Money and Banking: Understanding Foreign Exchange Transactions and Exchange Rates | Study notes Banking and Finance

Economics 311 Winter 2009

Money and Banking Adam S. Hersh

Handout on Foreign Exchange

The exchange rate is the price at which one country's national currency is exchanged for the national

currency of another currency. This process is called foreign exchange. There are several kinds of

foreign exchange transactions possible:

spot transactions – the immediate buying and selling of currencies

forward transactions – the immediate commitment to buy/sell at a given price at some specified

time in the future

swaps – an agreement to exchange currencies at a given price and time, and then to exchange

back at another time (and possibly price) in the future

While foreign exchange is traded on exchanges (most notably in London and the Chicago Mercantile

Exchange (futures)), the vast majority of foreign exchange transaction take place in over-the-counter

(OTC) inter-bank electronic markets.

Foreign exchange comprises by far the most traded asset in the world in volume terms. Most currencies

of the world cannot be directly exchanged for one another, but must be traded indirectly through

vehicle or key currencies—currencies that are perceived to be stable and reliable, and thus are widely

accepted internationally as means of payment, units of account, and stores of value. Currencies that can

be used as international money are referred to as hard currencies and include the US dollar, the British

Pound, the Euro, and the Japanese Yen. These also are often held by central banks as foreign exchange

reserves and so are called reserve currencies. Some empirical evidence does indeed suggest that these

are related to different measures of national military power, though most theories of international

reserve currencies ignore this (also, military power seems to be correlated with economic size and

stability, so analytically the causality is murky).

Papaioannou, Portes, and Siourrounis (2006) estimate the currency composition of foreign exchange

reserves in an assortment of countries. The US dollar accounts for between 59-71%; Euro for 18-25%;

Yen for 4-7%; Pound for 3-4%; and for very little the Swiss Franc and some others. The composition of

foreign exchange reserves is driven largely by:

a currency's acceptance as international money

currency denomination of foreign debts (public and private)

a country's trading partners

The existence of large funds of central bank foreign exchange reserves present a delicious target for

currency speculation—betting on the future appreciation or depreciation of a currency. Sizable

speculators (most famously, George Soros) may be able to exert such intense pressure as to overwhelm

central bank reserves (which are captured by the speculators).

Models of exchange rates

Just as institutions give structure and shape financial exchange in the domestic economy, countries

create institutions to govern international financial activities (movements of goods and capital across

their national boundaries. These can take a number of different forms with various costs and benefits,

but it is a fundamental principle that a country may have at most 2 of the following 3 institutions:

fixed exchange rate (managed by government policy, rather than freely floating/determined

by market mechanisms)

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Economics 311 Winter 2009 Money and Banking Adam S. Hersh Handout on Foreign Exchange The exchange rate is the price at which one country's national currency is exchanged for the national currency of another currency. This process is called foreign exchange. There are several kinds of foreign exchange transactions possible:  spot transactions – the immediate buying and selling of currencies  forward transactions – the immediate commitment to buy/sell at a given price at some specified time in the future  swaps – an agreement to exchange currencies at a given price and time, and then to exchange back at another time (and possibly price) in the future While foreign exchange is traded on exchanges (most notably in London and the Chicago Mercantile Exchange (futures)), the vast majority of foreign exchange transaction take place in over-the-counter (OTC) inter-bank electronic markets. Foreign exchange comprises by far the most traded asset in the world in volume terms. Most currencies of the world cannot be directly exchanged for one another, but must be traded indirectly through vehicle or key currencies—currencies that are perceived to be stable and reliable, and thus are widely accepted internationally as means of payment, units of account, and stores of value. Currencies that can be used as international money are referred to as hard currencies and include the US dollar, the British Pound, the Euro, and the Japanese Yen. These also are often held by central banks as foreign exchange reserves and so are called reserve currencies. Some empirical evidence does indeed suggest that these are related to different measures of national military power, though most theories of international reserve currencies ignore this (also, military power seems to be correlated with economic size and stability, so analytically the causality is murky). Papaioannou, Portes, and Siourrounis (2006) estimate the currency composition of foreign exchange reserves in an assortment of countries. The US dollar accounts for between 59-71%; Euro for 18-25%; Yen for 4-7%; Pound for 3-4%; and for very little the Swiss Franc and some others. The composition of foreign exchange reserves is driven largely by:  a currency's acceptance as international money  currency denomination of foreign debts (public and private)  a country's trading partners The existence of large funds of central bank foreign exchange reserves present a delicious target for currency speculation— betting on the future appreciation or depreciation of a currency. Sizable speculators (most famously, George Soros) may be able to exert such intense pressure as to overwhelm central bank reserves (which are captured by the speculators). Models of exchange rates Just as institutions give structure and shape financial exchange in the domestic economy, countries create institutions to govern international financial activities (movements of goods and capital across their national boundaries. These can take a number of different forms with various costs and benefits, but it is a fundamental principle that a country may have at most 2 of the following 3 institutions:  fixed exchange rate (managed by government policy, rather than freely floating/determined by market mechanisms)

 free flows of capital (as opposed to controls on the flow of capital)  macroeconomic policy autonomy These are known as the international trilemma and are covered extensively in Economics 321 International Monetary Theory. The first real exchange rate model was developed by Scottish Enlightenment philosopher David Hume (who was a close friend of Adam Smith), dubbed the price-specie flow mechanism. At the time, gold (or currency backed directly by gold) was the primary means of international payments. At the time (and in modern incantation, too, of sorts) people advocated for a policy to hoard gold (accumulate it from other countries). In practice, this could be achieved by manipulating the exchange rate, which was tied to gold, to depreciate, making their export goods more competitive internationally—so they could exchange goods produced at home for gold. Hume's was essentially a early statement of the quantity theory of money. An inflow of gold adds to the monetary base; the increased quantity of money chasing around the same, fixed quantity of goods leads to inflation (recall from Econ 204 that M/P = “real balances”; P will rise proportional to M). The rise in domestic prices means the domestic goods would not be so competitive anymore; they would export less and import more; and thus gold would flow back out of the country. Presumably back to some equilibrium point. While Hume's theory has provided the basis for liberal (free market) policies for several centuries, the mercantilist practice has seemed to work quite good for many countries throughout history, including the US, Britain, Japan, Germany, and most recently China. Modern parlance views money (and therefore foreign money) as an asset, giving us a basis for a model of exchange rate determination known as the interest parity condition , given by: iD^ = iF^ – [ Eet+1 – Et]/Et Which says that the dollar interest rate should equal the foreign interest rate less some expected change in the exchange rate. Through algebraic manipulation, we can get the expression for the exchange rate as a function of the two interest rates: Et = Eet+1 / ( iF^ – iD^ +1) Thus, assuming we have some knowledge about the future expected (direction of the) exchange rate, we can determine the present exchange rate. More complex expressions of this interest parity condition ( covered interest parity) use known forward exchange rates as a substitute for the expected future rate. These models provide a basis in economic fundamentals for predicting equilibrium exchange rates (what exchange rates should be). However, neither has had much luck in forecasting exchange rate movements. They work for some currency pairs over some periods of time, but all in all these models are not very good at describing exchange rate behavior. Exchange rates can move away from these (predicted) equilibrium rates for very long periods of time. They do however provide us an analytical framework for trying to understand the interaction of national financial systems.

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