Chapter Two
The Foreign
Exchange Rate
and the Foreign
Exchange
International Economics II
Market
By Netsanet G.
BDU, Department of Economics, 2026
2.1. The Foreign Exchange Rate and the
Market for Foreign Exchange
The foreign exchange (forex, FX) rate is the price
of one currency in terms of another.
There are two methods of expressing it:
• Domestic currency units per unit of foreign
currency (E.g., assuming dollar is the
domestic currency and euro the foreign
currency, #US$/€). This is a direct definition of
forex rate.
• Foreign currency units per unit of the
domestic currency (E.g., #€/US$). This is an
indirect definition of forex rate.
The Foreign Exchange Rate- Definition
Economic literature most often employs the
first definition. In what follows, we pursue the
direct definition of forex.
Cross Exchange Rate: Once the forex rate is
established between two currencies using a
vehicle currency, the rate can then be
determined between them.
The Market for Foreign Exchange
The foreign exchange market is the market in
which individuals, firms, and banks buy and sell
foreign currencies or foreign exchange.
The foreign exchange rate is determined by the
interaction of demand for and supply of foreign
exchange under a flexible exchange rate
system.
The main participants in the forex market
are retail clients, commercial banks, foreign
exchange brokers and central banks.
The Market for Foreign Exchange: Demand
Foreign exchange is demanded by those
• wishing to buy goods and services from or
send gifts or payments to another country.
• wishing to purchase financial assets in
another country.
• wishing to profit from exchange rate
changes (Forex Speculators).
• wishing to minimize risk from exchange
rate changes (Forex Hedgers).
The Market for Foreign Exchange: Supply
Foreign exchange is supplied by those
• selling goods and services to or
receiving gifts or payments from
another country.
• wishing to purchase domestic financial
assets.
• wishing to profit from exchange rate
changes (Forex Speculators).
• wishing to minimize risk from exchange
rate changes (Forex hedgers).
The Market for Foreign Exchange
$/€
S€
Qeq euros are traded,
and the equilibrium
eeq price is eeq.
D€ Euros
Qeq (€)/day
The Market for Foreign Exchange
$/€
S€
An increase in U.S. demand for
euros causes an appreciation
e'eq
of the euro.
eeq
D€ D'€
Euros
Qeq Q'eq (€)/day
The Market for Foreign Exchange
$/€
S€ S'€
An increase in the supply
of euros causes a
eeq depreciation of the euro.
e'eq
D€
Euros
Qeq Q'eq (€)/day
2.2. Exchange rate regimes, spot versus forward
exchange markets
A. Exchange rate systems (Regimes)
The choice of an exchange rate system should
depend on the particular circumstances facing
the country in question.
There are three polar exchange rate
regimes:
i. The absolutely fixed regime
ii. The pure-floating regime
iii. The fixed-but-adjustable exchange rate regime
(FBAR)
There are many “in-between” regimes that are
compromises of various kinds between any
two or between all three of these polar
regimes.
The absolutely fixed regime
The following analysis on exchange rate
systems assume the international mobility of
capital.
In the absolutely-fixed regime the country
has neither an independent exchange rate
policy nor an independent monetary policy.
There is absolute commitment to the rate.
The absolutely fixed regime
The principal examples of an absolutely
fixed exchange rate regime are:
• Dollarization - The use of other country’s
(“hegemonic” or anchor country) currency, and
the monetary policy is determined by another
country’s central bank. E.g., Ecuador, El Salvador
and Panama.
• Monetary union - There is a common currency
and a common central bank. E.g., the euro
currency and the European Central Bank (ECB)
among the European union countries who adopt
the euro currency (Eurozone).
The pure-floating regime
In the pure-floating regime, the country has
an independent monetary policy but not an
independent exchange rate policy.
Monetary policy can influence the exchange
rate, but, such policy is not formally or
informally directed to achieve particular
exchange rate targets.
• There is no commitment to a
particular exchange rate.
• The exchange rate responds both to
market forces and to monetary policy
acting on interest rates.
The FBAR
This regime is sometimes called the
“adjustable peg” regime.
