Chapter Two 21
CHAPTER 2
The Market for Foreign Exchange
CHAPTER OVERVIEW
Chapter 2 begins with a description of the foreign exchange market, and in particular the spot market for foreign exchange, and then defines the bilateral exchange rate as the relative price of two currencies. When the exchange rate is defined as the domestic currency required to purchase a unit of the foreign currency, a domestic currency appreciation is defined as a fall in the domestic to foreign ratio, and a depreciation is defined as a rise in this ratio. The initial section of this chapter shows how a pair of bilateral rates can be used to compute the cross rate for a given currency. The section also demonstrates how to compute the bid-ask spread and the bid-ask margin for a currency, and distinguishes between the nominal and real exchange rates.
The next section defines the concept of an “effective” exchange rate as weighted-average value of a currency relative to a selected group of currencies. Examples of such weighting include multilateral weights, which reflect the trade flow of the individual country with all countries included in the index relative to the total trade volume among all countries included in the index, and bilateral weights, which reflect the trade flow of the domestic country with respect to each of the countries relative to the total trade of the domestic country with each of the countries included in the index. A detailed numerical example is provided for a bilateral weighted effective exchange rate for the U.S. In addition, two examples of composite currencies, specifically the International Monetary Fund’s Special Drawing Rights currency and the European Currency Unit are discussed in detail.
The next sections of the chapter present the idea of arbitrage in foreign exchange markets and the role of supply and demand for foreign currency in determining the equilibrium exchange rate. The supply and demand curves are described at this stage simply as schedules that relate quantity and price. The distinction between shifts and movements in the curve is also introduced. The authors point out that the demand for foreign currency is a derived demand, which depend on the demand for a country’s goods, services, and assets. A more detailed discussion of the markets for foreign exchange begin in Chapter 9.
The final section of this chapter is devoted to the idea of purchasing power parity, PPP, as a simple theory of the determination of the exchange rate. Specifically, absolute PPP is equated to the international law of one price, and is defined as a condition whereby in the absence of transportation costs, tax differentials or trade restrictions, the price of any two internationally traded and identical goods or services must be the same once they are adjusted by the value of the exchange rate between the two national currencies. Relative PPP, by contrast, is defined as the condition whereby changes in the prices of any two internationally traded and identical goods or services must be the same once they are adjusted by the change in the value of the exchange rate between the two national currencies. The text discusses problems associated with the measurement of these PPP concepts as applied to baskets of goods, particularly when price deflators such as the CPI are based on different baskets for different countries. The chapter concludes by indicating that the empirical evidence tends to favor the weaker relative PPP condition more than it does the absolute PPP condition, but that both are relatively poor guides to short-run movements in the exchange rate for most major economies.
OUTLINE
I. Exchange Rates and the Market for Foreign Exchange
A. Role of the Foreign Exchange Market
1. Spot Market
2. Define the Spot Rate
B. Exchange Rate as Relative Prices
1. Appreciation vs. Depreciation
2. Implied Cross Rates
C. Bid-Ask Spreads
D. Bid-Ask Margins
E. Real Exchange Rates
II. Overall Strength or Weakness of a Currency
A. Effective Exchange Rate
1. Construction
2. Example
3. Intuition
B. Real Effective Exchange Rate
III. Composite Currencies
A. Definition
B. SDR Example
IV. Foreign Exchange Arbitrage
A. Spatial
B. Triangular
V. Supply and Demand of Currencies
A. Demand for
1. Relationship between the price and quantity demanded
2. Sources of Demand
B. Supply
1. Relationship between the price and quantity demanded
2. Sources of Demand
C. Equilibrium
VI. Purchasing Power Parity
A. Absolute
1. Relate to Arbitrage
2. P = S · P*
B. Relative
1. Relative Changes in Prices
2. %DS = %DP – %DP*
VII. Summary
FUNDAMENTAL ISSUES
1. What is the foreign exchange market?
2. What does it mean when a currency has appreciated or depreciated?
3. How is the general value of a currency measured?
4. What is foreign exchange arbitrage?
5. What determines the value of a currency?
6. What is purchasing power parity, and is it useful as a guide to movements in exchange rates?
CHAPTER FEATURES
1. Management Notebook: “How Sensitive Are Manufacturers to Exchange Rate Changes?”
The management notebook examines the channels through which exchange rate changes affect manufacturers. It notes that when, say, the U.S. dollar appreciates, U.S. exports may fall as their foreign currency denominated price will have risen; and that U.S. imports may rise, as the dollar price of foreign goods will have fallen.
