Chapter 11 Foreign Exchange Markets

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Chapter 11

Financial systems 3 foreign exchange

markets

CHAPTER 11 FOREIGN EXCHANGE MARKETS

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CHAPTER CONTENTS

LEARNING OUTCOMES ------------------------------------------------- 127

FOREIGN EXCHANGE RATES ------------------------------------------- 128

FLOATING EXCHANGE RATES 129

FIXED EXCHANGE RATES 133

SINGLE CURRENCY ZONES 133



LEARNING OUTCOMES

a) Explain the role of the foreign exchange market and the factors influencing

it, in setting exchange rates.



FOREIGN EXCHANGE RATES

An exchange rate is the rate at which one currency trades for another on the

foreign exchange market.

If US citizens wish to visit the UK, or a US firms wishes to acquire UK goods and the

exchange rate is £1 = $1.50, this means they will have to pay $1.50 to obtain £1

worth of UK goods or assets.

Assets traded in the foreign exchange markets are deposits of the currency itself as

well as bonds denominated in foreign currencies.

The main participants in foreign exchange markets include: banks, investments

institutions, businesses and currency speculators.

Foreign exchange markets arise from the need to trade, the main motives for

holding foreign exchange include: transaction needs, finance trade, investment

projects, risk management and speculation.

Exercise 1

A German firm is due to receive £25,000 from a UK customer. The banks quoted

£ exchange rate is 1.0650 1.0700.

A

B

C

D

Exercise 2

The current rate of inflation in the UK is 5% and 4% in US. The exchange rate

between the two countries stands at 1.6800 £/$. If exchange rates adjust to

maintain purchasing power parity, the exchange rate in one year from now will be

A 1.6961

B 1.7632

C 1.7640

D 1.6650



FLOATING EXCHANGE RATE

A floating exchange rate is when the government does not intervene in the foreign

exchange markets, but simply allows the exchange rate to be freely determined by

demand and supply.

Factors determining the demand and supply for a currency

The demand for a given currency extends as the exchange rate falls, whereas the supply of a given currency contracts as the exchange rate depreciates. The reason for the demand/supply effects is threefold and stems from:

o Trade effects

o Portfolio effects

o Speculative effects



Other influences on exchange rates

Trade balances

Interest rates

Inflation

Future expectations



Discussion 1

Complete boxes 2 and 3 below to denote the impact of a domestic currency

ed and

exported goods/services.

Currency appreciation:

Currency depreciation:

1

If a currency appreciates in value, then ..

2The price of its exports will ..........

3While price of its imports will ......

1

If a currency depreciates in value, then ..

2The price of its exports will ..........

3While price of its imports will ......



Advantages and disadvantages of floating exchange rates

Advantages:

Continuous and automatic adjustment.

Reduced need for government to hold foreign exchange reserves.

Encourages efficient allocation of resources.

Disadvantages:

Expose firms to currency risks.

Uncertainty regarding exchange rate movements may deter trade.

Significant fluctuation may be politically damaging.



FIXED EXCHANGE RATE

A fixed exchange rate regime entails governments using their reserves to create an

exact match between supply and demand for its currency so as to maintain a fixed

exchange rate. The rate being fixed against a standard such as the price of gold, a

major currency (e.g. US dollar) or a representative sample of major trading

currencies.

Advantages and disadvantages

Advantages:

Provides certainty which may encourage international trade.

Imposes economic discipline on countries.

Disadvantages:

Loss of flexibility over domestic economic policy.

Devaluation may be regarded as economic failure.

Single currency zones

Membership of the Eurozone requires a state to give up its own monetary policy

and accept that of the European Central Bank. The rationale behind the single

currency is that it will lead to increased trade and price transparency.

The overriding argument against a single currency concerns the one size fits all

approach to economic policy.



Documents

Chapter 11 Foreign Exchange Markets