the foreign exchange market


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the foreign exchange market

  1. 1. Chapter 8 International Trade Foreign Exchange Nations engage in international trade for the same reason that individuals engage in domestic trade Comparative Advantage Specialization & Int. Trade The Foreign Exchange Market Improve productivity More Consumption, Income Increase standard of living International trade requires the exchange of currencies Currency exchange is often regulated by government. ©Thomson/South-Western 2006 1 2 The Foreign Exchange Market The Foreign Exchange MarketThe foreign exchange (ForEx) market is the market in which parties International capital flowsexchange national currencies The acquisition of financial & real assets across national borders 90% of foreign exchange volume is associated with capital flowsIt is not a public outcry auction market, but rather operates as a computer (investment markets)driven over-the-counter market The direct or immediate participants (Dealers) U.S. & foreignThe volume of activity has escalated dramatically in response to the growth commercial banks with international deposits & foreign branchesin world trade volume in goods & services. The ultimate participants import & export firms, tourists & other travelers, & financial entities seeking to invest internationally. 3 4 The Foreign Exchange Rate The Foreign Exchange RateThe price at which one nation’s currency is exchanged for another’s is the The price at which one nation’s currency is exchanged for another’s is theforeign exchange rate foreign exchange rateAn exchange rate exists between each pair of nations that engage in trade An exchange rate exists between each pair of nations that engage in tradeusing different currencies using different currenciesA currency appreciates against other currencies when a single unit of that It depreciates against other currencies when when a single unit of thatcurrency buys more units of these foreign currency currency buys less units of these foreign currency Last month: THB 34.50 / $ Last month: $ 1.54 / £ This month: THB 32.25 / $ This month: $ 1.33 / £ 5 6 1
  2. 2. Table 8-1 Figure 8-1 7 8 Fixed & Floating Exchange Rates Spot & Forward Exchange MarketsFixed exchange rates : exchange rates do not change & countries mustact to maintain some predetermined level of value Spot transactions involve the exchange of currencies for immediate or (adjustable-Bretton Woods exchange rate system (adjustable-peg) “on the spot” delivery & payment required countries get IMF approval to change their exchange rates The system collapsed in the early 1970s The exchange rate at which such transactions take place is called the spot exchange rate.Major industrial states’ currencies currently float according to supply &demand for each currencyFloating exchange rates : exchange rates continuously changeaccording to supply & demand in the world marketplace. 9 10 Spot & Forward Exchange Markets Forward Transaction Forward transactions involve the purchase and sale of foreign currencies Forward Contractfor delivery & payment at some specific future date, at a price specified in Agreement to exchangeadvance Thai Baht for USD The exchange rate at which these forward transactions take place is the forward exchange rate Price: At 33 Baht/USD Forward exchange markets provide hedging for investors to avoid Time: In the next 3 months possible large losses due to changes in the spot exchange rate. Amount: 100,000 Baht Sign ______ (today) 11 12 2
  3. 3. Spot Transaction Forward Transaction Watches Watches U.S. Swiss U.S. Swiss Importer 100, Pay S Fr 100,000 Exporter Importer 100, Pay S Fr 100,000 Exporter in 30 days in 30 daysToday Spot rate = S Fr 1.25 / USD Today Spot rate = S Fr 1.25 / USDExpected cost = Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver in 30 days Actual cost =On the delivery day If that day’s Spot rate = S Fr 1.20 / USD(next 30 days) Then the Actual cost = On the delivery day Forward rate = S Fr 1.2489 / USD Actual cost = 13 14 The Importance of the Exchange Rate The Importance of the Exchange RateA country’s exchange rate level is important because, together with domestic prices, the Exchange rate influences Trade deficits/surplusexchange rate determines the cost of the nation’s products in foreign nations influencing the nation’s exports Because of the large influence of currency values upon trade, the cost of foreign products sold in the country influencing imports disputes among nations have arisen over one governments’Currency Appre products look more expensive decisions to intervene in the foreign exchange market Export less Managed float system.. Import more Trade DeficitCurrency Depre products look cheaper Export more Import less Trade Surplus 15 16 Exchange Rate Determination Figure 8-2The foreign exchange market is highly competitive many small buyers & small sellers relative to the total market homogenous product--a national currency In Freely Floating Exchange Rates, governments rarely intervene exchangerates are driven entirely by supply & demandIn a Managed Float (the system in place today), governments sometimesintervene in an effort to prevent exchange rate movements perceived to beexcessive or strongly at odds with national interests. 17 18 3
