currency
- foreign currency is demanded by:US importers of foreign goods and services
US investors that want to invest abroad
- The Law of Demand, relating the quantity demanded of any good and its price, states that:
“Other things remaining the same (ceteris paribus) the Quantity Demanded (QD) of foreign exchange decreases (increases) when the exchange raterises (falls).”
ERUS$ appreciates M are cheaper MQD of foreign exchange
Investing overseas is attractive KOUTQD of €.
ERUS$ depreciates M are more expensive MQD of foreign exchange
Investing overseas is less affordable KOUTQD of €.
Changes in the Quantity Demanded and Changes in Demand
- Recall that the law of demand holds true as long as “other things remain constant”. What other things? Everything but the price (exchange rate.) What if those things change?
-When the exchange ratechanges the quantity demanded changes accordingly.
(we move up or down the demand schedule we move up or down along the demand curve)
-When anything but the exchange rate changes it is the demand that changes.
(the whole demand schedule changes the demand curve shifts to the right or to the left)
- This seemingly minor distinction is very important and in fact it is a source of many mistakes when employing the Supply-Demand model. Make sure you understand it!
- Movements along the Demand curve:
-The exchange rate itself (ER):ERQDERQD
- Shifts of the Demand curve:
-Business cycle in the US (M):MDMD
-Rates of financial return US vs. EU (KOUT):KOUTDKOUTD
Supply of Foreign Currency
- foreign currency is supplied by:European importers of US goods and services
European investors that want to invest in the US
- The Law of Supply, relating the quantity supplied of any good and its price, states that:
“Other things remaining the same (ceteris paribus) the Quantity Supplied (QS) of foreign exchange increases (decreases) when the exchange rate rises (falls).”
ERUS$ depreciates X are cheaper XQS of foreign exchange
Investing in the US is attractive KINQS of €.
ERUS$ appreciates X are more expensive XQS of foreign exchange
Investing in the US less affordable KINQS of €.
Changes in the Quantity Supplied and Changes in Supply
- Recall that the law of supply holds true as long as “other things remain constant”. What other things? Everything but the price (exchange rate.) What if those things change?
-When the exchange ratechanges the quantity supplied changes accordingly.
(we move up or down the demand schedule we move up or down along the demand curve)
-When anything but the exchange rate changes it is the supply that changes.
(the whole demand schedule changes the demand curve shifts to the right or to the left)
- This seemingly minor distinction is very important and in fact it is a source of many mistakes when employing the Supply-Demand model. Make sure you understand it!
- Movements along the Supply curve:
-The exchange rate itself (ER):ERQSERQS
- Shifts of the Supply curve:
-Business cycle in the EU (X):X SX S
-Rates of financial return US vs. EU (KIN):KINSKINS
- Obviously, because multiple real and monetary factors affect the demand and supply of foreign exchange, the ER will be highly volatile:
-A recession in Germany (X and KIN) produces a depreciation of the US$
-Financial instability in Mexico (KOUT) appreciate the US$ and depreciate the Mexican Peso
-An expansion in the US has mixed effects: MUS$ depreciates, i (by the Fed to fight inflation)US$ appreciates.
-A recession in the US also has mixed effects: MUS$ appreciates, i (by the Fed to increase aggregate demand)US$ depreciates.
The Death and Birth of Currencies
- Currencies disappear and are created more frequently than we may think.
-Ecuador's domestic currency was replaced by the US$ in 2001.
-At the same time, the European Union (EU) has physically replaced the domestic currencies of the 12 countries participating in the European Monetary Union (EMU) with a brand new one, the Euro. It was created in 1999 and started to circulate in 2002. More on that later.
-Countries with high levels of inflation (e.g.: Latin American countries during the 80s) periodically replaced their devaluated currencies with new "creatures."
Spot and Forward Values of the Exchange Rate
- There are two basic types of exchange rates, depending on when the exchange of currencies actually takes place: the spot ER and the forward ER.
See Table 14.2
Spot ER: The ER used when the payment and receipt of the foreign exchange occurs within 2 days of agreeing upon the transaction.
Forward ER: The ER used when the payment and receipt of the foreign exchange occurs at a different date than the agreement.
