The fundamentals

of exchange rates

Trang Nguyen
Trangnt.tcnh@ftu.edu.vn
 Foreign Exchange Market

International Parity Conditions

Contents
Exchange Rate Theories

Foreign exchange rate determination

and Intervention
I – Foreign Exchange
Market
1. Functions of the Foreign Exchange Market
2. Structure of the Foreign Exchange Market
3. Transactions in the FEM
4. Foreign Exchange Rates and Quotations
• Foreign exchange market provides the physical and institutional
structure through which the money of one country is exchanged for
that of another country.
• Foreign exchange means the money of a foreign country.
• A foreign exchange transaction is an agreement between a buyer and
seller that a fixed amount of one currency will be delivered for some
other currency at a specified rate
Functions of the Foreign Exchange Market
• Transfer purchasing power between countries by exchanging money
• Obtaining or providing credit for international trade transactions
• Minimizing exposure to the risks of exchange rate changes
Structures of the Foreign Exchange Market
• The Global trading day
Structures of the Foreign Exchange Market
• Market Participants – the Players
- Liquidity seekers: wish to secure currency for transactions
- Profit seekers: look to profit from its future movements, and profit
from the liquidity seekers
Structures of the Foreign Exchange Market
• Institutional participants are:
- Bank and Nonbank Dealers: profit from buying foreign exchange at a bid price
(buying price) and reselling it at a slightly higher ask price (selling price).
- Commercial and Investment Transactors: Importers and exporters, international
portfolio investors, multinational corporations, tourists, and others use the
foreign exchange market to facilitate the execution of commercial or investment
transactions.
- Speculators and Arbitragers: seek to profit from trading within the market itself
- Central Banks and Treasuries (foreign exchange intervention): use the market to
acquire or spend their country’s foreign exchange reserves as well as to influence
the price at which their currency is traded
- Foreign exchange brokers: are agents who facilitate trading between dealers
without themselves becoming principals in the transaction
Transactions in the Foreign Exchange Market
• Spot Transactions: the purchase of foreign exchange with delivery and payment
between banks taking place normally on the second following business day
• Forward Transactions: requires delivery at a future value date of a specified
amount of one currency for a specified amount of another currency
• Swap transactions: the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates. Both purchase and sale are
conducted with the same counterparty
Foreign Exchange Rates and Quotations
- Foreign exchange rate: is the price of one currency expressed
in terms of another currency
𝐶UR! /CUR "
- Foreign exchange quotation: is a statement of willingness to
buy or sell at an announced rate
EUR 1.2174⁄USD
Currency Symbols
Exchange Rate Quotes
CUR! /CUR "
CUR! : Quote currency/Price currency/ counter currency
CUR " : Base currency/unit currency
- The quotation always indicates the number of units of the price currency,
CUR! , required in exchange for receiving one unit of the base currency,
CUR " .
E.g.: . EUR 1.2174⁄USD
USD: Base currency (a single unit)
EUR: Price currency
The exchange rate is: 1.2174 EUR = 1.00 USD
 • European terms: the quoting of the quantity of a
specific currency per one U.S. dollar (CHF/USD,
VND/USD)

Market • American terms: the U.S. dollar price of one

currency (USD/JPY)

Conventions • 2 major exceptions: EUR và GBP (USD/EUR và

USD/GPB)
 • Direct quotations: the price of a foreign
currency in domestic currency units
• Indirect quotations: the price of the
domestic currency in foreign currency units
• E.g.: Vietnam, 18/01/2024:

Market USD/VND = 23,700: 23,700VND (home

currency) per 1 USD (foreign currency) =>

Conventions direct
VND/USD = 0.000042: 0.000042USD
(foreign currency) per 1 VND (home
currency) => indirect
 • Bid rates: the price in one currency at
which a dealer will buy another currency
• Ask rates: the price (i.e., exchange rate)
at which a dealer will sell the other
currency

Market • Dealers bid (buy) at one price and ask

(sell) at a slightly higher price, making their
Conventions profit from the spread between the prices
Cross rates
• Many currency pairs are only inactively traded, so their exchange rate
is determined through their relationship to a widely traded third
currency.
• Currency per USD
Japanese yen JPY/USD 112.67
Mexican peso MXN/USD 19.6596

