CHAPTER 14

FOREIGN EXCHANGE MARKET

& EXCHANGE RATES
Dominick Salvatore (2016), International Economics, 12th edition, John Wiley & Sons, Inc.
LEARNING
GOAL
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

READ MORE
 FOREIGN EXCHANGE RATE

Most countries of the world have their own currencies

The trading of currencies and bank deposits is what makes up the
foreign exchange market.

Q&A:
1. List at least 5 currencies that you knew
2. Which activities arise the demand of foreign currencies and the
supply of foreign currencies
FOREIGN EXCHANGE RATE

The foreign exchange market is the market in which individuals,

firms, and banks buy and sell foreign currencies or foreign
exchange

The foreign exchange market refers to the organization setting

within which individuals, businesses, governments, and banks buy
and sell foreign currencies and other debt instruments

The foreign exchange market is a market for converting the

currency of one country into that of another country
FOREIGN EXCHANGE RATE
The foreign exchange market is a global network of banks, brokers, and
foreign exchange dealers connected by electronic communications systems:
Computers; Telephone systems; Electronic mail / instant messaging;
Internet/intranet; Blogs/wikis; Facsimile (fax) / file transfers Personal data
assistant etc.
The average total value of global foreign exchange trading in:
March 1986: $200 billion per day
April 2010: $4 trillion per day
April 2013: $5.3 trillion per day
April 2022: > $7.5 trillion per day
The most important trading centers are London (41%), New York (19%),
Singapore (5.7%), Tokyo (5.6%), Hongkong (4.1%)
The market is always open somewhere in the world—it never sleeps
TOP 10 GEOGRAPHIC TRADING CENTERS IN THE FOREIGN EXCHANGE MARKET (DAILY
AVERAGES IN APRIL, BILLIONS OF U.S. DOLLARS)

Q&A: Describe the chart of top 10 geographic trading centers in the foreign exchange
market and analyse the main trends or significant changes during the period (no more
than 250 words)
TOP 10 GEOGRAPHIC TRADING CENTERS IN THE FOREIGN EXCHANGE MARKET (DAILY
AVERAGES IN APRIL, BILLIONS OF U.S. DOLLARS)
THE NATURE OF THE FOREIGN EXCHANGE MARKET

Most transactions involve dollars on one side—it is a vehicle

currency
85% of all foreign exchange transactions involve the U.S. dollar
Other vehicle currencies are the euro, the Japanese yen, and
the British pound
China’s renminbi is still only used for about 0.3% of foreign
exchange transactions
 FOREX - 3 FUNCTIONS
1. Transfer of Funds or Purchasing Power from one Nation and Currency
to Another (The principal function of Forex)
A nation’s commercial banks operate as clearinghouses for the foreign
exchange demanded and supplied in the course of foreign transactions
by the nation’s residents.
If the nation’s total demand for foreign exchange in the course of its
foreign transactions exceeds its total foreign exchange earnings, the
rate at which currencies exchange for one another will have to adjust to
equilibrate the total quantities demanded and supplied
EX: Suppose a Vietnamese firm exporting to the US is paid in US$
The Vietnamese firm will exchange the US$ for VND at VCB
FOREX - 3 FUNCTIONS
Four levels of transactors or participants can be identified in the
foreign exchange market
The 1st level: The immediate users and suppliers of foreign
currencies (Ex: Tourist, importers, exporters...)
The 2nd level: Clearinghouses between users and earners of foreign
exchange (ex: Commercial banks)
The 3rd level: Foreign exchange brokers whom nation's commercial
banks even out their foreign exchange inflows and outflows among
themselves (called interbank, or wholesales market)
The 4th level (the highest level): The nation's central bank (are the
seller or buyer of last resort when the nation's total foreign exchange
earnings and expenditures are unequal
 FOREX - FUNCTION 1

Reading:
Case study 14.1 - The U.S. Dollar as the Dominant
International Currency
Case study 14.2 - The birth of a new currency
Q&A:
1. What is the vehicle currency? Why has US dollar (or Euro)
become the vehicle currency?
2. What does the country that owns the international
currency (so-called "vehicle currency") benefit from?
 FOREX - FUNCTION 2: CREDIT FUNCTION
Credit is usually needed when goods are in transit and also to
allow the buyer time to resell the goods and make the
payment.
In general, exporters allow 90 days for the importer to pay.
However, the exporters usually discount the importer’s
obligation to pay at the foreign department of his or her
commercial bank.
As a result, the exporter receives payment rights away, and the
bank will eventually collect the payment from the importer
when due.
Ex: L/C payment in exporting activities
FUNCTION 3: PROVIDE THE FACILITIES FOR HEDGING AND
SPECULATION

