Chapter 15
The Foreign Exchange Market
Foreign Exchange Market
What Are Foreign Exchange Rates?
Why Are Exchange Rates Important?
How Is Foreign Exchange Traded?
Exchange Rates in the Long Run
Following the Financial News: Foreign Exchange Rates
Law of One Price
Theory of Purchasing Power Parity
Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates
Factors That Affect Exchange Rates in the Long Run
Exchange Rates in the Short Run: A Supply and Demand Analysis
Supply Curve for Domestic Assets
Demand Curve for Domestic Assets
Equilibrium in the Foreign Exchange Market
Explaining Changes in Exchange Rates
Shift in the Demand for Domestic Assets
Recap: Factors That Change the Exchange Rate
Case: Effect of Changes in Interest Rates on the Equilibrium Exchange Rate
Case: Why Are Exchange Rates So Volatile?
Case: The Dollar and Interest Rates
Case: The Global Financial Crisis and the Dollar
The Practicing Manager: Profiting from Foreign Exchange Forecasts
◼ Overview and Teaching Tips
Chapter 15 explains behavior in the foreign exchange market by using a modern asset-market approach to
exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange
rate movements in the literature, and it has major advantages over the more conventional treatment of the
foreign exchange market typically found in financial markets and institutions textbooks.
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As the first case in the chapter indicates, the asset-market approach, in contrast to earlier approaches
emphasizing import and export demand, can be used to explain a feature of the foreign exchange market
that has received much attention in the press in recent years: the high volatility of exchange rates. This
phenomenon is not well explained by the earlier flow approach because it does not predict that exchange
rates should be highly volatile.
The asset-market approach is developed in several steps. First, the long-run determinants of the exchange
rate are laid out, and then the information about the long-run determinants is embedded in a model of the
short-run determination of exchange rates. The key idea that must be transmitted to the student is that
the demand for domestic currency (say dollar) assets is determined by the relative expected return on
these assets.
To help students achieve an intuitive grasp of how the relative expected return on domestic assets, and
hence the demand curve shifts, tell them to put themselves in the shoes of an investor who is thinking
about putting his or her money into foreign or domestic assets. When a factor changes, have them ask
themselves whether at the same exchange rate, they would earn a higher expected return on domestic
assets—if so, the demand curve has shifted to the right. This kind of thinking will help them manipulate
the demand curve so they can predict which way the exchange rate changes. Several summary tables in the
chapter should help students master the material, and I have found that using them in class helps greatly in
clarifying the discussion.
The four cases in the chapter, on the effect of interest rates and money growth on the exchange rate, why
exchange rates are so volatile, the relationship between the value of the dollar and interest rates, the global
financial crisis and the dollar, and the Practicing Manager discussion of how financial institutions use
foreign exchange forecasts to increase profits, can all be used in class to show students that the material
they have learned has practical uses. In teaching my class, I bring the previous day’s Wall Street Journal
Foreign Exchange column into class and then use the supply and demand analysis in the chapter to make
sense of this column to conduct a case discussion. The case discussion is always very lively and the
students love it.
◼ Answers to End-of-Chapter Questions
1. You are more likely to drink California wine because the franc appreciation makes French wine
relatively more expensive than California wine.
2. False. Although a weak currency has the negative effect of making it more expensive to buy foreign
4. It predicts that the value of the yen will fall 5% in terms of dollars.
6. Even though the Japanese price level rose relative to the American, the yen appreciated because the
Chapter 15: The Foreign Exchange Market 89
◼ Quantitative Problems
1. A German sports car is selling for 70,000 euros. What is the dollar price in the United States for the
German car if the exchange rate is 0.90 euros per dollar?
2. An investor in England purchased a 91-day T-bill for $987.65. At that time, the exchange rate was
$1.75 per pound. At maturity, the exchange rate was $1.83 per pound. What was the investor’s
holding period return in pounds?
3. An investor in Canada purchased 100 shares of IBM on January 1st at $93.00/share. IBM paid an
annual dividend of $0.72 on December 31st. The stock was sold that day as well for $100.25. The
exchange rate is $0.68/Canadian dollar on January 1st and $0.71/Canadian dollar on December 31st.
What is the investor’s total return in Canadian dollars?
4. The current exchange rate is 0.93 euros per dollar, but you believe the dollar will decline to
0.85 euros per dollar. If a euro-denominated bond is yielding 2%, what return do you expect in
U.S. dollars?
5. The 6-month forward rate between the British pound and the U.S. dollar is $1.75 per pound. If
6-month rates are 3% in the United States and 150 basis points higher in England, what is the current
exchange rate?
6. If the Canadian dollar to U.S. dollar exchange rate is 1.28 and the British pound to U.S. dollar
exchange rate is 0.62, what must the Canadian dollar to British pound exchange rate be?
7. The New Zealand dollar to U.S. dollar exchange rate is 1.36 and the British pound to U.S. dollar
exchange rate is 0.62. If you find that the British pound to New Zealand dollar is trading at 0.49,
what would you do to earn a riskless profit?
Chapter 15: The Foreign Exchange Market 91
Solution:
17. The interest rate in the United States is 4% and the euro is trading at 1 euro per dollar. The euro is
expected to depreciate to 1.1 euro per dollar. Calculate the interest rate in Germany.
Solution: