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Economics of the FOREX

The trade of different currencies takes place on the foreign exchange markets, at prices called exchanges rates. Most foreign exchange involves the trade of foreign-currencydenominated deposits between large commercial banks in international financial centres,
such as London, New York and Tokyo. There are different types of exchange rates and instruments, such as spot rates, forward rates, swaps, and options.
An EXCHANGE RATE is a price, namely the price of one currency in terms of another currency. This price is determined simply by demand and supply in the foreign exchange market. As the exchange is a price, a rise in the exchange rate indicates that the item being traded has becomes more expensive, just like any other price rise. Therefore, if the exchange rate of a Singapore dollar in terms of Euros rises, this indicates that the Singapore dollar has become very expensive. The exchange rate is special because it has high variability of price (only a few minutes later all quoted prices deviate from the price quoted before). As a result of this high variability, a given currency usually appreciates relative to some currencies and simultaneously depreciates relative to some other currency. As a result of international arbitrage, the same currency sells for (virtually) the same price at different locations at the same point in time. This also holds for cross exchange rates as a result of triangular arbitrage, involving the exchange of 3 currencies.
There are actually 2 quotes rates:
1) BID rate - the price at which banks are willing to buy $1 2) ASK rate - the price at which banks are willing to sell $1
The difference between the buying and selling rate is called the SPREAD (in percentages). It generates revenue for the currency trading activities of the banks. In general, the spread is quite small and decreases depending on how actively those 2 currencies are traded.

- COMMERCIAL BANKS - all major international transactions involve the debiting/
crediting of accounts at commercial banks, that is, most transactions relate to the exchange of bank deposits (in different locations denominated in different currencies). This puts commercial banks at the centre of the foreign exchange market.
- FIRMS - the international exchange of goods/services by firms almost always involves foreign exchange trading to pay for the activities involved.
- NON-BANK FINANCIAL INSTITUTIONS - foreign exchange transactions are also offered to the public by non-financial institutions (as a result of financial deregulation).
- CENTRAL BANKS - depending on various macroeconomic circumstances, such as the unemployment rate, the growth of the economy, the inflation rate, and explicit/implicit government policies, the CB may decide to buy/sell foreign exchange. Although the size of these CB interventions is usually relatively small,
its impact can be substantial as an indication of future macroeconomic policy changes.

1 SPOT exchange RATE - the price of buying or selling a particular currency at this moment
FORWARD exchange RATE - is the price at which you agree upon today to buy/sell an amount of currency at a specific date in the future. Suppose, that you represent a Japanese firm and have sold a thousand watches for delivery and payment in France in 3 months' time at a total price of €150,000. As the current exchange rate of €1 is ¥133.49, the payment of
€150,000 is worth ¥20,023,500. As the total cost of producing and delivering the watches for your company is about ¥19 mln., you stand to make a profit of about ¥1 mln. in this transaction. However, payment takes place only 3 months later, such that 3 months later the spot exchange rate for €1 is only ¥120.49. The payment of €150,000 is now worth only
¥18,051,000, which means that your company made a loss of about ¥1 mln. You could have avoided this loss by taking actions 3 months earlier using forward-looking instrument.
SWAP - is the simultaneous buying and selling of an amount of currency at some point in the future and a reverse transaction at another point in the future.
OPTION - gives you the right (but not an obligation) to buy or sell a currency at a given price during a given period.
NOTE: If the FORWARD RATE of the USD is higher than the SPOT RATE, we say the USD is selling at a premium. On the other hand, if the FORWARD RATE is below than the SPOT
RATE, we say the currency is selling at a discount (p.451).

FIXED exchange rate - the CB of a country sets the exchange at a particular level and it will not allow the currency to appreciate/depreciate relative to that level. To maintain the fixed exchange rate, the CB must be ready to intervene in the foreign exchange market by buying/
selling reserves or by increasing/decreasing the interest rate.
FLEXIBLE exchange rate - the CB does not intervene in the foreign exchange market and allows the currency to freely appreciate/depreciate in response to changes in market demand and supply.

