Chapter 15 Foreign exchange: The structure and operation of the FX market Learning objective 1: understand the nature, size and scope of the global FX markets and the fundamental exchange rate regimes used by different countries • Foreign exchange markets exist wherever transactions are denominated in a foreign currency,

including international trade transactions, cross-border capital transactions, speculative transactions and central bank transactions.

• The FX markets operate through a highly sophisticated network of telecommunications systems that link the numerous FX dealers and FX brokers located in all of the major cities of the world.

Learning objective 2: identify and discuss the major groups of participants in the FX markets • Participants in the FX markets also include those who have underlying commercial and financial

transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing overseas in a currency other than their home currency.

• In addition, there are speculators who buy and sell foreign currencies in the expectation of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and/or international interest rate differentials across the different international markets.

• Central banks also enter the FX markets as buyers and sellers of foreign currency. A central bank may enter the FX market in order to meet its government’s foreign currency requirements or, from time to time, in an attempt to influence the value of a currency in the market.

Learning objective 3: describe the functions and operations of the FX markets • The FX markets operate somewhere around the globe twenty-four hours a day. • The markets are dynamic, with exchange rates changing in response to the continuous flow of

economic, political, financial and social news and information into the markets. • It is estimated that around the equivalent of USD3.5 trillion pass through the FX markets each

day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems.

Learning objective 4: list and explain the types of FX transactions, in particular, spot and forward transactions • The contracts that are traded in the FX markets are distinguished by their maturity or delivery

dates. • Spot and forward contracts are the most common contracts traded. • Spot transactions have a value date that is two business days from today; that is, they require

delivery of the foreign currency and financial settlement two business days from the contract date.

• Forward contracts specify a value date more than two business days from today. Learning objective 5: introduce the conventions adopted for the quotation and calculation of spot exchange rates • Because of the technology-based nature of the trade in foreign currencies, universal conventions

are adopted in the markets. • For example, a spot quote may be AUD/USD0.7250–56. • The first-named currency in an FX quote is called the unit of the quotation, or the base currency.

The base currency represents one unit of the currency. • The second-named currency is known as the terms currency. • FX dealers, or price-makers, quote two-way rates: the first and lower rate is the one at which the

dealer buys the base currency; the second and higher rate is the one at which the dealer sells the base currency.

• FX dealers will abbreviate their verbal FX quotes. • Exchange rates with less than ten units are quoted to four decimal places, and currencies with

more than ten units are quoted to only two decimal places. • The spread is the difference between the bid and offer rates. • A point is the final decimal place in a quote. • It is possible to derive a range of additional exchange rates on the basis of existing published

rates; for example, transposed and cross-rates can be calculated. • To transpose a quote from, say, a direct (USD/AUD) to an indirect quote (AUD/USD), the rule is

to reverse the quote and then invert by dividing into 1. • As all currencies are quoted against the USD, it is often necessary to calculate a cross-rate that

does not incorporate the USD, for example, SGD/NZD. • To calculate the cross-rate for two direct quotes, place the new base currency quote first,

followed by the second quote. Simply divide opposite bid and offer rates. Learning objective 6: describe the role of the forward market and calculate forward exchange rates • The convention adopted in the quotation of forward rates is that the dealer quotes the forward

points rather than the outright forward rates. • To obtain the outright rate, the forward points are added to, or subtracted from, the spot rate. • In calculating the forward points, the dealer uses the spot rate and the differential rates of interest

of the two countries whose currencies are quoted. • The currency of the higher interest-rate country will be priced at a forward discount; the lower

interest-rate currency will be quoted at a forward premium. • If the forward points are rising they are added to the spot rate and vice-versa. Learning objective 7: identify factors that complicate FX market price quotations and calculations • We need to consider real-world complications such as different ‘interest rate year’ conventions

(e.g. the United States uses a 360-day year while the United Kingdom uses a 365-day year), two-way quotations, different borrowing and lending interest rates, and the effects of compounding periods, all of which affect the calculation of forward points and a forward exchange rate.

Learning objective 8: recognise the important impact on the FX market of the European Monetary Union • The European Monetary Union has had a significant impact on the structure and operation of the

FX markets. • Sixteen foreign currencies have been replaced by a single currency, the euro.

• The euro has become a hard-currency for commercial and financial transactions and a major currency traded in the FX markets.

Essay questions The following suggested answers incorporate the main points that should be recognised by a student.

An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.

1. Describe the functions, structure and operation of the international FX markets. Include in

your answer the main locations of the markets and explain the roles of FX dealers and FX brokers.