The market performs this function using

Spot exchange rates
Forward exchange rates
Currency swaps
A firm that protects itself against foreign exchange risk is
hedging
Hedging involves making use of forward contracts or options to
minimize exchange rate risk in international transactions
 FOREIGN EXCHANGE RATES

Exchange rate is the price of one currency in terms of another

The exchange rate between the dollar and the euro is equal to the
number of dollars needed to purchase one euro
Example 1: USD/EUR = 2, this means that € 1 is required to
purchase $ 2
Example 2: VND/USD = 21,000, this means that $ 1 is required to
purchase VND 21,000
Q&A:
Search for the exchange rate of VND in terms of two different
currencies.
I
 FOREIGN EXCHANGE RATES

Case study
Vietnamese firm export 100 million tons of rice to China at the
second quarter of 2023.
1. According to tradingeconomics.com, forecasting the price of
rice next month
2. According to the exchange rate of VND/USD and VND/CNY,
give suggestions the exchange rate that firm should export?
FOREIGN EXCHANGE RATES - QUOTATION

A foreign exchange quote is a statement of willingness to buy or

sell at an announced rate
In the retail market (newspapers and exchange booths),
quotes are often given as the home currency price of the
foreign currency
Interbank quotes – professionals state forex quotes in one of
two ways
The foreign currency price of one dollar (European Quote)
CHF 1.6000/USD, read as 1.600 Swiss francs per dollar
The dollar price of a unit of foreign currency (American Quote)
USD 0.6250/CHF, read as 0.6250 dollars per Swiss franc
FOREIGN EXCHANGE RATES - QUOTATION

Direct and Indirect Quotes

A direct quote is a home currency price of a unit of a foreign
currency
Ex: CHF 1.6000/USD is a direct quote in Switzerland
An indirect quote is a foreign currency price of a unit of the
home currency
Ex: CHF 1.6000/USD is an indirect quote in the US,
USD 0.6250/CHF is a direct quote in the US and an indirect
quote in Switzerland
Q&A: What quote does VND use mostly with other currencies?
Reading: Case study 14.3
EQUILIBRIUM FOREIGN EXCHANGE RATES

The exchange rate (R) between the dollar

and the euro is equal to the number of
dollars needed to purchase one euro
Under a flexible exchange rate system, the
dollar price of the euro (R) is determined by
the intersection of demand and supply
curves for euros
The vertical axis measures the dollar price of
the euro, or the exchange rate, R = USD/EUR
The horizontal axis measures the quantity of
euros
The equilibrium exchange rate of R = 1 (at the
intersection of demand and supply curve -
point E)
 EQUILIBRIUM FOREIGN EXCHANGE RATES

Q&A:
Give an explanation in some cases:
1. R> 1 (The exchange rate USD/EUR > 1)
2. R< 1
3. In the case of US demand curve shift
up, the new equilibrium point at G
To conclude, explain the situations below
and the effects on trade/investment
1. Depreciation
2. Appreciation
 DEPRECIATION - APPRECIATION

Depreciation refers to an increase in the domestic price of the foreign

currency (One country’s currency has depreciated when more of it is
needed to buy a unit of a foreign currency)
Appreciation refers to a decline in the domestic price of the foreign
currency (A currency has appreciated when less of it is needed to buy a
foreign currency)
An appreciation of the domestic currency means a foreign currency
depreciation and vice versa.
Once the exchange rate between each of a pair of currencies concerning
the dollar is established, however, the exchange rate between the two
currencies themselves, or cross-exchange rate, can easily be determined
Q&A:
 CROSS EXCHANGE RATES