GOLD STANDARD (1870-1914) - was a stable and credible fixed exchange rate regime in which countries valued (pegged) their currency in terms of gold. With countries issuing banks notes directly backed by gold, and by allowing gold to be freely imported/exported across borders according to the gold standard rules, and the exchange rate between currencies became fixed. The gold standard worked quite well at the end of the 19 th and the beginning of the 20th century, but there were also several flaws to the gold standard.
WORLD WARS AND RECESSION (1914-1945) - gold standard was broken by the WWI such that countries were no longer willing to give up their policy autonomy for a well-functioning international economic system. Consequently, when the Great Depression hit in 1929 countries engaged in non-cooperative, competitive beggar-thy-neighbour devaluations and many nations instituted capital controls to prevent the movement of gold. This led to a collapse of international trade system, unemployment rate of 30%, and outbreak of the
WWII. The BIS was then established in 1930. Britain returned to the gold standard which led to a significant deflation in the economy.
BRETTON WOODS (1945-1971) (exchange rates pegged to dollar, or to gold; initial capital controls) - in 1944 the delegates of 44 nations signed the Bretton Woods Agreement - a system of rules, institution, and procedures; and established the IMF and World Bank. The purpose of this was free trade and a prevention of beggar-thy-neighbour policies. Free trade involved lowering tariffs and other trade barriers, and a stable international monetary system to foster the development of trade and capital flows. To do this the gold standard was re-established indirectly through the role of the USD as an international reserve currency. The US government fixed the price of gold at $35 per ounce and made a commitment to convert dollars to gold at that price. As the US economy strengthened, this made dollars even better than gold as international reserves, as dollars earned interest while gold did not. Other countries pegged their currency to the USD at a par value and would buy/sell dollars to keep exchange rate within a band of ±1% of parity.
FLOATING RATES (1971-present) (managed floating, and some pegging; capital market liberalization) - the Bretton Woods system was collapsed due to n-1 problem, the convertibility of the $ to gold was ended as $ was devalued, and eventually the $ floated.
Although the present international monetary system is called the floating era, this does not mean that all currencies are floating. On the contrary, almost all countries at some time or another engage in some type of foreign exchange market intervention, either through their legal framework, direct intervention, or their interest rate policy.

3 Exam Q:What role was the IMF intended to perform in the international monetary system and what does it have now?

IMF (International Monetary Fund) - is the central institution of the international monetary system, established in 1946. Its objectives are: (1) the balanced expansions of world trade;
(2) stability of exchange rates; (3) avoidance of competitive devaluations; (4) orderly correction of balance of payments problems
Ideally, IMF was first designed to keep the exchange rate stability. This arrangement required Central Banks of major countries to hold enough exchange reserves to intervene in
FOREX markets, such that countries build up reserves during surpluses and run them down in deficit times. As the world trade was growing, this required the stock of reserves to grow to keep the exchange rate stability. Since the stock of gold was fixed, USD stocks needed to grow to provide additional international reserves and to keep up with growing international trade.
However, it was pointed out by Robert Triffin that the credibility of USD convertible into gold will eventually lead to the collapse of a system - the International Liquidity Problem. The solution to this problem was the introduction of new international reserve asset - IMF's special drawing rights (SDR). SDR is a low-interest rate credit facility (not money) between governments of poor countries and IMF. BUT it cannot be used to intervene in FOREX
market directly, so SDR had no significant roles in international monetary system and could not save the financial system.
NOW, the IMF employs 3 main functions:
1) SURVEILLANCE - this is the annual regular consultation and policy advice to IMF
members regarding policies to promote economic growth and stable exchange rates.
2) TECHNICAL ASSISTANCE - this consists of training and assistance of fiscal, monetary,
and exchange rate policies, supervision of the banking system, financial regulation,
and statistics provision. In 2010, the IMF helped Hungary, Latvia, and Montenegro to restructure banks, Iceland in emergency banking legislation, and Jamaica to assess the impact of debt restructuring.
3) LENDING - IMF is also a credit institution to the extent that all member governments put money in IMF and IMF can lend back to particular governments with balance of payments (BoP) problems, conditional on the implementation of a policy programme designed by IMF to correct these problems. In some cases, those recommended policies are subject to criticism because it may say that the government should cut its spending, raise interest rates and introduce some direct control to bring the situation under control. And obviously, these changes may introduce other problems, too. Countries with BoP problems usually turn to IMF
because when they try to borrow from the market the interest rate they have to pay is very high because they are much riskier (that's the current Greek situation). And so the IMF provides temporary loans usually at low interest rates (the rate at which the big governments would borrow and which small countries would not be able to obtain from the market). The IMF approval provides a lending signal to other institutions and investors, enabling the country to attract additional funds.
Initially, most lending went to industrial economies. In the 1970-80s many lower income countries borrowed from the IMF as a result of the oil and debt crisis.

4 NOTE that, IMF does not deal/trade with the private sector. It has no role in recent
FINANCIAL CRISIS because it was not the governments that needed loans but failing banks that needed a loan from governments, and these governments do not need to borrow from the IMF since they can borrow cheaply from the market on their own.