  4. 4. The Supply & Demand Model The Supply & Demand Model Demand Supply The demand curve for dollars stems from foreign buyers of American The supply curve for dollars stems from Americans seeking to purchase goods & services, U.S. financial & real assets foreign goods & services, financial & real assets The demand curve is downward sloping because, ceteris paribus, a The supply curve slopes upward because, given other factors, an decline in the price of $ makes everything from the United States increase in the dollar’s value reduces the price of foreign items in the United States. cheaper for foreign buyers. 19 20 Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants1. Relative Price Level Behavior (Inflation) 1. Relative Price Level Behavior (Inflation) Nations with chronically high inflation are likely to be weak-currencyNon-inflation factors nations—i.e., they are likely to see their currencies depreciate over the 2. preferences & product development (innovation) years against currencies of nations that experience lower inflation. 3. productivity behavior (growth) 4. tariffs & quotas (trade restrictions) 21 22 Figure 8-3 Increase in Japanese Prices Purchasing Power Parity Theory The purchasing power parity (PPP) theory says that exchange rates adjust Exchange Rate completely to offset the effects of different inflation rates in two countries S1$ Under highly restrictive & unrealistic conditions, PPP theory would always be valid The law of one price states that the cost of a single homogeneous good must be the same to an American or a foreigner, whether purchased at home or abroad 120 D 1$ Q$ 23 24 4
  5. 5. Purchasing Power Parity Theory Purchasing Power Parity Theory Original exchange rate = 40 THB/USD Why PPP doesn’t always work in the real world In Thailand, 1 hamburger = 80 THB In the real world, many products are not homogeneous in nature, some goods are non- In U.S., 1 hamburger = 2 USD tradable, some goods enjoy brand loyalty that keeps their prices artificially high, and Thailand experiences inflation of 10% some goods sell at higher prices simply because of consumers’ forces of habit. In Thailand, 1 hamburger = 88 THB 1 hamburger in Thailand = 1 hamburger in the U.S. PPP theory works: 88 THB = 2 USD well in accounting for major exchange rate movements The new exchange rate = 44 THB/USD poorly in explaining short-to-intermediate term changes 10% Inflation in Thailand 10% ________in THB 25 26 Figure 8-4 Long-Run Exchange Rate Determinants Non-inflation factors 2. preferences & product development (innovation) 3. productivity behavior (growth) 4. tariffs & quotas (trade restrictions) 27 28 Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants2. Preferences & Product Development 3. Productivity Japan produces new bread toaster improve in productivity production costs fall Foreigners start importing this new product Thai products have lower prices Foreigners demand ______Yen products look more attractive in world market Yen _________ more ________for THB THB ________ 29 30 5
  6. 6. Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants 4. Tariffs and Quotas 4. Tariffs and Quotas U.S. puts more tariffs more tax on imported U.S. puts more quotas products less quantity of imported products Imported products have higher prices U.S. people import _____ U.S. people import _______ supply _____USD supply _____USD USD _____________ USD ____________ 31 32 Spot - ForwardIn your new business venture, you expect a shipment of Swiss watches in 90 days. Upondelivery 90 days from now, you must pay the Swiss company 142,000 Swiss francs. What risk are you taking if you wait 90 days and then buy the needed francs in the spot market? What is the expected cost in $ if the current spot rate = 6.3 S Fr/$ What is the actual cost in $ if the future spot rate = 5.8 S Fr/$ If you enter 90 days Forward Contract and lock-in the forward rate at 6.15 S Fr/$, what is the expected cost? What is the actual cost? What is the benefit you get from entering Forward Contract? 33 6