#$% #$%/*+, !!"../

• &'( = &'(/*+, = !0..10. = 5.7310
ÞJPY 5.7310/MXN
ÞMXN 0.1745/JPY
Intermarket Arbitrage
• Cross rates can be used to check on opportunities for intermarket
arbitrage.
• Suppose the following exchange rates are quoted:
Citibank quotes U.S. dollars per euro USD 1.3297/EUR
Barclays Bank quotes U.S. dollars per USD 1.5585/GBP
pound sterling
Dresdner Bank quotes euros per pound EUR 1.1722/GBP
sterling

!"# !"#/"() */*.,-./

• $%&
= $%&/"() = */*.0010 = 1.1721 => EUR 1.1721/GBP
Forward quotations
• Spot rate: are typically quoted on an outright basis
• Forward rate: a commercial bank is willing to commit to exchange one currency for
another at some specified future date. (typically quoted in terms of points or pips).
Use the table from Bloom- berg below
to calculate each of the following:
a. Japanese yen per U.S. dollar
b. U.S. dollars per Japanese yen
c. U.S. dollars per euro
d. Euros per U.S. dollar
e. Japanese yen per euro
f. Euros per Japanese yen
g. Canadian dollars per U.S. dollar
h. U.S. dollars per Canadian dollar
i. Australian dollars per U.S. dollar
j. U.S. dollars per Australian dollar
k. British pounds per U.S. dollar
l. U.S. dollars per British pound
m. U.S. dollars per Swiss franc
n. Swiss francs per U.S. dollar
The following exchange rates are available to you. (You can buy or sell at the stated rates.) Assume you have an
initial SF12,000,000. Can you make a profit via triangular arbitrage? If so, show the steps and calculate the
amount of profit in Swiss francs (Swissies).
Mt. Fuji Bank: ¥ 92.00/$
Mt. Rushmore Bank: SF1.02/$ $0.98/SF
Mt. Blanc Bank: ¥ 90.00/SF $0.97/SF sell at mt.blanc bank buy at rushmore
12026.1437908SF 11764.705 $

buy at fuji bank

1082352.94118Y
The following exchange rates are available to you:
• Bank A: USD 0,0104 – 0,0108 /JPY (0,0104 – 08)
• Bank B: USD 1,5670 – 1,5675 /GBP (1,5670 – 75)
• Bank C: JPY 143 – 145/ GBP
Can you make a profit via triangular arbitrage?
II – International Parity
Conditions
1. Prices and Exchange Rates
2. Interest Rates and Exchange Rates
3. Prices, Interest Rates, and Exchange Rates
in Equilibrium
 The Law of One
1. Prices and Price
Exchange
Rates
Purchasing Power
Parity
The Law of one price
• If identical products or services can be sold in two different markets, and no
restrictions exist on the sale or transportation of product between markets, the
price should be the same in both markets

P !"# ×S $%#/!"# = P $%#

• E.g.:
Vietnam market: price of Big Mac is đ125,610
US market: price of Big Mac is $5.30
=> S (đ/$)= P(đ)/P($)=đ125,610/$5.30=đ23,700/$
1. The Economist publishes annually the "Big Mac Index" by
which they compare the prices of the McDonald's Corporation's
Big Mac hamburger around the world. The index estimates the
exchange rates for currencies based on the assumption that the
burgers in question are the same across the world and therefore,
the price should be the same. If a Big Mac costs $2.54 in the
United States and 294 yen in Japan, what is the estimated
exchange rate of yen per dollar as hypothesized by the
Hamburger index?
2. If the current exchange rate is ¥113/$, the price of a Big Mac
hamburger in the United States is $3.41 and the price of a Big
Mac hamburger in Japan is ¥280, then other things equal, the Big
Mac hamburgers in Japan is:
a) Correctly priced
b) Underpriced
c) Overpriced.
d) There is not enough information to determine if the price is
appropriate or not.
Limitations of LOP
• Big Macs cannot be traded across borders
• Costs and prices are influenced by a variety of other factors
in each country's market, such as real estate rental rates and
taxes
Purchasing Power Parity

• Absolute purchasing power parity

• Relative purchasing power parity
Absolute Purchasing Power Parity

• Absolute purchasing power parity states that the spot exchange

rate is determined by the relative prices of similar baskets of
goods
¥ PI ¥
S = $
$ PI
Where:
PI ¥ : the price of a Japanese basket of goods
PI $ : the price of a US basket of goods
Relative Purchasing Power Parity