Exam Q:-

Explain Purchasing Power Parity (PPP). Under what circumstances it is likely to hold, if at all?
Explain the implications of Purchasing Power Parity for exchange rates and inflation differentials and outline the empirical evidence on how well it holds in practice
Critically assess the concept of purchasing power parity (PPP) as an equilibrium condition for price levels and exchange rates.

PPP - is a theory which states that exchange rate between 2 currencies are in equilibrium when their purchasing power is the same in each of the 2 countries. This means that the exchange rate between 2 countries should equal the ratio of the 2 countries' price level.
When a country's domestic price level is increasing, that country's exchange rate must be depreciated in order to return to PPP. And vice-versa if the price level is decreasing.
The PPP is based on the "Law Of One Price" (LOOP) - similar goods will sell for the same price in 2 economies, taking into account the exchange rate and in the absence of transportation and other transaction costs.
For example, a particular apple (that is traded across boundaries) that sells for 10 MXN in
Mexico should cost 1 USD in USA when the exchange rate is 10 MXN/USD. HOWEVER, if the price of that apple in Mexico was only 5 MXN, this creates arbitrage opportunities consumers in USA would prefer buying apple in Mexico.
Since that apple in Mexico is now cheaper, the demand for apple in Mexico will increase and as a result the price of Mexican apples will increase. Moreover, as people buy MXN to buy that apple in Mexico, the demand for MXN increases and this will bid up the value of the
MXN (MXN appreciates). Meanwhile, the demand for apple in USA would fall this causes the price of apple in USA to fall as well. At the same time, as the demand for USD falls this causes the USD to fall in value (USD depreciates). This process continues until the goods have again the same price, such that LOOP and PPP hold.
NOTE that because of the problems with nominal exchange rates, economists often use the
"real exchange rate" when deriving PPP. It plays an important role in indicating the competitiveness of domestic goods relative to foreign goods, and the demand for domestic and foreign currencies.
Economists use 2 versions of PPP:
- Strong ABSOLUTE PPP (as described in the previous paragraph) equates the price levels in 2 countries when expressed in common currency, such that the purchasing power of unit of currency is same in 2 countries. Put formally, the exchange rate between Britain and
America is equal to the price level in Britain divided by the price level in the America.
Assume that the price level ratio PB/PA implies a PPP exchange rate of 1.3 GBP/USD. If today's exchange rate is 1.5 GBP/USD, PPP theory implies that the GBP will appreciate against the USD and the USD will in turn depreciate (get weaker) against the GBP:
PB = S * PA


Absolute PPP alone does not tell us everything, so we should also look at relative PPP, too.

6 - Weak RELATIVE PPP refers to rates of changes of price levels (inflation rates) over time.
This proposition states that the rate of appreciation/depreciation ( ∆ s) of a currency is equal to the difference in inflation rates between the foreign and the home country. For example,
if Britain has an inflation rate of 10% and the USA has an inflation rate of 5%, the GBP will depreciate against the USD by 5% per year.
∆πB=∆πA +∆s
Relative PPP usually holds only for long-term. We have to look at long-time period when deviations in 2 different countries get big & persistent, and arbitrage is strong in order to allow for these differences to have an impact on the exchange rate such that there is an incentive to eliminate these deviations. It usually takes several years for currencies to react to price differences. Hence, PPP does not determine exchange rate in the short-run.
Over a short-run, currencies cannot react quickly to price differences since ARBITRAGE
OPPORTUNITIES ARE NOT ALWAYS AVAILABLE because (even if arbitrage is available it is small such that there is little incentive to bring the prices back into line):
1) TRANSACTION COSTS & TAXES - because of the existence of transaction costs arbitrage is not profitable.
2) UNCERTAINTY - there is a risk in buying in one place and selling in another place,
and prices could change in the meantime.
3) NON-TRADED GOODS AND CHOICE OF INDEX - it was assumed that all goods were tradable. In fact, some goods are non-tradable (e.g. health services), that is products/services that cannot be traded between countries and for which arbitrage is not possible.
4) DIFFERENTIATED GOODS - we assumed that we were dealing with same basket of goods. In practice, it is not true because people in different countries consume different goods, so because of these differences people cannot arbitrage.
5) FIXED INVESTMENTS AND THRESHOLDS - the sunk costs of investment associated with engaging in arbitrage ensures that traders wait until sufficiently large opportunities open up to outweigh the initial fixed cost.

EXTRA NOTE: The law of one price applies to individual commodities whereas PPP applies to the general price level.


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