• the FX market is a global market facilitates transactions in international currencies 24-hours a day

• the FX markets exist whenever and wherever financial transactions are conducted which are denominated in a foreign currency

• major FX markets include London, New York, Tokyo, Singapore, Hong Kong, Sydney, Bahrain, Frankfurt, Paris and Zurich

• the FX market facilitates the exchange of value from one currency to another • the FX market allows market participants to buy and sell foreign currencies • important reasons that there is an enormous demand to buy and sell foreign currencies include:

o financial flows arising from international trade in goods and services o cross-border capital transactions—investment and borrowing o speculative transactions—profiting from exchange rate movements o central bank transactions with the markets

• the FX markets operate through the use of sophisticated electronic communication and information systems

• trading in FX is conducted using telephone, computer based systems such as SWIFT (society for worldwide interbank financial telecommunications)

• SWIFT is an electronic system that facilitates financial transactions for member institutions in the global market

• when carrying out transactions internationally adopted FX market conventions have developed • transactions are normally conducted through an FX dealer or an FX broker • FX dealer—financial institutions that quote buy and sell prices and act as principals in the FX

market • FX broker—obtains the best prices in the FX market and match FX dealers’ buy and sell orders,

for a fee 2. Importers, exporters, investors and borrowers may all be participants in the FX markets.

Explain why each of these parties would be involved in FX market transactions. Firms conducting international trade transactions (importers and exporters): • businesses that export goods or services in the international markets generally receive payments

in a foreign currency

• also businesses that import goods and services need to pay for those goods and services, usually in a foreign currency

• the dominant currency of international trade is the USD, but other currencies, such as the GBP, JPY and the EUR, are also prominent

• typically, an exporter is likely to sell foreign currency received and buy the local currency through an FX market

• importers have to buy foreign currency in order to pay for their imports Investors and borrowers in the international financial markets: • deregulation of the international financial markets has resulted in an enormous increase in the

volume of capital flows around the world • large corporations, financial institutions and governments raise funds in the international capital

markets • borrowers with good credit ratings are able to diversify their funding sources in the international

capital markets, such as the euromarkets • a large proportion of funds borrowed in the international markets is converted from the currency

borrowed back into the home currency, using the FX market • other corporations and financial institutions invest overseas • for example, funds managers for pension or superannuation funds will invest a proportion of

their investment portfolios in international stocks and debt securities • the funds managers need to purchase FX in order to make the investments • dividend or interest payments received by the funds managers will be denominated in a foreign

currency. The managers may sell on the FX markets to convert the receipts back into the home currency for distribution to fund members

3. (a) Distinguish between speculative and arbitrage transactions in the FX market. • speculative FX transactions are motivated by the pursuit of a profit • the sheer volume of speculative transactions implies that, at times, speculators are able to move

the market price of a currency • such transactions are always accompanied by an element of risk • arbitrage transactions are possible when price differences appear between markets • the arbitrageur is able to carry out simultaneous buy and sell transactions in two or more markets

to lock-in a risk-free profit (b) Give an example of an institutional speculator in the FX markets • if there is an expectation that the AUD will depreciate against the USD, a speculator might buy

the USD (sell the AUD) now. If correct, a profit will be made by converting the USD back into AUD after the AUD has depreciated. However, if the AUD appreciates instead, the speculator will lose

• a speculator may take a long position or a short position • long position—holding FX in expectation of a future sale • short position—entering into a forward contact to sell FX that is currently not held (c) Describe arbitrage transactions using an example of a triangular arbitrage.

• An arbitrageur will attempt to identify markets in which pricing equilibrium is not fully reflected in the price of a financial asset. For example, it may be possible to discover a cross-currency price advantage by buying and selling several foreign currencies in several FX markets at the same time.

• triangular arbitrage: occurs when exchange rates between three or more currencies are out of perfect alignment. Again, the arbitrageur will simultaneously buy and sell a combination of currencies to take advantage of the price differences

• arbitrage profit opportunities generally do not exist for long. The buy/sell actions of the arbitrageurs bring the prices back into equilibrium

4. Many developed economies operate within a floating exchange-rate regime. Where a

country has a floating exchange rate, identify and discuss the circumstances in which the central bank of that country might conduct transactions in the FX market.

The central banks of nation-states enter the FX markets periodically, for one or other of the following reasons:

• to acquire foreign currency to pay for their government’s purchases of imports, such as defence equipment, and to pay interest on, or to redeem, the government’s overseas borrowings

• to change the composition of the central bank’s holdings of foreign currencies as part of its management of official reserve assets. Official reserve assets are central bank’s holdings of foreign currencies, gold and international drawing rights

• to influence the exchange rate. Central bank intervention in the FX market would not exist if the value of a currency was determined purely by market forces, that is, a so-called clean-float. However, central banks may, at times, be significant buyers or sellers of a currency where it considers the exchange rate is moving too rapidly, and is trading well outside rates that can be supported by economic fundamentals. If the goal is to slow down an appreciation of the exchange rate, the central bank will sell its local currency. In another example, if the Reserve Bank wished to support the AUD to stop it depreciating and perhaps assist it to appreciate, it would buy AUD and sell foreign currency

5. Outline the features of the main types of contracts that are created in the FX markets,

distinguishing between short-dated, spot and forward transactions. • an FX transaction is described by its value date, that is, the day that the currency is delivered and

settlement is made • spot transactions—the FX contract value date is two business days from the date of the initial

order. The exchange rate is determined today, but delivery occurs in two business days. For example, a company places an order with an FX dealer to buy USD1 million at a rate of AUD/USD0.6032 on a Tuesday, then the dealer will deliver USD1 million on the Thursday and the company will pay AUD1 657 824.93 also on the Thursday