• If the spot exchange rate between two countries starts in equilibrium,

any change in the differential rate of inflation between them tends to
be offset over the long run by an equal but opposite change in the spot
exchange rate.
+! !45¥
•+ = !45$
hoặc ∆𝑆 = 𝜋¥ − 𝜋$ = −(𝜋$ − 𝜋¥ )
"
Where:
S! and S" : are exchange rates ¥/$ at 2 different times
𝜋¥ and 𝜋$ : inflation rate of Japan and US
Exchange rate Indices: Real and Nominal
• The nominal effective exchange rate index uses actual exchange rates to create an index, on a
weighted average basis, of the value of the subject currency over time.
• Real effective exchange rate is the nominal effective exchange rate (a measure of the value of a
currency against a weighted average of several foreign currencies) divided by a price deflator or
index of costs
$ $ 𝐶$
𝐸! = 𝐸# × $%
𝐶
Where:
𝐸!$ : The real effective exchange rate index for the U.S. dollar
𝐸#$ : The nominal effective exchange rate index
𝐶 $ : U.S. dollar costs
𝐶 $% : foreign currency costs
Note: 𝐸!$ > 100 means the currency would be considered “overvalued”
4. According to Big Mac Index, the implied PPP exchange rate is
Mexican peso 8.50/$1 but the actual exchange rate is peso
10.80/$1. Thus, at current exchange rates, the peso appears to
be ________ by ________.
a) overvalued; approximately 21%
b) overvalued; approximately 27%b
c) undervalued; approximately 21%
d) undervalued; approximately 27%
Exchange Rate Pass-through

Exchange rate pass-through is a measure of the response of

imported and exported product prices to changes in exchange
rates.
• Complete pass–through: the full percentage change in the
exchange rate is reflected in prices.
• Partial pass–through : the full percentage change in the exchange
rate is not reflected in prices.
Exchange Rate Pass-through
Assume that Volvo produces an automobile in Belgium and pays all production
expenses in euros. The price of this specific model is €50,000. When the firm
exports the auto to the United States, the price of the Volvo in the U.S. market
should simply be the euro value converted to U.S. dollars at the spot exchange
rate:
$ €
P$'()' = P$'(+' ×S $/€
Where:
$
P$'()' : the Volvo price in dollars
€
P$'(+' : the Volvo price in euros
S $/€ : is the spot exchange rate in number of dollars per euro
Exchange Rate Pass-through

• If the euro were to appreciate 20% versus the U.S. dollar

=> S $/€ =$1/€ à $1.20/€
Þthe new price of the Volvo in the U.S. market: $60,000
Þ If the price in dollars increases by the same percentage
change as the exchange rate, then there has been complete
pass-through (or 100%) of changes in exchange rates
$
P<=>?= $60,000
€
= = 1.20 𝑜𝑟 20% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒
P?=>?= $50,000
Exchange Rate Pass-through
• However, if Volvo worried that a price increase of this magnitude in the
U.S. market would severely decrease sales volumes
=> If the price of this same Volvo model rose to only $58,000 in the U.S.
market
Þ the percentage increase would be less than the 20% appreciation of the
euro versus the dollar.
$
P23453 $58,000
€ = = 1.16 𝑜𝑟 16% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒
P53453 $50,000
=> If the price in U.S. dollars rises by less than the percentage change in
exchange rates (as is often the case in international trade), then there has
been only partial pass-through of exchange rate changes.
Price Elasticity of Demand
• The price elasticity of demand for any good is the percentage
change in quantity of the good demanded as a result of the
percentage change in the good’s price:
%ΔQ &
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝜀% =
%ΔP
Trong đó:
Q & : quantity demanded
P: product price
Ø|𝜀% | < 1 => the good is relatively “inelastic.”
Ø|𝜀% | > 1=> the good is relatively “elastic.”
 • The Fisher Effect
• The International Fisher Effect
• The Forward Rate
2. Interest Rates • Calculation of Forward
Premiums
and Exchange Rates • Interest rate Parity – IRP
• Covered Interest Arbitrage – CIA
• Uncovered interest arbitrage –
UIA
The Fisher Effect
• Nominal interest rates in each country are equal to the required real
rate of return plus compensation for expected inflation.
i=r+𝜋
Where:
i: nominal rate of interest
r: real rate of interest FISHER

