Chapter 3A

Exchange Rates

Exchange rates are quoted as foreign currency per unit of domestic currency or vice versa.

• e.g. how much can be exchanged for one yen or for one dollar?

  

• e.g. 1.10 USD/EUR or 0.91 EUR/USD

• e.g. 3.65 QAR/USD or 0.27 USD/QAR

  • The numbers above are called quotes.

  • To get the indirect exchange rate, divide 1 by the direct quote. How much can be exchanged for one dollar?

Exchange rates allow us to denominate the cost or price of a good or service in a common currency.

e.g. if a Nissan costs ¥2,500,000 then;

Depreciation and Appreciation

Depreciation is a decrease in the value of a currency relative to another currency. A depreciated currency is less valuable (less expensive):

• It can be exchanged for (can buy) a smaller amount of foreign currency.

  • $1/€ ——> $1.20 € means the dollar has depreciated relative to the euro.

    • It now takes $1.20 to buy one euro, so the dollar is less valuable.

    • The euro has appreciated relative to the dollar: it is now more valuable.

• It can buy fewer foreign-produced goods denominated in foreign currency.

  e.g. a Nissan costs

  

  it is less expensive than

  

• A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.

  • it lowers the price of exports relative to the price of imports.

Appreciation is an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more expensive).

• It can be exchanged for (can buy) a larger amount of foreign currency.

  • $1/€ ——> $0.90/€ means the dollar has appreciated relative to the euro.

    • It now takes only $0.90 to buy one euro, so the dollar is more valuable.

    • The euro has depreciated relative to the dollar: it is now less valuable.

• It can buy more foreign-produced goods denominated in foreign currency.

  e.g. a Nissan costs

  

  becomes less expensive

  

• An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.

  • it raises the price of exports relative to the price of imports.

Foreign Exchange Markets

Foreign exchange markets are where foreign currencies and other assets are exchanged for domestic ones.

• Institutions buy and sell deposits of currencies + other assets for investment purposes.

  • most transactions exchange foreign currencies for U.S. dollars.

The participants:

1. Commercial banks and other depository institutions: transactions involve buying/selling deposits in different currencies for investment purposes.

2. Corporations (non-financial businesses) conduct foreign currency transactions to buy/sell goods, services and assets.

3. Non-bank financial institutions(mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment.

4. Central banks: conduct official international reserves transactions.

Buying + selling in the forex market are dominated by commercial and
investment banks.

• Interbank transactions of deposits in foreign currencies occur in amounts of $1 million or more.

• Central banks sometimes intervene, but the direct effects of their transactions are small and transitory (brief) in many countries.

Computer and telecommunications technology transmit information rapidly and have integrated markets.

• The integration of financial markets implies there can be no significant differences in exchange rates across locations.

• Arbitrage means: buying at low prices and selling at higher price for profit.

  • e.g. if the euro is selling for $1.1 in New York and $1.2 in London, ppl could buy euros in New York (cheaper) and sell them in London at a profit.

Spot Rates and Forward Rates

• Spot rates are ex rates for currency exchanges “on the spot” or when trading occurs in the present.
  

• Forward rates are ex rates for currency exchanges that will occur at a future (“forward”) date.

  • these are typically 30, 90, 180, or 360 days in the future.

  • rates are negotiated between two parties in the present, but the exchange occurs in the future.

  • spot and forward ex rates tend to move in a highly correlated fashion.

• Triangular arbitrage

• Cross rates

• Investing in different currencies