CHAPTER F O U R T E E N
14 International Economics
Twelfth Edition
Foreign Exchange Markets and
Exchange Rates
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Learning Goals:
◼ Understand the meaning and functions of the
foreign exchange market
◼ Know what the spot, forward, cross, and
effective exchange rates are
◼ Understand the meaning of foreign exchange
risks, hedging, speculation, and interest arbitrage
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.1 Introduction
◼ Foreign Exchange Market
◼ Where individuals, firms and banks buy and
sell foreign currencies or foreign exchange.
◼ All locations where a currency is bought or sold.
◼ Different monetary centers (such as London,
Paris, Zurich, Frankfurt, Singapore, Hong Kong,
and New York) are connected electronically,
forming a single foreign exchange market.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.2 Functions of the Foreign Exchange
Markets
Primary function is to transfer purchasing power
from one nation and currency to another.
◼ Demand for currency arises when:
◼ Tourists visit another country
◼ Domestic firm wants to import from other countries
◼ Individual wants to invest abroad
◼ Supply of currency arises from:
◼ Foreign tourist expenditures
◼ Export earnings
◼ Receiving foreign investments
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.2 Functions of the Foreign Exchange
Markets
◼ Commercial banks act as clearinghouses for foreign
exchange demanded and supplied by a country’s
residents.
◼ Banks with excess supply or demand for a
currency buy and sell through foreign exchange
brokers.
◼ If the quantity supplied and demanded of a currency
are not equal, ultimately, the exchange rate must
change, or the central bank must act as a lender of last
resort, lending or borrowing its stock of foreign
exchange reserves.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.2 Functions of the Foreign Exchange
Markets
◼ Participants
◼ Those needing currency to fund transactions
◼ Tourists, importers, exporters, investors, etc.
◼ Commercial banks
◼ Serve as the clearinghouses for currency exchange
◼ Foreign exchange brokers
◼ Clearinghouse for surpluses and shortages between
the commercial banks
◼ Central banks
◼ Buyer or seller of last resort in the foreign exchange
market
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.2 Functions of the Foreign Exchange
Markets
◼ U.S. dollar is a vehicle currency.
◼ Used for transactions that do not involve U.S.
buyers and sellers at all.
◼ The U.S. receive a seignorage benefit, essentially an
interest-free loan from foreigners to the U.S. on the
amount of dollars held abroad.
◼ More than 60% of U.S. currency is held abroad.
◼ Average total value of foreign exchange traded daily in
2013 was about $5.3 trillion dollars in 2013.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.2 Functions of the Foreign Exchange
Markets
Other functions of the foreign exchange market
◼ Provide credit for foreign transactions
◼ Credit is needed when goods are in transit, and to
allow the buyer time to resell the goods to make the
payment.
◼ Provide facilities for hedging and speculation.
◼ About 90% of foreign exchange trading reflects purely
financial transactions, and only about 10% trade
financing.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ Assume only two economies, the United States
and the European Monetary Union (EMU).
◼ Domestic currency = dollar ($)
◼ Foreign currency = euro (€)
◼ The exchange rate between the dollar and the euro
(R) is equal to the number of dollars needed to
purchase one euro.
R = $/€
If R = $/€ = 1, then one dollar is required to purchase
one euro.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ Under a flexible exchange system, R is determined by
the intersection of market demand and supply curves
for euros.
◼ Depreciation is an increase in the domestic price of the
foreign currency.
◼ If the dollar price of the euro increases from $1 to $1.50,
the dollar has depreciated.
◼ Appreciation refers to a decline in the domestic price
of the foreign currency.
◼ If the dollar price of the euro decreases from $1 to
$0.50, the dollar has appreciated.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
FIGURE 14-1 The Exchange Rate Under a Flexible Exchange
Rate System.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ Cross exchange rate
◼ Once the exchange rate between each of a pair of
currencies with respect to the dollar is established,
the exchange rate between the two currencies
themselves, or cross exchange rate, can be
calculated.
◼ Example:
◼ Suppose $/€ exchange rate is $1.25 and the $/£
exchange rate is $2.
$ value of £ 2
R = €/£ = = = 1.60
$ value of € 1.25
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ Effective exchange rate
◼ A weighted average of the exchange rates
between the domestic currency and the
nation’s most important trading partners.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ Arbitrage
◼ The purchase of currency in one market for
immediate resale in another market.
◼ Arbitrage keeps the exchange rate between any
two currencies the same across different markets.
◼ The purchase/resale closes differences in exchange
rates by reducing currency available in the low
price market and increasing availability in the
high price market, until rates equalize.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ The Exchange Rate and the Balance of Payments
◼ In Figure 14.2, suppose that the demand for euros
increases.
◼ If the U.S. monetary authorities wished to keep the
exchange rate at $1/€, they would have to supply €250
from their foreign exchange reserves.
◼ Alternatively, the EMU monetary authorities could buy
dollars and supply euros to the market.
◼ In either case, the official settlements balance of the U.S.
would show a €250 loss of international reserves, a BOP
deficit.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ The Exchange Rate and the Balance of Payments
◼ In Figure 14.2, suppose that the demand for euros
increases.
