THE FOREX Market Dr. Gormus

THE FOREX MarketDr. GormusForeign Exchange MarketMost countries of the world have their own currencies: the U.S dollar., the euro in Europe, the Brazilian real, and the Chinese yuan, just to name a few.The trading of currencies and banks deposits is what makes up the foreign exchange market.What are Foreign Exchange Rates?Two kinds of exchange rate transactions make up the foreign exchange market:Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate (S).Forward transactions involve a contract signed today to make an exchange at some future date, completed at the forward rate (F).Why Are Exchange Rates Important?When the currency of your country appreciates relative to another country, your countrys goods prices abroad and foreign goods prices in your country.Makes domestic businesses less competitiveBenefits domestic consumers (you)Why Are Exchange Rates Important?For example, in 1999, the euro was valued at $1.18. On June 7, 2013, it was valued at $1.32.

Euro appreciated 11% (1.32 - 1.18) / 1.18Dollar depreciated 11% (0.76 - 0.85) / 0.85Note: 0.75 = 1 / 1.32, and 0.85 = 1 / 1.18How is Foreign Exchange Traded?FX traded in over-the-counter marketInvolve buying / selling bank deposits denominated in different currencies.Trades involve transactions in excess of $1 million.Typical consumers buy foreign currencies from retail dealers, such as American Express.FX volume exceeds $4 trillion per day.Exchange Rates in the Long RunExchange rates are determined in markets by the interaction of supply and demand.An important concept that drives the forces of supply and demand is the Law of One Price.Exchange Rates in the Long Run: Law of One PriceThe Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.Exchange Rates in the Long Run: Law of One PriceLaw of one price E = 100 yen/$

Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels.PPP Domestic price level 10%, domestic currency 10%Application of law of one price to price levelsWorks in long run, not short runExchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)Problems with PPPAll goods are not identical in both countries (i.e., Toyota versus Chevy)Many goods and services are not traded (e.g., haircuts, land, etc.)Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run

Explaining Changes in Exchanges Rates

Here are how some of the factors impact demand curvesApplication: Interest Rate ChangesChanges in domestic interest rates are often cited in the press as affecting exchange rates.We must carefully examine the source of the change to make such a statement. Interest rates change because either (a) the real rate or (b) the expected inflation is changing. The effect of each differs.Effect of Changes in Interest Rates on the Equilibrium Exchange RateWhen the domestic real interest rate increases, the domestic currency appreciates. When the domestic expected inflation increases, the domestic currency reacts in the opposite directionit depreciates. This is shown on the next slide.Effect of Changes in Interest Rates on the Equilibrium Exchange Rate

Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected InflationInterest Parity ConditionThe interest parity condition relates foreign/domestic interest rates with FX rates.Derived from expected returns.An investor can earn interest rate of id on US dollars and can borrow at the same rateAlso, the same investor can earn interest rate of if in the foreign country (lets assume Germany for this example) and can borrow at the same rate.St is the spot rate and E(St+1) is the expected spot rate next periodInterest Parity ConditionUncovered Interest Rate Parity(1+id) = (1/St) (1+if) E(St+1)Means: there should be no difference between investing in the US vs. taking your dollars, converting them to Euros, investing in Germany wait for a year and convert those Euros back to dollars.This equilibrium should hold as long as:E(St+1) = St+1In other words: as long as what you predict the spot rate will be is the same as what it actually becomes in one year, this parity should hold.What if it doesnt?Then, there is an arbitrage opportunity (receiving more return than you should)Covered Interest Rate ParityThis time, instead of using our Expectations, we plug in the actual Forward rate (F)This assures us that there are no expected surprises and if there are, it creates an arbitrage opportunity.(1+id) = (1/St) (1+if) F365or(1+id) = (F365/St) (1+if)

Covered Interest Rate ParityHere is an example:The interest rate in the US is 2%. The Current Spot rate for Euros is 1.58. In Germany, the interest rate is 3% and the Forward price for Euros is 1.54. Is there an arbitrage opportunity? If yes, how would you take advantage of this?

Covered Interest Rate Parity(1+0.02) = (1.54/1.58)(1+0.03) 1.02 > 1.00This means that the equivalent interest rate in US is higher then the one in Germany. Do we borrow at the higher rate or invest at the higher rate? Of course you would want to borrow at the cheaper rate and invest at the higher rate.So, Yes, there is an arbitrage opportunity. You would borrow in Germany, Convert the Euros to Dollars, Invest in the US while getting into a forward contract. Wait for one year, collect your proceeds in dollars...and convert your dollars back to Euros (using the forward rate which is already agreed upon).You should end up with more Euros then the German interest rate pays.If E = 100 yen/$ then price are:

American SteelJapanese Steel

In U.S.$100$100

In Japan10,000 yen10,000 yen

If E = 50 yen/$ then price are:

American SteelJapanese Steel

In U.S.$100$200

In Japan5000 yen10,000 yen