The Foreign Exchange Market Assoc. Prof. Hülya Hazar Faculty of Economics and Administrative Sciences,

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BUS 362 Financial Institutions and
Markets
Week 10: The Foreign Exchange Market
Assoc. Prof. Hülya Hazar
Faculty of Economics and Administrative Sciences, Department of
Business Administration
[email protected]
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Financial Institutions and Markets
1. Foreign Exchange Market
2. Foreign Exchange Rates
3. Exchange Rates in the Short and Long Run
4. Equilibrium Exchange Rate
5. Volatility
6. Intervention
7. Exchange Rate Regimes in the International
Financial System (Fixed, Floating)
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Financial Institutions and Markets
Foreign Exchange Market
• Most countries of the world have their own currencies: the
U.S dollar., the euro in Europe, the Brazilian real, and the
Chinese yuan, Turkish Lira in Türkiye…
• The trading of currencies and banks deposits is what makes
up the foreign exchange market.
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Financial Institutions and Markets
What are Foreign Exchange Rates?
• Two kinds of exchange rate transactions make up the
foreign exchange market:
• Spot transactions involve the near-immediate
exchange of bank deposits, completed at the spot
rate.
• Forward transactions involve exchanges at some
future date, completed at the forward rate.
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Financial Institutions and Markets
Why Are Exchange Rates Important?
• When the currency of your country appreciates relative to
another country, your country’s goods prices abroad and
foreign goods prices in your country.
• Makes domestic businesses less competitive
• Benefits domestic consumers (you)
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Financial Institutions and Markets
How is Foreign Exchange Traded?
• FX traded in over-the-counter market
• Involve buying / selling bank deposits denominated in
different currencies.
• Trades involve transactions in excess of $1 million.
• Typical consumers buy foreign currencies from retail
dealers.
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Financial Institutions and Markets
Exchange Rates in the Long Run - Law of One Price
• Exchange rates are determined in markets by the interaction
of supply and demand.
• An important concept that drives the forces of supply and
demand is the Law of One Price.
• The Law of One Price states that the price of an identical
good will be the same throughout the world, regardless of
which country produces it.
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Financial Institutions and Markets
Exchange Rates in the Long Run - Theory of Purchasing
Power Parity (PPP)
• The theory of PPP states that exchange rates between two
currencies will adjust to reflect changes in price levels.
• PPP Domestic price level 10%, domestic currency
10%
• Application of law of one price to price levels
• Works in long run, not short run
• Problems with PPP
• All goods are not identical in both countries
(i.e., Toyota versus Chevy)
• Many goods and services are not traded
(e.g., haircuts, land, etc.)
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Financial Institutions and Markets
Factors Affecting Exchange Rates in Long Run
• Basic Principle: If a factor increases demand for domestic
goods relative to foreign goods, the exchange rate
• The four major factors:
• relative price levels
• tariffs and quotas
• preferences for domestic vs. foreign goods
• productivity
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Financial Institutions and Markets
Factors Affecting Exchange Rates in Long Run
• Relative price levels: a rise in relative price levels cause a
country’s currency to depreciate.
• Tariffs and quotas: increasing trade barriers causes a
country’s currency to appreciate.
• Preferences for domestic vs. foreign goods: increased
demand for a country’s good causes its currency to
appreciate; increased demand for imports causes the
domestic currency to depreciate.
• Productivity: if a country is more productive relative to
another, its currency appreciates.
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Financial Institutions and Markets
Exchange Rates in the Short Run
• In the short run, an exchange rate is the price of domestic
bank deposits in terms of foreign bank deposits.
• The usual approach to supply-demand analysis focused on
import/export demand.
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Financial Institutions and Markets
Exchange Rates in the Short Run
• Dollar assets supplied is primarily the quantity of bank
deposits, bonds, and equities in the United States. This is
fairly fixed in the short-run.
• The quantity supplied at any exchange rate does not
change, so the supply curve, S, is vertical.
• The demand curve traces out the quantity demanded at
each current exchange rate
• The current exchange rate and the expected future
exchange rate are held constant in this analysis.
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Financial Institutions and Markets
Equilibrium in the Foreign Exchange Market
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Financial Institutions and Markets
Factors That Shift the Demand Curve for Domestic Assets and
Affect the Exchange Rate
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Financial Institutions and Markets
Factors That Shift the Demand Curve for Domestic Assets and
Affect the Exchange Rate
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Financial Institutions and Markets
Effect of Changes in Interest Rates on the Equilibrium
Exchange Rate
• When the domestic real interest rate increases, the domestic
currency appreciates.