Cross exchange rate: The exchange rate between currency A and

currency B, given the exchange rate of currency A and currency B with
respect to currency C.
Cross exchange rate between two currencies is calculated from their
exchange rates with a third, benchmark currency - frequently the US
dollar
Q&A:
Calculate the cross-exchange rate JPY/SGDSGD or GBP/EUR
NOMINAL AND EFFECTIVE EXCHANGE RATES
The nominal exchange rate (e) is the price of one currency in terms of a
number of units of some other currency.
The real exchange rate (E) is the purchasing power of a currency relative to
another at current exchange rates and prices
The real exchange rate = (nominal exchange rate X foreign price index) /
(domestic price index)
Effective exchange rate: A weighted average of the exchange rates between
the domestic currency and the nation’s most important trade partners, with
weights given by the relative importance of the nation’s trade with each of
these trade partners.
Effective exchange rate: An index of a currency's value relative to a group (or
basket) of other currencies, where the currencies in the basket are given
weights based on the amount of trade between the countries that use the
currencies
ARBITRAGE
Arbitrage: This refers to the purchase of a currency in the monetary center
where it is cheaper, for immediate resale in the monetary center where it is
more expensive, in order to make a profit
Types of Arbitrage
Two-point arbitrage
€ 1 = $ 0.99 in New York
€ 1 = $ 1.01 in Frankfurt

Triangular or three-point arbitrage

$ 0.96 = € 1 in New York
€ 1 = £ 0.64 in Frankfurt
£ 0.64 = $ 1 in London
 THE EXCHANGE RATE AND THE BALANCE OF PAYMENT
Examine the relationship between the
exchange rate and the nation’s balance of
payments
The vertical axis measures the dollar price of
the euro, or the exchange rate, R = USD/EUR
The horizontal axis measures the quantity of
euros
The equilibrium exchange rate of R = 1 (at the
intersection of demand and supply curve -
point E)
The new demand curve for euros labeled D'
--> The US demand for EUR arises from the US
demand of import of goods and services from
European Union market arise or US invesment in
the EU ==> The capital outflow from the US
(debit transaction)
 THE EXCHANGE RATE AND THE BALANCE OF PAYMENT
The supply of EUR arises
<--> US export to EU
<--> EU investment in US

=> The capital inflow to the US (credit

transaction)
 FOREIGN EXCHANGE RISKS
1. Spot Exchange Rates
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 are determined by the interaction between supply and
demand, and so change continually
2. Forward Exchange Rates
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 exchange rate governing such a
future transaction
Forward rates are typically quoted for 30, 90, or 180 days into the
future
 FOREIGN EXCHANGE RISKS
3. Foreign Exchange Swaps
A Foreign Exchange Swap is the simultaneous purchase and sale of a
given amount of foreign exchange for two different value dates
Swaps are used when it is desirable to move out of one currency into
another for a limited period without incurring foreign exchange rate
risk
Spot rate
4. Foreign exchange futures
Is a forward contract for standardized currency amounts and selected
calendar dates traded on an organized market
Trade currencies:
Japanese yen; Canadian dollar; British pound; Swiss franc;
Australian dollar; Mexican peso; Euro
 FOREIGN EXCHANGE RISKS
4. Foreign exchange futures
Eg: International Monetary Market (IMM) of Chicago Mercantile
Exchange (CME)
Standardized currency: JPY, CAD, GBP, AUD, CHF, Mexican peso,
euro
Standardized currency amounts: ¥12.5 million; C$100,000; £ 62,500,
€ 125,000
Selected calendar dates traded: Only four dates per year are
available: the third Wednesday in March, June, September, and
December
Buyers and sellers pay a brokerage commission and are required to
post a security deposit or margin (about 4 percent of the value of the
contract)
 FOREIGN EXCHANGE RISKS
4. Foreign exchange futures
A futures contract is like a forward contract:
It specifies that a certain currency will be exchanged for another at
a specified time in the future at prices specified today.
A futures contract is different from a forward contract:
Futures are standardized contracts trading on organized
exchanges with daily resettlement through a clearinghouse.
5. A foreign exchange option
is a contract giving the purchase the right, but not the obligation, to
buy (a call option) or to sell (a put option) a standard amount of a
traded currency on a stated date or at any time before a stated date
and at a stated price.
 FOREIGN EXCHANGE RISKS
Contracted future foreign currency payments may become more
expensive if the domestic currency falls in value.
Eg 1:
A contract requires a €200,000 payment in six months time.
If the exchange rate is currently $1/€1, the expected dollar cost is
$200,000.
If the exchange rate changes to $1.10/ €1 in the intervening months,
the dollar cost rises to $210,000.
 FOREIGN EXCHANGE RISKS
Contracted future foreign currency receipts may fall in value if the
domestic currency increases in value.
Eg 2:
A producer expects to receive a payment of €100,000 in six 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.