The Spot Market for

Foreign Exchange

Market Characteristics:
An Interbank Market
The spot market is a market for immediate
delivery (2 to 3 days).
Primarily an interbank market, which is the
trading of foreign-currency-denominated
deposits between large banks.
Approximately $US1.4 - 1.6 trillion daily in
global transactions.
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Market Quotes: The WSJ

Currency Trading Table
Provides spot and forward rates. Forward
rates are for forward contracts, or the future
delivery of a currency.
US $ equivalent is the dollar price of a
foreign currency.
Currency per US $ is the foreign currency
price of one US dollar.
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Market Quotes:
Direct - Indirect Quotes
Direct quote is the home currency price of a
foreign currency.
Indirect quote is the foreign currency price
of the home currency.

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Appreciating and
Depreciating Currencies
A currency that has lost value relative to
another currency is said to have depreciated.
A currency that has gained value relative to
another currency is said to have appreciated.
This terms relate to the market process and are
different from devaluation and revaluation
(Chapter 3).
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Appreciating and
Depreciating Currencies
We use the percentage change formula to
calculate the amount of depreciation.
Example, on Monday, the peso traded at
0.1021 $/P. On Tuesday the market closed
at 0.1025 $/P.
The peso has appreciated, as it now takes
more $ to purchase each peso.
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Appreciating and
Depreciating Currencies
Example, on Monday, the peso traded at
0.1021 $/P. On Tuesday the market closed
at 0.1025 $/P.
The amount of appreciation is:
[(0.1025 - 0.1021)/0.1021] * 100 = 0.39%

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Bid - Ask Spreads:

Example from Financial Times
The bid is the price the bank is willing to
pay for the currency, e.g., 0.9002 $/ is the
bid on the euro in terms of the dollar.
The ask is what the bank is willing to sell
the currency for, e.g. 0.9010 $/, is the ask
on the euro in terms of the dollar.
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Bid - Ask Spread:

Cost of Transacting
The bid - ask spread of a currency reflects, in
general, the cost of transacting in that currency.
It is calculated as the difference between the ask
and the bid.
Example, 0.9020 - 0.9002 = 0.0018.

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Bid - Ask Margin:

Percent Cost of Transacting
The bid - ask spread can be converted into a
percent to compare the cost of transacting among a
number of currencies.
The margin is calculated as the spread as a percent
of the ask.
(Ask - Bid)/Ask * 100
Example, (0.9020 - 0.9002)/9.020 * 100 = 0.20%.

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Cross-Rates: Unobserved Rates

A cross-rate is an unobserved rate that is
calculated from two observed rates.
For example, the spot rate for the Canadian
dollar is 0.6770 $/C$, and the spot rate on the
euro is 0.9002 $/. What is the Canadian dollar
price of the euro (C$/)?
Note that ($/)/($/C$) = ($/)*(C$/$)=C$/.
In this example, 0.9002/0.6770 = 1.3297 C$/.

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Arbitrage:
Consistency of Cross Rates
Arbitrage is the simultaneous buying and
selling to profit (as opposed to speculation).
The ability of market participants to arbitrage
guarantees that cross rates will be, in general,
consistent.
If a cross rate is not consistent, the actions of
currency traders (arbitrage) will bring the
respective currencies in line.
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Spatial Arbitrage
Spatial Arbitrage refers to buying a
currency in one market and selling it in
another.
Price differences arise from geographical
(spatial) dispersed markets.
Due to the low-cost rapid-information
nature of the foreign exchange market,
these prices differences are arbitraged away
quickly.
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Triangular Arbitrage
Triangular arbitrage involves a third currency
and/or market.
Arbitrage opportunities exist if an observed rate
in another market is not consistent with a crossrate (ignoring transaction costs).
Again, profit opportunities are likely to be
arbitraged away quickly, meaning that crossrates are, for the most part, consistent with
observed rates.
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Triangular Arbitrage: An Example

The British pound is trading for 1.455 ($/)
and the Thai baht for 0.024 ($/b) in New
York, while the Thai baht is trading for 0.012
(/b) in London.
The cross-rate in New York is:
0.024/1.455 = 0.016 (/b)

Hence, an arbitrage opportunity exists.

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Example Continued
A trader with $1, could buy 0.687 in New
York.
The 0.687 would purchase b57.274 in
London.
The b57.274 purchases $1.375 in New
York, or 37.5% profit on the transaction.
To understand the arbitrage opportunity,
remember buy low, sell high.
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Real Exchange Rates:

Measuring Relative
Purchasing Power

Real Exchange Rates

Real Measures
Nominal variables, such as an exchange
rate, do not consider changes in prices
over time.
Real variables, on the other hand,
include price changes.
A real exchange rate, therefore, accounts
for relative price changes.
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Real Exchange Rates

A nominal exchange rate indicates the purchasing power
of one nations currency over the currency of another
nation.
Real exchange rates indicate the purchasing power of a
nations residents for foreign goods and services relative
to their purchasing power for domestic goods and
services.
A real exchange rate is an index. Hence, we compare its
value for one period against its value in another period.

