How the Foreign Exchange Market Works

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Copyright  2011 Pearson Canada Inc. 19 - 1 Chapter 19 The Foreign Exchange Market Copyright  2011 Pearson Canada Inc. 19 - 2 Foreign Exchange • Exchange rate - price of one currency in terms of another • Foreign exchange market - the financial market where exchange rates are determined • Spot transaction - immediate (two-day) exchange of bank deposits – Spot exchange rate • Forward transaction - the exchange of bank deposits at some specified future date – Forward exchange rate Copyright  2011 Pearson Canada Inc. 19 - 3 Canadian Exchange Rates Copyright  2011 Pearson Canada Inc. 19 - 4 Foreign Exchange • Appreciation—a currency rises in value relative to another currency • Depreciation—a currency falls in value relative to another currency • When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa Copyright  2011 Pearson Canada Inc. 19 - 5 Exchange Rates in the Long Run • Law of one price • Theory of Purchasing Power Parity – Assumes all goods are identical in both countries – Trade barriers and transportation costs are low – Many goods and services are not traded across borders Copyright  2011 Pearson Canada Inc. 19 - 6 Factors that Affect Exchange Rates in the Long Run • if a factor increases the demand for domestic goods relative to foreign goods , the domestic currency will appreciate • If a factor decreases the relative demand for domestic goods, the domestic currency will depreciate. – Relative price levels – Trade barriers – Preferences for domestic versus foreign goods – Productivity Copyright  2011 Pearson Canada Inc. 19 - 7 Purchasing Power Parity Canada/United States Copyright  2011 Pearson Canada Inc. 19 - 8 Factors Affecting Exchange Rates in the Long Run Copyright  2011 Pearson Canada Inc. 19 - 9 Exchange Rates in the Short Run • An exchange rate is the price of domestic assets in terms of foreign assets • Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other Copyright  2011 Pearson Canada Inc. 19 - 10 Supply Curve for Domestic Assets • Treat Canada as the home country • Domestic assets denominated in dollars • Generally use euros to represent foreign country’s currency. • Quantity of dollar assets is supplied by bank deposits, bonds and equities in Cnaada • Can take this amount as fixed with respect to exchange rate • vertical supply curve [...]... of the dollar (everything else equal), the quantity demanded of dollar assets is higher • Supply – The amount of bank deposits, bonds, and equities in the U.S – Vertical supply curve Equilibrium in the Foreign Exchange Market Response to an Increase in the Domestic Interest Rate Response to an Increase in the Foreign Interest Rate Response to an How the Foreign Exchange Market Works How the Foreign Exchange Market Works By: OpenStaxCollege Most countries have different currencies, but not all Sometimes small economies use the currency of an economically larger neighbor For example, Ecuador, El Salvador, and Panama have decided to dollarize—that is, to use the U.S dollar as their currency Sometimes nations share a common currency A large-scale example of a common currency is the decision by 17 European nations—including some very large economies such as France, Germany, and Italy—to replace their former currencies with the euro With these exceptions duly noted, most of the international economy takes place in a situation of multiple national currencies in which both people and firms need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders The market in which people or firms use one currency to purchase another currency is called the foreign exchange market You have encountered the basic concept of exchange rates in earlier chapters In The International Trade and Capital Flows, for example, we discussed how exchange rates are used to compare GDP statistics from countries where GDP is measured in different currencies These earlier examples, however, took the actual exchange rate as given, as if it were a fact of nature In reality, the exchange rate is a price—the price of one currency expressed in terms of units of another currency The key framework for analyzing prices, whether in this course, any other economics course, in public policy, or business examples, is the operation of supply and demand in markets Visit this website for an exchange rate calculator 1/13 How the Foreign Exchange Market Works The Extraordinary Size of the Foreign Exchange Markets The quantities traded in foreign exchange markets are breathtaking A survey done in April, 2013 by the Bank of International Settlements, an international organization for banks and the financial industry, found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy In contrast, 2013 U.S real GDP was $15.8 trillion per year [link] shows the currencies most commonly traded on foreign exchange markets The foreign exchange market is dominated by the U.S dollar, the currencies used by nations in Western Europe (the euro, the British pound, and the Australian dollar), and the Japanese yen Currencies Traded Most on Foreign Exchange Markets as of April, 2013(Source: http://www.bis.org/publ/ rpfx13fx.pdf) Currency % Daily Share U.S dollar 87.0% Euro 33.4% Japanese yen 23.0% British pound 11.8% Australian dollar 8.6% Swiss franc 5.2% Canadian dollar 4.6% Mexican peso 2.5% Chinese yuan 2.2% Demanders and Suppliers of Currency in Foreign Exchange Markets In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency—and vice versa To get a sense of this, it is useful to consider four groups of people or firms who participate in the market: (1) firms that are involved in international trade of goods and services; (2) tourists visiting other countries; (3) international investors buying ownership (or part-ownership) of a foreign firm; (4) international 2/13 How the Foreign Exchange Market Works investors making financial investments that not