SG15e_Chapter_2 foreign exchange

CHAPTER 17THE FOREIGN EXCHANGE MARKETMain contents of the chapterA foreign exchange transaction is a trade of one national money for another. The exchange rate is the price at which the moneys are traded. The spot exchange rate is the price for immediate exchange of the two currencies. The forward exchange rate is the price agreed now for a currency exchange that will occur sometime in the future. Banks and their traders are at the center of the foreign exchange market. They use computers and telephones to conduct foreign exchange trades with customers (the retail part of the market) and with each other (the interbank part of the market). Spot foreign exchange serves a clearing function, permitting payments to be made between entities who want to hold or use different currencies. The exchange rate is determined by supply and demand, within any constraints imposed by the governmental choice of an exchange rate system or regime. Under a freely flexible or floating exchange rate system,market supply and demand set the equilibrium price (exchange rate) that clears the market. A floating exchange rate changes over time as supply and demand shift over time. Under a fixed exchange rate system (also called a pegged exchange rate system), monetary officials buy and sell a currency so as to keep its exchange rate within an officially stipulated band. When the currency's value lies at the bottom of its official band, officials must buy it by selling other currencies. When the currency's value presses against the top of its official price range, officials must sell it in exchange for other currencies.Objectives of the ChapterThis chapter deals with the nature and organization of the foreign exchange market. At its most basic, the equilibrium exchange rate can be thought of as the price that equates the international supply of and demand for a country’s money. For example, the exchange rate on the British pound (expressed as American dollars per British pound) would be determined by the supply of pounds arising from British purchases of American goods, services, and assets, and by the demand for British pounds arising from American purchases of British goods, services, and assets.You might want to track a few of the major currencies and related commentaries in the daily listings in the financial press.After studying Chapter 17 you should be able to identify1. what an exchange rate is.2. what the reciprocal of the exchange rate means.3. the organization of the modern foreign exchange market.4. the distinction between spot and forward exchange rates.5. determinants of demand and supply for foreign exchange.6. how a system of flexible foreign exchange rates works.7. how a system of fixed foreign exchange rates works.Important ConceptsAppreciation (depreciation): An increase (decrease) in the market price of a currency under afloating exchange rate system.Fixed exchange rate: A rate whose officially declared value is maintained by central bankintervention. (Also referred to as a pegged exchange rate.)Floating exchange rate: A rate whose value is determined purely by the market forces ofsupply and demand, with no direct intervention by central banks.(Also referred to as a flexible exchange rate.)Foreign exchange market: A computerized communications network embracing all the majorfinancial centers in the globe, where sellers and buyers of anynational money can quickly and efficiently carry out any desiredcurrency exchange.Foreign exchange market When a central bank buys or sells foreign exchange in order to intervention:manipulate or peg the exchange rate.(Foreign) exchange rate:The price of one country’s currency expressed in terms of anothercountry’s currency. (Note that, in this text, the exchange rate isexpressed in terms of domestic currency units required to purchaseone unit of a foreign currency.)Foreign exchange swap: A “package trade”in which a spot purchase of a currency isaccompanied by a forward sale of that currency, or a spot sale of acurrency is accompanied by a forward purchase of that currency andpayment. This transaction allows for temporary foreign exchangeneeds and is free of exchange risk.Forward exchange rate: The exchange rate applicable to foreign exchange transactionsagreed upon today for later delivery (usually in 30, 90, or 180 days). Revaluation (devaluation): A revaluation is an official increase in the par value of a currencyunder a fixed exchange rate system; a devaluation is an officialdecrease in the par value.Spot exchange rate: The rate applicable to foreign exchange transactions requiringcontemporaneous delivery and payment.Triangular arbitrage: The process that ensures consistency among the sets of bilateral“cross rates” of the world’s traded currencies. For example, if theBritish pound trades for US$2, and 100 Japanese yen trade for US$1,the exchange rate between the yen and the pound must be 200 yenper pound. Otherwise, there is an opportunity for an arbitrageur tobuy a currency cheaply in one market and sell it for a higher price inanother market.Vehicle currency: A currency used to facilitate an indirect trade between two othercurrencies. The U.S. dollar is often used as a vehicle currency.Warm-up QuestionsTrue or False? Explain.1. T / F An increase in U.S. imports from France will give rise to a supply of euros in exchangefor dollars.2. T / F Central bank intervention is more prevalent under a floating exchange rate system thanunder a pegged exchange rate system.3. T / F If Americans suddenly refuse to lend money to Mexico, we would expect the dollar toappreciate relative to the peso.4. T / F Art appreciation courses have nothing to do with exchange rates.5. T / F If a currency is undervalued in a fixed exchange rate system, officials from that country’scentral bank will have to sell their currency to keep it pegged.Multiple Choice1. Suppose the exchange rate between the Canadian dollar (C$) and the American dollar (US$)changes from C$1.340/US$ to C$1.325/US$, but the Canadian government wants to maintain a fixed exchange rate of C$1.340/US$. What should the Bank of Canada do?A. Stop trading with the U.S. so that fewer U.S. dollars will flow into Canada.B. Sell U.S. dollars (buy Canadian dollars).C. Sell Canadian dollars (buy U.S. dollars).D. Purchase British pounds and sell French francs.2. If a dollar equals 400 Mexican pesos in the foreign exchange market, what is the value of onepeso?A. $250B. $0.0025C. $0.04D. $1.25E. None of the above.3. Which of the following statements is false?A. British imports of Florida oranges will create a demand for U.S. dollars.B. If all Americans buy Japanese cars, the dollar will appreciate relative to the yen.C. The American dollar is often used as a vehicle currency.D. Australia, Canada, New Zealand and Taiwan all use currencies called “dollars.”4. When American residents buy bonds from Her Majesty’s Treasury in London, in the foreignexchange market this will give rise toA. a demand for American dollars.B. a supply of British pounds.C. a supply of American dollars.D. another Boston Tea Party. 5. The demand curve for a foreign currency slopes downward becauseA. at lower exchange rates, foreign goods look cheaper to home country residents.B. at higher exchange rates, the home currency can buy more foreign goods.C. the quantity supplied of the foreign currency rises as the exchange rate falls.D. marginal utility theory says that individuals substitute into any commodity whose price hasfallen.Problems1. The currency of Leinster is the Leinster lira (Ll); the currency of Saxony is the Saxon scudo (Ss).Consider the following diagram of the foreign exchange market in Saxony:Figure 17.1a. What is the equilibrium price of one Leinster lira in Saxony?b. Can you also determine what the equilibrium price of the Saxon scudo is in Leinster?Ll 20 (billions) E x c h a n g e r a t e r S (S s p e r L l )c. Suppose a doctor in Leinster shows that eating Saxon bread can reduce the level ofcholesterol in one’s blood. What would you expect to happen to the exchange rate between lira and scudos in a floating exchange rate system?d. If the Saxon finance minister wants to peg the exchange rate at the value you determined in(a), what must she do to counteract the impact on the exchange rate of the event described in(c)?2. Suppose that the Saxon scudo appreciates relative to the Leinster lira. Determine whether theeconomic agents listed below would see that appreciation as a good thing or a bad thing.a. A Leinster resident who imports goods priced in scudos.b. A Saxon who exports goods priced in scudos.c. A Leinster resident who exports goods priced in lira.d. A Saxon who has a retirement account denominated in scudos.e. Anyone who expected the lira to depreciate.3. For the most part, the exchange rate between the U.S. dollar and the euro is floating. What effectwill each of the following events have on the $/€ exchange rate?a. The French government bans the import of American movies.b. Americans learn that drinking French red wine will prevent heart disease.c. An American mutual fund purchases stock in Renault.d. Parisian perfume makers buy chemicals from a company in New Jersey.e. New York foreign exchange speculators believe the euro is going to depreciate in the nextfew hours.4. Assume that U.S. government officials