Exchange rate and Foreign exchange market:

An asset-market based approach

Objective
 This chapter reviews the concepts and the role of the
exchange rate in international trade
 This chapter discusses the determination of the
exchange rate in the asset market
Contents
 The concepts of the exchange rate
 The foreign exchange market
 The demand for assets
 The asset-based determination of the exchange rate
1. The exchange rate and international transactions
What is the exchange rate?

 Exchange rate is the price of one currencies in terms of

another currency
➢ Ex. 1: E(VND/USD): 1 USD = 22500 VND
➢ Ex. 2: E(USD/EUR): 1 EUR = 1.1788 USD
1. The exchange rate and international transactions
The exchange rate quotation

 Direct quotation shows the value of the foreign

currency in terms of the domestic currency
➢ Ex. 1 USD = 22500 VND
➢ Ex. 1 EUR = 1.1971 USD
 Indirect quotation shows the value of domestic
currency in terms of foreign currencies
➢ Ex. 1 VND = 0.000044 USD
➢ Ex. 1 USD = 0.8354 EUR
1. The exchange rate and international transactions
Measuring changes in the exchange rate

 The movement in the exchange rate is often expressed

in terms of the percentage change from a benchmark
value
 Appreciation/revaluation means an increase in the
value of a currency in terms of another currency
 Depreciation/devaluation refers to a fall in the value of
a currency in terms of another currency
1. The exchange rate and international transactions
The exchange rate and international transactions I

 Exchange rates make it possible to compare the price

of goods and services produced in different countries.
 The price of a goods produced in one country can be
translated into the price of the same good in terms of
another country’s currency using the exchange rate
➢ Ex. T-shirt (produced in Vietnam): 225000 VND/ 1 T-shirt
(price in Vietnam)
 10 USD / 1 T-shirt (the price in the U.S. dollar)
1. The exchange rate and international transactions
The exchange rate and international transactions II

 A devaluation (or depreciation) of the domestic

currency reduces the price of domestic goods in terms
of the foreign currency
➢ Ex. Given a 10% devaluation of VND, the dollar price of T-
shirt becomes: 225000/24750 = 9.1 USD
• A revaluation (or appreciation) of the domestic
currency increases the price of domestic goods in
terms of the foreign currency
➢ Ex. Given a 10% revaluation of VND, the dollar price of T-
shirt becomes: 225000/20250 = 11.1 USD
2. The Foreign Exchange Market
The actors
 Commercial banks: bank acts as intermediaries in the
market. A vast majority of the foreign exchange
transactions involve the debiting and crediting of the
accounts at commercial banks
 Firms, individuals, and organization: all firms, private and
public organizations and individuals that engage in
international transactions.
 Non-bank financial institution: insurance companies or
investment funds can trade foreign currencies
 Central banks: central banks often intervene in the foreign
exchange market to affect the demand for and the supply
of foreign exchange and the exchange rate.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market I
 Foreign exchange trading takes place in all countries, but
concentrates in three major financial centers (Tokyo, New York
and London)
 The global foreign exchange market has been growing rapidly
since 1990. Large part of foreign trading is conducted through
direct phone, fax and internet.
 The links through phone, fax and internet make each trading
center a part of the single world market that never sleeps.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market II
 Most of foreign exchange transactions between two currencies
go through US dollars
 US dollar serves as a vehicle currency and is widely used in
international trade and investment
 Exchange rates quotes at different banks and location tend to
converge.
 Any significant difference between the exchange rates quoted
at different locations will trigger arbitrage activities.
2. The Foreign Exchange Market
Arbitrages I

 The exchange rate between VND and USD is quoted

at two different banks as follows
➢ Bank A (bid-ask rates): 22420-22460
➢ Bank B (bid-ask rates): 22480-22510
 Is there any opportunity for arbitrage to take place?
What is the impacts of the arbitrage on the exchange
rate between VND and USD?
2. The Foreign Exchange Market
Arbitrages II

 The exchange rate between VND, EUR and USD is

quoted as follows
➢ Bank A: 1 USD = 20000 VND
➢ Bank B: 1 EUR = 24500 VND
➢ Bank C: 1 EUR = 1.2 USD
 Is there any opportunity for arbitrage to take place?
What is the impacts of the arbitrage on the exchange
rate between VND, EUR and USD?
2. The Foreign Exchange Market
Foreign exchange transactions I

 Spot transactions
 Swap transactions
 Forward transactions
 Future contracs
 Option contracts
2. The Foreign Exchange Market
Foreign exchange transactions II

