How people trade different currencies

1. International Foreign
Exchange Market

2. Definition: Foreign Exchange Market
• Foreign exchange market is the market composed
primarily of banks, serving firms and consumers who
wish to buy and sell various currencies
• Foreign exchange market business facilitate
international trade and transactions
• The term should not be thought of as a special
building or location where traders exchange
currencies
• Usually foreign exchange completed without the
transacting parties meeting physically
• Arrangements can be made by phone, or via the
internet

3. Geographical Extent of the Forex Market
• Foreign exchange market is the largest financial
market in the world
• It is open somewhere in the world 365 days a year,
24 hours a day
• Daily trading of spot and forward foreign exchange
exceeds $5.1 trillion per day
• London is the largest foreign exchange trading centre

4. Geographical Extent of the Forex Market
• There are three major segments
1. Austrasia: with Sydney, Tokyo, Hong Kong, Singapore
Singapore and Bahrain as the major trading centres
2. Europe: with Zurich, Frankfurt, Paris, Brussels,
Amsterdam and London - major trading centres
3. North America: with New York, Montreal, Toronto,
Chicago, San Francisco and Los Angeles as the main
trading centres
• The 24 hour a day trading follows the sun around the
globe
• Most trading rooms operate over 9-12 hour working
day, some use three 8-hour shifts to trade around the
clock

5. Organisation and Functions of Forex Market
• Trading does not take place in a central marketplace
where buyers and sellers meet
• It is done over-the-counter (OTC)
• This is a worldwide linkage of bank currency traders,
non-bank dealers and foreign exchange brokers
• These assist in trades connected to one another via
network of telephones, computer terminals, internet
and automated dealing systems
• The communication system of the forex market is the
the most advanced, even more advanced than those
of industry, government, military and intelligence
operations

6. Spot Market

7. Spot Market
Meaning and Functions of the Spot Market
• The spot market involves the immediate purchase or
sale of foreign exchange
• It is the most common type of foreign exchange
transactions
• The foreign exchange transaction are agreed upon
and executed immediately at the rate that is known
as the spot rate
• Due to the geography of the forex market, normally
settlements are done within two business days
• This accounts for about 1/3 of the forex trades

8. Spot Market
•At any given point in time, the spot exchange
rate between two currencies should be similar
across various banks
•If there is a large discrepancy, customers or
other banks would purchase large amounts of
currency from a lower quoting bank and sell
immediately to a higher quoting bank
•Such actions are known as arbitrage
•They would eliminate those discrepancy

9. Direct and Indirect Spot Quotation
Direct Quote
• Is the amount of domestic currency which is equal to
one foreign currency unit
• e.g. TZS 2200=$ 1 is a direct quotation for Tanzania
Indirect Quote
• Is the amount of foreign currency that is equal to one
one domestic currency unit
• In Tanzania and most other countries direct quotes
are more common
• In UK indirect quotes are commonly used

10. Direct and Indirect Quotation
• Currencies may be quoted in either direction
• US $ and Euro might be quoted €/$ or $/€
• i.e €1.1414/$ or $0.8763/€
• Direct quote is simply the reciprocal of the indirect
quote
• If a currency is quoted €1.1414/$, the € is the term
currency (reference currency) and the $ is the base
currency
European Terms: When the $ is priced in terms of a
foreign currency (an indirect quote from US perspective)
perspective)
American Terms: other currencies are priced in terms of
$ (direct quote from the US perspective)

11. Direct and Indirect quotations
• It is a standard practice to use American terms
• However, most currencies in the interbank market
are quoted in European terms

12. Bid – Ask Spread
• Banks do not charge a commission on their currency
transactions
• They profit from the spread between the buying and
selling rates of the foreign exchange transactions
• Quotes are always in pairs
• The first rate is the buying or bid price
• The second is the selling or ask or offer price
• The bid price is the price the dealer is willing to pay for a
a currency
• The ask price is the amount the dealer wants you to pay
for the currency
• The bid-ask spread is the difference between the bid and
and ask prices

13. Bid – Ask Spread
•When considering the prices banks use,
remember that the bank will buy the base
currency low and sell the base currency high
•Example
•A dealer would likely quote these prices as 72-
77
•It is presumed that anyone trading $10m
already knows the “big figure”

14. Example of Spot Quotation
Given a quotation $1.9072-77/£
•Base currency is £
•Bid price is $1.9072/£: the dealer buys and the
customer sells the £
•Ask price $1.9077/£: the dealer sells and the
customer buys the £
•The customer receives less when selling and
pays more when buying the base currency
•Dealer’s Profit = Ask Price – Bid Price
•Dealer’s profit =1.9077-1.9072 =$0.0005/£