• When the domestic expected inflation increases, the
domestic currency reacts in the opposite direction—it
depreciates.
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Financial Institutions and Markets
Exchange rate volatility
• Exchange rate overshooting is important because it helps
explain why foreign exchange rates are so volatile.
• Another explanation deals with changes in the expected
appreciation of exchange rates. As anything changes our
expectations (price levels, productivity, inflation, etc.),
exchange rates will change immediately.
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Financial Institutions and Markets
Intervention in the Foreign Exchange Market
• Foreign exchange markets are not free of government
intervention.
• Foreign exchange interventions occur when central banks
engage in international transactions to influence exchange
rates.
• International reserves refers to a central bank’s holdings in a
foreign currency.
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Financial Institutions and Markets
Exchange Rate Regimes in the International Financial System
• There are two basic types of exchange rate regimes in the
international financial system:
• Fixed exchange rate regime
• Floating exchange rate regime
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Financial Institutions and Markets
Exchange Rate Regimes in the International Financial System
• Fixed exchange rate regime
• The values of currencies are kept pegged relative to
one currency so that exchange rates are fixed.
• The currency against which the others are pegged is
known as the anchor currency.
• Floating exchange rate regime
• The values of currencies are allowed to fluctuate
against one another.
• When countries attempt to influence exchange rates
via buying and selling currencies, the regime is
referred to as a managed float regime (or a dirty
float).
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Financial Institutions and Markets
Fixed Exchange Rate Systems - Bretton Woods
• Created the International Monetary Fund (IMF), which sets
rules and provides loans to deficit countries
• Setup the International Bank for Reconstruction and
Development (World Bank), which provides loans to
developing countries
• The U.S. emerged from World War II as the world’s largest
economic power. The U.S. dollar was called the reserve
currency, meaning it was used by other countries to
denominate the assets they held in international reserves.
• The system was abandoned in 1971.
• Even post-1971, the dollar was the “reserve currency” in
which most international financial transactions were
conducted.
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Financial Institutions and Markets
Fixed Exchange Rate Systems: How they work
• Domestic currency is either:
• Overvalued:
• When the domestic currency is overvalued, the
central bank must purchase domestic currency to
keep the exchange rate fixed. As a result, the
central bank loses international reserves.
• Undervalued:
• When the domestic currency is undervalued, the
central bank must sell domestic currency to keep
the exchange rate fixed. As a result, the central
bank gains international reserves.
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Financial Institutions and Markets
Fixed Exchange Rate Systems: How they work
• Devaluation can occur when the domestic currency is
overvalued. Eventually, the central bank may run out of
international reserves, eliminating its ability to prevent the
domestic currency from depreciating.
• Revaluation will occur when the central bank decides to stop
intervening when its domestic currency is undervalued.
Rather than acquiring international reserves, it lets the par
value of the exchange rate reset to a higher level.
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Financial Institutions and Markets
Fixed Exchange Rate Systems: The Policy Trilemma
• A country (or a currency union like the Eurozone) can’t
pursue the following three policies at the same time:
• free capital mobility
• a fixed exchange rate, and
• an independent monetary policy.
• Dollarization: where a country adopts the currency of a
foreign country, in this case – US$
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Financial Institutions and Markets
Exchange Rate Regimes in the International Financial System:
Managed Float
• Central banks are reluctant to give up their ability to
intervene in foreign exchange markets.
• Limiting changes in exchange rates makes it easier for firms
and individual to plan purchases/sales in the international
marketplace.
• Countries with a trade surplus are reluctant to allow their
currencies appreciate since it hurts domestic sales.
• On the other hand, countries with a trade deficit do not want
to see their currency lose value since it makes foreign goods
more expensive.
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Subjects Covered
1. Foreign Exchange Market
2. Foreign Exchange Rates
3. Exchange Rates in the Short and Long Run
4. Equilibrium Exchange Rate
5. Volatility
6. Intervention
7. Exchange Rate Regimes in the International
Financial System (Fixed, Floating)
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References
Readings:
Chapter 15 and 16
Reference Book:
Mishkin, Frederic S. Financial Markets and Institutions. Eighth Edition.
UK: Pearson, 2016.
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Financial Institutions and Markets
See you next week…
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