- Are they the same? No. Since ERs greatly oscillate with time, when you buy currency at a forward ER you may be
-paying a forward premium: Forward ER > Spot ER.You are buying a foreign currency in the future more expensively than it is now because the Spot ER is expected to rise.
-receiving a forward discount: Forward ER < Spot ER. You are buying a foreign currency in the future more cheaply than it is now because the Spot ER is expected to fall.
- Forward ERs are very useful when a company knows with certainty that an operation involving foreign currency for a certain amount is going to be closed at a certain date.
- These contracts are of variable length and can be negotiated for any desired amount. They are not tradable.
- Once you have the ER between the US$ and all other currencies you can easily calculate the currency cross rates through a single process of triangulation that is the basis of arbitrage.
- Arbitrage involves buying a currency in a market where it is cheaper for immediate resale at a market where it is more expensive. Due to this process the ER between two currencies is almost the same in all foreign exchange markets at any given moment in time.
- Price differentials arise from temporary shortages or surpluses of a currency in a particular market. For example, a major loan is due for repayment in euros and Frankfort is short.
- These pricing differences are often minimal but a small difference in US$/€ ERs in Tokyo and London is very important when the volumes of deposits bought and sold amount to millions of US$.
- This is what most foreign exchange traders do, look for small differences in spot or forward foreign exchange valuations that can render a profit.
Are Foreign Exchange Markets Efficient?
- How often do today's Forward ERs coincide with tomorrow's Spot ERs?
On average they do quite often but only because they overestimate tomorrow's ER as often as they underestimate it.
- Are those evaluation errors very significant?
Yes. The foreign exchange market is very volatile but since we all know it and there are tools to cover our transactions against that risk we can live with it.
- Fixed ERs are determined by central banks or governments and defended from devaluation and revaluation forces by intervention in the foreign exchange market.
-Speculators might try to force a devaluation by selling large amounts of the domestic currency (D€). The central bank will have to S€ keep ER fixed.
-Speculators might try to force a revaluation by buying large amounts of the domestic currency (S€) The central bank will have to D€ keep ER fixed.
- These speculative attacks are considered attrition wars because the first player to run out of money suffers huge financial loses.
Foreign Exchange Risks, Hedging and Speculation
- ERs are very volatile (they experience large and sudden changes in value) because they depend on many variables: tastes for domestic and foreign goods, growth rates of the world economy, international inflation and interest rates, expectations...
(See Figure 14.3)
- These unexpected variations of ERs can generate losses on investments and transactions -which usually are not "spot operations." That is called foreign exchange risk.
-If importing BMWs, while you wait for the cars to be delivered from the German factory a US$ depreciation can make them more expensive to pay for and eat up your profit margin.
-If you buy Mexican stock and the Peso depreciates while you wait to collect dividends the returns that you end up collecting are worth close to nothing in US$.
- This variability represents a risk for buyers and sellers of foreign currency. You can protect your operations against that risk (hedging) or you can play the market and make a profit (speculation.)
- Half of the transactions in the foreign exchange market are currency swaps, operations that involve the spot sale of a currency with a forward repurchase of the same currency –as part of the same transaction.
-Keep in mind that what banks trade in these markets are deposits of somebody else’s money or companies’ excess of cash flow, not personal savings.
Hedging
- In order to avoid unexpected changes in the future Spot ER you may decide to buy today all the foreign exchange that you are going to use during the next year.
(this is not very practical because you are tying down your resources)
- Instead, we can use the Forward ER for operations that will close in a longer timeframe.
- You can sign a Forward ER contract with a commercial bank specifying the amount of foreign exchange, and the price, that you want to sell or buy at a specified date.
-The BMW importer can set today the ER for the € he/she will have to pay the German producer when the cars are delivered.
-The American investor can guarantee that the Pesos are translated into a significant amount of US$ when repatriating the benefits from the investment.
- Chances are that tomorrow's Spot ER will not coincide with today's Forward ER so some people would have paid too high a price for their foreign exchange and some people would have sold it too cheap. This is a perfect situation for speculation.
Speculation
- The most basic way to play the Foreign Exchange market is to buy foreign exchange at today's Spot ER if we expect it to appreciate tomorrow or vice-versa.
