Economics
Unit 8:Exchange Rates. BoP
Javier Marroquin
Exchange rates
In foreign commerce, as in international dialogue, somebody has to translate. People in different countries use different currencies as well as different languages.
The translator between different currencies is the exchange rate, the price of one country’s money in units of another country’s money. You can go only so far using just one currency. If an American wants to buy something from a foreign resident, the foreign resident will typically want to have the payment translated into her home currency.
The spot exchange rate is the price for “immediate” exchange. (For standard large trades in the market, immediate exchange for most currencies means exchange or delivery in two working days after the exchange is agreed, while it means one working day after the exchange is agreed for exchanges between U.S. dollars, Canadian dollars, and Mexican pesos.)
The forward exchange rate is the price set now for an exchange that will take place sometime in the future, such as 30, 90, or 180 days from now.
Using the Foreign Exchange Market: an example
1. Consider a British firm that has purchased a small airplane (a corporate jet) from the U.S. producer of the plane and now is making the payment for it. If the British firm pays by writing a check in pounds sterling, the U.S. firm receiving the sterling check must be content to hold on to sterling bank deposits or sell the sterling for dollars. Alternatively, if the U.S. firm will accept payment only in dollars, then it is the British buyer who must sell sterling to get the dollars to pay the U.S. exporter.
2. Let’s assume that the latter is the case. The British firm contacts its bank and requests a quotation of the exchange rate for selling pounds and acquiring dollars. If the rate is acceptable, the British firm instructs its bank to take the pounds from its demand deposit (checking) account, to convert these pounds into dollars, and to transfer the dollars to the U.S. producer. The British bank holds dollar demand deposits in the United States, at its correspondent bank in New York.
3. The British bank instructs its correspondent bank in New York to take dollars from its demand. As with most payments that are purely domestic, demand deposits are used in this foreign exchange trade and in completing the international payment for the airplane.
4. The British firm uses the pounds in its demand deposit account to acquire the dollars needed. The U.S. producer uses its demand deposit account to receive the dollar payment.
5. The British bank uses its dollar demand deposits in its correspondent bank in
New York for two purposes:
as the dollars that it sells to its customer in the foreign transaction and
as the (same) dollars that are then transferred to the U.S. producer as payment.
Interbank Foreign Exchange Trading
Around 40 percent of foreign exchange trading is trading among the dealer banks themselves in the interbank (or interdealer) part of the foreign exchange market. What’s being traded is still the same—demand deposits denominated in different currencies. But each deal is between one foreign exchange trader and another trader, not an “outside” customer.
The interbank part of the market serves several functions.
Participation in the interbank (or interdealer) part of the market provides a bank with a continuous stream of information on conditions in the foreign exchange market through communications with traders at other banks and through observing the prices (exchange rates) being quoted.
Interbank trading allows a bank to readjust its own position quickly and at low cost when it separately conducts a large trade with a customer.
Demand and Supply of Foreign Exchange market
A nation’s export of goods and services typically causes foreign moneys to be sold in order to buy that nation’s money. For instance, the importer in a foreign country desires to pay using her currency, while the U.S. exporter desires to be paid in dollars. Somewhere in the payments process, foreign money is exchanged for dollars.
Thus, U.S. exports of goods and services create a supply of foreign currency and a demand for U.S. dollars to the extent that foreign buyers have their own currencies to offer and U.S. exporters prefer to end up holding U.S. dollars and not some other currency.
Importing goods and services correspondingly tends to cause the home currency to be sold in order to buy foreign currency. For instance, if a U.S. importer desires to pay in dollars, and the British exporter desires to be paid in pounds because she wants to end up holding her home currency, then somewhere in the payments process dollars must be exchanged for pounds.
Thus, U.S. imports of goods and services create a demand for foreign currency and a supply of U.S. dollars to the extent that U.S. importers have dollars to offer and foreign exporters prefer to end up holding their own currencies.
Floating Exchange Rates
The simplest system is the floating exchange-rate system without intervention by governments or central bankers. The spot price of foreign currency is market driven, determined by the interaction of private demand and supply for that currency. The market clears itself through the price mechanism.
What makes the demand curve slope downward?
As the pound declines below $1.98, a sweater selling for £50 in London would cost
American tourists $99 (= 50 * $1.98).
If the pound suddenly sank to $1.60, the same £50 wool sweater would cost American tourists only $80. They would start buying more. To pay for the extra sweaters, they would want more pounds sterling, to be paid to British merchants.
Fixed Exchange Rates
Here, officials strive to keep the exchange rate virtually fixed (or pegged) even if the rate they choose differs from the current equilibrium rate. Their usual procedure under such a system is to declare a narrow “band” of exchange rates within which the rate is allowed to vary. If the exchange rate hits the top or bottom of the band, the officials must intervene.
Example:
British officials have announced that they will support the pound at 1 percent below par (about $1.98) and the dollar at 1 percent above par (about $2.02). They are forced to intervene in the foreign exchange market, buying £50 billion (and selling $99 billion, equal to £50 billion times $1.98 per pound).
