# 1 Foreign Exchange Markets and Exchange Rates

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2 The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. An exchange rate quotation is given by stating the number of units of "term currency" or "price currency" that can be bought in terms of 1 unit currency (also called base currency). For example, in a quotation that says the EURUD exchange rate is 1.3 (1.3 UD per EUR), the term currency is UD and the base currency is EUR. Quotes using a country s home currency as the price currency (e.g., EUR 1.00 = \$1.45 in the U) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries. Quotes using a country s home currency as the unit currency (e.g., = \$1.00 in the U) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone. direct quotation: 1 home currency unit = x foreign currency units indirect quotation: 1 foreign currency unit = x home currency units Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. When looking at a currency pair such as EURUD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example: EURUD = , means EUR is the base and UD the term, so 1 EUR = UD. 1.2 Nominal and Real Exchange Rates The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency. The real exchange rate (RER) is defined as RER = e P *, P where P is the domestic price level and P* the foreign price level. P and P* must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e. The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of good increases 10% in the, and the Japanese currency simultaneously appreciates 10% against the currency, then the price of the good remains constant for someone in Japan. The people in the, however, 2

4 Using Π to represent the rate of inflation, the above equation can be rearranged as We can rewrite this in an approximate form as 1+ U ( t + 1) = 1+ ( t) U & + where & now stands for the rate of exchange in the dollars-per-pound exchange rate. Example We suppose that inflation in witzerland during the year is equal to 4 percent and inflation in the United tates is equal to 10 percent. Then, according to the RPPP, the price of the wiss franc in terms of the U.. dollar should rise, that is, the U.. dollar declines in value in terms of the wiss franc. Using our approximation, the dollar-per-franc exchange rate should rise by & F U F = 10% - 4% = 6% & ŚF where stands for the rate of change in the dollars-per-franc exchange rate. That is, if the F wiss franc is worth UD 1.03 at the beginning of the period, it should be worth approximately UD 1.09 ( ) at the end of the period. The RPPP says that the change in the ratio of domestic commodity prices of two countries must be matched in the exchange rate. This version of the law of one price suggests that to estimate changes in the spot rate of exchange, it is necessary to estimate the differences in relative inflation rates. In other words, we can express our formula in expectational terms as & E F F = E( U ) E( ) If we expect the U.. inflation rate to exceed the wiss inflation rate, we should expect the dollar price of wiss francs to rise, which is the same as saying that the dollar is expected to fall against the franc. 2.1 Interest Rates and Exchange Rates: Interest-Rate Parity The forward exchange rate and the spot exchange rate are tied together by the same sort of arbitrage that underlies the law of one price. If forward exchange rates are greater than the spot exchange rate in a particular currency, the forward foreign currency is said to be at a premium (this implies the domestic currency is at a discount). If the values of forward 4

7 This implies that the forward rate of exchange is equal to the expected spot, or (in general terms) and F(0,1) = E[(1)] F(0,1) E[ (1)] =. (0) (0) Equilibrium is achieved only when the forward discount (or premium) equals the expected change in the spot exchange rate. 2.3 Exchange-Rate Risk Exchange-rate risk is the natural consequence of international operations in a world where foreign currency values move up and down. International firms usually enter into some contracts that require payments in different currencies. For example, suppose that the treasurer of an international firm knows that one month from today the firm must pay GBP 2 million for goods it will receive in England. The current exchange rate is UD 2.00/GBP, and if that rate prevails in one month, the dollar cost of the goods to the firm will be UD 2.00/GBP GBP 2 million = UD 4 million. The treasurer in this case is obligated to pay pounds in one month. (Alternately, we say that he is short in pounds). A net short or long position of this type can be very risky. If the pound rises in the month to UD 2.5/GBP, the treasurer must pay UD 2.5/GBP GBP 2 million = UD 5 million, an extra UD 1 million. This is the essence of foreign-exchange risk. The treasurer may want to hedge his position. When forward markets exist, the most convenient means of hedging is the purchase or sale of forward contracts. In this example, the treasurer may want to consider buying 2 million pounds sterling one month forward. If the one-month forward rate quoted today is also UD 2.00/GBP, the treasurer will fulfill the contract by exchanging UD 4 million for GBP 2 million in one month. The GBP 2 million he receives from the contract can then be used to pay for the goods. By hedging today, he fixes the outflow one month from now to exactly UD 4 million. hould the treasurer hedge or speculate? There are usually two reasons why the treasurer should hedge: 1. In an efficient foreign-exchange-rate market, speculation is a zero NPV activity. Unless the treasurer has special information, nothing will be gained from foreign exchange speculation. 2. The costs of hedging are not large. The treasurer can use forward contracts to hedge, and if the forward rate is equal to the expected spot, the costs of hedging are negligible. Of course, there are ways to hedge foreign exchange risk other than to use forward contracts. For example, the treasurer can borrow dollars and buy pounds sterling in the spot market today and lend them for one month in London. By the interest-rate-parity theorem, this will be the same as buying the pounds sterling forward. 7

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