involve ownership Let’s consider these categories in turn Firms that buy and sell on international markets find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened So, a Chinese firm exporting abroad will earn some other currency—say, U.S dollars—but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China In the foreign exchange markets, this firm will be a supplier of U.S dollars and a demander of Chinese yuan International tourists will supply their home currency to receive the currency of the country they are visiting For example, an American tourist who is visiting China will supply U.S dollars into the foreign exchange market and demand Chinese yuan Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories Foreign direct investment (FDI) refers to purchasing a firm (at least ten percent) in another country or starting up a new enterprise in a foreign country For example, in 2008 the Belgian beer-brewing company InBev bought the U.S beer-maker Anheuser-Busch for $52 billion To make this purchase of a U.S firm, InBev would have to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S dollars The other kind of international financial investment, portfolio investment, involves a ...Bank of England Interest Rate Announcements and the Foreign Exchange Market ∗ Michael Melvin, a Christian Saborowski, b,c Michael Sager, c,e and Mark P. Taylor d,f a BlackRock b World Bank c Department of Economics, University of Warwick d Warwick Business School e Wellington Management f Centre for Economic Policy Research Since 1997, the Bank of England Monetary Policy Com- mittee (MPC) has met monthly to set the UK policy interest rate. Using a Markov-switching framework that incorpo- rates endogenous transition probabilities, we examine intra- day, five-minute return data for evidence of systematic patterns in exchange rate movements on MPC policy announcement days. We find evidence for non-linear regime switching between a high-volatility, informed trading state and a low-volatility, liquidity trading state. MPC surprise announcements are shown to significantly affect the probability that the market enters and remains within the informed trad- ing regime, with some limited evidence of market positioning just prior to the announcement. JEL Codes: E42, E44, F31. 1. Introduction The Bank of England (BoE) was granted operational independence to set its key interest rate in May 1997, with the goal of implementing ∗ We are grateful to two anonymous referees for helpful and constructive comments on an earlier draft of this paper, the editor, Frank Smets, Charles Goodhart, Richard Meese, Carol Osler, and seminar participants at the London School of Economics, the University of Warwick, and the 2008 Global Conference on Business and Finance, held in San Jose, Costa Rica. Responsibility for any remaining omissions or errors remains with the authors. Christian Saborowski acknowledges financial support from the European Commission Marie Curie Fellowships. Corresponding author (Taylor): mark.taylor@wbs.ac.uk. 211 212 International Journal of Central Banking September 2010 policy consistent with stable inflation and economic growth. 1 Inter- est rate decisions are made by the Bank’s Monetary Policy Com- mittee (MPC), which meets for two days each month—as well as an additional pre-meeting briefing day—and issues a statement regard- ing interest rate decisions at noon on the second meeting day. This framework allows a natural laboratory setting for examining the impact of monetary policy decisions around a known time and date. Since market participants know that interest rate announcements arrive at noon on the second meeting day, there may be positioning prior to the announcement and news effects after the announcement that result in systematic differences in the behavior of financial mar- ket variables on MPC meeting days compared with other, non-MPC days. In this paper, we concentrate on the pattern of exchange rate volatility surrounding the MPC’s interest rate decisions as well as the role played by the surprise content of these announcements. Although activities directly related to each MPC meeting are spread over three different days, our empirical analysis will focus upon the second MPC meeting day, when the policy decision is made and announced. We use high-frequency, intraday data and a Markov-switching econometric model where exchange rate returns switch between a high-volatility, informed trading state and a low- volatility, uninformed or liquidity trading state. This framework allows for a characterization of macroeconomic news effects on the foreign exchange market that International Business 7e by Charles W.L. Hill McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 The Foreign Exchange Market 9-3 Introduction  A firm’s sales, profits, and strategy are affected by events in the foreign exchange market  The foreign exchange market is a market for converting the currency of one country into that of another country  The exchange rate is the rate at which one currency is converted into another 9-4 The Functions Of The Foreign Exchange Market The foreign exchange market:  is used to convert the currency of one country into the currency of another  provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates) 9-5 Currency Conversion International companies use the foreign exchange market when:  the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies  they must pay a foreign company for its products or services in its country’s currency  they have spare cash that they wish to invest for short terms in money markets  they are involved in currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates) 9-6 Insuring Against Foreign Exchange Risk  The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm)  A firm that insures itself against foreign exchange risk is hedging 9-7 Insuring Against Foreign Exchange Risk  The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day  Spot rates change continually depending on the supply and demand for that currency and other currencies 9-8 Classroom Performance System The ________ is the rate at which one currency is converted into another. a) Exchange rate b) Cross rate c) Conversion rate d) Foreign exchange market 9-9 Insuring Against Foreign Exchange Risk  To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges  A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future  A forward exchange rate is the rate governing such future transactions  Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future 9-10 Insuring Against Foreign Exchange Risk  A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates  Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk [...].. .The Nature Of The Foreign Exchange Market The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems—it is not located in any one place The most important trading centers are London, New York, Tokyo, and Singapore The markets is always open somewhere in the world—it never sleeps 9-11 The Nature Of The Foreign Exchange. .. 9-21 The Efficient 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 4/17/2012 10 4/17/2012 11 4/17/2012 12 4/17/2012 13 4/17/2012 14 4/17/2012 15 4/17/2012 16 4/17/2012 17 [...]...4/17/2012 11 4/17/2012 12 4/17/2012 13 4/17/2012 14 4/17/2012 15 4/17/2012 16 4/17/2012 17 International Financial market and Korean Economy Prepared by Seok-Kyun HUR Introduction to Exchange Rates and the Foreign Exchange Market Introduction  Exchange rates affect large flows of international trade by influencing the prices in different currencies  Foreign exchange also facilitates massive flows of international investment, which include direct investments as well as stock and bond trades  In the foreign exchange market, trillions of dollars are traded each day and the economic implications of shifts in the market can be dramatic Introduction The topics we cover today include: • exchange rate basics • basic facts about exchange rate behavior • the foreign exchange market • two key market mechanisms: arbitrage and expectations Exchange Rate Essentials • An exchange rate (E) is the price of some foreign currency expressed in terms of a home (or domestic) currency • Because an exchange rate is the relative price of two currencies, it may be quoted in either of two ways: The number of home currency units that can be exchanged for one unit of foreign currency The number of foreign currency units that can be exchanged for one unit of home currency • Knowing the format in which exchange rates are quoted is essential to avoid confusion, so we now establish a systematic rule, even if it is arbitrary Exchange Rate Essentials Defining the Exchange Rate • To avoid confusion, we must specify which country is the home country and which is foreign • Throughout the remaining chapters of this book, when we refer to a particular country’s exchange rate, we will quote it in terms of units of home currency per units of foreign currency • For example, Denmark’s exchange rate with the Eurozone is quoted as Danish krone per euro (or kr/€) Exchange Rate Essentials Appreciations and Depreciations • If one currency buys more of another currency, we say it has experienced an appreciation – its value has risen, appreciated or strengthened • If a currency buys less of another currency, we say it has experienced a depreciation – its value has fallen, depreciated, or weakened Exchange Rate Essentials Appreciations and Depreciations In U.S terms, the following holds true:  When the U.S exchange rate E$/€ rises, more dollars are needed to buy one euro The price of one euro goes up in dollar terms, and the U.S dollar experiences a depreciation  When the U.S exchange rate E$/€ falls, fewer dollars are needed to buy one euro The price of one euro goes down in dollar terms, and the U.S dollar experiences an appreciation Exchange Rate Essentials Appreciations and Depreciations Similarly, in European terms, the following holds true:  When the Eurozone exchange rate E€/$ rises, the price of one dollar goes up in euro terms and the euro experiences a depreciation  When the Eurozone exchange rate E€/$ falls, the price of one dollar goes down in euro terms and the euro experiences an appreciation Exchange Rate Essentials Appreciations and Depreciations To determine the size of an appreciation or depreciation, we compute the proportional change, as follows: Exchange Rate Essentials Multilateral Exchange Rates To aggregate different trends in bilateral exchange rates into one measure, economists calculate multilateral exchange rate changes for baskets of currencies using trade weights to construct an average of all the bilateral changes for each currency in the basket The resulting measure is called the change in the effective exchange rate Arbitrage and Spot Exchange Rates Arbitrage with Three Currencies • Triangular arbitrage works as follows: you sell dollars in exchange for euros, then immediately sell the same euros in exchange for pounds • In general, three outcomes are again possible The direct trade from dollars to pounds has a better rate: E£/$ > E£/€ E€/$; the indirect trade has a better rate: E£/$ < E£/€ E€/$; or the two trades have the same rate and yield the same result: E£/$ = E£/€ E€/$ Only in the last case are there no profit .. .How the Foreign Exchange Market Works The Extraordinary Size of the Foreign Exchange Markets The quantities traded in foreign exchange markets are breathtaking A survey... mean the depreciation or weakening of the other 7/13 How the Foreign Exchange Market Works [link] (b) shows the exchange rate for the Canadian dollar, measured in terms of U.S dollars The exchange. .. because the exchange rate of the U.S 6/13 How the Foreign Exchange Market Works dollar is being measured using a different currency the Canadian dollar But exchange rates always measure the price