CHAPTER 9

CURRENCY EXCHANGE RATES

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 1. INTRODUCTION
The foreign exchange (FX) market is the market for trading currencies against
each other.
- The FX market is the world’s largest market.
- The FX market facilitates world trade.
- The FX participants buy and sell currencies needed for trade, but also
transact to reduce risk (hedge) and speculate on currency exchange rates.
•An exchange rate is the price of a country’s currency in terms of another
country’s currency.

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 2. THE FOREIGN EXCHANGE MARKET
• Currencies are referred to by their Example:
ISO code (e.g., USD, PKR, INR). PKR/USD = 255
• Exchange rate: The number of units •This means that one US dollar will
of one currency (the price currency) buy 255 Pakistani rupees.
that one unit of another (the base
currency) will buy. •If this exchange rate falls to 250, the
dollar will buy fewer Pakistani
• Convention for exchange rate: rupees. In other words,
A/B = Number of units of A that one - The US dollar is depreciating
unit of B will buy. relative to the rupee or
A = Price currency - The rupee is appreciating relative
B = Base currency to the US dollar

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 REAL EXCHANGE RATES

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 SPOT AND FORWARD RATES
• A spot exchange rate is an exchange rate for an immediate delivery (that is,
exchange) of currencies.
• A forward exchange rate is an exchange rate for the exchange of currencies
at some specified, future point in time.

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 THE FX MARKET
PARTICIPANTS AND PURPOSES TYPES OF FX PRODUCTS
•Companies and individuals • Currencies for immediate delivery
transact for the purpose of the (spot market).
international trade of goods and • Forward contracts, which are
services. agreements for a future exchange
•Capital market participants transact at a specified exchange rate.
for the purpose of moving funds into or • FX swaps, which are a
out of foreign assets. combination of a spot contract and
•Hedgers, who have an exposure to a forward contract, used to roll
exchange rate risk, enter into positions forward a position in a forward
to reduce this risk. contract.
•Speculators participate to profit from • FX options, which are options to
future movements in foreign enter into an FX contract some
exchange. time in the future at a specified
exchange rate.

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 3. CURRENCY EXCHANGE
RATE QUOTES
• A direct currency quote uses
the domestic currency as the
price currency and the foreign
currency as the base currency.
• An indirect currency quote
uses the domestic currency as
the base currency and the
foreign currency as the price
currency.

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 IN PRACTICE
• There are a number of conventions, which simply refer to a particular exchange
rate [see Exhibit 9-6 for a more comprehensive list].

Actual Ratio
FX Rate Quote Name
(Price currency/Base
Convention Convention
currency)
EUR euro USD/EUR
JPY dollar–yen JPY/USD
GBP sterling USD/GBP
EURGBP euro-sterling GBP/EUR

• Dealers will quote a bid (at which the dealer will buy) and an offer price (at
which the dealer will sell). [Note: bid < offer]

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 APPRECIATING OR DEPRECIATING

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 CURRENCY CROSS-RATES

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 FORWARD RATE QUOTATIONS
• Forward exchange rates are
quoted in terms of points (pips:
points in percentage).
If forward rate > spot rate,
the base currency is trading at a
forward premium.
If forward rate < spot rate,
the base currency is trading at a
forward discount.
• Points are 1:10,000 (move the
decimal place four places).
• Forward quotes can be specified
as the number of pips from the
spot rate or as a percentage of
the spot rate.

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 FORWARD DISCOUNTS AND PREMIUMS

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 CALCULATING FORWARD RATES

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 4. EXCHANGE RATE REGIMES
• An exchange rate regime is the policy framework for foreign exchange.
• The ideal currency regime (which does not exist) would consist of the following
circumstances:
1. Exchange rate is credibly fixed.
2. All currencies are fully convertible.
3. All countries able to undertake independent monetary policy for domestic
objectives.

Exchange rate regime choices:

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 EXCHANGE RATE REGIMES
Regime Type Description
No separate legal Fixed Dollarization: Use another nation’s currency as the
tender medium of exchange (USD).
Shared currency Fixed Monetary union: Use a currency of a group of
countries as the medium of exchange.
Currency board Fixed Use another currency in reserve as the monetary
system base, maintaining a fixed parity.
Fixed parity or fixed Fixed Use another currency or basket of currencies in
rate system reserve, but with some discretion (parity bands).
Target zone Fixed Fixed parity (peg) with fixed horizontal intervention
bands.

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 EXCHANGE RATE REGIMES
Regime Type Description
Active and passive Peg Adjust the exchange rate against a single
crawling pegs currency, with adjustments for inflation (passive)
or announced in advance (active).
Fixed parity with Peg Similar to target zone, but bands can be widened.
crawling bands
Managed float Float Allow exchange rate to float, but intervene to
manage it toward targets.
Independently Float Exchange rate is market determined (supply and
floating rates demand).

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 5. EXCHANGE RATES, INTERNATIONAL TRADE,
AND CAPITAL FLOWS
• The net effect of imports and exports affects a country’s capital flows:
Trade deficit → Capital account surplus
Trade surplus → Capital account deficit
• Using the national accounts relationship, we see the relationship between trade
and expenditures/savings and taxes/government spending:
X–M = (S – I) + (T – G)
↑ ↑ ↑
Exports less imports Savings less Taxes less government
investment spending
↑ ↑
Trade surplus or deficit Fiscal surplus or deficit

• The potential flow of financial capital in or out of a country is mitigated by

changes in asset prices and exchange rates.