 Spot transactions:
➢ Spot transactions that are executed immediately after
the agreement is reached.
➢ Spot exchange rate: Spot trading employs the current
exchange rate, which is called the spot exchange rate.
➢ Value date: In practice the spot trading are often
executed two days after the agreement is reached.
➢ The value date is the date that the parties involved in the
spot transaction actually receive funds they have
purchased.
2. The Foreign Exchange Market
Foreign exchange transactions III
 Forward transactions:
➢ The forward transactions involve trading of foreign
currencies at some date in the future.
➢ Forward trading uses a forward exchange rate, which is
determined when the transactions is agreed and can be
different from the current spot rate.
➢ Forward discount and premium: represent the extent to
which the forward rate is lesser (or higher) the the spot
rate
2. The Foreign Exchange Market
Foreign exchange transactions IV
 Forward transactions:
➢ Forwards transactions is widely used to hedge against the
foreign exchange risk brought about by the movement in the
exchange rate
➢ Hedging the future receipt of foreign exchange: a firm that
has future receipt in a foreign currency can hedge against
the exchange risk by selling the foreign currency forward.
➢ Hedging the future payment of foreign exchange: a firm that
has future payment denominated in a foreign currency can
hedge against the exchange risk by purchasing the foreign
currency forward.
2. The Foreign Exchange Market
Foreign exchange transactions
 Swap Transactions
➢ Currency swap: the swap transaction is a spot sale of a currency
combined with a forward repurchase of the currency.
➢ An exporter has just received one million dollars, but will have to
pay one million dollars for imported inputs in three months. The
exporter may join a swap transaction which allow it to sell one
million dollars and repurchase it three months later.
➢ Swaps often result in lower fees or transactions costs because
they combine two transactions, and they allow parties to meet
each others needs for a temporary amount of time.
2. The Foreign Exchange Market
Foreign exchange transactions V
 Futures contracts: Foreign exchange futures are a forward
contract for a standardized volume of a specific currency
and selected calendar date traded in an organized market.
 In the futures market, only few currencies are traded for
standardized amount and at few selected dates.
 The trade of futures takes place in an organized market
with few geographical locations.
 Future contracts can be sold at any time up until maturity,
but the forward contract cannot.
2. The Foreign Exchange Market
Foreign exchange transactions V
 Currency option: the option contract gives the buyer the right, but not
obligation, to sell or purchase a particular currency at a specified exchange rate
and date.
 The seller of the option must fulfill the contract if the buyer so desires, but the buyer
of the option can forgo the contract if it turns out unprofitable.
 The buyer of a option pays the seller a premium (the option price), which
ranges from 1% to 5% of the contract value
 Put and call options: a call option specifies the right to buy a currency, while
the put option specifies the right to sell a currency.
 European and American options: An European option must be implemented
on the specified date, but the American option can e implemented at any time
before the stated date.
 The amount of the option contract is standardized for the trading that takes
place in the organized market.
4. The demand for foreign currency
Assets

 People can hold their wealth in various forms or assets,

such as bonds, stocks, bank deposits, gold and precious
metals, cash, real estate, ...
 The demand for assets depends on the following:
 The return to assets: the expected return to assets
 Risks
 Liquidity
4. The demand for foreign currency
Rate of return to assets I

 The return to an asset measures the change in the value of

the investment in the asset between two dates.
 The change in the value of an assets is brought about by
the change in
➢ (i) Its price and
➢ (i) The interest earned during a period of time.
4. The demand for foreign currency
Rate of return to assets II

 Return to an asset: an example

 Example 1: An investor bought 1000 USD in early 2008 at
the exchange rate was 1 USD = 16000 VND. The current
exchange rate (August 2010) was 1 USD = 19500 VND.
What is the return to the investment in US dollars
 Example 2: An investor bought 1 share of the stock issued
by a commercial bank in 2009 at the price of 50000 VND
per share. The investor received a dividend of 2000 VND
per share at the end of 2009, and the price of the stock also
rose to 58000 VND at the yearend. What is the return to the
stock.
4. The demand for foreign currency
Rate of return to assets III
 Expected return to assets
➢ Since people do not know the return to an asset before they
buy the asset, the demand for an asset largely depends on
the expected return to the asset.
➢ The expected return to an asset measures the change in the
expected value of the asset using its expected prices and
interest over a given period
4. The demand for foreign currency
Rate of return to assets IV

 The real return to an asset

➢ Because the value of assets measured in terms of money, the
change to the value of money has an impact on the value of
asset.
➢ The demand for an asset depends not only on the nominal
return to the asset, but also on its real rate of return.
➢ The expected real rate of return to an asset is the expected
nominal rate of return minus the (expected inflation during a
given period.
4. The demand for foreign currency
Rate of return to assets V
 The real return to an asset
➢ Example 1: A saver deposits 1 million VND at a bank. The
one-year interest rate is 8%, and the expected inflation over
the next year is 6%. What is the real rate of return to the
bank deposit
➢ Example 2: A saver deposits 1 million VND at a bank. The
one-year interest rate is 10%, and the expected inflation over
the next year is 12%. What is the real rate of return to the
bank deposit
4. The demand for foreign currency
Risk and liquidity

