The market for foreign exchange (FOREX)

International finance

Chapter 3

Assoc. Prof. Dr. Mehmed Ganić Faculty of Business and Administration

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Preview
The basics of exchange rates
 Exchange rates and the prices of goods
 The foreign exchange markets
 The demand for currency and other assets
 A model of foreign exchange markets
 role of interest rates on currency deposits
 role of expectations about exchange rates

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Defining The Foreign Exchange Market
 The Foreign Exchange Market can be defined in terms of
specific functions, or the institutional structure that:
 (1) Facilitates the conversion of one country’s currency into
another.
 Through the buying and selling of currencies.
 Allows global firms to move in and out of foreign currency as needed.
(2) Sets and quotes exchange rates.
 This is the ratio of one currency to another.
 These rates determine costs and returns to global businesses.
 (3) Offers contracts to manage foreign exchange exposure.
 These hedging contracts allow global firms to offset their foreign
currency exposures and manage foreign exchange risk.
 Thus, they can concentrate on their core business.
Quick Review of Market Characteristics
 World’s largest financial market.
 Estimated at $3.2 trillion dollars per day in trades.
 NYSE-Euronext currently running about $40 billion per day.

 Market is a 24/7 over-the-counter market.

 There is no central trading location.
 Trades take place through a network of computer and telephone
connections all over the world.
 Major trading center is London, England.
 34% of all trades take place through London (New York second at
17%).
 Most popular traded currency is the U.S. dollar.
 Accounts for 86% of all trades (euro second at 27%).
 Most popular traded currency pair is the U.S. dollar/Euro.
 Represents 27% of all trades (dollar yen second at 13%)
 Currencies are either traded for immediate delivery (spot)
or some specified future delivery (forward).
Measuring Foreign Exchange Market Activity: Average
Electronic Conversions per Hour

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The Foreign Exchange Market
 The main players:
1. Commercial banks and other depository institutions:
 transactions involve buying/selling of bank deposits
 in different currencies for investment.
2. Non-bank financial institutions (pension funds,
 insurance funds) may buy/sell foreign assets.
3. Private firms: conduct foreign currency transactions
 to buy/sell goods, assets, or services.
4. Central banks: conduct official international
 reserve transactions; foreign exchange intervention.

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Cont.
 Buying and selling in the FX market are dominated by
commercial banks.
 ♦ Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more per
transaction.
 ♦ Central banks sometimes intervene, but the
direct
effects of their transactions are usually small and
transitory (unless they can have a major effect on
expectations of future policies and exchange rates; see
below).
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 Characteristics of the FX market:
 Trading occurs mostly in major financial cities: London,
New York, Tokyo, Frankfurt, Singapore.
The volume of FX market has grown:
 in 1989 the daily volume of trading was $600 billion,
 in 2004 the daily volume of trading was $1.9 trillion.
 FX trading volume per day in 2017 $5.3 trillion dollars,
 The trading volume of the FX market is 4x the global GDP
 More than 85% of the global FX transactions happens on
only 7 currency pairs known as the majors – EUR/USD,
USD/JPY, GBP/USD, AUD/USD, NZD/USD, USD/CAD
and USD/CHF
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Cont.
 Electronic information transmission (most recently
internet) has helped to integrate regional FX markets since
the 1860s.
The integration of markets implies that there is no significant
arbitrage between markets.
♦ if dollars are cheaper in New York than in London, people
will buy them in New York and stop buying them in
London.
The price of dollars in New York
 rises and the price of dollars in London falls, until
 the prices in the two markets are equal.

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Spot Rates and Forward Rates
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.
 ♦ forward dates are typically 30, 90, 180 or 360 days in
the future.
 ♦ rates are negotiated between individual institutions
in the present, but the exchange occurs in the future.

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The Demand for Currency Deposits
 A currency’s interest rate is the amount of a currency an
individual can earn by lending a unit of the currency for a
year.
The rate of return for a deposit in domestic currency is the
interest rate that the bank deposit earns.
• To compare the rate of return on a deposit in domestic
currency with one in foreign currency, we need to consider
2 factors:
♦ (i) the interest rate for the foreign currency deposit
♦ (ii) the expected rate of appreciation or depreciation of the
foreign currency against the domestic currency.

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Cont.
 Suppose the interest rate on a dollar deposit is 2%.
 Suppose the interest rate on a euro deposit is 4%.
Does a euro deposit yield a higher expected rate of
return? It depends …
♦ Suppose today the exchange rate is $1/€1, and the
expected rate 1 year in the future is $0.97/€1.
♦ $100 can be exchanged today for €100.
♦ These €100 will yield €104 after 1 year.
♦ These €104 are expected to be worth $0.97/€1 x €104
=$100.88.