15. Spot Quotation
• We also use the following notation
• 𝑆𝑏 $
£ = 1.7072 𝑎𝑛𝑑 𝑆𝑎 $
£ = 1.7077

16. Spot Foreign Exchange Trading
•For most currencies quotations are carried out
to four decimal places in both the American
and European terms
•However, for some currencies (e.g. Japanese
Yen) quotation in European terms are carried
out only to two or three decimal places, but in
American terms the quotations of the Yen may
be carried out to as many as eight decimal
places

17. Spot Foreign Exchange Trading
•In the interbank market, the standard size trade
trade among large banks in the major
currencies is for the equivalent of $10 million
•Dealers quote both the bid and the ask, willing
to either buy or sell up to $10 million at the
quoted prices

18. Spot Foreign Exchange Trading
• The interbank foreign exchange traders use a
shorthand abbreviation in expressing spot currency
quotation
• Consider the $/£ bid-ask quote given above: i.e.
$1.9072-1.9077/£
• Here 1.90 is known as the big figure
• It is assumed to be known by all traders
• The last two digits to the right are referred to as the
small figure
• It is unambiguous for a trader to respond to a 72-77
when asked what his quote for the £ is
• Retail bid-ask spread is wider than the interbank
spread

19. Cross Exchange Rate Quotations
• Cross-exchange rate is the exchange rate
between a currency pair where neither currency
is the domestic currency
• The cross exchange rate can be calculated from
the US $ exchange rates for the two currencies
using either the American or European term
quotations

20. Cross Exchange Rate Quotations
• The €/£ cross rate can be calculated from American
terms quotation as follows
• Given S($
£ )=1.5272 and S($
€ )=0.9764 give the
𝑆 €
£
𝑆 €
£ =
$
£
$
€
=
1.5272
0.9764
= 1.5641
• In European terms
• 𝑆 €
£ =
€
$
£
$

21. Cross Exchange Rate
A tourist from UK who is now in Las Vegas USA wants
to visit Ruaha National Park. He wishes to change his
Pound Sterlings into Tanzanian Shillings ad goes into a
Vegas bureau de change and observes the following
exchange rate quotations
TZS/USD 2080-95
USD/GBP 1.8300-10
At what rate will the bureau sell TZS spot vs the £?
At what rate will the bank buy TZS spot vs the £?
What will be the two-way quotation of spot TZS vs £?

22. Cross Exchange Rate
• Steps for calculation of Cross Rate
• For Ask Rate
𝐴𝑠𝑘 𝑇𝑍𝑆
𝐺𝐵𝑃 = 𝐴𝑠𝑘(𝑇𝑍𝑆
𝑈𝑆𝐷) × 𝐴𝑠𝑘(𝑈𝑆𝐷
𝐺𝐵𝑃)
Or
𝐴𝑠𝑘 𝑇𝑍𝑆
𝐺𝐵𝑃 = 𝐴𝑠𝑘(𝑇𝑍𝑆
𝑈𝑆𝐷) ×
1
𝐵𝑖𝑑(𝐺𝐵𝑃
𝑈𝑆𝐷)
• For Bid Rate
𝐵𝑖𝑑 𝑇𝑍𝑆
𝐺𝐵𝑃 = 𝐵𝑖𝑑(𝑇𝑍𝑆
𝑈𝑆𝐷) × 𝐵𝑖𝑑(𝑈𝑆𝐷
𝐺𝐵𝑃)
or
𝐵𝑖𝑑 𝑇𝑍𝑆
𝐺𝐵𝑃 = 𝐵𝑖𝑑(𝑇𝑍𝑆
𝑈𝑆𝐷) ×
1
𝐴𝑠𝑘(𝐺𝐵𝑃
𝑈𝑆𝐷)

23. Cross Exchange Rates
• How can we get the above exchange rates from the rates
rates given?
𝑇𝑍𝑆
𝐺𝐵𝑃
=
𝑇𝑍𝑆
𝐺𝐵𝑃
×
𝑈𝑆𝐷
𝐺𝐵𝑃
We multiply because the currencies are in alternating
positions
1. Bank sells the TZS (Bank buys the USD) x Bank buys
the USD (bank sells the GBP)= 2080 x 1.8300
=3806.4
2. Bank buys TZS (bank sells USD) x Bank buys USD
(Bank sells GBP) 2095 x 1.8310 =3835.9
Two way quotation TZS 3806.4 – 3835.9/GBP

24. Spot Rate Movements
•Exchange rate movement is caused by the
market interaction (supply and demand forces)
•It is called appreciation or depreciation
•In other cases the currency value change may
be initiated by the government when it up-
value or devalue its currency

