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 $C P 1.44 9.56 0.62 Year Ago 1.52 10.19 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

0
80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 19 00 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

Demand Q0
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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 ($/) Dollar depreciation B A S

S1
S0

Q0
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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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Increase in the Demand for the Euro

S ($/) S

S1
S0 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

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, S0. 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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