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
• Forwards: closely related to Expected Future
Spot FX rate
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:
• Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
• 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
• 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
(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