SG15eChapter2 foreign exchange.docx
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SG15eChapter2 foreign exchange.docx
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SG15eChapter2foreignexchange
Chapter17
theforeignexchangemarket
Maincontentsofthechapter
A foreignexchange transactionisatradeofonenationalmoneyforanother.The exchangerate isthepriceatwhichthemoneysaretraded.The spotexchangerate isthepriceforimmediateexchangeofthetwocurrencies.The forwardexchangerate isthepriceagreednowforacurrencyexchangethatwilloccursometimeinthefuture.Banksandtheirtradersareatthecenteroftheforeignexchangemarket.Theyusecomputersandtelephonestoconductforeignexchangetradeswithcustomers(theretailpartofthemarket)andwitheachother(theinterbankpartofthemarket).
Spotforeignexchangeservesaclearingfunction,permittingpaymentstobemadebetweenentitieswhowanttoholdorusedifferentcurrencies.Theexchangerateisdeterminedbysupplyanddemand,withinanyconstraintsimposedbythegovernmentalchoiceofanexchangeratesystemorregime.Underafreelyflexibleor floatingexchangeratesystem,marketsupplyanddemandsettheequilibriumprice(exchangerate)thatclearsthemarket.Afloatingexchangeratechangesovertimeassupplyanddemandshiftovertime.Underafixedexchangeratesystem (alsocalledapeggedexchangeratesystem),monetaryofficialsbuyandsellacurrencysoastokeepitsexchangeratewithinanofficiallystipulatedband.Whenthecurrency'svalueliesatthebottomofitsofficialband,officialsmustbuyitbysellingothercurrencies.Whenthecurrency'svaluepressesagainstthetopofitsofficialpricerange,officialsmustsellitinexchangeforothercurrencies.
ObjectivesoftheChapter
Thischapterdealswiththenatureandorganizationoftheforeignexchangemarket.Atitsmostbasic,theequilibriumexchangeratecanbethoughtofasthepricethatequatestheinternationalsupplyofanddemandforacountry’smoney.Forexample,theexchangerateontheBritishpound(expressedasAmericandollarsperBritishpound)wouldbedeterminedbythesupplyofpoundsarisingfromBritishpurchasesofAmericangoods,services,andassets,andbythedemandforBritishpoundsarisingfromAmericanpurchasesofBritishgoods,services,andassets.
Youmightwanttotrackafewofthemajorcurrenciesandrelatedcommentariesinthedailylistingsinthefinancialpress.
AfterstudyingChapter17youshouldbeabletoidentify
1.whatanexchangerateis.
2.whatthereciprocaloftheexchangeratemeans.
3.theorganizationofthemodernforeignexchangemarket.
4.thedistinctionbetweenspotandforwardexchangerates.
5.determinantsofdemandandsupplyforforeignexchange.
6.howasystemofflexibleforeignexchangeratesworks.
7.howasystemoffixedforeignexchangeratesworks.
ImportantConcepts
Appreciation(depreciation):
Anincrease(decrease)inthemarketpriceofacurrencyunderafloatingexchangeratesystem.
Fixedexchangerate:
Aratewhoseofficiallydeclaredvalueismaintainedbycentralbankintervention.(Alsoreferredtoasapeggedexchangerate.)
Floatingexchangerate:
Aratewhosevalueisdeterminedpurelybythemarketforcesofsupplyanddemand,withnodirectinterventionbycentralbanks.(Alsoreferredtoasaflexibleexchangerate.)
Foreignexchangemarket:
Acomputerizedcommunicationsnetworkembracingallthemajorfinancialcentersintheglobe,wheresellersandbuyersofanynationalmoneycanquicklyandefficientlycarryoutanydesiredcurrencyexchange.
ForeignexchangemarketWhenacentralbankbuysorsellsforeignexchangeinordertointervention:
manipulateorpegtheexchangerate.
(Foreign)exchangerate:
Thepriceofonecountry’scurrencyexpressedintermsofanothercountry’scurrency.(Notethat,inthistext,theexchangerateisexpressedintermsofdomesticcurrencyunitsrequiredtopurchaseoneunitofaforeigncurrency.)
Foreignexchangeswap:
A“packagetrade”inwhichaspotpurchaseofacurrencyisaccompaniedbyaforwardsaleofthatcurrency,oraspotsaleofacurrencyisaccompaniedbyaforwardpurchaseofthatcurrencyandpayment.Thistransactionallowsfortemporaryforeignexchangeneedsandisfreeofexchangerisk.
Forwardexchangerate:
Theexchangerateapplicabletoforeignexchangetransactionsagreedupontodayforlaterdelivery(usuallyin30,90,or180days).
Revaluation(devaluation):
Arevaluationisanofficialincreaseintheparvalueofacurrencyunderafixedexchangeratesystem;adevaluationisanofficialdecreaseintheparvalue.
Spotexchangerate:
Therateapplicabletoforeignexchangetransactionsrequiringcontemporaneousdeliveryandpayment.
Triangulararbitrage:
Theprocessthatensuresconsistencyamongthesetsofbilateral“crossrates”oftheworld’stradedcurrencies.Forexample,iftheBritishpoundtradesforUS$2,and100JapaneseyentradeforUS$1,theexchangeratebetweentheyenandthepoundmustbe200yenperpound.Otherwise,thereisanopportunityforanarbitrageurtobuyacurrencycheaplyinonemarketandsellitforahigherpriceinanothermarket.