𝜋: expected rate of inflation

The International Fisher
• The relationship between the percentage change in the spot
exchange rate over time and the differential between
comparable interest rates in different national capital markets is
known as the international Fisher effect.
S! − S@ i¥ − i$
=
S@ 1 + i$
With S(¥/$)

INTERNATION
FISHER
The Forward Rate
• A forward rate (or outright forward) is an exchange rate quoted
today for settlement at some future datei.
• A forward exchange agreement between currencies states the
rate of exchange at which a foreign currency will be “bought
forward” or “sold for- ward” at a specific date in the future
(typically after 30, 60, 90, 180, 270, or 360 days).
¥ x
¥/$
1 + (i × 360)
FA = S ¥/$ × x
$
1 + (i × )
360
Calculation of Forward Premiums
• The percent per annum deviation of the forward from the spot
rate is termed the forward premium.
• Using the foreign currency as the price of the home currency
(the unit), JPY/USD spot and forward rates, and 90 days
forward, the forward premium on the yen, f JPY, is calculated as
follows:
¥
Spot − Forward 360
f = × ×100 FW PREMIUM
Forward days
Ø If f ¥ >0, the Japanese yen is selling forward at a premium
ØIf f ¥ <0 the Japanese yen is selling discount at a discount
Interest Rate Parity - IRP

• The difference in the

national interest rates for
securities of similar risk and
maturity should be equal to,
but opposite in sign to, the
forward rate discount or
premium for the foreign
currency, except for
transaction costs.
-€/$ ./0€
• =
"€/$ ./0$

IR PARITY
Covered Interest Arbitrage - CIA
• The spot and forward exchange markets are not constantly in
the state of equilibrium described by interest rate parity. When
the market is not in equilibrium, the potential for “riskless” or
arbitrage profit exists. The arbitrager who recognizes such an
imbalance will move to take advantage of the disequilibrium by
investing in whichever currency offers the higher return on a
covered basis. This is called covered interest arbitrage (CIA)
Rule of thumb
• If the difference in interest rates is greater than the forward premium
(or expected change in the spot rate), invest in the higher interest-
yielding currency. If the difference in interest rates is less than the
forward premium (or expected change in the spot rate), invest in the
lower interest-yielding currency
• For example, in Exhibit 6.7, the difference in 180-day interest
rates is 2.00% (dollar interest rates are higher by 2.00%). The
premium on the yen for 180 days forward is as follows:
Uncovered Interest Arbitrage (UIA)
• investors borrow in countries and currencies exhibiting relatively
low interest rates and convert the proceeds into currencies that
offer much higher interest rates.
• The “yen carry-trade”
3. Equilibrium between Interest Rates and Exchange Rates
Derek Tosh is attempting to determine whether USD/Japanese Yen
financial conditions are at parity. The current spot rate is a flat
¥89.00/$, while the 360-day forward rate is ¥84.90/$. Forecast inflation
is 1.100% for Japan, and 5.900% for the United States. The 360-day
euroyen deposit rate is 4.700%, and the 360-day eurodollar deposit
rate is 9.500%.
a. Diagram and calculate whether international parity conditions hold
between Japan and the United States.
b. Find the forecasted change in the Japanese yen/ U.S. dollar (¥/$)
exchange rate one year from now.
Hyundai’s Pass-Through. Assume that the export price of a Hyundai Sonata
from Seoul, South Korea, is KRW23,460,000. It exports the car to Malaysia.
The exchange rate is 279.48/RM. The forecast inflation rate in Malaysia is
2.0% per year and in South Korea it is 1.5% per year. Use these data to
answer the following questions on exchange rate pass-through.
a. What was the export price for the Sonata at the beginning of the year
expressed in Malaysian ringgit?
b. Assuming purchasing power parity holds, what should be the exchange
rate at the end of the year?
c. Assuming 100% exchange rate pass-through, what will be the Malaysian
ringgit price of a Sonata at the end of the year?
d. Assuming 60% exchange rate pass-through, what will be the Malaysian
ringgit price of a Sonata at the end of the year?
Casper Landsten—CIA (A). Casper Landsten is a foreign exchange
trader for a bank in New York. He has $1 million (or its Swiss franc
equivalent) for a short-term money market investment and wonders
whether he should invest in U.S. dollars for three months or make a CIA
investment in the Swiss franc. He faces the following quotes:
Arbitrage funds available: $1,000,000
Spot exchange rate (SFr/$): 1.2810
3-month forward rate (SFr/$): 1.2740
U.S. dollar 3-month interest rate: 4.800%
Swiss franc 3-month interest rate: 3.200%
IV – Exchange Rate Determination
1. Monetary Approach