• forward transactions—the FX contract value date occurs at a specified date beyond the spot date, for example an order to sell EUR in three months. Again, the exchange rate is set today that will apply at spot plus three months. If today is 24 March then the 3-month forward value date will be 26 June, providing that is a business day (if not, the date will be moved forward to the next business day)

• tod transactions—an FX contract will settlement and delivery today • tom transactions—an FX contract with settlement and delivery tomorrow

6. The FX dealing room of a major bank has calculated that it is long in the USD, but is short in the EUR. Explain what is meant by these positions.

• if the dealer is long in USD it means that it is holding surplus USD on its account, that is, the USD are in excess to its currency requirements to meet existing FX contracts

• if the dealer is short the EURO it means that the dealer has entered into a forward contract to sell the EUR when in fact it currently does not hold sufficient EUR in its FX portfolio. The dealer may be holding the short position in an expectation that the EUR will depreciate before the forward value date. The dealer will then buy the actual EUR at the lower price on the value date and sell at the higher price specified in the forward contract

7. ‘The FX market has a well-established set of language conventions. These conventions have

been developed to allow the efficient communication of market data.’ Explain and illustrate this statement by reference to the language conventions used in the spot FX markets. Use an example to explain your answer.

• assume the following quote AUD/USD0.7052–56 • the first-named currency in the quote is the base currency or the unit of the

quote, that is one AUD equals USD0.7052–56 • the second named currency is the terms currency, the USD. The terms

currency is valued relative to the base currency • the quote is a two-way price, that is, a bid price (buy) and an offer price (sell) • the first number is the bid price—AUD/USD0.7052 • the second number is the offer price—AUD/USD0.7056 • the market convention is to drop common numbers between the bid/offer price • the bid/offer is from the perspective of the dealer, that is, the dealer will buy

AUD1 for USD0.7052, or sell AUD1 for USD0.7056 • the difference between the dealer’s bid/offer prices is the spread • the spread in the example is 4 points (a point is the last decimal point in a

quote) 8. Using the context of the currency pair USD/JPY, explain the base currency, terms

currency, direct quotation and indirect quotation. • base currency—the first named currency in an FX quote that is expressed as one unit in terms of

the second currency. In the USD/JPY example the base currency is the USD and is expressed as USD1 will be bought/sold for the amount of JPY that will be given in the quote

• terms currency—the second named currency in the quote, that is, the JPY • direct quotation—when the USD is the base currency of the unit of the quotation as in the

USD/JPY example • indirect quotation—when the USD is the terms currency and the other currency is the base

currency in the quotation. In that case the above quote would be transposed to JPY/USD 9. An FX dealer is quoting spot USD/SGD1.4750–56. (a) explain from the perspective of the dealer what the FX quote indicates, and • the price maker FX dealer will buy USD1 for SGD1.4750. For the party that has entered into the

FX contract with the dealer they will sell USD1 and receive SGD1.4750

• also, the dealer will sell USD1 for SGD1.4756; the customer will receive USD1 and pay the dealer SGD1.4756

• the dealer will make a margin of 6 points between its bid and offer transactions (b) transpose the quotation. • the USD/SGD1.6150–56 is a direct quote; the USD is the base currency • it is possible to transpose the direct quote to an indirect quote (SGD/USD) • rule: reverse then invert

USD/SGD1.4750–1.4756 Reverse the bid/offer prices 1.4756–1.4750 take the inverse, that is, divide both numbers into 1 SGD/USD0.6777–0.6780 10. A toy manufacturer in Thailand is exporting goods to New Zealand. In order to ascertain

the firm’s exposure to foreign exchange risk the company needs to calculate the THB/NZD cross-rate. An FX dealer quotes the following rates:

USD/NZD 1.6940–55 USD/THB 34.32–48

Calculate the THB/NZD cross-rate. • most currencies are quoted against the USD, therefore it is necessary to calculate the cross rate to

obtain the THB/NZD quote • crossing two direct FX quotations

o place the currency that is to become the unit of the quotation first o divide opposite bid and offer rates, that is:

to obtain the bid rate: divide the base currency offer into the terms currency bid to obtain the offer rate: divide the base currency bid into the terms currency offer

o therefore, place the USD/THB quote first: USD/THB 34.32–48

USD/NZD 1.6940–55 To determine the THB/NZD cross rate: 1.6940 / 34.48 = 0.0491 1.6955 / 34.32 = 0.0494 THB/NZD 0.0491–94

11. An Australian manufacturer generates receipts in JPY from exports to Japan. At the same

time, the company imports component parts from the United States, incurring commitments in USD. The company needs to determine its net open position to the JPY. Rates are quoted at:

USD/JPY 91.45–50 AUD/USD 0.7246–56

Calculate the AUD/JPY cross-rate. • it is possible to use two methods to calculate this cross-rate; first transpose the

AUD/USD rate to a direct USD/AUD rate and then use the two direct quote method (see question 10), or second, use the direct and indirect quote method

• crossing a direct and an indirect FX quotation: o to obtain the bid rate—multiply the two bid rates o to obtain the offer rate—multiply the two offer rates

• to determine the AUD/JPY cross rate: 91.45 × 0.7246 = 66.26 91.50 × 0.7256 = 66.39 AUD/JPY 66.26–39

12. An importer has entered into a contract under which it will require payment in GBP in one

month. The company is concerned at its exposure to foreign exchange risk and decides to enter into a forward exchange contract with its bank. Given the following (simplified) data, calculate the forward rate offered by the bank.