This intervention fills the gap AB between nonofficial supply and demand at the $1.98 exchange rate.
Under the floating-rate system a fall in the market price (the exchange-rate value) of a currency is called a depreciation of that currency; a rise is an appreciation.
Official reduction in the otherwise fixed par value of a currency as a devaluation; revaluation is the antonym describing a discrete raising of the official par. Devaluations and revaluations are the main ways of changing exchange rates in a nearly fixed-rate system, a system where the rate is usually, but not always, fixed.
Risk
A person (or an organization like a firm) is exposed to exchange-rate risk if the value of the person’s income, wealth, or net worth changes when exchange rates change unpredictably in the future. They have acquired exposures to exchange-rate risk in the course of their regular activities, but they seek to reduce or eliminate their risk exposure by hedging.
Although there is a difference in the specific definitions of risk and uncertainty, for our purposes and in most financial literature the two terms are used interchangeably. For most investors, risk means the uncertainty of future outcomes. An alternative definition might be the probability of an adverse outcome.
Hedging a position exposed to rate risk, here exchange-rate risk, is the act of reducing or eliminating a net asset or net liability position in the foreign currency.
Speculating refers to the act of conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain or other major value.
Common dates for future exchange are 30, 90, and 180 days forward (one, three, and six months). For larger transactions involving international trade in goods and services, international financial investment, or pure speculation on future exchange-rate movements, forward foreign exchange and forward exchange rates are often useful.
In financial jargon, hedging means reducing both kinds of “open” positions in a foreign
Example:
To buy £100,000 of 90-day forward sterling at $1.6745/£,
Sign an agreement today with your bank = 90 days from now
you will deliver $167,450 in dollar bank deposits
receive £100,000 in pound bank deposits
The exchange of these amounts = the forward contract, regardless of what the actual spot exchange rate turns is in 90 days.
Example:
Consider a U.S. company that has bought some merchandise and will have to pay £100,000 three months from now. Assuming that this represents an overall net liability position in pounds, the company is exposed to exchange-rate risk.
It does not know the dollar value of its liability because it does not know the spot exchange rate that will exist 90 days from now. One way to hedge its risk exposure is to enter into a forward contract to acquire (or buy) £100,000 in 90 days.
If the current forward rate is $1.6745/£, then the company must deliver (or sell) $167,450 in 90 days. The company has an asset position in pounds through the forward contract (the company is owed pounds in the contract).
Perfect hedge: The company now is assured that the merchandise will cost $167,450 regardless of what happens to the spot exchange rate in the next 90 days.
What Determines Exchange Rates?
Long-term trends.
In the figure, over the entire period the Japanese yen, Swiss franc, and German mark (DM) tended to appreciate, with the Swiss franc almost quintupling in value, the yen more than tripling and the DM (fixed to the euro in 1999 and then retired in 2002) more than doubling. Over the period, and especially up to early 2000s, the Italian lira, British pound, Australian dollar, and Canadian dollar tended to depreciate.
From 1970 to 2002, the lira (also fixed to and then replaced by the euro) lost about seven-tenths of its exchange-rate value against the dollar, the Australian dollar lost about a half, the pound lost about four-tenths, and the Canadian dollar lost about a third. Still other currencies, such as the Israeli shekel and Argentine peso, dropped so far in value that they would almost hit zero if we added them to Figure 19.1B.
1. Long term. PPP
Understanding of exchange rates in the long run is based on the proposition that there is a predictable relationship between product price levels and exchange rates.
The relationship relies on the fact that people choose to buy goods and services from one country or another according to the prices they must pay.
The law of one price posits that a product that is easily and freely traded in a perfectly competitive global market should have the same price everywhere, once the prices at different places are expressed in the same currency.
The law of one price proposes that the price (P) of the product measured in domestic currency will be equated to the price (Pf ) of the product measured in the foreign currency through the current spot exchange rate (e, Domestic currency/Foreign currency):
P = e • Pf
Absolute Purchasing Power Parity
Absolute purchasing power parity posits that a basket or bundle of tradable products will have the same cost in different countries if the cost is stated in the same currency. Essentially, the average price of these products, often called the product-price level, or just price level, stated in different currencies is the same when converted to a common currency:
P = e • Pf
Here P and Pf refer to the average product price or price level in the domestic and the foreign countries. The equation can be rearranged to provide an estimate of the spot exchange rate that is consistent with absolute PPP:
e = P / Pf
International comparison program:
https://www.worldbank.org/en/programs/icp
Relative PPP provides some strong predictions about exchange-rate trends, especially
in the long term:
• Countries with relatively low inflation rates have currencies whose values tend to
appreciate in the foreign exchange market.
• Countries with relatively high inflation rates have currencies whose values tend to
depreciate in the foreign exchange market.