25. Spot Rate Movements
•The percentage appreciation or depreciation of
of one currency against another currency is
calculated as follows
𝑄𝐶 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 (𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) =
𝑁𝑒𝑤 𝐵𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑄𝐶 − 𝑂𝑙𝑑 𝐵𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑄𝐶
𝑂𝑙𝑑 𝐵𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑄𝐶
× 100%
𝐵𝐶 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛(𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) =
𝑁𝑒𝑤 𝑄𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝐶 − 𝑂𝑙𝑑 𝑄𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝐶
𝑂𝑙𝑑 𝑄𝐶 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝐶
× 100%

26. Spot Rate Movements
• A Tanzanian investor bought shares of Ugandan
company on Kampala Stock exchange when the rate
was TZS 0.125 per UGX 1. Overtime the TZS
appreciated against the UGX to a rate of TZS 0.120
per UGX 1. What is the UGX depreciation. What is
the TZS appreciation
𝑈𝐺𝑋 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
0.120−0.125
0.125
× 100%= 4%

27. Triangular Arbitrage
• If direct quotes are not consistent with the cross-
exchange rates, a triangular arbitrage profit is
possible
• Triangular arbitrage is the process of trading out the
domestic currency into a second currency and then
trading it for a third currency which is in turn traded
for the domestic currency

28. The Forward Market

29. The Forward Market
• The forward market involves contracting today for
the future purchase or sale of foreign exchange at
the rate that is agreed upon today
• The forward price may be the same as the spot price
price
• But usually it is higher (at a premium) or lower (at a
discount) than the spot rate
• Forward exchange rates are quoted on most
currencies for a variety of maturities
• Most common maturities are 1, 3, 6, 9 and 12
months
• These are readily available

30. The Forward Market
• Quotations on non standard, or broken term
maturities are also available
• Maturities extending beyond one year are becoming
more frequent
• For good bank customers a maturity extending out
out to 5 and even as long as 10 years is possible
Notation
• For exchange rate quoting the $ for the pound 6
months forward, we write
• 𝐹6
£
$ , where F indicates the forward rate, 6
denotes the six-month maturity based on a 360 day
year

31. The Forward Market
Quotations
•Forward quotes are either direct or indirect
•The indirect quote is the reciprocal of the other
other
•The meaning of the direct and indirect is
exactly as we had in the spot rate terminologies
terminologies

32. Forward Rate
• Consider the American term Swiss Franc forward
quotations in relationship to the spot rate
quotations
𝑆 𝑈𝑆𝐷
𝐶𝐻𝐹 = 0.6653
𝐹1
𝑈𝑆𝐷
𝐶𝐻𝐹 = 0.6660
𝐹2
𝑈𝑆𝐷
𝐶𝐻𝐹 = 0.6670
𝐹3
𝑈𝑆𝐷
𝐶𝐻𝐹 = 0.6684
• In American terms the Franc is
trading at a premium to the
Dollar
• In European terms The dollar is
trading at a discount to the
Swiss Franc and the discount
increases out the further the
forward maturity date is

33. Long and Short Forward Position
•Taking a Long position means buying foreign
exchange forward
•Taking a short position means selling foreign
exchange forward
•Bank customers as well as interbank traders
can take long or short position by dealing with
a trader from a bank

34. Swap vs Outright Forward transactions
Outright Forward transaction is uncovered
speculative position in a currency, even though it might
be part of the currency hedge to the bank customer on
the other side of the transaction
Swap Transaction is the simultaneous sale (or
purchase) of spot foreign exchange against a forward
purchase (or sale) of approximately an equal amount of
foreign currency
The swap transaction takes place because traders do not
want to leave their position uncovered

35. Forward Points
• Bank dealers often use shorthand notation to
quote bid and ask forward prices in terms of
forward points that are either added or
subtracted from the spot bid and ask quotation
Example
Contract Exchange rate
Spot 1.5267 – 1.5272
One Month 32 – 30
Three Month 57 -54
Six Month 145 - 138

36. Contract Exchange rate
Spot 1.5267 – 1.5272
One Month 32 – 30
Three Month 57 -54
Six Month 145 - 138
• These forward points are subtracted from the spot
bid and ask prices to obtain the outright forward
rates
Spot ($/£) $1.5267 -$1.5272
Forward Point Quotations Outright Forward Quotations
One-month 32 - 30 1.5235 -1.5242
Three-month 57 – 54 1.5210 – 1.5218
Six-month 145 - 138 1.5122 – 1.5134
Forward Points
Note that the second
number in the forward
point pair is smaller than
the first

37. Note
• The Pound is trading at a forward discount to the
dollar
• The bid prices are lower than the ask prices
• The bid ask spread increases in time to maturity
These three conditions prevail only because the forward
points were subtracted from the spot prices.
• If the forward prices were trading at a premium to
the spot price, the second number in a forward point
pair would be larger than the first
• The trader would have to add the points to the spot
bid and ask prices to obtain the outright forward bid
and ask rate.
Forward Points

38. Advantages of Quoting Forward rates in
terms of forward points:
• Forward points may remain constant for long
periods of time, even if the spot rates fluctuate
frequently
• In Swap transactions where the trader is
attempting to minimize currency exposure
• The actual spot and outright forward rates are
often of no consequences.
• What is important is the premium or discount
differential, measured in forward points.