The notebook discusses two studies that examine how exchange rate changes have affected different industries. The first constructs a “net external orientation” measure for 20 U.S. manufacturing sectors that is designed to indicate whether a U.S. dollar appreciation is likely to positively or negatively impact the sector’s international price competitiveness. The measure is calculated as the share of export revenues out of total revenues minus the share of imported inputs out of total input expenditures. A positive (negative) value suggests that the sector is harmed (aided) by the U.S. dollar appreciation. The results indicate that industrial machinery and instruments had the highest measure of external orientation, and that leather and fabricated metal products had the lowest external orientation.
The second study examined the impact of the euro’s 1999 decline against the U.S. dollar on European manufacturers, citing the exaggerated effect of a euro depreciation relative to the U.S. dollar given other nations that anchor their currency against the dollar. They find that the European industries most affected by exchange rate changes are computing and office equipment and those least exposed are press and publishing.
For Critical Analysis: The European manufacturers of computing and office equipment were shown to be the most exposed. An industry like press and publishing may be the least exposed if one considers the fact that most press and publishing business may be done for the domestic market. For example, the cost of shipping published works may suggest that local market production, rather than exporting, maybe the cost effective way to serve a market. In this regard, European exports and imports of press and publishing would be rather insensitive to exchange rate changes.
2. Policy Notebook: “The Big Mac Index”
This feature describes the Economist magazine’s popular Big Mac index, a regular annual feature of the magazine. The index compares the average price of a Big Mac among different countries in dollar prices after adjusting for the exchange rate. Comparisons of these dollar prices are used to imply over- or undervaluation of a currency using the underlying PPP theory.
For Critical Analysis: Check to make sure students have correctly applied the absolute and relative PPP equations to the data they use.
3. Management Notebook: “Does the Border Between Canada and the United States Matter?”
The notebook applies the idea of purchasing power parity to compare prices of goods in cities similar distances apart. In one pair of cities, the cities are located in the same country; while another pair of cities will be located in adjoining countries. A comparison should allow us to see whether, after controlling for distance between the cities, a border seems to matter for international prices. A study cited indicates that the border between the U.S. and Canada is equivalent to 1,780 miles. Thus, a border still seems to matter, even after a free trade agreement like NAFTA.
For Critical Analysis: If prices in the U.S. and Canada showed evidence of price stickiness, we may expect the spot exchange rate between these countries to remain relatively constant, if PPP holds. If PPP does not hold, we may expect other factors that influence the spot rate (for example, changes in the demand for, or supple of a foreign currency) to affect the spot rate.
ANSWERS TO END OF CHAPTER QUESTIONS
1. Since it cost fewer dollars to purchase a euro after the exchange rate change, the euro depreciated and the dollar appreciated. The rate of depreciation was [(0.8836 – 0.8828)/0.8828]100 = 0.09 percent.
2.
NUMERATORDENOMINATOR / U.S. $ / U.K. £ / Canadian $ / Euro (€)
U.S. $ / 0.668 / 1.517 / 1.082
U.K. £ / 1.497 / 2.271 / 1.620
Canadian $ / 0.659 / 0.440 / 0.713
Euro (€) / 0.924 / 0.617 / 1.402
3. An arbitrage opportunity does exist. If one were to take the $1,000,000 and purchase U.K. pounds in the New York market, one could secure 668,002.67 U.K. pounds. To see this, divide the $1,000,000 by the $1.497/£ U.K. spot rate. Then the individual could purchase euros with the U.K. pounds in the London market and receive 1,102,204.4 euros. This is obtained by multiplying the 668,002.67 U.K pounds by the €1.650 /£ U.K. spot rate. Finally, the individual could exchange these euros for U.S. dollars back in New York to end up with $1,018,436.9. This is obtained by multiplying the 1,102,204.4 euros by the New York spot rate of $0.924/€. The profit would therefore be $18,436.9 absent any transaction costs.
4. Because 2000 is the base year, the value of the bilateral effective exchange rate is 100. Using the data in the table, the weight assigned to the French franc is 0.1152 and the weight assigned to the Canadian dollar is 0.8848. Using these weights, the effective exchange rate in 2001 is 86.04. This suggests a 13.96 percent appreciation. If we construct a real bilateral weighted effective exchange rate, the 2001 effective exchange rate is 88.97; which suggests an 11.03 percent appreciation.
5. In nominal terms the euro depreciated, as it cost more euros to purchase the dollar in July of 2000 than in January of 1999. The rate of depreciation was 20 percent [((1.08 – 0.90)/0.90)100 = 20%]
6. January 1999 real exchange rate for the euro = 0.90(108.0/105.3) = 0.923
July 2000 real exchange rate for the euro = 1.08(113.3/108.8) = 1.1247
7. Based on the real exchange rate, the euro depreciated 21.8 percent.
8. By PPP, the July spot rate should be 108.8/113.3= 0.960. The actual spot rate, however, was 1.08, suggesting that relative to PPP theory, the actual spot rate was too high. This, relative to PPP, the euro was undervalued by 12.5 percent.
9. By relative PPP theory, the euro should have gained 1.59 percent in value; i.e., the euro should have appreciated 1.59 percent. Thus, we can deduce that the spot rate in July 2000 should have been 0.8857 euros per U.S. dollar.
10. Since, in July 2000, the actual euro to U.S. dollar spot rate was 1.08 (rather than the 0.8857 euro to dollar spot rate predicted by the relative PPP theory), the euro was undervalued by 21.94 percent.
MULTIPLE CHOICE EXAM QUESTIONS
1. A market that requires immediate sale or purchase of an asset is known as a(n) ______market.
A. exchange
B. bond
C. spot
D. free
Answer: C
2. The minimum value of a spot currency transaction is generally
A. $100,000.
B. $500,000.
C. $1 million.
D. $5 million.
Answer: C
3. If the dollar equivalent exchange rate of the New Zealand dollar is 1.5, what is a New Zealand dollar
worth in terms of U.S. dollars?
A. $0.50 B. $0.67 C. $1.0 D. $1.50
Answer: B
4. The dollar equivalent exchange rate of the Argentinean peso is 1. If the peso were to undergo a 50
percent depreciation, the dollar equivalent exchange rate of the Argentinean peso would be
A. 50 pesos.
B. 2 pesos.
C. 1 peso.
D. 0.5 pesos.
Answer: B
5. For which of the following sets of exchange rates has the cross rate been correctly calculated?
A. £1 = 15 French francs; $3.00 = £1; $1 = 5 French francs
B. ¥200 = $1.00; 1 ringgit = $0.15; 20 ringgit = ¥1
C. £1 = 4 DM; 3 Swiss francs = 1 DM; 12 Swiss francs = £1
D. 10 French francs = $1.00; 1 DM = 4 French francs; 1 DM = $0.50
Answer: C
6. A Korean trader wishes to make a purchase of Czech crystal worth 3 million korunas.
Unfortunately, there is no published value of the Korean won to Czech koruna exchange rate. In order
to calculate the current price of the crystal in won, the trader will need to calculate
A. the real exchange rate.
B. a cross rate.
C. the purchasing power parity rate.
D. South Korea’s effective exchange rate.
Answer: B
7. Suppose the dollar equivalent rate for the Canadian dollar is 1.37, while the dollar equivalent exchange
rate for the British pound is 0.66. What is the cross rate of British pounds per Canadian dollar?
A. 2.08 B. 1.37 C. 0.66 D. 0.48