Chapter 1: The Foreign Exchange Market
The foreign exchange market is defined as a market where the various national currencies are bought
and sold. Exactly what factors determine how much domestic currency has to be given in exchange
to obtain a unit of foreign currency, the behavior of exchange rates and the impact of exchange rate
changes on the economy is one of the major fields of study in international economics.
Two definitions of the exchange rate:
1. Domestic currency units per unit of the foreign currency: taking the pound sterling as the
foreign currency, that is $1.58/£1.
2. Foreign currency units per unit of domestic currency: £0.6329/$1.
The first definition is typically used in the theoretical economic literature. In this course we use the
first definition.
A rise in the exchange rate from $1.58/£1 to say $1.80/£1 would mean that more dollars are
required to purchase one pound, so that the pound has appreciated or, equivalently, the dollar has
depreciated.
The bid rate is the rate at which a bank will buy sterling, while the offer rate is the rate at which the
bank will sell sterling in exchange for dollars. The difference is known as the bid-offer spread and
represents the gross profit margin of the bank.
The foreign exchange market is a worldwide market and is made up primarily of commercial banks
foreign exchange brokers and other authorized agents trading in most of the currencies of the world.
The main participants in the foreign exchange market can be categorized as follows:
Retail clients. These are made up of businesses, international investors, multinational
corporations and the like who need foreign exchange for the purposes of operating their
businesses. They do not directly purchase or sell foreign currencies themselves; rather they
operate by placing buy/sell orders with the commercial banks.
Commercial banks. The commercial banks carry out buy/sell orders from their retail clients
and buy/sell currencies on their own account (known as proprietary trading) so as to alter
the structure of their assets and liabilities in different currencies. The banks deal either
directly with other banks or through foreign exchange brokers.
Foreign exchange brokers. Often banks do not trade directly with one another, rather they
offer to buy and sell currencies via foreign exchange brokers. Operating through such brokers
is advantage because, since they collect buy and sell quotations for most currencies from
many banks, the most favourable quotation is obtained quickly and at very low cost. One
disadvantage of dealing through a broker is that a small brokerage fee is payable which is not
incurred in a straight bank deal. Each financial centre normally has just a handful of
authorized broker through which commercial banks conduct their exchanges.
Central banks. Normally the monetary authorities of a country are not indifferent to changes
in the external value of their currency. Even though exchange rates of the major
industrialized nations have been left to fluctuate freely since 1973, central banks frequently
intervene to by and sell their currencies in a bid to influence the rate at which their currency
is traded. Under a fixed exchange rate system the authorities are obliged to purchase their
currencies when there is excess supply, and sell the currency when there is excess demand.
Arbitrage is the exploitation of price differentials for riskless guaranteed profits. One of the most
important implications deriving from the close communication of buyers and sellers in the foreign
exchange market is that there is almost instantaneous arbitrage across currencies and financial
centres.
, Financial centre arbitrage ensures that the dollar-pound exchange rate quoted in New York will be
the same in London and other financial centres.
Cross currency arbitrage. Suppose that the exchange rate of the dollar against the pound is $1.58/£1
and the exchange rate of the dollar against the euro is $1.30/€1. Currency arbitrage implies that the
exchange rate of the euro against the pound will be €1.21254/£1 (1.58/1.30).
The spot exchange rate is the quotation between two currencies for immediate delivery (the current
exchange rate).
The forward exchange rate. In addition to the spot exchange rate it is possible for economic agents
to agree today to exchange currencies at some specified time in the future.
Nominal exchange rate is merely the price of one currency in terms of another with no reference
mad to what this means in terms of purchasing power of goods/services.
Real exchange rate is the nominal exchange rate adjusted for relative price between the countries
P¿
under consideration. Sr =S , where Sr is the index of the real exchange rate, S is the nominal
P
¿
exchange rate in index form, P is the index of the domestic price level and P is the index of the
foreign price level.
The effective exchange rate is measure of whether or not he currency is appreciating or depreciating
against a weighted basket of foreign currencies. The US conducting 30% of its foreign trade with the
UK and 70% of its trade with Europe. This means a weight of 0.3 will be attached to the bilateral
exchange rate index with the pound an 0.7 to the euro.
Since the adoption of floating exchange rates in 1973 there has developed an exciting new set of
theories attempting to explain exchange rate behavior, generally known as the modern asset-market
approach to exchange rate determination. For now we look at a simple model of exchange rate
determination. The exchange rate of the pound will be determined by the intersection of the supply
and demand for pound on the foreign exchange market.
As the dollar appreciates against the euro (Germany is the domestic, US is foreign country), the price
of the Germany export to US importers increases, which leads to a lower quantity of exports and
with it a reduced demand for dollars. Hence, the demand curve for dollars slopes down from left to
right. The supply of dollars is in essence the US demand for euros. As the dollar appreciates, the cost
of Germany exports becomes cheaper for US residents. As such, they demand more Germany
exports. This results in an increased demand for euros. If the goods demand response is sufficiently
strong, US residents have to increase the amount of
dollars supplied in the foreign exchange market, and this
yields an upward-sloping supply of dollars. When the
exchange rate is left to float freely it is determined by the
interaction of the supply and demand curves.