Spot AUD/GBP0.4156–76 One-month Australian interest rate: 6.75% p.a. One-month United Kingdom interest rate: 4.25% p.a.

• the quote is from the perspective of the dealer relative to the base currency • the importer needs to buy GBP therefore it will sell AUD to the dealer. The dealer is therefore

buying AUD, so need to use the bid rate • note: both countries use a 365 day year; assume 30 day contract

year)in days/dayscontract ( 1year)in days/dayscontract ( 1

⎥⎦

⎤⎢⎣

⎡×+×+

IbItS

where: S = spot rate Ib = interest rate of base currency It = interest rate of terms currency Therefore, based on the above data: 0.4156{[1 + (0.0425 × 30/365)] / [1 + (0.0675 × 30/365)]} = 0.4156 (1.003 493 / 1.005 548) = AUD/GBP0.4148 13. When considering interest rate differentials and forward exchange rate calculations

between the USD and the GBP, what important adjustments need to be taken into account? • the USA uses a 360-day year convention while the UK uses a 365-day convention • need to recognise this variation in the forward exchange contract formula

14. The internationalisation of financial markets and the development of sophisticated technology-based systems mean that foreign exchange dealers must have access to up-to-date information systems. Identify one major global information provider typically used by FX dealers, and briefly describe the type of information that may be available.

• in a physical sense, the FX market consists of a vast and highly sophisticated global network of telecommunications systems

• to facilitate FX transactions it is essential that the various dealing rooms around the globe have access to the same information at each moment in time

• the information sought by the FX dealing rooms will be the current buy and sell rates for the various currencies, plus economic, political and social news that may affect the values of any particular currency

• there are a number of global networks that provide such information, including Reuters or Bloomberg

• these organisations facilitate the efficient flow of information into the FX markets • FX dealing rooms typically access more than one information provider 15. ‘The European Monetary Union has had a significant impact on the structure and

operation of the FX markets.’ Discuss the process of monetary union in Europe and the issues relevant to the FX markets that are implied in the above statement.

• the Maastricht treaty seeks to create economic and monetary union within Europe • as at January 2009, 19 countries are full member of the EU; 16 of those countries participate in

the EMU • a further 8 countries are provisional members of the EU and not eligible to participate in the

EMU • EMU has seen the removal of 16 foreign currencies from the FX market • the euro was introduced for financial transactions in January 1999 • euro notes and coins introduced in January 2002 • the euro has become a hard currency used for international trade and financial transactions • central banks around the world support the euro by holding the euro as part of their foreign

reserves • the removal of 16 currencies and the introduction of one major currency (the euro) has increased

the liquidity in the FX market • the introduction of the euro has removed foreign exchange risk for trade and financial

transactions denominated in euro that are carried out between member states

Chapter 16 Foreign exchange: Factors that influence the exchange rate Learning objective 1: explain currency demand and supply issues that impact the determination of an equilibrium exchange rate • An exchange rate is the price of one currency in terms of another currency. • Most developed economies operate a floating exchange-rate regime whereby the price of the

currency is determined by the demand for and the supply of that currency in the FX market. • Any change in the factors that impact upon the demand for and supply of a currency will result

in a change in the exchange rate. • A country that maintains a pegged, crawling peg or managed exchange-rate regime, whereby the

local currency is tied to another currency such as the USD, or a basket of other currencies, is effectively tied into supply and demand factors that affect the currency to which it is pegged.

Learning objective 2: consider mechanisms and relationships of factors that influence exchange rate movements, particularly:

o relative inflation rates o relative national income growth rates o relative interest rates o exchange rate expectations o central bank or government intervention

• Of the theories advanced to explain the exchange rate, and changes in the equilibrium rate, the purchasing power parity (PPP) theory is the longest standing.

• Under PPP, a country with a higher inflation rate relative to another country can expect its currency to depreciate.

• Perhaps the most critical shortcoming of PPP is that there are variables in addition to inflation that affect the value of a currency.

• The Extended learning section considers PPP calculations that apply inflation differentials between two countries to determining the expected change in the exchange rate.

• There is wide agreement that changes in the relative rates of growth in national incomes affect the exchange rate.