39. Forward Premium
• It is common to express the premium or
discount of a forward rate as an annualized
percentage deviation from the spot rate.
• The forward premium (or discount) is useful
for comparing against interest rate differential
between two countries.
• The forward premium or discount can be
expressed in American or European terms.
• Obviously, if a currency is trading at a premium
(discount) in American terms, it will be at a
discount (premium) in European terms.

40. Formula for forward premium or discount in American terms:
• fN, ¥ v $ = F
$
¥
− S
$
¥
𝑆
$
¥
x
360
days
Contract Exchange rate $/¥ Exchange rate ¥/$
Spot 0.008433 118.58
One Month 0.008448 118.37
Three Month 0.008471 118.05
Six Month 0.008508 117.53
Example: Given the American terms $/¥ exchange rates
Forward Premium
f3, ¥ vs $ =
0.008471−0.008433
0.008433
𝑋
360
90
x 100 =2%

41. • In European terms the forward premium or discount is
calculated as
fN,$ vs ¥ = F
¥
$
− S
¥
$
𝑆
¥
$
x
360
days
• Using the data for the European quotations of the ¥
the forward premium or discount can be calculated as:
f3, $ vs ¥ =
118.05−118.58
118.58
×
360
90
= -0.0175
• We see that the three month forward discount is -
0.0175, or -1.75 percent. In words we say that the US
$ is trading versus the Japanese yen at 1.75 percent
discount for delivery in 3 months.
Forward Premium

42. Speculation:
• Speculation is an attempt to profit by trading
on expectations about price changes in the
future.
• In the foreign exchange markets, one
speculates by taking an open (unhedged)
position in a foreign currency and then by
closing that position after the exchange rate
has moved in the expected direction.

43. Speculating in the Spot Market:
Assume the US $ is currently quoted as follows in the
BOT today:
Spot Rate TZS2190/$
If you have TZS10,000,000 with which to speculate, and
you believe that in six months the spot rate for the
dollar will be TZS2250/$.
• What is required in speculation in the spot market is
only the belief by the speculator that the foreign
currency ($) will appreciate in value

44. Speculating in the spot Market
The following steps will be required for the Speculation in the spot
market
1.Today use the TZS10,000,000 to buy $4566.21 spot at
TZS2190/$.
2.Hold the $4566.21 indefinitely, until the value of the dollar
reaches the target value.
3.When the target exchange rate is reached, Sell $4566.21 at the
new spot rate TZS2250/$ receiving $4566.21 X TZS2250/$
= TZS 10,273,972 The profit is TZS 273,972
• This ignores the interest income on the $ being held, and the
opportunity cost of the TZS for the moment.
• The potential maximum gain is unlimited, while the maximum
loss will be TZS 10,000,000 if the TZS drops in value to zero.
• With the speculation in the spot market, you may set a target
date: say six months.
• But you may buy the TZS back earlier or later if you wish.

45. Speculating in the Forward Market
• Forward Market speculation occurs when the
speculator believes that the spot price at some
future date will differ from today’s forward price
for that same date.
• Success does not depend on the direction of the
movement of the spot rate
• But on the relative position of the future spot
rate and the current forward rate

46. Speculating in the Forward Market
• Example:
Given the following quotations of the spot and
six-month forward rates:
If the future spot rate after six months is
forecasted to be TZS2360/$
The following steps will be required for the
speculation in the forward market:
Spot Rate TZS2190/$
Six month Forward TZS2245/$

47. Speculating in the Forward Market
1. Today buy $4,454.34 forward six month at the forward quote
of TZS2245/$. Note that this step requires no outlay of cash.
2. In six months, fulfill the forward contract and receive
$4,454.34 at the rate of TZS2245/$ for the cost of TZS
10,000,000
3. Simultaneously sell the $4,454.34 in the spot market, receiving
TZS10,512,242.
4. Profit TZS 512,242.
The profit of TZS512,242 cannot be related to an investment
base to calculate a return on investment because the dollar funds
were never needed.
• On the completion of six month you just cross your payment
obligation of TZS 10m with the receipts of TZS 10,512,242 and
gets a profit of TZS 512,242

