EXCHANGE RATES

 

 

People and firms who engage in international transactions and international business may often need to convert their dollars to other currencies.  We say they need "foreign exchange" -- and this normally takes the form of foreign currency bank deposits.

 

Vast amounts of currecies are exchanged daily.  During the 1990s the average daily volume around the world reached  1 trillion (dollars) worth.  If you consider that world trade is about  5-10 trillion a year, the figure is enough to finance world trade 50 times over.  This indicates that the majority of exchanges are not for trade but for loans, investments, and speculation.

 

Specific rates and how rates are stated:

The easy way (for us) is to express the exchange rate in terms of US dollars per unit of the currency (the dollar price of the pound, the mark, etc.).  This is easy because it tells us how much each currency is worth. We say that exchange rates stated in this way are in “American terms.”  The pound is worth a dollar plus, the Euro is worth a little more than one dollar, the Canadian dollar is worth around $0.75, etc.  A depreciation of the pound would mean than the dollar price of the pound would fall.  A depreciation of the dollar would mean the dollar price of the pound would rise.

 

The inverse relationship is important too, and just expresses the value of the foreign currency as the amount of the foreign currency per 1 US dollars.   Thus, very roughly,  the yen, in recent years has had an exchange rate of around 100.  The pound: .70.  These rates are quoted in “European terms”.  If you have the one rate, you divide it into ONE to get the inverse rate.  That is, if the dollar price of the pound were to be 1.60, the inverse rate is    1/1.6=.62  This works both ways.

 

How rates are determined:

Supply and demand make exchange rates go up and down in floating rate system.  The world has had predominantly floating rates since the early 1970s.

Understanding the “Balance Of  Payments” helps one understand the specific actions that which would raise the value of the dollar, or lower it.  Some countries try to maintain a fixed rate of exchange against a major currency, such as the euro or the dollar.  In order to maintain that fixed rate requires conscious policies and practices on the part of that country.  It is not a matter of just “setting it”.

 

Spot Market vs. Forward Market

The spot market is for foreign exchange now – for example, go to the bank and give up the dollars now and get the other currency now.  Whereas, the forward market is for foreign exchange needed in the near future, where you can establish the rate of exchange you will get, despite any major realignment which may occur.

The forward market is part of the interbank market, where future purchases and sales of foreign currency can be arranged for 30,90,180 days hence. 

 

 

ARBITRAGE

 

There will be a rate of exchange of dollars for pounds, and a rate for pounds for Canadian dollars, and a rate for Canadian dollars for dollars.  These have to be consistent in practice, because, otherwise arbitrage activities will force them into alignment.

 

Example: if the dollar price of the pound is $1.60, and if the pound price of the Canadian dollar  is L.33, and if the dollar price of the Canadian dollar is $0.60 there is an opportunity for gain:

Consider:  say you can buy 1 pound for 1.60, buy  3 Canadian dollars with the pound, then buy dollars with the Canadian dollars and get back 3 x $0.60 = $1.80  (profit of $0.20 in the deal).  If this type of thing were possible it would happen in overwhelming volume.  The result would be that the prices of the three currencies would be affected (up or down) until there was a kind of parallelism between the rates.

 

Similarly, if the dollar price of the pound is different in London than in NY arbitrage will bring them into equality :  result is that differences are so small its not "worth it"

 

 

STABILIZATION

 

Thirty years ago all currencies were on fixed exchange rates -- this was the agreed upon approach.

 

Now, major currencies are freely floating in relation to each other, and are determined by supply and demand.  But many of the lesser countries are fixed in relation to what is the most important currency to them.

 

If a country's exchange rate is fixed, then the government will have to take action to see to it that the rate is maintained.  They have to stand ready to buy their currency at times (through the central bank of the country, using other currencies as payment) so as to keep its value from dropping.  All the more so if the currency is freely convertible.  Let's say there is a balance of payments deficit which means that there is more of the country's currency supplied than demanded, which would tend to force down its value.  The central bank will have to make up the difference by buying the currency, or satisfying those who wish to convert from it.  (The government has certain other options open to it, so as to address the payments problem in another way).