The exchange rate is determined by

the supply and demand for national Changes in the supply and demand
monetary stocks, as well as the for money are the primary
expected future levels and rates of determinant of inflation
growth of monetary stocks.
2. Asset market Approach (portfolio balance
approach)

Exchange rates are determined by the supply and Changes in monetary and fiscal policy alter
demand for financial assets of a wide variety, expected returns and perceived relative risks of
including bonds financial assets, which in turn alter rates.
Impacts of open market operations
Real income growth and portfolio
balance theory
V- Currency market intervention
• Foreign currency intervention: the active management, manipulation, or intervention in
the market’s valuation of a country’s currency
• Motivations:
- To maintain the price competitiveness of their exports.
- A currency devaluation or depreciation may prove highly inflationary, and, in the
extreme, impoverish the country’s people
- Most countries would like to see stable exchange rates and to avoid the entanglements
associated with manipulating currency values
V- Currency market intervention
• Intervention methods:
- Direct intervention: the active buying and selling of the domestic currency against
foreign currencies
- Indirect intervention: are drivers of capital to flow into and out of specific
currencies
The most obvious and widely used factor here is interest rates
- Capital controls: the restriction of access to foreign currency by the government
+) limiting the ability to exchange domestic currency for foreign currency
+) allowing access to hard currency for the purchase of imports only.
Mundell – Fleming model
• Similar to the IS – LM model
• IS-LM for the small open economy
• Focuses on the relationship between commodity markets and currency markets
• Assumptions:
Ø Fixed price.
Ø Small and open economies
Ø Free flow of capital
IS Line
Y = C + 𝐺 + I r ∗ + NX(e)
Where: Y: real GDP
C: consumption
I: Investment
G: Government spending
NX: net export
↓ 𝒆 ⇒ ↑ 𝑵𝑿 ⇒ ↑ 𝒀
LM Line: Money market

M 6 = L(r ∗ , Y)
P
The equilibrium of
Mundell – Fleming
model

• Y = C Y − T + I r ∗ + G + NX e
• 2 ⁄3 = L(r ∗ , Y)

MUNDELL -
FLEMING
EQUILIBRIUM
Fiscal policy under Floating exchange rate regimes

Expansionary fiscal policy => ∆e > 0, ∆Y = 0

Þ In a liberally capitalized open economy,
fiscal policy cannot affect real GDP.
Þ Under the floating exchange rate regime,
fiscal policy is ineffective
Monetary policy under floating exchange rate

↑ M ⇒↑ LM
Þ ∆e < 0, ∆Y > 0
• Monetary policy affects the output of the
economy:
- Closed economy: ↑ M ⇒ ↓ r ⇒↑ I ⇒↑ Y
- Open economy: ↑ M ⇒ ↓ e ⇒↑ NX ⇒↑ Y
• Expansionary monetary policy does not
increase international aggregate demand,
it simply shifts demand from international
products to domestic products.
Trade policy under floating regime

• At any value of e, tariff/quota => ↓

IM và ↑ EX => IS shifts to the right
• ∆e > 0, ∆Y = 0
Fiscal policy under
Fixed exchange
rate regimes

• Under a fixed exchange

rate regime, fiscal policy is
very effective.
• ∆e = 0, ∆Y > 0
Monetary policy under Fixed
exchange rate regimes

•↑M⇒
LM 𝑠hifts to the right ↓
e <= Central Bank buy
domestic currency => ↓ M ⇒
LM shifts to the left
• ∆e = 0, ∆Y = 0
Trade policy under fixed
regime

• Import restrictions => ↑e <= sell domestic

currency => ↑ M ⇒
LM shifts to the right
• ∆e = 0, ∆Y > 0