• There is disagreement, however, as to the nature of the effect. • An increase in the relative rate of growth is likely to result in an increased demand for imports,

which will result in a depreciation of the currency. • On the other hand, an increase in the growth rate may also result in an increase in foreign

investment inflows, which will cause the currency to appreciate. • Both mechanisms are likely to operate, with the balance between the two changing from time to

time. • The interest rate differential between two countries is also important in determining the demand

for and supply of the currency in the FX market, however, the effects of a change in the interest rate differential are ambiguous.

• It is important to determine whether the change is due to a change in inflationary expectations or a change in the real rate of interest.

• If the increase in interest rates is a result of an increase in inflation expectations a currency

should depreciate. However, if the increase is due to a rise in the real rate of interest, then the currency should appreciate.

• In addition to the economic fundamentals, exchange rate expectations are critically important in determining the FX value of a currency.

• If the markets expect the exchange rate to depreciate, this will ultimately result in FX buy or sell transactions that cause the depreciation; if an appreciation is expected, an appreciation typically will be experienced.

• The modelling of expectations is a particularly difficult task. Theoretically, expectations should be formed on the basis of the expected values of economic fundamentals. In practice, it is the latest, and often limited, information coming into the market that has an immediate impact on market expectations.

• At times, the actions of governments or central banks are another variable that may be important in the FX markets.

• A government or central bank may intervene in the FX markets to directly influence the level of an exchange rate by intervening in international trade flows, intervening in foreign investment flows, or conducting FX transactions in the markets.

• In an attempt to increase the FX value of its currency, a central bank may sell foreign currency and buy the local currency; alternatively, to reduce the value of its currency, the central bank may buy foreign currency.

Learning objective 3: explore regression analysis as a statistical technique applied to variables that impact an exchange rate. • Regression analysis is a statistical technique that may be used to try to ascertain the relationship

between a dependent variable (the exchange rate) and changes in independent variables such as inflation, national income growth, interest rates, government or central bank intervention, and market expectations.

Essay questions The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion. 1. Within the context of a floating exchange rate regime, discuss the demand for a currency

and its supply, and the resultant equilibrium exchange rate. • floating exchange rate—the value of one currency relative to another currency is determined by

factors of supply and demand Demand for a currency: • the demand for a currency is represented in a downward-sloping demand curve • the downward slope derives from the expectation that the cheaper the local currency, the greater

the demand for the currency by the rest of the world

• a fall in the exchange rate is equivalent to a reduction in the price of goods, services and assets in that country, therefore, more of those goods, services and assets will be demanded. Therefore there will be an increase in the quantity of the local currency demanded in the FX markets

• to purchase local goods, services or assets the overseas buyer must first buy (demand) the local currency to pay for the transaction

Supply of a currency: • the supply of the local currency on the FX market increases as the exchange rate appreciates • therefore the supply curve is upward sloping • the supply of a local currency onto the FX market comes about as a result of holders of that

currency buying foreign currency • as the price of the local currency increases in the FX markets the relative price of a foreign

currency falls • with the fall in the price of the foreign currency, from the point of view of holders of the local

currency, the price of overseas goods, services and assets becomes cheaper • the demand for those goods, services and assets will increase. As the demand for them increases,

the demand for the foreign currency increases • buyers will need to sell (supply) local currency to the FX market to buy the foreign currencies

needed to purchase the cheaper goods, services and assets • conversely, as the price of the local currency declines, the supply curve shows that less will be

supplied • a decline in the price of the local currency is the equivalent of there being an increase in the price

of a foreign currency. Holders of the local currency will perceive the price of foreign goods, services and assets as having increased and thus they will demand fewer of them. As the demand for foreign goods declines, the demand for the foreign currency will also decline; that is, there will be a smaller quantity of the local currency supplied to the market.

Equilibrium exchange rate: • when the demand and supply curves are drawn together it will show the unique exchange rate at

which both the demanders and suppliers of a local currency will be satisfied • only at that rate is the quantity of the currency supplied to the market equal to the demand for the

currency • this rate is labelled the market clearing rate or the equilibrium exchange rate • unless there is a change in the demand curve, or the supply curve, this rate will continue to

prevail • any price other than the equilibrium rate is not sustainable.

2. Draw a graph that depicts the USD/SGD demand curve and supply curve. Plot the equilibrium exchange rate at USD/SGD1.6200. If the spot exchange rate is USD/SGD1.6500, what impact will that have on the demand and supply position in the FX markets?

• assume the Singapore dollar is the local currency • at the USD/SGD1.6500 exchange rate the price of local goods and services in the international

markets increases and the demand for the SGD will fall; also the cost of imports is cheaper therefore the supply of SGD increases as locals buy the USD to purchase overseas goods and services

• in order to sell the increased supply of SGD market participants will bid down the currency until it comes into equilibrium at USD/SGD1.6200

3. ‘Under a free-floating, market-determined exchange rate system, the exchange rate will

always adjust so that the demand for and the supply of a currency in the FX market will be equal.’

(a) Having regard to this statement, describe the mechanisms through which equilibrium is maintained in the event of a change in the demand or supply curves.