◼ Under a flexible exchange rate system, the dollar would
depreciate to R = 1.50.
◼ Under a managed floating exchange rate system,
monetary authorities might intervene, letting the dollar
depreciate (to R=1.25 in the figure), but not by the full
amount that would occur otherwise.
◼ Thus the official settlements balance shows only the
extent of monetary intervention.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange
Rate System.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.3 Foreign Exchange Rates
◼ The Exchange Rate and the Balance of Payments
◼ The U.S. does not calculate the BOP surplus or
deficit in its reporting.
◼ The measurement of the BOP surplus or deficit is
still important.
◼ Links international transactions and national income.
◼ Important when rates are fixed, as in many developing
countries.
◼ IMF requires BOP calculation by member nations.
◼ Shows degree of monetary intervention.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.4 Spot and Forward Rates, Currency Swaps,
Futures, and Options
◼ Spot rate
◼ Short term transactions (payment and receipt of
the foreign exchange within two business days)
are called spot transactions and are conducted at
the spot rate.
◼ Forward rate
◼ A forward transaction involves an agreement to buy
or sell a currency at a specified future date at a
rate agreed upon when the contract is made, the
forward rate.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.4 Spot and Forward Rates, Currency
Swaps, Futures, and Options
◼ Forward discount
◼ The percentage per year by which the forward rate
is below the spot rate.
◼ Forward premium
◼ The percentage per year by which the forward rate
is above the spot rate. For a 90-day forward rate,
FD or FP = FR - SR x 4 x 100
SR
where FR = forward rate and SR = spot rate
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.4 Spot and Forward Rates, Currency
Swaps, Futures, and Options
◼ Foreign Exchange Swap
◼ A spot sale of a currency combined with a
forward repurchase of the same currency – as
part of a single transaction.
◼ Swap rate is the difference in spot and forward
rates.
◼ Most interbank trading involving the purchase
or sale of currencies for future delivery are
done as currency swaps.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.4 Spot and Forward Rates, Currency
Swaps, Futures, and Options
◼ Foreign Exchange Futures
◼ Forward currency contracts for standardized
currency amounts and select dates trade on the
International Money Market (IMM) or Chicago
Mercantile Exchange (CME)
◼ Amount of daily fluctuation is limited.
◼ Traded currencies:
◼ U.S. dollar, Japanese yen, Canadian dollar, British
pound, Swiss franc, Australian dollar, Mexican
peso, euro
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Spot and Forward Rates, Currency Swaps,
Futures, and Options
◼ Foreign Exchange Options
◼ Contracts giving the purchaser the right, but not
the obligation, to buy (call option) or to sell (put option)
a standard amount of a traded currency on a
stated date (European option) or any time before the
stated date (American option) at a stated price (strike or
exercise price).
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Whenever a future payment must be made or
received in foreign currency, a foreign
exchange risk is involved because spot rates
vary over time.
◼ Figure 14.3 shows the variation in exchange rates
between the U.S. dollar and the yen, the euro, the pound,
and the Canadian dollar from 1971-2014.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
FIGURE 14-3 Exchange Rates of the G-7 Countries and Effective Exchange Rate of the Dollar, 1970-2014.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Contracted future foreign currency payments may
become more expensive if the domestic currency
falls in value.
◼ Example:
◼ A contract requires a €100,000 payment in three
months time.
◼ If the exchange rate is currently $1/€1, the
expected dollar cost is $100,000.
◼ If the exchange rate changes to $1.10/ €1 in the
intervening months, the dollar cost rises to
$110,000.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Contracted future foreign currency receipts may
fall in value if the domestic currency increases in
value.
◼ Example:
◼ A producer expects to receive a payment of
€100,000 in three months time.
◼ If the exchange rate is currently $1/€1, the
expected dollar receipt is $100,000.
◼ If the exchange rate changes to $0.90/ €1 in the
intervening months, the dollar receipt falls to
$90,000.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Hedging is the avoidance of foreign exchange risk,
closing an open position.
◼ Options:
1. Buy at the current spot rate and deposit the receipts in an
interest earning account until the funds are needed.
2. Buy a forward contract
◼ Typically entails paying a forward premium, increasing
the cost of the transaction.
3. Buy a call option
◼ If not exercised, the premium is lost.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Speculation, the opposite of hedging, is the
acceptance of foreign exchange risk (taking an
open position) in the hope of making a profit.
◼ Example:
◼ If the speculator expects the spot rate in three
months time to be $1/€1, she may sell euros at a
current three month forward rate of $1.10/€1
with the expectation that she will be able to buy
euros to cover her sale at the lower spot rate.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Stabilizing Speculation
◼ The purchase of a foreign currency when the
domestic price falls or is low, in the expectation
that it will soon rise, leading to a profit, OR
◼ The sale of a foreign currency when the domestic
price rises, in the expectation that it will fall.