THE LONG RUN: THE MONETARY APPROACH
Purchasing power parity indicates that, at least in the long run, exchange rates are
closely related to the levels of prices for products in different countries. But this also
suggests the next question: What determines the average national price level or the rate at which it changes, the inflation rate?
Medium-term trends
(over periods of several years), and these medium-term trends are sometimes counter to the longer trends. For instance, the Swiss franc, DM, and to a lesser extent the yen depreciated during the period 1980–1985. Another trend is the appreciation of the pound and the lira from 1985 to 1988. The decline in the dollar value of the euro from its introduction at the beginning of 1999 to late 2000, and then the euro’s rise back up in value from late 2000 to early 2008, can be seen in either of two currencies shown (DM, lira) that it has replaced.
Short term
Rather little of the $5 trillion of foreign exchange trading that occurs each day is related to international trade in goods and services. Most of it is related to the positioning or repositioning of the currency composition of the portfolios of international financial investors.
1. Asset market approach
The asset market approach to exchange rates emphasizes the role of portfolio repositioning by international financial investors. As demand for and supply of financial assets denominated in different currencies shift around, these shifts place pressures on the exchange rates among the currencies. The exchange-rate value of a foreign currency (e) is raised in the short run by the following change:
A rise in the foreign interest rate relative to our interest rate (if – i).
Balance of Payments
In balance of payments accounting, we need to keep track of flows of value both in and out of the country and assign a positive sign to one direction and a negative sign to the other direction:
• A credit item (measured with a positive sign) is an item for which the country must be paid. It sets up the basis for a payment by a foreigner into the country—that is, it creates a monetary claim on a foreigner.
• A debit item (measured with a negative sign) is an item for which the country must pay. It sets up the basis for a payment by the country to a foreigner—that is, it creates a monetary claim owed to a foreigner.
Balance of payments accounting is just an international application of the fundamental accounting principle of double entry bookkeeping .
Double-entry bookkeeping has a key implication. If we add up all the positive items (credits) and all the negative items (debits) in a country’s balance of payments, the total will be— zero .
Current Account
The current account includes all debit and credit items that are exports and imports of goods and services, income receipts and income payments, and gifts.
Exports and imports of goods (also called merchandise) are easy to understand. But what are the major services that are exported and imported? Tourism or travel services include the expenditures of foreign visitors on such items as hotel rooms, meals, and transportation. In addition, nations trade transportation, insurance, education, financial, technical, telecommunications, and other business and professional services.
Nations also pay each other royalties for use of technologies or brand names. If we add up all the items for exports and imports of goods and services, we get the goods and services balance, an important balance within the current account.
The balance on goods and services measures the country’s net exports.
Financial Account
The net value of flows of financial assets and similar claims (excluding official
international reserve asset flows) is the private financial account balance.
The values reported in the financial account are for the principal amounts only of assets traded—any flows of earnings on foreign assets are reported in the current account.
Here are four possible items:
A U.S. resident increasing his holding of a foreign financial asset (a stock, a bond, or an IOU from a loan) is a debit. The U.S. individual is making a payment now (or extending a loan now) to the foreigner, so funds are flowing out of the United States now (negative item).
2. A foreign resident increasing her holding of a U.S. financial asset (a stock, a bond, or an IOU from a loan) is a credit. The U.S. seller (or borrower) is receiving payment now (or getting a loan now) from the foreigner, so funds are flowing into the United States now (a positive item).
3. A U.S. resident decreasing her holding of a foreign financial asset (a stock, a bond, or an IOU from a loan) is a credit. The U.S. individual is receiving a payment now (or receiving repayment of a previous loan) from the foreigner, so funds are flowing into the United States now (positive item).
4. A foreign resident decreasing his holding of a U.S. financial asset (a stock, a bond, or an IOU from a loan) is a debit. The U.S. buyer (or borrower) is making a payment now (or repaying a previous loan) to the foreigner, so funds are flowing out of the United States now (a negative item).
Official International Reserves
The third major part of the balance of payments keeps track of changes in official holdings of international reserves. Official international reserve assets are money-like assets that are held by governments and that are recognized by governments as fully acceptable for payments between them.
The majority of countries’ official reserve assets are now foreign exchange assets, financial assets denominated in a foreign currency that is readily acceptable in international transactions. For the United States, these foreign exchange assets are euro and Japanese yen assets.
For other countries these foreign exchange assets are often U.S. dollar assets. Two other small categories of official reserve assets are claims that a country has on the International Monetary Fund (IMF)—the country’s reserve position in the fund and the country’s holdings of special drawing rights (SDRs), a reserve asset created by the IMF.
Statistical Discrepancy
At the bottom of the accounts comes the suspicious item statistical discrepancy. If the flows on the two sides of every transaction were correctly recorded, there would not be any statistical discrepancy. In fact, as shown in the table, the statistical discrepancy for the balance of payments for 2013 was a credit of $28 billion, meaning that the credit items for the United States were less fully measured than its debit items.
It is the net result of errors and omissions on both the credit and debit sides.
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