The exchange rate is determined by policy
and is maintained by direct intervention in
the foreign exchange market, or by the
central bank actually making the market,
offering to buy and sell foreign exchange at a
fixed price.
There is a high commitment to a particular
policy determined exchange rate.
Changes in it reflect either official
perceptions of changes in
“fundamentals” that require an
exchange rate adjustment, or strong
market pressures.
The “In-between” regimes
1. Between the absolutely fixed and FBAR:
Currency board (Convertibility plan)
• The exchange rate is strictly pegged (fixed)
with the chosen anchor foreign currency. And,
there is very high commitment to keep this rate.
• The money base (money supply) should be at
least 100% backed by the anchor foreign
currency reserve.
• The money supply may change in tandem with
the change in the reserve of the anchor
currency.
• There are no exchange controls (unlimited
convertibility). E.g., Hong Kong (US$1=HK $7.8).
The “In-between” regimes
• Under the currency board regime, the money
supply cannot be increased to finance budget
deficits, and to finance a central bank’s role as
rescuer of the financial system, and in
particular as the lender of last resort for banks.
• Rather, government budget deficits and
rescuing the financial system rescuing
finances must be generated through tax and
borrowing by issuing bond.
• This is because the domestic currency must
be backed by at least 100% of the anchor
currency reserve.
The “In-between” regimes
2. Between FBAR and pure-floating regime
i. The pegged rate regime
a. Flexible peg- The exchange rate is fixed at
a point in time by the central bank, and it
may be stable for short periods. But it can
be altered readily.
There is low commitment, and only in the
short run.
It differs from the FBAR in that there is not a
strong commitment to the rate, and it differs
from pure floating in that it avoids short-run
instability.
The “In-between” regimes
b. Crawling peg (active/pre-announced vs.
Passive)
It has been adopted when a country has started
with a significant degree of inflation relative to
trading partners or competitors.
The rate depreciates steadily at intervals,
though it is pegged by the central bank at a
point in time.
The rate may be altered at intervals if a change
in the real exchange rate (measure of
competitiveness) is thought necessary.
The “In-between” regimes
With the active (or pre-announced) crawling
peg regime there is a “tablita” which sets out
the rate of depreciation of the exchange rate in
advance, and is designed to act as a nominal
anchor. There is a strong commitment to the
tablita.
With a passive (or ex-post) crawling peg
regime the exchange rate is adjusted regularly
in the light of the rate of inflation at a recent
date, the aim being to keep the real exchange
rate constant.
The “In-between” regimes
ii. The target zone or band regime
• It is an amalgam of the FBAR (or possibly the
pegged rate) and either managed or pure
floating.
• There is a central (pegged) rate and there is a
band (lower and upper limit) around it within
which the actual rate floats.
• There is some commitment to the pegged rates
at the limits, though the extent of the
commitment can vary.
The “In-between” regimes
iii. The managed floating regime
• The central bank is free to intervene in
the foreign exchange market.
• This regime differs from the FBAR and the
pegged rate because there is no commitment
to a rate, not even a short-run one.
• It differs from pure floating because the
central bank can intervene to stabilize the rate,
to change the rate in any way it chooses, or
even aim to make a profit in the foreign
exchange market.
The Exchange Rate System (Regimes)- the
“In-between” regimes relationship
B. Types of foreign exchange transactions: spot
versus forward exchange rates
i. The Spot Exchange rate
The spot exchange rate is the quotation
between two currencies for immediate delivery.
In practice, there is normally a two-day lag
between a spot purchase or sale and the actual
exchange of currencies to allow for verification,
paper work and clearing of payments after the
day the transaction is agreed upon.
The spot Exchange rate
The spot market is the daily or current
market for foreign exchange, and the
corresponding foreign exchange rate is the
spot exchange rate.
There are many foreign exchange markets, but
they all tend to generate the same exchange
rate regardless of location.
• This is the result of arbitrage.
Arbitrage
Arbitrage occurs when individuals see an
opportunity to buy something at a low price in
one market, then immediately sell it for a
higher price in a second market for the sake of
profit.
