International Business Chapter 20 What Required This Instance Real Exchange Rate The Real Exchange Rate Provides

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CHAPTER 20

THE FOREIGN EXCHANGE MARKET

Learning Objectives:

■ Summarize fundamental underpinnings of the foreign exchange market.

■ Explain the functioning of the spot exchange market and various measures of the spot

exchange rate.

I. Outline

Introduction

– The Yen Also Rises (and Falls)

The Foreign Exchange Rate and the Market for Foreign Exchange

– Demand Side

– Supply Side

Summary

II. Special Chapter Features

III. Purpose of Chapter

The purpose of this chapter is to introduce students to the nature, components, and

functioning of the foreign exchange market. Special attention is focused on the links between

the foreign exchange market and the money markets.

IV. Teaching Tips

C. It is increasingly common to read about different exchange rate concepts in the news

media. We therefore have devoted more space than is usual in texts to explaining what the

various measures are and of what use they are to the international business person/traveler. If

you are pressed for time, you may find it advantageous to leave this material for students to read

on their own. We do, however, think that it is important that students be exposed to these

different exchange rate concepts.

F. It is important to show how the foreign exchange markets are linked to the domestic

money markets, particularly at this point in time when financial markets are becoming more

completely integrated worldwide. Although there are a number of ways of doing this, we have

found the method used in Figure 8 at the end of the chapter to be particularly effective.

Establishing the link between the foreign sector and the money markets is a useful transition

from the micro-trade section to the international macro section.

V. Answers to End-of-Chapter Questions and Problems

1. If Japan were to reduce its investment in the United States, the supply of foreign

exchange (Japanese yen) would be reduced, i.e., there would be a shift to the left from Stotal to S’

2. No, there is not cross-rate equality, since ($.0075/yen)/ (£.005/yen) = $1.50/£, not

$2.00/£. Consequently, arbitragers would use dollars to acquire yen, use yen to acquire pounds,

3. This statement is true. Unless one knows what happened to relative prices in the two

4. The real exchange rate provides an estimate of the purchasing power of a currency

relative to some previous period by removing the effect of price changes in each country by

5. 2014 PPPrelpeso/$ = [e2005peso/$][PI2014Mexico/PI2014US]

Given the 2014 exchange rate of 14.72 peso/$, PPPrel would suggest that the peso is undervalued

6. The condition for equilibrium in this instance is that iNY ≈ iLondon + xa – RP [or (iNY –

iLondon) ≈ xa – RP]. In this example, the rate of return in New York is less than the expected rate

of return in London after accounting for expected depreciation of the pound and the required

payment for risk associated with the U.K. investment, i.e., 0.02 < 0.06 + (-0.01) – 0.02, [or (0.02

– 0.06) < (-0.01 – 0.02)]. As a result, investment funds should flow from the United States to the

United Kingdom. This raises the spot rate on pounds and, other things equal, reduces xa since xa

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premium (due to the increased exposure in the United Kingdom). These adjustments should take

place until iNY is approximately equal to iLondon after taking account of the expected depreciation

of the pound and the required risk premium.

7. For the financial markets to be in equilibrium, the difference between the interest rates in

the two countries should be approximately equal to the forward premium, after taking account of

8. With an increase in the U.K. interest rate, there is an incentive for short-term financial

investments to move from the United States to the United Kingdom. As these flows take place,

9. (a) The Swiss franc was at premium with respect to the dollar since the forward rate is

greater than the spot rate (in $/Swiss franc). The percentage premium is equal to [(efwd/espot) – 1]

(b) In this example the dollar is at discount relative to the yen (the yen is at premium

relative to the dollar) because the forward rate on the dollar is less than the spot rate. The

10. If all markets are working efficiently, then the 1.2 percent 3-months forward premium

should equal the expected forward premium (and hence the expected appreciation of the Swedish

krona) if the difference between a higher 3-months interest rate in the United States and the

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strictly interpret the forward premium as being a good indication of expectations regarding the

movement of the krona over the next three months.

VI. Sample Exam Questions

1. Explain the difference between the spot rate, the forward rate, the real exchange rate, and

2. If interest rates differ between two countries, it is an indication that the financial markets

are not in equilibrium, and that financial investment flows should be taking place between the

two countries. Agree? Disagree? Explain.

3. Balance-of-payments accounting indicates that any surplus (deficit) in the current account

must be offset by a deficit (surplus) in the financial account. Explain why this is so, using

4. You note that over the last five years, the Swiss franc has appreciated from Sfr 1.60/$1 to

Sfr 1.45/$1. During that same period, the U.S. consumer price index rose from 100 to 120 and

5. How do speculators and arbitragers affect the foreign exchange market? Briefly describe

6. You and a friend get into a heated discussion about the value of the U.S. dollar in which

you argue that the dollar is currently undervalued against the Japanese yen. Failing to resolve

7. Indicate the meaning of the terms “covered interest parity” (CIP) and “uncovered interest

parity” (UIP). Then, focusing on “covered interest parity,” explain by numerical example and

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currency equals the forward rate on the foreign currency. (Assume that the two interest rates are

on comparable assets of the same risk.)

8. (a) Why does a “demand for foreign exchange” exist by a country’s economic actors?

Explain. Why does this demand curve have its downward slope? Briefly explain.

(b) What economic actions give rise to a “supply of foreign exchange” to a country?

Explain. Can we be sure that this supply curve will always have an upward slope?

9. (a) Draw a demand curve for foreign exchange (spot foreign exchange) by a home

country and briefly indicate why the curve has a downward slope. Then draw an upward-

sloping supply curve of foreign exchange to that country. (You do not need to explain

why it is upward-sloping.) Then indicate the equilibrium exchange rate in this spot

market and briefly explain why the market moves to this equilibrium position.

not change in foreign countries. In the context of covered interest arbitrage, what forces

are set in motion and what will happen to the spot and forward exchange rates because of

this change in domestic interest rates? Carefully explain.

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