Vehiclecurrency:
Acurrencyusedtofacilitateanindirecttradebetweentwoothercurrencies.TheU.S.dollarisoftenusedasavehiclecurrency.
WarmupQuestions
TrueorFalse?
Explain.
1.T/FAnincreaseinU.S.importsfromFrancewillgiverisetoasupplyofeurosinexchangefordollars.
2.T/FCentralbankinterventionismoreprevalentunderafloatingexchangeratesystemthanunderapeggedexchangeratesystem.
3.T/FIfAmericanssuddenlyrefusetolendmoneytoMexico,wewouldexpectthedollartoappreciaterelativetothepeso.
4.T/FArtappreciationcourseshavenothingtodowithexchangerates.
5.T/FIfacurrencyisundervaluedinafixedexchangeratesystem,officialsfromthatcountry’scentralbankwillhavetoselltheircurrencytokeepitpegged.
MultipleChoice
1.SupposetheexchangeratebetweentheCanadiandollar(C$)andtheAmericandollar(US$)changesfromC$1.340/US$toC$1.325/US$,buttheCanadiangovernmentwantstomaintainafixedexchangerateofC$1.340/US$.WhatshouldtheBankofCanadado?
A.StoptradingwiththeU.S.sothatfewerU.S.dollarswillflowintoCanada.
B.SellU.S.dollars(buyCanadiandollars).
C.SellCanadiandollars(buyU.S.dollars).
D.PurchaseBritishpoundsandsellFrenchfrancs.
2.Ifadollarequals400Mexicanpesosintheforeignexchangemarket,whatisthevalueofonepeso?
A.$250
B.$0.0025
C.$0.04
D.$1.25
E.Noneoftheabove.
3.Whichofthefollowingstatementsisfalse?
A.BritishimportsofFloridaorangeswillcreateademandforU.S.dollars.
B.IfallAmericansbuyJapanesecars,thedollarwillappreciaterelativetotheyen.
C.TheAmericandollarisoftenusedasavehiclecurrency.
D.Australia,Canada,NewZealandandTaiwanallusecurrenciescalled“dollars.”
4.WhenAmericanresidentsbuybondsfromHerMajesty’sTreasuryinLondon,intheforeign
exchangemarketthiswillgiveriseto
A.ademandforAmericandollars.
B.asupplyofBritishpounds.
C.asupplyofAmericandollars.
D.anotherBostonTeaParty.
5.Thedemandcurveforaforeigncurrencyslopesdownwardbecause
A.atlowerexchangerates,foreigngoodslookcheapertohomecountryresidents.
B.athigherexchangerates,thehomecurrencycanbuymoreforeigngoods.
C.thequantitysuppliedoftheforeigncurrencyrisesastheexchangeratefalls.
D.marginalutilitytheorysaysthatindividualssubstituteintoanycommoditywhosepricehasfallen.
Problems
1.ThecurrencyofLeinsteristheLeinsterlira(Ll);thecurrencyofSaxonyistheSaxonscudo(Ss).ConsiderthefollowingdiagramoftheforeignexchangemarketinSaxony:
Figure17.1
Ll
a.WhatistheequilibriumpriceofoneLeinsterlirainSaxony?
b.CanyoualsodeterminewhattheequilibriumpriceoftheSaxonscudoisinLeinster?
c.SupposeadoctorinLeinstershowsthateatingSaxonbreadcanreducethelevelofcholesterolinone’sblood.Whatwouldyouexpecttohappentotheexchangeratebetweenliraandscudosinafloatingexchangeratesystem?
d.IftheSaxonfinanceministerwantstopegtheexchangerateatthevalueyoudeterminedin(a),whatmustshedotocounteracttheimpactontheexchangerateoftheeventdescribedin(c)?
2.SupposethattheSaxonscudoappreciatesrelativetotheLeinsterlira.Determinewhethertheeconomicagentslistedbelowwouldseethatappreciationasagoodthingorabadthing.
a.ALeinsterresidentwhoimportsgoodspricedinscudos.
b.ASaxonwhoexportsgoodspricedinscudos.
c.ALeinsterresidentwhoexportsgoodspricedinlira.
d.ASaxonwhohasaretirementaccountdenominatedinscudos.
e.Anyonewhoexpectedtheliratodepreciate.
3.Forthemostpart,theexchangeratebetweentheU.S.dollarandtheeuroisfloating.Whateffectwilleachofthefollowingeventshaveonthe$/€exchangerate?
a.TheFrenchgovernmentbanstheimportofAmericanmovies.
b.AmericanslearnthatdrinkingFrenchredwinewillpreventheartdisease.
c.AnAmericanmutualfundpurchasesstockinRenault.
d.ParisianperfumemakersbuychemicalsfromacompanyinNewJersey.
e.NewYorkforeignexchangespeculatorsbelievetheeuroisgoingtodepreciateinthenextfewhours.
4.AssumethatU.S.governmentofficialsaretryingtokeeptheexchangeratebetweenthedollarandtheeuropegged.ForeachoftheeventsdescribedinProblem3,whatactionsmusttheseofficialstaketoreturntheexchangeratetoitspreviouslevel?
5.Youhavebeengivenonemillionyentoplaywith.Usethefollowingexchangeratestoshowhowyoucanmakearisklessprofitintermsofyen:
1euro=70yeninMunich
1yen=1Americanpennyi
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