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 Cont.
 The rate of return in terms of dollars from investing in euro
deposits is ($100.88-$100)/$100 = 0.88%.
Let’s compare this rate of return with the rate of return
from a dollar deposit.
♦ rate of return is simply the interest rate
♦ After 1 year the $100 is expected to yield $102:
($102-$100)/$100 = 2%
The euro deposit has a lower expected rate of return:
all investors will prefer dollar deposits and none are willing to
hold euro deposits.

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The Demand for Currency Deposits (cont.)
 Note that the expected rate of appreciation of the euro
is ($0.97- $1)/$1 = -0.03 = -3%.
We simplify the analysis by saying that the dollar rate of
return on euro deposits approximately equals
 the interest rate on euro deposits
 plus the expected rate of appreciation on euro deposits
 4% + -3% = 1% ≈ 0.8%
R€ + (Ee$/€ - E$/€)/E$/€ ≈ dollar return on euros

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The Market for Foreign Exchange
We use the
 demand for (rate of return on) dollar denominated
deposits, and
 the demand for (rate of return on) foreign currency
denominated deposits to construct a model of the foreign
exchange market.
 The FX is in equilibrium when deposits of all currencies
offer the same expected rate of return: interest parity.
 interest parity implies that deposits in all currencies are
deemed equally desirable assets if they offer the same
expected rate of return

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 The Market for Foreign Exchange (cont.)
 Depreciation of the domestic currency today lowers the
expected return on deposits in foreign currency.
♦ A current depreciation of domestic currency will raise the
initial cost of investing in foreign currency, thereby lowering
the expected return in foreign currency. (Alt: it lowers the
expected future depreciation rate of domestic currency.)
• Appreciation of the domestic currency today raises the
expected return of deposits in foreign currency.
♦ A current appreciation of the domestic currency will lower
the initial cost of investing in foreign currency, thereby
raising the expected return in foreign currency. (Alt: it raises
the expected future depreciation rate of domestic currency.)

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Cont.
The effects of changing interest rates:
 an increase in the interest rate paid on deposits
denominated in a particular currency will increase the
rate of return on those deposits.
 This leads to an appreciation of the currency.
 A rise in dollar interest rates causes the dollar to
appreciate.
 A rise in euro interest rates causes the dollar to
depreciate.

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Figure 13-5
 Figure 13-5 shows a rise in the interest rate on dollars, from
R$1 to R$2, as a rightward shift of the vertical dollar deposits
schedule.
 At the initial exchange rate E $/€, the expected return on
dollar deposits is now higher than that on euro deposits by
an amount equal to the distance between points 1 and 1'.
 As we have seen, this difference causes the dollar to
appreciate to E2 $/€ (point 2).
 Because there has been no change in the euro interest rate
or in the expected future exchange rate, the dollar's
appreciation today raises the expected dollar return on
euro deposits by increasing the rate at which the dollar is
expected to depreciate in the future.

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 Figure 13-6
 Figure 13-6 shows the effect of a rise in the euro interest rate R£. This
change causes the downward-sloping schedule (which measures the
expected dollar return on euro deposits) to shift rightward. (To see why,
ask yourself how a rise in the euro interest rate alters the dollar return
on euro deposits, given the current exchange rate and the expected
future rate.)
 At the initial exchange rate E1 $/€ , the expected depreciation rate of the
dollar is the same as before the rise in R£, so the expected return on
euro deposits now exceeds that on dollar deposits. The dollar/euro
exchange rate rises (from E1 $/€ to E2 $/€) to eliminate the excess
supply of dollar assets at point 1.
 As before, the dollar's depreciation against the euro eliminates the
excess supply of dollar assets by lowering the expected dollar rate of
return on euro deposits.
 A rise in European interest rates therefore leads to a depreciation of the
dollar against the euro or, looked at from the European perspective, an
appreciation of the euro against the dollar. 23
The Effect of a Rise in the Expected Future $/Euro
Exchange Rate