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Real Exchange Rates

An Example
In 1996 the spot rate between the dollar and the
pound was 0.6536 (/$).
In 2000 the rate was 0.6873.
Hence, the pound depreciated relative to the dollar
by 5.16 percent {[(0.6873-0.6536)/0.6536]*100}.
Based on this alone, the purchasing power of US
residents for British goods and services (relative to
US goods and services) rose by 5.16 percent.
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Example: Continued
Suppose in 1996 the British CPI was 156.4 and the
US CPI was 154.7. In 2000, the CPIs were 170.5
and 172.7 respectively.
Based on this, British prices rose 9.0 percent while
US prices rose 11.6 percent, a 2.6 difference.
Since the prices of British goods and services rose
slower than the prices of US goods and services,
there was an increase in purchasing power of
British goods and services relative to the
purchasing power of US goods and services.
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Combining the Two Effects

A real exchange rate combines these two effects the gain in purchasing power of US residents due
to the nominal depreciation of the pound and the
gain in relative purchasing power due to British
prices rising at a slower rate than US prices.
To construct a real exchange rate, the spot rate, as
it is quoted here, is multiplied by the ratio of the
US CPI to the UK CPI.
(/$) x (US CPI/UK CPI)
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Combining the Two Effects

1996 Real Rate = 0.6536 x (154.7/156.4) =
0.6465.
2000 Real Rate = 0.6873 x (172.7/170.5) =
0.6962.
The real depreciation of the pound was 7.69
percent.

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Conclusion
The nominal exchange rate change resulted in a 5.2
percent gain in the purchasing power of UK goods
and services for US residents.
The difference in price changes resulted in a 2.6
percent gain in purchasing power of UK goods and
services relative to US goods and services for US
residents.
Note how the 5.2 percent decline was augmented
by the 2.6 gain, resulting in an overall 7.7 percent
gain in purchasing power.
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More on Prices and the

Exchange Rate
A Hitchhikers Guide to Understanding
Exchange Rates by Owen Humpage, an
economic advisor at the Federal Reserve
bank of Cleveland, is a very helpful article
on prices and real exchange values.

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Effective Exchange Rate

A measure of the general value of a
currency.

Effective Exchange Rate

On any given day, a currency may appreciate in
value relative to some currencies while
depreciating in value against others.
An effective exchange rate is a measure of the
weighted-average value of a currency relative to a
select group of currencies.
Thus, it is a guide to the general value of the
currency.
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Weighted Average Value

To construct an EER, we must first pick a
set of currencies we are most interested in.
Next, we must assign relative weights. In
the following example, we weight the
currency according to the countrys
importance as a trading partner.
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Weights
Suppose that of all the trade of the US with
Canada, Mexico, and the UK, Canada
accounts for 50 percent, Mexico for 30
percent, and the UK for 20 percent.
These constitute our weights (0.50, 0.30, and
0.20).
Now consider the following exchange rate
data.
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Exchange Rate Data

Today

Year Ago

$C

1.44

1.52

9.56

10.19

0.62

0.61

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Calculating the EER

The EER is calculating by summing the
weighted values of the current period rate
relative to the base year rate.
The weighted-average value is calculated as:
(weight i)(current exchange value i)/(base exchange value i)

where i represents each individual country

included in the weighted average.

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Calculating the EER

Commonly this sum is multiplied by 100 to
express the EER on a 100 basis.
Hence, an EER is an index.
As we shall see next, the base-year value of
the index is 100.
The index, therefore, is useful is showing
changes in the weighted average value from
one period to another.
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Example
Let last year be the base year.
The effective exchange rate last year was:
[(1.52/1.52)*0.50 + (10.19/10.19)*0.30
+ (0.61/.61)*0.20]*100

= 100.
As with any index measure, the base year
value is 100.
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Example
Todays value of the EER is:
(1.44/1.52)*0.50 + (9.56/10.19)*0.30
+ (0.62/0.61)*0.20

or (0.958) 95.8
The dollar, therefore, has experienced a 4.2
percent depreciation in weighted value.

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Effective Exchange Measures

There are a number of effective exchange
measures available in the popular press.
Some common measures are:
Bank of England Index: The Economist.
J.P. Morgan: The Wall Street Journal and
the Financial Times.

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180

160
United States
140

120

100

United Kingdom

80
Japan
60

40

20

The Demand for and Supply

of Currencies
A Derived Demand

The Demand for a Currency

The demand for a currency is a derived
demand. That is, the demand for the
currency is derived from the demand for the
goods, services, and financial assets the
currency is used to purchase.
If, for example, foreign demand for
European goods and services increases, the
demand for the euro increases.
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The Demand Curve is

Downward Sloping
If, for example, the euro depreciates, European
goods, services, and financial assets become less
expensive to foreign residents. Foreign residents
will increase their quantity demanded of the euro
to purchase more European goods, services, and
financial assets.
The downward slope of the demand curve shows
the negative relationship between the exchange
rate and the quantity demanded.
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The Demand Curve

S ($/)

S0
S1
Demand
Q0
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Important Note
It is vital to construct and label supply and
demand diagrams properly.
Note here we are diagramming the market for the
euro. Hence, it is crucial to represent the correct
exchange rate on the vertical axis.
The correct exchange rate is one that reflects the
price of the euro. That is, it must be an indirect
quote.
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An Increase in Demand
Consider an increase in the demand for the euro.
Suppose, for example, that savers desire eurodenominated financial assets relative to
dollar-denominated financial assets because of a
change in economic conditions.
The demand for the euro rises as savers desire
more euros to purchase greater amounts of
European financial assets.
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An Increase in Demand for the Euro

S ($/)

S0

D
Demand
Q0
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Q1

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The Supply of a Currency

The supply of a currency is also a derived
demand.
Consider the demand schedule for the dollar.
If the dollar depreciates relative to the euro,
there is an increase in the quantity demanded
of dollars.
As more dollars are purchased, the quantity of
euros supplied in the foreign exchange market
increases.
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The Supply of a Currency

S ($/)

S1
S0

Dollar depreciation B
A

Q0
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Quantity
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Equilibrium
The market is in equilibrium when the
quantity supplied of a currency is equal to
the quantity demanded.
This is the market clearing exchange rate
because there is no surplus or shortage of
the currency.

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Equilibrium
S ($/)
S

S0

D
Q0
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Quantity
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Increase in the Demand

for the Euro

S ($/)

S
S1
S0

D
D
Q0

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Over and Under-Valued Currencies

If a currencys value is market determined,
how can it be over- or under-valued?
A currency is said to be over- or undervalued if the market exchange rate is
different from the rate that a model or
individual predicts to be the correct rate.
In other words, the individual believes the
market has it wrong.
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Over and Under-Valued Currencies

S ($/)
The euro is undervalued

S*
S0
D
Q0
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Undervalued
In the previous slide, the euro is said to be
undervalued.
The predicted or expected spot rate, S*, lies
above the market determined rate, S 0.
Hence, it should take a greater amount of
dollars to buy each euro. The euro,
therefore, is underpriced, or undervalued.
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Purchasing Power Parity

Purchasing Power Parity

Absolute or the Law of One Price
Suppose The Economist magazine sells for 2.50
in the UK and $3.95 in the US.
Arbitrage, therefore, should guarantee that the
exchange rate between the dollar and the pound
be s = 3.95/2.50 = 1.580 ($/).
In words, the dollar price of The Economist in
the UK should equal the dollar price of the
Economist in the US (ignoring transportation
costs).
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Absolute PPP
Absolute PPP is expressed as P = P*S,
where P is the domestic price, P* is the
foreign price, and S is the spot rate,
expressed as domestic to foreign currency
units.
Often it is rearranged as: S = P/P*.

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Absolute PPP as a Guide to

Exchange Values
Suppose the actual spot rate pertaining to the
previous example is 1.480 whereas PPP says the
rate should be 1.580.
Only a slight difference exists, but we can
conclude (for instructional purposes) that the
pound is undervalued relative to the dollar.
In percentage terms (1.580-1.480)/1.480 100 =
6.76 percent.
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Relative PPP - A Weaker Version

Rearrange APPP to S = P/P*.
Divide one period equation by another period, e.g.,
S1/S0= (P1/P0)/(P*1/P*0)
Rearrange as: S1 = S0(P1/P0)/(P*1/P*0)
Can be used as a model of exchange rate
movements.
Note that the emphasis is on exchange rate
movements, not levels, though it may appear
otherwise.
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Example
Suppose the exchange rate between the
dollar and the pound was 1.58 in 1999 and
is 1.60 today. Further, the UK CPI was 110
and is now 115, while the US CPI was 108
and is now111.
Plugging this into the formula we have
st = (1.58)[(111/108)/(115/110)] = 1.55
Hence the is overvalued (3.125%).
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Another Expression
Often economists will take the log of the previous
expression of RPPP to obtain the following.
- * = S
In words, domestic inflation less foreign inflation
should equal the change in the spot rate.
Implies that the higher inflation country should see
its currency depreciate.

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