48. Use of Money and Capital Market to Create
Forward Rate
Money market hedging
• The basic idea is to avoid future exchange rate uncertainty by
making the exchange at today’s spot rate
• This is achieved by depositing/borrowing the foreign currency
until the e actual transaction cash flow occurs
• If a Kenyan company needs to pay a Tanzanian supplier in TZS
in three months time, and it does not have enough cash to pay
now, but will have sufficient cash in three months’ time, the
company could
1. Borrow the appropriate amount in KShs now
2. Convert the KShs to TZS immediately
3. Put the TZS on deposit in a TZS account
4. When the time comes to pay the company
a) Pay the supplier out of the TZS bank account
b) Repay the KShs loan

49. Corporate Foreign Exchange Exposure
Money market hedging
• A UK company owes a Danish supplier Kr 3.5m in 3 months’ time. The
spot exchange rate is Kr 7.5509-7.5548/£. The company can borrow in
Pound for 3 months at 8.6% per annum and can deposit Kr for 3 months
at 10%
• Calculate the cost in pounds with a money market hedge

50. Corporate Foreign Exchange Exposure
Money market hedging
Future foreign
currency cash flow
• Settle liability with
receipt from customer
• Borrow the present
value of the future
receipt
• Sell today at spot
• (place domestic
currency on deposit)
• Use deposit to pay
supplier
• Borrow in domestic
currency
• Buy the present value of
the future payment today
at spot
• Place on deposit
Receipt
Payment
NOW
FUTURE
TRANSACTIO
N DATE
Interest Interest

51. Parity Relationships

52. Meaning of Parity Relationships
• Parity relationships refer to equilibrium
relationships that should apply if markets are
not impeded
• The equilibrium relationships involve product
prices, interest rates, spot rates and forward
exchange rates
• The parity relationships are useful in
forecasting changes under both fixed rate and
floating rate systems

53. Arbitrage Conditions in International Finance
• Arbitrage is one of the most important concepts
in finance
Definition of Arbitrage
• Arbitrage is the simultaneous purchase and sale
of the same assets or commodities on different
markets to profit from price discrepancies
• As long as there are profitable arbitrage
opportunities, the market cannot be in
equilibrium
• The market can be said to be in equilibrium
when no profitable arbitrage opportunity exist

54. Law of One Price
Law of One Price
• In the competitive markets characterised by
numerous buyers and sellers having low cost
access to information, exchange adjusted
prices of identical tradable goods and financial
assets must be within transaction costs of
equality worldwide
• This idea is known as the law of one price,
and is enforced by international arbitrageurs
who follow the profit guaranteed wisdom of
“buy low, sell high
• This prevent deviations from equality

55. Key Parity Relationships
• In this diagram, if inflation in Tanzania is expected to exceed
inflation in the USA by 3% for the year, then the TZS should
decline in value by about 3% relative to the USD

56. Key Parity Relationships
• Similarly the one year forward TZS should sell at a 3%
discount relative to the USD

57. • Likewise one year interest rates in Tanzania should be about
3% higher than one-year interest rates on securities of
comparable risk in the USA

58. Parity Relationships
• The link between these parity conditions is the
adjustment of the various rates and prices to
inflation
• The expansion of money supply in excess of real
output growth is the main cause of inflation
• The theory is in line with the basic price theory
• As the supply of one commodity increases
relative to supplies of other commodities, the
price of the first commodity must decline
relative to the price of other commodities
• A good harvest of maize causes price decline

59. Parity Relationships
• Similarly, as the supply of money increases
relative to the supply of goods and
services, the purchasing power of money
(the exchange rate between money and
goods) must decline

60. Purchasing Power Parity
• Purchasing Power parity focuses on the
inflation-exchange rate relationship
The Absolute Form (Law of One Price)
• Prices of similar products in two different
countries should be equal when measured in
common currency
• If there is a discrepancy in prices measured
by a common currency, demand should shift
until prices converge
• Existence of transportation costs, tariffs and
quotas may prevent absolute PPP

61. Purchasing Power Parity
Relative form of PPP
• The rate of change in the prices of
products should be similar when measured
in a common currency as long as
transportation costs and trade barriers are
unchanged

62. Purchasing Power Parity
Derivation of the PPP
If ih and if are the periodic price-level
increases (rates of inflation) for the home
country and the foreign country
respectively
• e0 is the home currency value of one
unit of foreign currency at the
beginning of the period and
• et is the spot exchange rate in period
t, then

63. Purchasing Power Parity
Derivation of the % Change of Currency
value
• Starting with
• And taking t=1 we have
Subtracting 1 from both sides
• We get

64. Could be modified
Purchasing Power Parity

65. • The formula above shows that the exchange
rate change during a period should equal the
inflation differential for the same period
In effect, the PPP says:
• The currencies with high rate of inflation
should depreciate relative to currencies with
low inflation
The Purchasing Power Parity

