The document discusses key aspects of foreign exchange markets including: - The global foreign exchange market facilitates international trade and investment by determining currency exchange rates. It operates 24/5 from major trading centers like London, New York, Singapore, and Tokyo. - Primary currencies traded are the US dollar, euro, British pound, Swiss franc, Japanese yen, Australian dollar, Canadian dollar, and New Zealand dollar. - Exchange rates are determined by the supply and demand of currencies based on exports, imports, capital flows, central bank policies, and speculative trading. Fundamental economic factors like trade balances, inflation rates, productivity, and policies influence exchange rates in the short, medium, and long run.

1. Olesia Verchenko, PhD
KSE Insights
July 9, 2015
The Anatomy of Exchange
Rate

2. Global Foreign Exchange Market
2
 The foreign exchange market (forex, FX, or currency
market) - a global, worldwide decentralized financial
market for trading currencies and determining their
relative values.
 The primary purpose: to assist international trade and
investment.
 In terms of volume of trading, it is by far the largest
market in the world.
 It works virtually non-stop:
 24 hours a day except for holidays (opens at GMT 20:15
on Sundays and closes at GMT 22:00 on Fridays)
 Main trading locations:
 London (about 40% of all forex transactions in the world)
 New-York (about 20%)
 Singapore (about 6%)
 Tokyo (about 6%)

3. Primary Currencies
3
 Primary currencies are the ones in which most
daily forex transactions are conducted:
 USD
 EUR
 GBP
 CHF
 JPY
 Other popular currencies:
 AUD
 СAD
 NZD

4. Currency Convertibility
4
 Freely convertible (hard) currencies have no limit
on financial transactions of any kind, may be
used by residents and non-residents of a country,
and can be converted into any foreign currency.
 Partially convertible currencies are usually those
with a number of restrictions on use by non-
residents and a specific range of allowed
transactions.
 Non-convertible currencies have restrictions for
both residents and non-residents barring a
number of financial transactions. They are used
only inside their specific countries (mostly
developing countries).

5. Foreign Exchange Market
5
 How is market exchange rate determined?
 Market equilibrium: supply of forex = demand for forex.
 Let E denote the exchange rate (e.g., UAH 22 per USD 1)
 Market players:
 On the demand side:
 Imports
 Capital outflows
 On the supply side:
 Exports
 Capital inflows
 On both sides:
 Central Bank’s policy
 Savings in hard currencies
 Arbitrage and speculation
Exchange
rate
(UAH/USD)
Quantit
y
of USD
Suppl
y
Deman
d

6. Exchange Rate Determinants
 Fundamental economic factors
 Trade balances
 Consumer tastes towards domestic and foreign goods and their
availability
 Imported inputs for production
 Profitability (return) and riskiness of investments
 Relative production efficiency
 Relative inflation rates
 Government policy w.r.t. international trade (trade
barriers etc.)
 Monetary and fiscal policy
 Market expectations
 News on future market factors
 Speculative expectations of future exchange rate movements.
6

7. Relative Importance of Factors
 Short term (days and hours)
 The most critical are financial flows that react to
 Differences in interest rates
 Changes in exchange rate expectations
 Medium term (months)
 The most important are economic cycles
 Monetary and fiscal policies
 Trade balances
 News on future market factors
7

8. Relative Importance of Factors
 Long term (years)
 The most important are flows of goods, services
and investments that are determined by
 Relative price (inflation) levels
 Investment attractiveness
 Tastes of consumers
 Productivity
 Trade policy
8

9. Exchange Rate and Inflation
9
 Law of one price:
 In competitive markets, free of transportation costs
and barrier to trade, identical goods sold in different
countries must sell for the same price once
converted in the same currency:
where Pj is the domestic price of good j, Pj* is the
foreign price of good j, and E is the market
exchange rate.
 Under these assumptions prices of tradable
goods in different countries should be equalized
due to international arbitrage.
EPP jj  *

10. Purchasing Power Parity
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 Law of one price for consumption baskets:
where P is the price of the domestic consumption
basket, P* is the price of the foreign consumption
basket and E is the market exchange rate
 Notice: if a country has a fixed exchange rate regime
(the central bank intervenes in the foreign exchange
market buying or selling forex when the exchange rate
deviates from its target level), then the domestic
inflation level is the same as foreign inflation.
10
EPP  *

11. To Fix or not to Fix?
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 In a fixed exchange rate regime, the central bank
announces the exchange rates between the
domestic currency and other major currency
(currencies) and intervenes in the domestic
foreign exchange market (buying or selling forex)
when the market rate deviates from the target
rate.
 Reasons:
 To control inflation, and more generally, to signal
economic stability and attract foreign investors.
 To support the country’s development strategy (to
make imported inputs cheaper or to promote
exports).

12. To Fix or not to Fix?
12
 Downsides of a fixed exchange rate regime:
 Loss of independent monetary policy – domestic
central bank cannot use monetary policy to offset
domestic shocks.
 Open to speculative attacks - fixed exchange rates
are unsustainable if markets believe that the central
bank does not have enough official international
reserves.
 Adjustment to external shocks - a floating currency
allows a country to adjust to external shocks
through the exchange rate; in countries with a fixed
currency, domestic wages and prices will come
under pressure instead.

13. Supply Shock and Inflation
13
 Now assume that a country with a fixed exchange
rate regime experiences a supply shock, e.g. due
to war on a part of its territory (production facilities
are destroyed, production cycles of other
producers are disrupted etc.)
 As a result of this supply shock, domestic price
level increases.
Quantity
Price
($)
S0
Qe
Pe
D
S1
Q1
P1

14. Inflation and Exchange Rate
14
 What happens to the exchange rate?
 If there is capital flight, demand for foreign currency
sharply increases, and domestic currency devalues (E
) and the central bank losses its reserves.
 If the central bank introduced harsh restrictions on
capital outflows that are very effective, would it help to
stabilize the exchange rate?
 According to the PPP relation,
if P increases and E is fixed, importers’ profits increase
dramatically. Trying to take advantage of the situation,
they increase imports (while exporters decrease
exports). This means higher demand (and lower supply)
for forex and E must .
,*
EPP 

15. Inflation and Exchange Rate
15
 To keep market exchange rate E at the previous
level, the central bank must keep supplying
foreign currency to the domestic foreign
exchange market.
 Eventually, the central bank runs out of
international reserves and has to switch to a
floating exchange rate policy – the exchange rate
is determined by market forces and the central
bank does not intervene into the forex market.

16. To Float or not to Float?
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 Downsides of a floating exchange rate regime:
 Uncertainty - the fact that a currency changes in value
from day to day introduces instability into trade.
 Lack of investment - the uncertainty can lead to a lack of
investment internally as well as from abroad.
 Volatility - if a couple of mutual funds suddenly decided
to make a serious investment, the country’s exchange
rate could rocket, starting an unsustainable boom in the
property and banking sector, and causing havoc for
exporters.
 Lack of discipline in economic management - there is
danger that governments will follow inflationary
economic policies (inflation is not punished) that then
lead to a level of inflation that can cause problems for
the economy.

17. 17

18. 18
What policy is right for Ukraine?