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					Foreign Exchange Market
• The basics of exchange rates
• Exchange rates and the prices of goods
• The foreign exchange markets

             1. The Foreign Exchange Market

       Characteristics of the market:
       • Trading occurs mostly in major financial
         cities: London, New York, Tokyo, Frankfurt,
       • Infrastructures or supportive system of market
         transactions are important.
       • The volume of foreign exchange has grown rapidly.
       • About 90% of transactions involved US dollars.

      2. FX Markets Instruments
• Spot

• Forwards: closely related to Expected Future
  Spot FX rate

• Futures
• Options
• Swap
       3. Spot Rates and Forward Rates
  • Spot FOREX rate or S is exchange rate for currency exchanges “on the
    spot”, or when trading is executed in the present.
       current spot FOREX rate = St
       Spot FOREX rate of the future = St+1
       expected future FOREX rate for the next period = tSt+1 e
  • Forward rates or F is today’s exchange rate for currency exchanges that
    will occur at a future (“forward”) date: Rates are negotiated between
    individual institutions in the present, but the exchange occurs in the

  – Contract is done today; the rate is set and known today
  – Delivery will be done in the future; forward dates are typically 30, 90,
    180 or 360 days in the future.

               4. Definitions of Exchange Rates:
                       Direct Quotation
• Exchange rates are quoted as foreign currency per unit of
  domestic currency or domestic currency per unit of foreign
  currency(E) .

• For Canadians, E = E units of Canadian dollars to get one unit
  of U.S. dollar = E Canadian$/U.S.$

• This quotation make the best economics sense:

       – How much does a Honda cost? $3,000
       – How much does a unit of U.S. dollar cost = Canadian $1.02

       Different Notation for FX Rates
• E
• Some textbooks use S
 (Do not be confused with ‘S’ for Supply)

• Thus we will use E and/or S together.

       4. Depreciation and Appreciation
• Depreciation is a decrease in the value of a currency
  relative to another currency. Appreciation is an
  increase in value.
• Suppose that our quotation of S per FOREX goes up:
       – Canadian $1/U.S.$1 -- Canadian $1.20/U.S.$1
       – FOREX becomes more expensive;
       – Appreciation of FOREX (U.S. dollar)
       – Depreciation of domestic currency (Canadian dollar)

  Depreciation and Appreciation (cont.)
• Appreciation is an increase in the value of a currency
  relative to another currency.
       – An appreciated currency is more valuable (more expensive)
         and therefore can be exchanged for (can buy) a larger
         amount of foreign currency.
       – $1/€1 -> $0.90/€1 means that the dollar has appreciated
         relative to the euro. It now takes
         only $0.90 to buy one euro, so that the dollar is more

     5. Forward Rate and Future FX Rate
• Forward FX rate is the FX rate set today for a future delivery; thus it is
  based on today(time t)’s expectations of what S might be at time t+1.
  Thus “the expected future spot FX rate is equal to the Forward FX rate”.
       tS t+1 = Ft+1

•     The difference between Forward Rate of t+1 and Actual Rate(realized) of
     t+1 is Random Errors
    tS t+1 = St+1 + random errors

• Therefore, forward rate is, on average, equal to expected future FX rate;
   “Forward FX rate is the best predictor for future FX rate”.
   Ft+1 = St+1 + random errors
  On Average, Ft+1 = St+1 because the average of random errors is zero.
 Forward Premium tells the expected
            change in S:

• Δ% Se = (Se – S)/S

If FOREX market is efficient, then Se = F

• Δ% Se = (F- S)/ S
 Forward premium(+) or discount(-) is equal to
  the market’s expected change in FX rates.
• Numerical example in class:

If you are a Canadian exporter with delayed
   receivable of U.S. $ 1 million; U.S. forward
   premium is 0.01.
Are you going to have capital gains or loss from
   FX market?
(Answer) expected capital gains = 1.01-1.00 = F-
   S = Se - S
    *Test of FOREX Market Efficiency
•   t   Se t+1 = St+1+ e

Note that F has replaced Se

• Thus, Ft+1 = St+1 + e

Forward Rate is the best predictor for the future
  spot rate.


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