• Given the data in the diagram below, the equilibrium exchange rate based on the supply and demand curves is AUD/USD0.72500

• this is the exchange rate that is sustainable over time, assuming there is no change in factors influencing the supply and demand curves

• any other exchange rate is not sustainable • for example, at a rate of AUD/USD0.6924 the quantity of AUD demanded is 25 billion, but the

quantity supplied is only 15 billion • there is an excess demand for the AUD • the FX dealers would not be able to meet the demands of their clients • their clients would have to instruct their dealers to offer a higher price • the effect of the higher price is twofold; first, as the price of the AUD is bid up the quantity

supplied would increase; second, some who demanded the AUD at 0.6924 would withdraw from

Supply curve

Demand curve

1.6500

1.6200

Quantity of the currency E

USD/SGD

the market as the exchange rate appreciates. The combined effect is that the increase in the price reduces the excess demand

• the price would continue to be bid up to a rate of 0.7250 at which point there is no pressure in the marketplace for the price to change further

• this conclusion stands only while the demand and supply curves remain where they are • factors that determine the positions of the curves change through time • with changes in these variables, and thus in the positions of the curves, the equilibrium exchange

rate will change • variables that may affect the positions of the demand and supply curves include the relative

inflation rates, relative national income growth, relative interest rates, exchange rate expectations and central bank or government intervention

(b) Draw a diagram showing the appropriate demand and supply curves.

4. List and briefly comment on the economic variables that are commonly identified as

affecting the exchange rate of a currency. Economic factors that may influence exchange rate movements, include relative inflation rates,

relative national income growth rates, and relative interest rates. Other (non-economic) factors also include exchange rate expectations and central bank or government intervention.

Relative interest rates: • the purchasing power parity theory (PPP) is the most enduring hypothesis advanced to explain

changes in the equilibrium exchange rate • PPP considers the exchange rate effect of changes in the rates of inflation between two countries • for example, if Australia and the USA had been experiencing similarly low rates of inflation, and

then the USA experienced a substantial and prolonged increase in its inflation rate, PPP contends that there would be a movement in the demand and supply curves, and a resultant change in the equilibrium exchange rate

• the price of goods and services imported from the USA would increase and thus Australian demand for US goods and services, and therefore USD, would decline

• in addition, the surge in US inflation would cause US residents to search for relatively cheaper goods in the rest of the world

• some of this US demand would switch to the relatively cheaper Australian goods and services • the increased demand for the AUD, combined with the reduced supply, would cause an

appreciation of the AUD

S

DQuantity of AUD

(billion $)

AUD/USD Price

0.7250

15 20 25

0.6924

Relative national income growth rates: • a second economic factor that can affect the equilibrium exchange rate is changes in relative

income growth between countries • for example, assume that the growth in Australian national income rises substantially, while that

in the USA remains stagnant • in this scenario Australia’s demand for imports would increase. To pay for the imports there

would be an increase in the supply of AUD on the FX market as holders of AUD sell them to buy the foreign currency

• with national income in the USA being stagnant the US demand for Australian goods and services, and thus the demand for AUD, would remain at its original level

• the effect on the equilibrium exchange rate is that the AUD would depreciate. Relative interest rates: • a third impact is the rate of interest in Australia relative to the rate of interest in the rest of the

world • consider the situation in which Australian interest rates rise, while those in the USA remain

relatively stable • in this situation residents and institutions in the USA can be expected to place some of their

excess cash in interest-bearing instruments in Australia in order to obtain the higher rate of return • this is represented by an increase in demand for AUD • at the same time, Australian businesses are likely to keep their surplus funds in banks and

instruments in Australia rather than in the lower rate of return in the USA. With fewer AUD being placed overseas there is a reduction in the supply of AUD in the FX market

• the combined effect is that the increase in interest rates in Australia has resulted in an increase in the demand for AUD, and a reduction in the supply of AUD, and consequently the AUD has appreciated

5. Draw a chart and explain in words what is expected to happen to the Indian rupee demand

and supply curves (USD/INR) if there is a forecast increase in India’s inflation rate while the inflation rate remains stable in the United States.

• purchasing power parity contends that exchange rates will adjust to ensure prices on the same goods are equal between countries

• a sustained surge in Indian inflation will increase the costs of local goods • USA demand for the Indian goods would fall • therefore there would be a reduction in the demand for the Indian rupee • the demand curve would move from D0 to D1 • at the same time India would seek relatively cheaper goods from overseas • the supply of the INR would increase as importers purchased the USD • the supply curve would move from S0 to S1 • the net result would be a depreciation in the INR to and exchange rate of USD/INR48.25 6. Draw a chart and explain in words what is expected to happen to the New Zealand dollar

demand and supply curves (USD/NZD) if there is a forecast increase in New Zealand’s national income relative to a stable growth rate in the United States.