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 EXCHANGE RATES AND TRADE
There are two theories on the exchange rate/trade relationship:
[Link]–Lerner theory
- The effectiveness of currency devaluations or depreciation on trade depends
on the price sensitivities (that is, price elasticities) of the goods and services.
- If the goods and services are highly elastic, trade responds to devaluation or
depreciation, improving the trade balance
- If the demand for exports and imports is price inelastic, trade is less
responsive to devaluation or depreciation.
2. The Absorption Approach
- Devaluation or depreciation of the exchange rate must decrease expenditure
relative to income to improve the trade balance.
- This affects national income through the wealth effect: reduced purchasing
power of domestic-currency-denominated assets leads to lower expenditure
and increased saving.

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 CONCLUSIONS AND SUMMARY
• The foreign exchange market is by far the largest financial market in the world.
It has important effects, either directly or indirectly, on the pricing and flows in
all other financial markets.
- There is a wide diversity of global FX market participants that have a wide
variety of motives for entering into foreign exchange transactions.
• Individual currencies are usually referred to by standardized three-character
codes. These currency codes can also be used to define exchange rates (the
price of one currency in terms of another). There are a variety of exchange rate
quoting conventions.
- A direct currency quote takes the domestic currency as the price currency
and the foreign currency as the base currency.
- An indirect quote uses the domestic currency as the base currency.
- To convert between direct and indirect quotes, invert the quote.
- FX markets use standardized conventions for quoting exchange rate for
specific currency pairs.

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 CONCLUSIONS AND SUMMARY
• Currencies trade in foreign exchange markets based on nominal exchange
rates. An increase in the exchange rate, quoted in indirect terms, means that
the domestic currency is appreciating versus the foreign currency.
• The real exchange rate measures the relative purchasing power of the
currencies. An increase in the real exchange rate implies a reduction in the
relative purchasing power of the domestic currency.
• Given exchange rates for two currency pairs—A/B and A/C—we can compute
the cross-rate (B/C) between currencies B and C.
• Spot exchange rates are for immediate settlement (typically, T + 2), whereas
forward exchange rates are for settlement at agreed-on future dates.
• Forward rates can be used to manage foreign exchange risk exposures or can
be combined with spot transactions to create FX swaps.

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 CONCLUSIONS AND SUMMARY
• The spot exchange rate, the forward exchange rate, and the domestic and
foreign interest rates must jointly satisfy an arbitrage relationship that equates
the investment return on two alternative but equivalent investments.
• Forward rates are typically quoted in terms of forward points. The points are
added to (or subtracted from) the spot exchange rate to calculate the forward
rate.
• The base currency is said to be trading at a forward premium if the forward rate
is higher than the spot rate (that is, forward points are positive). Conversely,
the base currency is said to be trading at a forward discount if the forward rate
is less than the spot rate (that is, forward points are negative).
• The currency with the higher interest rate will trade at a forward discount.
• Points are proportional to the spot exchange rate and to the interest rate
differential and approximately proportional to the term of the forward contract.
• Empirical studies suggest that forward exchange rates may be unbiased
predictors of future spot rates, but the margin of error on such forecasts is too
large for them to be used in practice.

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 CONCLUSIONS AND SUMMARY
• Virtually every exchange rate is managed to some degree by central banks.
The policy framework that each central bank adopts is called an “exchange
rate regime.”
• An ideal currency regime would have three properties:
1. The exchange rate between any two currencies would be credibly fixed;
2. All currencies would be fully convertible; and
3. Each country would be able to undertake fully independent monetary policy
in pursuit of domestic objectives, such as growth and inflation targets.
• The IMF identifies the following types of regimes: dollarization, monetary union,
currency board, fixed parity, target zone, crawling peg, crawling band,
managed float, and independent float.
- Most major currencies traded in FX markets are freely floating, albeit
subject to occasional central bank intervention.

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 CONCLUSIONS AND SUMMARY
• Any factor that affects the trade balance must have an equal and opposite
impact on the capital account, and vice versa.
• The impact of the exchange rate on trade and capital flows can be analyzed
from two perspectives.
1. The elasticities approach focuses on the effect of changing the relative
price of domestic and foreign goods. This approach highlights changes in
the composition of spending.
2. The absorption approach focuses on the impact of exchange rates on
aggregate expenditure/saving decisions.

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 CONCLUSIONS AND SUMMARY
• The elasticities approach leads to the Marshall–Lerner condition, which
describes combinations of export and import demand elasticities such that
depreciation of the domestic currency will move the trade balance toward
surplus and appreciation will lead toward a trade deficit.
• The idea underlying the Marshall–Lerner condition is that demand for imports
and exports must be sufficiently price sensitive so that an increase in the
relative price of imports increases the difference between export receipts and
import expenditures.
- If there is excess capacity in the economy, then currency depreciation can
increase output/income by switching demand toward domestically produced
goods and services.
- If the economy is at full employment, then currency depreciation must reduce
domestic expenditure to improve the trade balance.

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