66. Lesson of the PPP
• Just as the price of goods in one year cannot
be meaningfully compared with the price of
goods in another year without adjusting for
inflation
• So exchange rate changes may indicate
nothing than the reality that countries have
different inflation rates
• According to PPP, exchange rate movements
should just cancel out changes in the foreign
price level relative to domestic price level
• Real exchange rate is more important
The Purchasing Power Parity

67. Real Exchange Rate
• Is the nominal exchange rate (𝒆𝒕) adjusted for
changes in the relative purchasing power of
each currency since some base period
• In technical terms, the real exchange rate at
time t 𝑒𝑡
′
relative to the base period (t0) is
• Where Pf is the foreign price level and Ph the
home price level at time t (indexed 100 at t=0)
The Purchasing Power Parity
𝒆𝒕
′
= 𝒆𝒕
𝑷𝒇
𝑷ℎ

68. Real Exchange Rate
• If the nominal exchange rate
et = USD 1.36/EUR
• If the German price of a burger is 2.5 EUR and the
U.S. price of the same burger is USD 3.40, then The
RER 𝒆𝒕
′
𝒆𝒕
′
= 𝒆𝒕
𝑷𝒉
𝑷𝒇
= (1.36) x (2.5) ÷ 3.40 =1
• But if the German price were 3 EUR and the U.S.
price USD 3.40, then the RER (𝒆𝒕
′
) would be
1.36 x 3 ÷ 3.40 = 1.2.
The Purchasing Power Parity

69. Example of PPP
1. The inflation rate in Great Britain is
expected to be 4% per year, and the
inflation rate in Switzerland is expected
to be 6% per year. If the current spot
rate is £1 = SF 12.50, what is the
expected spot rate in two years?
The Purchasing Power Parity

70. Example of PPP
2. From base price levels of 100 in 2018,
Japanese and U.S. price levels in 2019
stood at 102 and 106, respectively. a. If
the 2018 $/¥ exchange rate was
$0.007692, what should the exchange
rate be in 2019?
The Purchasing Power Parity

71. Example of PPP
3. Two countries, the United States and
England, produce only one good,
wheat. Suppose the price of wheat is
$3.25 in the United States and is £1.35
in England. What is the exchange rate?
The Purchasing Power Parity

72. Example of PPP
4. Chase Econometrics has just published
projected inflation rates for the United
States and Germany for the next five years.
U.S. inflation is expected to be 10 percent
per year, and German inflation is expected
to be 4 percent per year
If the current exchange rate is $0.95/€, what
should the exchange rates for the next five
years be?
The Purchasing Power Parity

73. Example of PPP
5. On January 1, the U.S. dollar:Japanese yen
exchange rate is $1 = ¥250. During the year,
U.S. inflation is 4% and Japanese inflation is
2%. On December 31, the exchange rate is
$1 = ¥235. What are the likely competitive
effects of this exchange rate change on
Caterpillar Tractor, the American
earth-moving manufacturer, whose
toughest competitor is Japan's Komatsu?
The Purchasing Power Parity

74. Fisher Effect is another parity condition
• Fisher effect holds that an increase in expected
inflation rate in a country will cause a
proportionate increase in the interest rate in
the country
• In other words a decrease in the expected
inflation rate in a country will cause a
proportionate decrease in the interest rates in
the country
• The fisher effect states that the nominal
interest rate r is made up of two components
• A real required return a and an inflation premium i
The Fisher Effect

75. Formerly the fisher effect is:
1+nominal rate=(1+real rate)(1+expected inflation rate)
(1+r)=(1+a)(1+i)
1+r=1+a+i+ai
r=a+i+ai
But since ai is very small it can be ignored: so r=a+i
• The fisher equation says: if the required return is 3%
and the expected inflation is 10% then the nominal
interest rate will be about 13%
• The logic behind: TZS 1000 next year will have the
purchasing power of TZS 900 in today’s prices
• So the borrower pays the lender TZS 130 (100 to
compensate for the erosion of purchasing power and
30 for the real return)
The Fisher Effect

76. • Fisher effect asserts that the real returns are
equalized across countries through arbitrage
• i.e. 𝑎ℎ = 𝑎𝑓
• If expected real returns were higher in one country
than another, capital would flow from the second to
the first country
• The process of arbitrage would continue, in the
absence of government intervention until expected
returns are equalized
• So in equilibrium, with no government intervention,
the nominal interest rate differentials will
approximately equal the anticipated inflation
differentials between the two currencies
• 𝑟ℎ − 𝑟𝑓 = 𝑖ℎ − 𝑖𝑓 where r is the nominal interest rate
The Fisher Effect