 

 If they run out of reserves, which is their stock of foreign currency with which to buy their own currency, then they would have to devalue: reduce their fixed rate (a depreciation of their currency).  Maybe they would be unwilling to use of their reserves.  One way they can make their life easier is to have exchange controls:  you can not exchange the domestic currency for foreign unless you have permission.   In that way it restricts the activities of importers, foreign travel, investments in other countries.  These restrictions are common, but are the mark of a less than free society.

 

Even the major currencies are influenced by their governments -- but only occasionally (called a dirty float).  The exchange value of the dollar against the yen or the euro has sometimes been subject to concerted action by either ourselves or others.  An agreement is sometimes reached between the countries to do this.

 

Speculation

 

When people think they can make a profit by selling a currency, with the expectation that it will go down in the near future, they are speculating.  If it does go down into the future they can buy it back cheaper than they sold it, making a profit.

 

Lets say I expect the dollar to depreciate against the Canadian dollar.  I can sell US dollars to buy Canadian dollars.  If the the US dollar does fall, later I can buy  US dollars with Canadian dollars make a profit.   Result: when a currency looks like it is heading down, there may  be speculative activity which will hasten its decline, or make it happen even if it wouldn't have.    Who are the speculators? Ans.: banks, big international companies, mutual funds, individual investors.   These crises can wreak havoc in a country  -- destabilizing banks, ruining companies and individual investors.

 

Review of dollar bolstering move (as mentioned above in stabilization)   1) dollar is too low or it is feared it will move downward  2)central bank(s) buy dollars  3) with an increase in demand for dollars, the dollar appreciates (goes up in value as measured by other currency).   This would be done as a temporary measure, usually.

 

What Determines Forward Rate?

Answer: Ignoring inflation, there would be two main things.

1)  Anticipation of appreciation/depreciation of the currency in the relevant time frame (3 mos. if we are talking the 90 day forward rate). If the Brazilian real were expected to fall, that would be built into the forward rate.  Say the $/real rate is $.50 on the spot market, and the dollar were expected to depreciate, then the forward rate might be $.45

 

2)  Differences in interest rates between the two countries.

 

Interest Partity

If the interest rate on short term investments (say government T-bills, thus riskless) is higher in London than in New York, people will find it attractive to take funds out of the US and move them to London to take advantage of the difference.  So they will buy pounds and invest them in the London market.   But what if the exchange rate changes and the dollar appreciates?  Then when they reconvert (maybe in 90 days) month) they won't get back as many dollars as they expected and the deal will turn out badly.  They will want to protect (cover) against the exchange rate risk.  Thus the American investor will sell pounds forward in an amount which will guarantee they won't get caught.  They will be nailing down now the exchange rate they will get in one month.  We can see that there is some kind of link between the financial markets of the two countries and the forward rate of exchange.  This leads to the interest parity theory; namely that the forward rate of exchange will neutralize the benefits of investing in short-term interest-bearing investments in another country.

 

 

Trade and Purchasing Power Parity

 

 

It seems logical that the same product should sell for the same price in different countries, once the exchange rate were taken into account.  If the dollar price of the yen is .01, and if something were to cost $1.00 in the US, we would expect its price to be Y100.  And, indeed, the “Law of One Price” tends to bring this about. The purchasing power parity exchange rate is the particular rate, which given actual prices in the two countries, would equalize the prices of same/similar goods.

 

It turns out that the forces tending toward this equalization are not always strong enough to bring about PPP exchange rates.   Why?   Many goods aren't traded across borders.  Barriers and tariffs will affect things, and the degree of competition in the country is a factor.   And, importantly, speculative currency flow may overwhelm currency flows due to trade.    So the theory only works in a general way.