D0

S0

S1

USD/NZD

Quantity NZD

49.50

48.25

D1 D0

S0

S1

USD/INR

Indian Rupee (billion)

• New Zealand’s demand for imports would increase • increase in supply of NZD in order to purchase USD to pay for imports • the supply curve would move from S0 to S1 • with USA national income unchanged the USA demand for New Zealand goods, and thus the

NZD, will remain unchanged • the demand curve is therefore unchanged • the net effect is a depreciation in the NZD However, as discussed in question 7 we need to consider the impact of increased investment on the

exchange rate as well 7. Consider the following apparently contradictory statements: (i) ‘An increase in the rate of growth in a country’s national income relative to that in the rest

of the world will result in a depreciation of that currency.’ (ii) ‘An increase in the rate of growth in a country’s national income relative to that in the rest

of the world will result in an appreciation of the currency.’ (a) Outline the mechanisms through which forecasters responsible for the above comments see

the change in national income affecting the FX markets. • there are two factors that can affect the equilibrium exchange rate due to changes in relative

income growth: o increased demand for imports o increased overseas investment

• each of these factors has an opposite impact on exchange rate movements Increased demand for imports: • this effect will result in a depreciation of the local currency • refer to your answer in question 6 Increased overseas investment: • if we continue to use the question 6 example of an increase in the national income of New

Zealand relative to the USA, improved growth prospects will encourage New Zealand businesses to expand

• to do so they will require additional funds, and these may be raised through the issue of additional equity or through increased debt

• some of the equity and debt is likely to be provided by foreign investors • foreign investors will be attracted to New Zealand debt and equity since, with higher growth in

the economy, it is reasonable to expect improved profits • the foreign currency that foreign investors provide will have to be converted into NZD for use in

New Zealand • that is, there will be an increase in demand for the NZD in the FX market • if this impact could be taken in isolation, the higher growth rate in New Zealand would result in

an appreciation of the NZD

(b) Is it possible to deem one or other of the forecasters to be correct? Explain your response. • there are conflicting influences on the value of the currency arising out of changes in relative

income • one effect results in a depreciation of the currency while the other effect results in an

appreciation of the currency • the net outcome is not clear • the question of which influence dominates cannot be resolved at a theoretical level • what is required to attempt to resolve the issue is the use of empirical techniques, such as

regression analysis, and a familiarity with what is going on in the economy and with how domestic and foreign investors are reacting to economic developments

8. Draw a chart and explain in words what is expected to happen to the Indonesian rupiah

demand and supply curves (USD/IDR) if there is a forecast increase in Indonesia’s interest rates relative to interest rates in the United States.

• if Indonesian interest rates rise, while those in the USA remain relatively stable, overseas residents and institutions can be expected to place some of their excess cash in interest-bearing instruments in Indonesia in order to obtain the higher rate of return

• this is represented by an increase in demand for IDR • at the same time, Indonesian businesses are likely to keep their surplus funds in banks and

instruments in Indonesia rather than in the lower rate of return overseas • with fewer IDR being placed overseas there is a reduction in the supply of IDR in the FX market • the combined effect is that the increase in interest rates has resulted in an increase in the demand

for IDR, and a reduction in the supply of IDR, and consequently the IDR has appreciated

D0

D1

S0

USD/NZD

Quantity NZD

However, as discussed in question 9 we need to consider the reason for the higher interest rates in

Indonesia 9. Each of the following statements has been put forward as an explanation of determinants

of exchange rates: ‘The increase in the value of a currency is because rates of interest in that country have risen

relative to those in the rest of the world.’ ‘The decrease in the value of a currency is because rates of interest in that country have risen

relative to those in the rest of the world.’ Explain and reconcile these two statements. Appreciation of AUD in rising interest rate environment: • in question 8 we recognised that an increase in relative interest rates may lead to increased

investment in Indonesia by overseas investors, plus increased investment by local investors, resulting in an appreciation of the currency

• however, if we extend our question 8 discussion further we are able to introduce the prospect that the higher relative interest rates may lead to a depreciation in the currency (opposite to our question 8 outcome)

• the nominal interest rate includes the real rate of interest plus an inflation expectation component • the scenario put forward in question 8 assumes the increase in interest rates was due to an

increase in the real rate of interest (currency appreciated) • however, if the increase in interest rates was because of an increase in the inflation expectation

component then the currency may depreciate • under PPP a sustained increase in inflation will result in a depreciation of the currency (see

question 5 answer) • further, the higher inflation component may result in investors limiting their investment within

the local economy and investing overseas in order to protect against the rising inflation. This will lessen the appreciation effect discussed in question 8

D0 D1

S1

S0

USD/IDR

Quantity IDR

10. Consider the data in the two scenarios in the table below. Under which scenario will a US-based investor consider investing funds in the Australian money markets? Explain why this is so. Also, explain why the investor would not find the other scenario attractive.