77. • The exact form of relationship is
(1 + 𝑟ℎ)
(1 + 𝑟𝑓)
=
(1 + 𝑖ℎ)
(1 + 𝑖𝑓)
• This version of the Fisher Effect says that the
currencies with higher rates of inflation should bear
higher interest rates than currencies with lower
inflation
• For example, if inflation rates in Kenya and Tanzania
were 4% and 7% respectively, then the FE says that
the nominal interest rates should be about 3% higher
in Tanzania than in Kenya
The Fisher Effect

78. Examples
• If expected inflation is 100 percent and the
real required return is 5 percent, what will
the nominal interest rate be according to the
Fisher effect?
The Fisher Effect

79. The International Fisher Effect
• The PPP implies that the exchange rates will move
to offset changes in inflation rates
• The Fisher effect implies that interest rates will
move to offset changes in inflation rate
differentials
• So a rise in the domestic inflation rate relative to
those of other countries will be associated with a
fall in the home currency value
• It will also be associated with a rise in the
domestic interest rates relative to foreign interest
rates
• When we combine these two conditions we get the
International Fisher Effect (IFE)

80. The International Fisher Effect
•
𝑒𝑡
𝑒𝑜
=
(1+𝑟ℎ)𝑡
(1+𝑟𝑓)𝑡
• Where 𝑒𝑡 is the expected exchange rate in period t
• Similarly, for a single period
•
𝑒1
𝑒𝑜
=
(1+𝑟ℎ)
(1+𝑟𝑓)
• We can rearrange to compare the returns of investing at home
(1 + 𝑟ℎ) and expected home currency return from investing
abroad
𝑒1
𝑒𝑜
(1 + 𝑟𝑓)
• 1 + 𝑟ℎ =
𝑒1
𝑒𝑜
(1 + 𝑟𝑓)
• So the expected return from investing at home should equal the
expected home currency return from investing abroad

81. The International Fisher Effect
• Taking
𝑒1
𝑒𝑜
=
(1+𝑟ℎ)
(1+𝑟𝑓)
and subtracting 1 from both
sides
•
𝑒1
𝑒𝑜
− 1 =
1+𝑟ℎ
1+𝑟𝑓
− 1
•
𝑒1
𝑒𝑜
−
𝑒𝑜
𝑒𝑜
=
1+𝑟ℎ
1+𝑟𝑓
−
1+𝑟𝑓
1+𝑟𝑓
•
𝑒1−𝑒𝑜
𝑒𝑜
=
1+𝑟ℎ − 1+𝑟𝑓
1+𝑟𝑓
•
𝑒1−𝑒𝑜
𝑒𝑜
=
𝑟ℎ−𝑟𝑓
1+𝑟𝑓
≅ 𝑟ℎ − 𝑟𝑓
• This equation holds if 𝑟𝑓 is very small
• IFE: the nominal interest rate differentials reflect
the expected change in exchange rates

82. Interest Rate Parity
• Interest rate parity is this arbitrage condition
• 1 + 𝑟ℎ = 𝐹
𝑆 (1 + 𝑟𝑓)
• Which must hold when international financial markets
are in equilibrium
Derivation
Suppose a US investor has $1 to invest over 1 year period
• Consider two alternative ways to invest
1. Invest domestically at US interest rate or,
2. Invest in a foreign country, say UK, at the UK rate of
interest and hedge exchange risk by selling the maturity
value of the foreign investment forward
• Suppose the US rate of interest is 𝑟ℎthe maturity value
will be $1(1+𝑟ℎ), and we assume that the investment is
risk free

83. Interest Rate Parity
• To invest in UK he has to carry the following sequence of
transactions
1. Exchange $1 for the pound amount at the prevailing
spot rate S($
£) and gets £(1/S)
2. Invest the pound amount at the UK rate of interest
𝑟𝑓with maturity value of £(1
𝑆)(1 + 𝑟𝑓)
3. Sell the maturity value of the UK investment forward in
exchange for predetermined $ amount $[ 1
𝑆 1 + 𝑟𝑓 ]𝐹
where F is the forward exchange rate
• When the British investment matures he will receive
£(1
𝑆)(1 + 𝑟𝑓) the full maturity value
• He delivers the amount of pounds to pay for the forward
contract and gets the $

84. Interest Rate Parity
• The arbitrage equilibrium will be
1 + 𝑟ℎ = (𝐹
𝑆)(1 + 𝑟𝑓)
• This is the formal IRP

85. Covered Interest Arbitrage (CIA)
• CIA is a situation which occurs when IRP does not
hold, thereby allowing certain arbitrage profits to be
made without the arbitrageur investing any money
out of pocket or bearing any risk.
Example:
• Suppose that the annual interest is 5% in the US and
8% in the UK, and that the spot exchange rate is
$1.50/£ and the forward exchange rate, with one-
year maturity, is $1.48/£. Assume that the arbitrageur
can borrow up to $1,000,000 or £666,667, which is
equivalent to $1,000,000 at the current spot
exchange rate.
• Is there arbitrage opportunity? Give the strategy for
covered interest arbitrage.