➢ The risk of an asset refers to the uncertainty of its expected

return.
➢ Given all other things equal, the more risky an asset is, the lower
the demand for it.
➢ The liquidity of an asset refers to the speed and cost of
disposing an asset. All else equal, the more liquid an asset
is, the higher the demand for it.
4. The demand for foreign currency
Domestic and foreign deposits
 The interest rate
➢ The interest rate is the rate of return to the deposit at the
bank. When you deposit money, you are buying the asset
‘deposit’
➢ Example: A saver deposits 10 millions VND at a
commercial bank with annual interest rate of 10%. After one
year, he will receive 1 million VND in interest. The rate of
return is 10%
4. The demand for foreign currency
Domestic and foreign deposits
 The exchange rate and foreign assets
➢ The return to the foreign currency deposit consists of not
only the interest rate, but also the expected change in the
exchange rate.
➢ Example: Suppose the interest rate offered for 3-month
deposit in VND is 9%. The three-month deposit in US
dollars is 5%. Vietnamese dong is expected to depreciate by
5% against US dollar over next three months. What is the
expected rate of return on the USD deposit?
4. The demand for foreign currency
The rate of return to foreign assets

 The rate of return to a foreign-currency denominated

asset is equal to the interest offered by the asset plus
the expected depreciation of domestic currency.
 Rate of return to foreign deposit
 Rate of Return= R* + (Ee – E)/E
 Where R* is the interest rate offered to foreign
currency deposits, E is the current exchange
rate, Ee is the expected exchange rate
5. Equilibrium in the foreign exchange market
Equilibrium in the foreign exchange market

 The foreign exchange market is in equilibrium when bank

deposits of all currencies offer the same rate of return.
 If the dollar deposit offers a higher rate of return as
compared to the dong deposit, investors will move from
dong deposit to dollar deposit, and thus creating excess
demand for dollar.
 If the dollar deposit offers a lower rate of return as
compared to the dong deposit, investors will move toward
dong deposit from dollar deposit, and thus creating excess
demand for dong.
5. Equilibrium in the foreign exchange market
Interest parity condition (UIP)
 The interest parity condition establish an equality between
the rates of return on domestic-currency deposits and
foreign currency deposits (uncovered interest parity – UIP)
 R = R* + (Ee – E)/E
 Here R is the interest rate on domestic-currency deposits
 The UIP shows the difference in interest rates equals to the
expected rate of depreciation of domestic currency.
 R – R* = (Ee – E)/E
 When the interest parity condition holds, the foreign
exchange market is in equilibrium
5. Equilibrium in the foreign exchange market
Adjustment to equilibrium

 If the UIP condition does not hold, the exchange rate will adjust to
bring about the equilibrium in the foreign exchange market
 Question 1: what would happen if the rate of return on foreign
currency deposits is higher than that of domestic currency deposits?
 Question 2: What would happen if the rate of return on foreign
currency deposits is lower than that of domestic currency deposits
5. Equilibrium in the foreign exchange market
Graph Presentation
 Expected return on Exchange rate FCD return
foreign currency curve
 In the graph, the vertical
schedule indicates the
current exchange rate,
and the horizontal
schedule indicates the
rate of return on
domestic and foreign
deposits measured in
terms of domestic
currency. The return to
FC deposits is described
by a downward-sloping
curve.
Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
 The equilibrium DCD return
FCD return
exchange rate
 The return to domestic
currency deposit if
indicated with a vertical .B
line. The equilibrium in
the foreign exchange
market is reached at point E1 A
A where the expected
return on domestic .
C
currency deposits and
foreign currency deposits
are equal.
R1
Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate DCD return
 Adjustment to FCD return
equilibrium
 The exchange rate
will adjust to E2 .B

maintain the
equilibrium in the E1 A
foreign exchange .
E3
market C

R1
Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
 Home interest rate DCD return
FCD return
and the current
exchange rate
 An increase in the .

interest rate on
domestic currency E1 A
deposit raises the
B
rate of return on DC E2
deposits, causing an
appreciation of R1 R2
domestic currency. Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate DCD return
 Foreign interest
rate and the
exchange rate E2 B
.
 A higher foreign
interest rate raises
the rate of return E1 A
on FC deposits,
FCD return
causing a
depreciation of
domestic currency. R1 R2
Expected rate
of return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange rate
 The expected DCD return

exchange rate and

the current
exchange rate E2 B
.
 A rise in the
expected exchange
rate raises the rate E1 A
of return on FC
deposits, causing FCD return
the current
exchange rate to
rise. R1 R2
Expected rate
of return