Expected change in Scenario iAUD (%) iUSD (%) value of AUD (%) 1 9 6 –5 2 6 9 +5 • in scenario 1, although rates of interest are higher in Australia than they are in the USA, there

would not be an inflow of funds into Australia • from the perspective of a US-based investor, if funds were placed in Australia to take advantage

of the higher rate of interest, and if the expected 5% depreciation of the AUD did eventuate, then the investor would be 2% per annum worse off compared with the return that would be earned in the USA

• the 3% per annum benefit obtained by placing funds in the Australian money market would be more than offset by the 5% depreciation of the AUD

• despite the higher rate of interest in Australia, the AUD would depreciate • there would be a reduced demand for the AUD from US investors • at the same time there would be an increased supply of the AUD associated with the increased

outflow of AUD for investment into the USA money markets • in scenario 2, the US-based investor will be attracted to invest in Australia so long as he/she is

confident that the expected appreciation of the AUD of 5% will occur • the 5% appreciation of the currency will offset the lower interest rate available in Australia 11. It may be argued that exchange rate expectations are of critical importance in determining

the FX value of a currency. Identify and discuss factors that may be relevant when forming exchange rate expectations.

• a large proportion of the turnover in the FX market is not accounted for by transactions associated with payments for imports and exports of goods and services and capital market transactions

• FX transactions conducted by speculators and traders represent a significant proportion of international FX market transactions

• it may be argued that once market participants’ expectations are formed, their trading activities become self-fulfilling

• if speculators expect a depreciation of a currency then, all else being constant, a depreciation is what will occur

• for example, the anticipation of a depreciation say the AUD would provide a strong incentive to move funds off-shore

• this would result in an increase in the supply of AUD on the FX market as holders of the AUD seek to buy foreign currencies before the value of the AUD falls (S1). Simultaneously there would be a reduced demand for the AUD (D1) as purchases of the currency are deferred until after the expected depreciation occurs

• since it is argued that changes in relative inflation, relative income and relative rates of interest

each affect the equilibrium exchange rate, it is reasonable to hypothesise that expectations about the future developments in each of these variables should influence exchange rate expectations

• it is quite probable that expectations will dominate the other variables in influencing the value of the currency

• for example, if Australia’s rate of inflation is higher than that in the USA, then a PPP-type of forecast would have the AUD depreciate

• however, if market participants expect that the government will put in place policies aimed at reducing inflation, the AUD may well remain stable in value, or appreciate

• that is, the current value of the currency may be reflecting expectations about the future levels of the relevant variables

12. If a central bank or a government wishes to influence the value of the currency under a

floating exchange-rate regime, it may attempt to do so through three methods of intervention.

(a) Identify the three broad methods that may be used. • intervening in international trade flows • intervening in foreign investment flows • intervening directly in the FX market (b) Explain and give examples of how these methods might be implemented. 1. Intervening in international trade flows: • aimed at increasing exports or reducing imports • increase exports by providing subsidies to exporters to make products more competitive in the

international markets. Increased demand will result in an increased demand for the local currency as exporters convert their export earnings back to the local currency

• reducing imports may be achieved by implementing tariffs, quotas or embargoes • reduced imports will lower supply of local currency in the FX market as there is less need to

purchase foreign currencies

D1 D0

S0

S1

AUD/USD

Quantity AUD

0.7200

0.7150

2. Intervening in foreign investment flows: • aimed at influencing capital flows into and out of a country • may be achieved through capital market regulation (note: there has been significant deregulation

of international capital flows) • may be achieved through taxation arrangements, for example, a withholding tax on interest

earned by foreign investors may be a disincentive to investors 3. Intervening directly in the FX market: • where floating exchange rate regimes exist there are two motivations for central bank

intervention in the FX market • first: to smooth out volatility that may be evident from time to time in the market • this may occur where speculators are having too great an influence on the market and the central

bank considers the volatility is not warranted by the underlying economic fundamentals • the objective is to introduce stability back into the market • second: to achieve an exchange rate target that is different to the market’s expectations of the

appropriate level • the central bank will take one side of the market in an attempt to actually shift the market • however, if market expectations are strong it is unlikely that the central bank actions will have

more than a limited temporary effect of the exchange rate 13. A market-determined exchange rate is affected by changes in relative inflation, national

income growth rates, interest rate differentials, government or central bank intervention, and market expectations. Regression analysis is a statistical technique used in the analysis of exchange rate movements. Having regard to these variables, explain how FX market participants use regression analysis in the analysis of exchange rate movements.

• regression analysis is frequently used to assess how movements in a range of variables might affect another variable

• the regression model, using the identified variables, may be specified as: % change in AUD/USD in period t

= a0 + a1(IUS – IA)t + a2(YUS – YA)t + a3(iUS – iA)t + a4(GA)t+ a5(GUS)t + Ut

where a0 equals the intercept term or constant, a1 to a4 equals the regression coefficients that measure the responsiveness of the exchange rate to the variable inflation (I), national income growth (Y), interest rates (i), central bank and government intervention (G), and U equals the regression error term. The model assumes an efficient market, therefore the exchange rate expectation variable should be zero

• once the data for all variables are compiled, and the regression program is run, estimates of each of the regression coefficients will be provided

• the output needs to be analysed and interpreted. Section 16.4 of the text provides some analysis of regression coefficients

• statistical tests can be carried out to ascertain the statistical significance of the results (this is beyond the scope of material covered in this text)