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The Effect of a Rise in the Expected
Future $/Euro Exchange Rate (cont.)
 If people expect a higher value for the $/euro rate in
the future than they did previously, then euro
investments will pay off later in a more valuable
(“stronger”) euro, so that these future euros will be
able to buy more dollars and more dollar-denominated
goods.
♦ the expected return on euro deposits therefore
increases.
♦ an expected future appreciation of a currency leads to
a current appreciation; an expected future
depreciation of a currency leads to a current
depreciation
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How does the FX Market Quote Currencies?
• (1) American Terms:
– Expresses the exchange rate as the number of U.S. dollars per
one unit of some foreign currency.
• For example, $2.00 per (1) British pound.
• (2) European Terms:
– Expresses the exchange rate as the number of foreign
currency units per one U.S. dollar.
• For example, 120 yen per (1) U.S. dollar.
• Most of the world’s currencies are quoted for trade
purposes on the basis of European terms.
– Exceptions include: British pound, Euro, Australian dollar.
• Newspapers, like the Wall Street Journal, however,
usually quote both.
 Quotes are Given by Time of Settlement
 Spot Exchange Rate:
 Quotes for immediate transactions (actually within 1 or 2
business days)
 Forward Exchange Rate:
 Quotes for future transactions in a currency (3 business
days and out).
 Forward markets are used by businesses to protect against
unexpected future changes in exchange rates.
 Forward rate allows businesses to “lock” in an exchange rate for
some future period of time.
Observing Changes in Spot Exchange Rates:
What do they Mean?
 Appreciation (or strengthening) of a currency:
 When the currency’s spot rate has increased in value in
terms of some other currency.
 Depreciation (or weakening) of a currency:
 When the currency’s spot rate has decreased in value in
terms of some other currency.
Forward Rate Quotes
• As a rule, forward exchange rates are set at either a
premium or discount of their spot rates.
– If a currency’s forward rate is higher in value than its
spot rate, the currency being quoted at a forward
premium.
• For example: the Japanese 1 month forward is greater than its
spot (0.009034 versus 0.008999)
– If a currency’s forward rate is lower in value than its spot
rate, the currency is being quoted at a forward discount.
• For example, the British pound 6 month forward is less than
its spot (2.0417 versus 2.056).
Base and Quote Currency
 Given that a foreign exchange quote is simply the
ratio of one currency to another, a “complete”
market maker quote must have two ISO
designations (e.g., EUR/USD or USD/JPY):
 The first ISO currency quoted is called the base
currency.
 The second ISO currency quoted is called the quote
currency.
 For examples above:
 EUR/USD: EUR is the base currency and USD is the quote currency.
 USD/JPY: USD is the base currency and JPY is the quote currency.
Bid and Ask Quotes
 Recall that a market maker always provides the
market with two prices, both a buy and sell quote
(or price) for a currency.
 For Example: EUR/USD: 1.2102/1.2106
 The first number quoted by the market maker is the
market maker’s buy price ($1.2102).
 It is called the market maker’s bid quote (or buy price)
 The second quoted number is the market marker’s sell
price ($1.2106).
 It is called the market maker’s ask quote (or sell price)
 Note: The bid quote is always lower than the ask quote.
What Currency is The Market Maker Buying
and Selling?
• Given the example: EUR/USD: 1.2102/1.2106, which
currency is the market maker selling and which
currency is the market maker buying?
– Answer: Market makers are always quoting prices at
which they will buy or sell ONE UNIT of the base
currency (against the quote currency).
– So in the above example:
• The market maker will buy euros for $1.2102
– This is the bid price for euros.

• The market maker will sell euros for $1.2106

– This is the ask price for euros.
 Reading and Understanding Quotes
 When viewing a foreign exchange quote, assign a value of 1 to
the base currency (the base currency is the first in the ISO
pair). The quotes you see refer to one unit of this base
currency.
 For example, if you see a market maker’s ask price for the EUR/USD of
1.2811, that means that if you were to buy one Euro (the base currency)
you are going pay $1.2811.
 If you see a market maker’s bid price for the USD/JPY of 120.10 that
means if you were to sell one dollar (the base currency) you are going to
get 120.10 for it.
 Also, whenever the bid and ask prices are moving up, that
means that the base currency is getting stronger and the quote
currency is getting weaker.
Summary
 Exchange rates are prices of foreign currencies in
terms of domestic currencies, or vice versa.
• Depreciation of a country’s currency means that it is
less expensive (valuable) and goods denominated in it
are less expensive: exports are cheaper and imports
more expensive.
♦ A depreciation will hurt consumers of imports but
help producers of exports.

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Cont.
 Appreciation of a country’s currency means that it is
more expensive (valuable) and goods denominated in
it are more expensive: exports are more expensive and
imports cheaper.
♦ An appreciation will help consumers of imports but
hurt
producers of exports.
• Commercial banks that invest in deposits of different
currencies dominate the foreign exchange market.
♦ Expected rates of return are most important in
determining the market demands for these deposits.
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Cont.
 Returns on bank deposits in the foreign exchange
market are influenced by interest rates and expected
exchange rates.
• Equilibrium in the foreign exchange market occurs
when expected returns on deposits in domestic
currency and in foreign currency are equal: interest
rate parity.
• An increase in the interest rate on a currency’s deposit
leads to an increase in the rate of return and to an
appreciation of the currency.

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 Cont.
 A higher expected appreciation of a currency (for
example) leads to an increase in the expected rate of
return for that currency, and leads to an actual
appreciation.
• Covered interest parity says that rates of return on
domestic currency deposits and “covered” foreign
currency deposits using the forward exchange rate are
the same.
 (This is true regardless of uncertainty, etc.-- it is a pure
arbitrage relation.)

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