Floating exchange rate regime
The foreign exchange market is defined as a market where the various national currencies are bought
and sold. Exactly what factors determine how much domestic currency has to be given in exchange
to obtain a unit of foreign currency, the behavior of exchange rates and the impact of exchange rate
changes on the economy is one of the major fields of study in international economics.
Two definitions of the exchange rate:
1. Domestic currency units per unit of the foreign currency: taking the pound sterling as the
foreign currency, that is $1.58/£1.
2. Foreign currency units per unit of domestic currency: £0.6329/$1.
The first definition is typically used in the theoretical economic literature. In this course we use the
first definition.
A rise in the exchange rate from $1.58/£1 to say $1.80/£1 would mean that more dollars are
required to purchase one pound, so that the pound has appreciated or, equivalently, the dollar has
depreciated.
The bid rate is the rate at which a bank will buy sterling, while the offer rate is the rate at which the
bank will sell sterling in exchange for dollars. The difference is known as the bid-offer spread and
represents the gross profit margin of the bank.
The foreign exchange market is a worldwide market and is made up primarily of commercial banks
foreign exchange brokers and other authorized agents trading in most of the currencies of the world.
The main participants in the foreign exchange market can be categorized as follows:
Retail clients. These are made up of businesses, international investors, multinational
corporations and the like who need foreign exchange for the purposes of operating their
businesses. They do not directly purchase or sell foreign currencies themselves; rather they
operate by placing buy/sell orders with the commercial banks.
Commercial banks. The commercial banks carry out buy/sell orders from their retail clients
and buy/sell currencies on their own account (known as proprietary trading) so as to alter
the structure of their assets and liabilities in different currencies. The banks deal either
directly with other banks or through foreign exchange brokers.
Foreign exchange brokers. Often banks do not trade directly with one another, rather they
offer to buy and sell currencies via foreign exchange brokers. Operating through such brokers
is advantage because, since they collect buy and sell quotations for most currencies from
many banks, the most favourable quotation is obtained quickly and at very low cost. One
disadvantage of dealing through a broker is that a small brokerage fee is payable which is not
incurred in a straight bank deal. Each financial centre normally has just a handful of
authorized broker through which commercial banks conduct their exchanges.
Central banks. Normally the monetary authorities of a country are not indifferent to changes
in the external value of their currency. Even though exchange rates of the major
industrialized nations have been left to fluctuate freely since 1973, central banks frequently
intervene to by and sell their currencies in a bid to influence the rate at which their currency
is traded. Under a fixed exchange rate system the authorities are obliged to purchase their
currencies when there is excess supply, and sell the currency when there is excess demand.
Arbitrage is the exploitation of price differentials for riskless guaranteed profits. One of the most
important implications deriving from the close communication of buyers and sellers in the foreign
exchange market is that there is almost instantaneous arbitrage across currencies and financial
centres.
, Financial centre arbitrage ensures that the dollar-pound exchange rate quoted in New York will be
the same in London and other financial centres.
Cross currency arbitrage. Suppose that the exchange rate of the dollar against the pound is $1.58/£1
and the exchange rate of the dollar against the euro is $1.30/€1. Currency arbitrage implies that the
exchange rate of the euro against the pound will be €1.21254/£1 (1.58/1.30).
The spot exchange rate is the quotation between two currencies for immediate delivery (the current
exchange rate).
The forward exchange rate. In addition to the spot exchange rate it is possible for economic agents
to agree today to exchange currencies at some specified time in the future.
Nominal exchange rate is merely the price of one currency in terms of another with no reference
mad to what this means in terms of purchasing power of goods/services.
Real exchange rate is the nominal exchange rate adjusted for relative price between the countries
P¿
under consideration. Sr =S , where Sr is the index of the real exchange rate, S is the nominal
P
¿
exchange rate in index form, P is the index of the domestic price level and P is the index of the
foreign price level.
The effective exchange rate is measure of whether or not he currency is appreciating or depreciating
against a weighted basket of foreign currencies. The US conducting 30% of its foreign trade with the
UK and 70% of its trade with Europe. This means a weight of 0.3 will be attached to the bilateral
exchange rate index with the pound an 0.7 to the euro.
Since the adoption of floating exchange rates in 1973 there has developed an exciting new set of
theories attempting to explain exchange rate behavior, generally known as the modern asset-market
approach to exchange rate determination. For now we look at a simple model of exchange rate
determination. The exchange rate of the pound will be determined by the intersection of the supply
and demand for pound on the foreign exchange market.
As the dollar appreciates against the euro (Germany is the domestic, US is foreign country), the price
of the Germany export to US importers increases, which leads to a lower quantity of exports and
with it a reduced demand for dollars. Hence, the demand curve for dollars slopes down from left to
right. The supply of dollars is in essence the US demand for euros. As the dollar appreciates, the cost
of Germany exports becomes cheaper for US residents. As such, they demand more Germany
exports. This results in an increased demand for euros. If the goods demand response is sufficiently
strong, US residents have to increase the amount of
dollars supplied in the foreign exchange market, and this
yields an upward-sloping supply of dollars. When the
exchange rate is left to float freely it is determined by the
interaction of the supply and demand curves.
Floating exchange rate regime