◼ Stabilizing speculation moderates fluctuations in
exchange rates over time, serving a useful
function.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.5 Foreign Exchange Risks, Hedging, and
Speculation
◼ Destabilizing Speculation
◼ The sale of a foreign currency when the domestic
price falls or is low, in the expectation that it will
fall even lower, OR
◼ The purchase of a foreign currency when the
domestic price rises, in the expectation that it will
rise even higher.
◼ Destabilizing speculation magnifies fluctuations
in exchange rates over time, and can be very
disruptive to international flow of trade and
investments.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.6 Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
◼ Interest arbitrage is the transfer of short-term
liquid funds abroad to earn a higher rate of
return.
◼ Uncovered interest arbitrage occurs when the transfer
abroad entails foreign exchange risk due to the
possible depreciation of the foreign currency during
the investment period.
◼ Carry trade is the borrowing of fund in low-yielding
currencies and lending in high-yielding currencies.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.6 Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
◼ Covered interest arbitrage is the spot purchase of the
foreign currency to make the investment and the
offsetting simultaneous forward sale of the foreign
currency to cover, or remove, the foreign exchange
risk.
◼ When the interest rate differential is equal to the
forward discount or premium on the foreign
currency, the currency is said to be at covered interest
arbitrage parity (CIAP)
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
FIGURE 14-4 Covered Interest Arbitrage.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.6 Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
◼ In Figure 14.4, the diagonal line shows all points of
CIAP. At these points, (i – i*) = FD or FP.
◼ If i < i*, (i – i*) = FD
◼ If i > i*, (i – i*) = FP
◼ FD or FP can be expressed as (FR – SR)/SR.
◼ Then (i – i*) = (FR – SR)/SR.
◼ Covered interest arbitrage margin (CIAM), the
percentage gain from covered interest arbitrage then
equals:
CIAM = (i – i*) - (FR – SR)/SR.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.6 Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
◼ More precisely, as derived in the Appendix,
CIAM = (i – i*)/(1+i*) - (FR – SR)/SR.
◼ If CIAP holds, CIAM = 0, and if not, currency flows
should quickly eliminate the arbitrage opportunity.
◼ In the real world, there can be significant CIAMs,
due to other forces, such as taxes or country risks, or
limited investment opportunities in some countries.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.6 Interest Arbitrage and the Efficiency of
Foreign Exchange Markets
◼ Efficiency of Foreign Exchange Markets
◼ Markets are efficient if prices reflect all possible
information.
◼ The foreign exchange market is efficient if
forward rates accurately predict future spot
rates
◼ Some empirical studies show fairly efficient
markets.
◼ But rates are volatile, respond quickly to news,
and are hard to forecast, making the forward rate
a poor predictor of the spot rate.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.7 Eurocurrency or Offshore Financial
Markets
◼ Eurocurrency refers to commercial bank deposits
outside the country of their issue.
◼ Eurodollar, Eurosterling, Eurodeposit
◼ The market in which the borrowing and lending
of these balances takes place is the Eurocurrency
market.
◼ In non-European cases, deposits denominated in
a currency other than that of the country is called
an offshore deposit.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
14.7 Eurocurrency or Offshore Financial
Markets
◼ Reasons for Offshore Deposits
◼ Interest rates on short term deposits abroad
are often higher than domestic rates.
◼ International corporations often find it
convenient to hold balances abroad for short
periods in currency they need for payments.
◼ International corporations can overcome
domestic credit restrictions by borrowing in
the Eurocurrency market.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Eurocurrency or Offshore Financial Markets
◼ Eurobonds - long-term debt securities sold
outside the borrower’s country to raise long-term
capital in a currency other than the currency of
the nation where the bonds are sold.
◼ Euronotes - medium-term financial instruments
used by corporations, banks and countries to
borrow medium-term funds in a currency other
than the currency in which the notes are sold.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Case Study 14.1 The Dollar as the Dominant
International Currency
◼ Table 14.1
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Case Study 14.3 Foreign Exchange Quotations
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Case Study 14.4 Size, Currency, and
Geographic Distribution of the Foreign
Exchange Market
◼ Table 14.3
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Case Study 14.6 Size and Growth of
Eurocurrency Market
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Appendix: Derivation of the Formula for the
Covered Interest Arbitrage Margin
◼ From Formula 14A-1:
𝑖 𝐾 𝑖∗
𝐾(1 + ) <=> 1+ 𝐹𝑅
4 𝑆𝑅 4
◼ Dividing by K and omitting the division by 4
𝐹𝑅
1 + 𝑖 = ( )(𝐼 + 𝑖 ∗)
𝑆𝑅
◼ Solving for the FR and rearranging
(𝑖 − 𝑖 ∗) (𝐹𝑅 − 𝑆𝑅)
𝐶𝐼𝐴𝑀 = −
(1 − 𝑖 ∗) 𝑆𝑅
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
◼ Copyright 2016 John Wiley & Sons, Inc.
◼ All rights reserved. Reproduction or translation of this work beyond
that permitted in section 117 of the 1976 United States Copyright Act
without express permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may
make back-up copies for his/her own use only and not for distribution
or resale. The Publisher assumes no responsibility for errors, omissions,
or damages caused by the use of these programs or from the use of the
information herein.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