are trying to keep the exchange rate between the dollarand the euro pegged. For each of the events described in Problem 3, what actions must these officials take to return the exchange rate to its previous level?5. You have been given one million yen to play with. Use the following exchange rates to showhow you can make a riskless profit in terms of yen:1 euro = 70 yen in Munich1 yen = 1 American penny in Tokyo1 American dollar = 3 euro in New York CityDiscussion Topics1. What do you see as the benefits and costs of each country having its own currency?2. What problems would you foresee in a world where some countries have floating exchange rateswhile others try to keep their exchange rates fixed?The answers to Chapter 2True/False1. False: to purchase the imports, we supply dollars in exchange for francs.2. False: intervention is more prevalent under pegged rates.3. True.4. True (unless you are Swiss and are bidding at Sotheby’s!)5. True.Multiple Choice1. C2. B3. B4. C5. AProblems1. a. The equilibrium exchange rate is 100 scudos per lira, or Ss 100/Ll.b. Since this is a nominal “bilateral” exchange rate, just invert it (or yourself) to find that theexchange rate from Leinster’s point of view is 0.01 Ll/Ss.c. You would expect the supply of lira in exchange for scudos to increase, shifting the supply curveto the right and pushing the exchange rate down. So it would take fewer scudos to buy a lira, or a lira would not exchange for as many scudos. This is an appreciation of the scudo and adepreciation of the lira.d. If the minister had wanted to keep the exchange rate at Ss 100/Ll, she would have to satisfy theexcess demand for scudos that would arise when the supply of lira increased. (In fixed exchange rate terminology, the scudo would be undervalued at the old exchange rate of Ss 100/Ll.) Thiswould require the Saxon minister of finance to sell scudos and buy up lira.2. a. Keep in mind throughout this problem that an appreciation of the scudo means it costs more lirato buy one scudo (or that it takes fewer scudo to purchase one lira).Because it will take more lira to buy the scudo, the Saxon goods denominated in scudo will bemore expensive for someone in Leinster to purchase.b. The Saxon goods will now bring in more lira than before. Unfortunately, the increase in the priceof those goods to Leinster residents may mean that fewer Saxon goods are purchased byLeinster’s residents than before.c. The Leinsterian goods will now bring in fewer scudo than before. The upside to this is thatSaxons see Leinster’s goods becomin g cheaper and may purchase more of them.d. If the retiree is a Saxon, the appreciation of the scudo means she can buy more Leinsterian goodsthan before, although it won’t change her ability to purchase domestic goods. If the retiree lives in Leinster, she has protected her ability to purchase imports, and if she cashes the scudo in for lira, she will get many more lira than before.e. If those who expected a depreciation of the lira had sold them all for scudos, the appreciation ofthe scudo (that is, the depreciation of the lira) will turn out to have been a very good thing. Their scudos are now worth many more lira.3 a. Since the supply of euros would fall, we would expect the $/€ exchange rate to rise: the eurowould appreciate and the dollar would depreciate.b. The American demand for euros would rise, so the exchange rate would rise: the euro wouldappreciate and the dollar would depreciate.c. The American demand for euros would rise, so the euro would appreciate and the dollar woulddepreciate.d. The French supply of euros would rise, so the euro would depreciate and the dollar wouldappreciate.e. The American demand for euros will fall as American speculators dump the euro, and theexchange rate would fall, too: the euro would depreciate, in a “self-fulfilling prophecy.”4. a. The U.S. must sell euros and buy dollars to keep the dollar from depreciating.b. As in 4.a., the U.S. must sell euros and buy dollars to keep the dollar from depreciating.c. Once again, the U.S. must sell euros and buy dollars.d. The U.S. must buy euros and sell dollars to keep the dollar from appreciating.e. The U.S. must buy euros and sell dollars to keep the dollar from appreciating.5. The “route to follow” would be Tokyo yen to New York dollars to Munich euros to Tokyo yen.In Tokyo: take the million yen and trade them for dollars, receiving $10,000.In New York: take the $10,000 and trade them for euros, receiving €30,000.In Munich: take the €30,000 and trade them for yen, receiving Y2.1 million.You would end up with a profit of 1.1 million yen for being so observant and taking advantage of triangular arbitrage.。