Arbitrage causes currency prices to be similar
across forex market centers, and makes cross
rates between currencies consistent.
Example: Suppose the pound quoted in NY is $1.75,
but pound quoted in London is $1.78. The arbitrageur
buys pound from the cheapest market (NY) and sells
it in the market where it is expensive (London).
Arbitrage
Assuming the total transacted amount to be 10
million Pounds, then an arbitrageur
• Buys 10M pounds in NY: cost = $17.5M
• Sells 10M pounds in London: revenue = $17.8M
• Profits = $300,000 less the cost of telephone,
cable transfer. The supply of pound shrinks in NY,
increases in London.
• Market Adjustment mechanism: In NY, the
arbitrageur buys pounds → demand for pounds
rises → pound appreciates in NY (price moves
above $1.75). In London, the arbitrageur sells
pounds → supply of pounds increases → pound
depreciates in London (price falls below $1.78).
• This continues until: the exchange rate equalizes
in both NY London.
ii. The Forward Exchange rate
It is possible for economic agents to agree today
to exchange currencies at some specified time
in the future, most commonly for 30 days, 90
days, 180 days, 270 days, and 360 days.
The rate of exchange at which such a
purchase or sale can be made is known as the
forward exchange rate.
The demand for and supply of forward foreign
exchange arise in the course of hedging, from
foreign exchange speculation, and from
covered interest arbitrage.
The Forward Market
Suppose a U.S. company agrees to buy 5 trucks
from a French company at a price of €50,000
each, with delivery in 6 months, the equivalent
of $70,000 at today’s spot exchange rate of
$1.4/€.
What if the euro appreciates to $1.6/€? Now
the price in dollars has risen to $80,000.
There is a way to hedge against this potential
risk.
• The buyer and seller can agree to make the
sale at today’s forward exchange rate.
• This agreement gives the buyer the right
to a specific exchange rate at a specific
time in the future.
Forward premium vs Forward discount
The forward rate can be equal to, above, or
below the corresponding spot rate when the
forward contract is at maturity.
Defining the forward and spot rates as the units
of domestic currency per unit of foreign
currency, then
• the foreign currency is said to be at a forward
discount with respect to the domestic
currency if the forward rate is below the
present spot rate.
• the foreign currency is said to be at a
forward premium if the forward rate is
above the present spot rate.
Forward premium vs Forward discount
To calculate the Premium or Discount:
FP/FD = [FR- SR]/SR*100
To annualize the premium/discount,
FP/FD = [FR- SR]/SR*12/contract months*100
Example: If FR t=90 = 1.98$/£ and SR = 2$/£, then
• The 3 months forward discount is
FD= (1.98-2)/2 *(100) = -1% (for the three month
period, each pound has a discount of 0.01 cents
in terms of dollar).
• Annualized forward discount is
FD= ((1.98 – 2)÷ 2) * (12 ÷ 3)*100%= -4%.
• What if FR t=90 = 2.02 $/£?
.
Gains and Losses from Spot and Forward
Rate Differences
Case 1: Forward Discount (FR < SR):
Forward seller of the pound: Sells pounds at
a lower rate than the spot → loses.
Forward buyer of the pound: Buys pounds at
the lower forward rate → gains.
Case 2: Forward Premium (FR > SR):
Forward seller of the pound: Sells pounds at
a higher rate → gains.
Forward buyer of the pound: Buys pounds at
a higher rate → loses.
Bottom line: the gain or loss depends on
whether the pound’s forward rate is above
or below the spot rate and whether you are
selling or buying pounds
Foreign Exchange Risks, Hedging, and
Speculation
Foreign Exchange Risks- whenever a future
payment must be made or received in a foreign
currency, a foreign exchange risk, or a so-called
open position, is involved because spot
exchange rates vary over time.
Hedging- refers to the avoidance of a foreign
exchange risk, or the covering of an open
position. E.g., buying or selling the foreign
currency at the forward market.
Speculation- is the act of seeking a foreign
exchange risk, or an open position, in the
hope of making a profit.