Carbaugh, Chap. 16 1

Exchange rate system alternatives

Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 1998

US dollar 60.3% 64.3% 57.1%German mark 12.1 14.7 10.1Japanese yen 5.1 7.0 3.7British pound 3.9 3.1 4.6French franc 1.3 1.4 1.2ECU 0.8 1.8 -Swiss franc 0.7 0.2 1.0Netherlands guilder 0.4 0.3 0.4Other 15.4 7.2 21.9

All Industrial DevelopingKey currency countries countries countries

• Introduction• Currencies are traded in foreign exchange

markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averaged $4 trillion in 2010, 20% higher than in 2007.

• An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another.

• Exchange rates are an important instrument of monetary policy

• Measuring the exchange rate• Exchange rates are expressed in various ways:• Spot Exchange Rate - the spot rate is the rate for a currency at today’s market

prices• Forward Exchange Rate - a forward rate involves the delivery of currency at a

specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market

• Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro

• Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country.

• Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.

• Hedging Function:• A third function of the foreign exchange market is to

hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money.

• What is Forex?• FOREX, an acronym for Foreign Exchange, is the largest financial

market in the world. With an estimated $1.5 trillion in currencies traded daily, Forex provides income to millions of traders and large banks worldwide. The market is so large in volume that it would take the New York Stock Exchange, with a daily average of under $20 billion, almost three months to reach the amount traded in one day on the Foreign Exchange Market.

• Forex, unlike other financial markets, is not tied to an actual stock exchange. Forex is an over-the-counter (OTC) or off-exchange market.

• Purpose• The foreign exchange market is the mechanism by which

currencies are valued relative to one another, and exchanged. An individual or institution buys one currency and sells another in a simultaneous transaction. Currency trading always occurs in pairs where one currency is sold for another and is represented in the following notation: EUR/USD or CHF/YEN. The exchange rate is determined through the interaction of market forces dealing with supply and demand.

• Definition of 'Currency Arbitrage'•

A forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of this disparity.

For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank A and then back into euros with Bank B. The end result is that the trader who started with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if trading fees are not taken into account.

• What is Speculation?• Currency speculation exists whenever someone

buys a foreign currency, not because she needs to pay for an import or is investing in a foreign business, but because she hopes to sell the currency at a higher rate in the future (in technical language the currency "appreciates"). This is nothing more than the old rule of buying low and selling high—only with foreign money

• Some currency speculation is necessary to facilitate international trade. Take, for example, a car manufacturer in Germany which exports cars to the United States. As the U.S. importer of German cars is paying her bill in U.S. dollars, the German exporter receives U.S. currency.

Determinants of Exchange RatesNumerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.

1. Differentials in InflationAs a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

• . Current-Account DeficitsThe current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficitin the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, seeUnderstanding The Current Account In The Balance Of Payments.)

2. Differentials in Interest RatesInterest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)