(This is not very sophisticated and is akin to playing the lotto)
- We can use the Forward ER to play the Foreign Exchange market:
-If we expect the foreign currency to appreciate in the future we can sign a Forward ER contract with a favorable rate, execute it when it's due and sell the currency at a profit.
(in the meantime our money is available for other uses -e.g.: buying CDs or stocks)
-If we expect the foreign currency to depreciate in the future we can sign a Forward ER contract selling it with an attractive rate, when the contract is due we buy the foreign currency at the Spot ER and cash in the difference.
- This type of speculation is also risky because forward contracts can not be traded and have to be executed since they are legally binding. The bank fees can be significant.
Other Forms of Speculation
- We can use Foreign Exchange Futures: A Forward ER contract for standardized currency amounts and specific dates. These can be sold and bought many times in organized markets such as the International Monetary Market, the Chicago Mercantile Exchange, or Globex.
-If the Spot ER does not behave as we expected we can sell our future contract.
-Buyers are required to put up a margin to guarantee they can honor the contract. If your daily losses grow you have to pay for them by increasing your margin.
-It has the drawback of being issued only for some currencies.
- We can use Foreign Exchange Options: A contract giving the purchaser the right –but not the obligation to buy or sell a standard amount of a traded currency on a stated date.
-If the Spot ER shows a strong US$ and we have an option to buy it cheaper we execute the option and collect a profit.
-If the Spot ER shows a weak US$ and we have an option to buy it a higher price we don't execute the option and so don't lose money on it.
-Options can be used as insurance, for hedging. There is a premium involved in buying them so if we don't execute them we are wasting money.
-Since they are so flexible they are the natural tool for speculation.
- Speculation can be stabilizing; playing a foreign exchange market in disequilibrium in the "belief" that it will get back to normal ERs , or destabilizing; playing a foreign exchange market in disequilibrium in the "belief" that the imbalance will grow.
(That is how George Soros made his fortune in 1992 against the EMS)
Covered and Uncovered International Investment
- Most of the times it is very difficult to tell the difference between speculators that operate in the foreign exchange market and regular investors that need to exchange currency.
- Since the largest fraction of foreign exchange transactions correspond to financial flows we have to study how forward ERs are involved in investment operations.
Example:
-An American investor wants to put US$ 1 million to the best possible use
-The interest rate on US Federal Bonds is 6.5%, and the interest rate in Germany is 7%. The best thing to do will be to invest the money in German Federal Bonds.
(we can also imagine the US investor borrowing the money from an American bank)
-ER US$/€ = 0.45, so US$ 1 million transforms into € 2.2 million to be invested in German Federal Bonds.
-After holding the German Bonds for one year the American investor takes the profits back to the USA.
-What ER is he/she facing?
-The Spot ER one year from today (this is called uncovered international investment)
(this is very risky because if the US$ appreciates more than 0.5% the profit is gone)
-The Forward ER determined when he/she bought the euros (this is called covered international investment)
- If ERs were to be fixed there will be no risk involved in holding foreign assets but since there is ER volatility, domestic and foreign assets are not perfect substitutes.
- When considering foreign investment opportunities then, investors have to account for interest rate differentials and for Forward exchange rates.
- We are going to see that those two are inversely related.
- In order to calculate the profit margin of an international investment operation we can use the following expression for the covered interest rate differential (CD):
CD = [ (ERFOR - ERSPOT) / ERSPOT] + (i* - i)
where * denotes the foreign country
-If ERFOR = ERSPOT and i* = i there is no profit opportunity
(this was the case inside the EMU after 1999 when internal ERs were fixed)
-If ERFOR = ERSPOT and i* > i we will see American funds invested in Germany
(as it happens when Europe grows faster than the US and the ECB raises i*)
-If ERFOR = ERSPOT and i > i* we will see German money invested in the US
(as it happens when the US grows faster than Europe and the Fed raises i)
- Since money can be transferred over the phone instantly and banks can have fast access to forward exchange rate contracts the movement of money on the heels of interest rate differentials is staggering.
- These operations of international "low" borrowing and "high" lending are called covered interest arbitrage and are basically riskless.
- Are these profit opportunities frequent?
(if i > iEUROPE and ERs are favorable, why is not everybody doing it?)