86. Covered Interest Arbitrage (CIA)
In terms of our notation rh = 5%, rf = 8%, S = $1.50
and F = $1.48
First check whether IRP is holding under current market
conditions:
(F/S)(1+rf) = (1.48/1.50)(1.08) = 1.0656
(1 + rh) = 1.05
So the current market condition is characterized by
(1 + rh) < (F/S)(1+rf)
IRP does not hold and so profitable arbitrage
opportunity exists.
Since rh < rf an arbitrage transaction should involve
borrowing in the US and lending in the UK.

87. Covered Interest Arbitrage (CIA)
• The arbitrager can carry out the following
transactions:
• In the US, borrow $1,000,000. Repayment in one year
will be $1,050,000.
• Buy £666,667 spot using $1,000,000.
• Invest £666,667 in the UK. The maturity value will be
£720,000 = £666,667 x 1.08
• Sell forward £720,000 in exchange for $1,065,600 =
(£720,000)($1.48/£)
• So the arbitrageur will make a profit of $1,065,600 -
$1,050,000 = $15,600
• The arbitrageur makes this profit without investing
any money out of his pocket, and without bearing any
risk

88. IRP and Exchange Rate Determination
• IRP has an immediate implication for exchange rate
determination
1 + 𝑟ℎ = (𝐹
𝑆)(1 + 𝑟𝑓) could be rearranged in terms of
spot rate
𝑆 = 𝐹
(1 + 𝑟𝑓)
(1 + 𝑟ℎ)
• This equation implies that given the forward exchange
rate, the spot rate depends on relative interest rates
• Ceteris paribus, an increase in the domestic interest rate
will lead to higher foreign exchange value of the
domestic currency
• In addition to the relative interest rates, the forward
exchange rate can be viewed as the expected future
spot rate
• 𝐹 = 𝐸(𝑆𝑡+1|𝐼𝑡)

89. IRP and Exchange Rate Determination
• Substituting this in the IRP
• We have
• 𝑆 =
(1+𝑟𝑓)
(1+𝑟ℎ)
𝑡 + 1
𝐸(𝑆𝑡+1|𝐼𝑡)

90. Foreign Exchange Market Efficiency
• Banks and independent consultants offer many
currency forecasting services
• Some MNCs have their own forecasting departments
in their offices
• Yet no one should pay for currency forecasting
services if foreign exchange markets are perfectly
efficient
The efficient market hypothesis holds
1. Spot rates reflect all the current information and
adjust quickly to new information
2. It is impossible for market analysts to consistently
beat the market
3. All currencies are fairly priced

91. Foreign Exchange Market Efficiency
Foreign exchange markets are efficient if:
1. There are many well-informed investors with ample
funds for arbitrage opportunities when they present
themselves
2. There are no barriers to the movement of funds from
one currency to another
3. Transaction costs are negligible
• Under these conditions exchange rates reflect all
available information
• So exchange rate changes at any time must be due to
new information only
• Since information come randomly, exchange rates
movements are also random

92. Foreign Exchange Market Efficiency
• No one can consistently beat the market if the
foreign exchange markets are efficient.
• There are no underpriced currencies, since all
currencies are fairly priced in efficient exchange
markets
• So no investors can earn unusually large profits in
in foreign exchange markets
Three forms of Market efficiency
1.Weak form Efficiency
2.Semistrong form efficiency
3.Strong form efficiency

93. Three forms of Market Efficiency
1. Weak form Efficiency
• All information contained in the past exchange rate
movements is fully reflected in the current exchange rates
• Hence information about recent trends in a currency’s price
would note be useful for forecasting exchange rate
movements
2. Semistrong form Efficiency
• The current exchange rates reflect all publicly available
information making such information useless for forecasting
exchange rate movements
3. Strong form Efficiency
• Current exchange rate reflect all relevant publicly available
and privately held information, so even insiders are not in
better position

94. Implications of EMH
• The current exchange rate reflect all relevant information
such as money supply, inflation rates, trade balances and
output growth
• The exchange rate will change only when the market
receives new information
• New information is unpredictable
• So the exchange rate will change randomly overtime
• Incremental changes in the exchange rate will be
independent of the past history of exchange rates
• In other words the exchange rate follows a random walk
• So one may predict future exchange rate using either the
current spot exchange rate or the current forward
exchange rate

95. Advantages of EMH
1. EMH is based on market-determined prices, and so
it is costless to generate forecasts
• Both the current spot and forward exchange are
public information
2. Since the foreign exchange markets are assumed
efficient, it is difficult to outperform the market
based forecasts unless the forecaster has access to
private information that is not yet reflected in the
current exchange rate