Exchange Rates and Exchange Rate

Systems

Econ 314
Lecture 8

1
 Reasons for holding Foreign Currencies
1. Trade and investment purposes : Importers and exporters and
investors transact in foreign currencies while receiving or making
payments in another country’s currency. Tourists are included in
this category.

2. Interest rate arbitrage : Arbitrageurs acquire money where interest

rates are relatively low and lend it where rates are relatively high.
By moving financial capital this way, interest rate arbitrage keeps
interest rates from diverging too far.

3. Speculation : Speculators buy or sell a currency because they expect

its price to rise or fall. The profit or loss depends on the accuracy of
anticipating changes in a currency’s market value.

2
 Definitions
Exchange Rate Risk : the risk that stems from the fact that currencies are
constantly changing in value and as a result, expected future payments that will be
made or received in a foreign currency will be a different domestic currency
amount from the amount when the contract was signed.

When investors purchase a bond that is designated in another currency other than
their home countries, investors are opened up to exchange risk. This is because the
payment of interest and principal will be in a foreign currency. When investors
receive that currency, they have to go into the foreign currency markets and sell it
to purchase their home currency. The risk is that their foreign currency will be
devalued compared to the currency of their home countries and that they will
receive less money than they expected to receive.

3
 Definitions
Hedging : Bondholders and other interest rate arbitrageurs often use
forward market to protect themselves against the foreign exchange risk
incurred while holding foreign bonds and other financial assets. This is
accomplished by buying a forward contract to sell foreign currency at the
same time that the bond or other interest earning asset matures.

A hedge is an investment that's made, to prevent or offset another

potentially risky situation. For example, gold can be bought as a direct
investment if the price is likely to go up, either due to excess demand or
excess supply. However, buying gold is a hedge if you want to protect
yourself from the effects of inflation. That's because gold keeps its value
when the dollar loses its. If the prices of most things you buy goes up,
then so will the price of gold.
4
 Definitions
Spot Market : the market for buying and selling in the present. For
example, if one wishes to purchase Company ABS shares and own them
immediately, one would go to the cash market in which the shares are
traded (the Stock Exchange). If one wanted to buy gold on the spot
market, one could go to a coin dealer and exchange cash for gold.

The foreign exchange market (FOREX) is one of the largest spot markets in
the world.

Spot markets are influenced solely by supply and demand, whereas

futures markets are influenced by a host of other factors like expectations
about future prices, storage costs, etc.

5
 Definitions
Forward Exchange Rate : the rate of exchange agreed upon now, for a foreign
exchange market transaction that will occur at a specified date in future.
Forward rates are based on the spot rate, adjusted for the cost of carry and refer
to the rate that will be used to deliver a currency, bond or commodity at some
future period of time.

The forward rate specified in an agreement is a obligation that must be honored

by the parties involved. Consider an American exporter with a large export order
pending for Europe, who undertakes to sell 10 million euros in exchange for
dollars at a rate of 1.35 euros per U.S. dollar in six months from now. The
exporter is obligated to deliver 10 million euros at the specified rate on the
specified date, regardless of the status of the export order or the exchange rate
prevailing in the spot market at that time.

6
 Definitions
Forward Market : the market in which the buying and
selling of currencies for future delivery takes place. A
market in forward exchange exists because people
committing themselves to future transactions involving
foreign currencies want to know at present what these
commitments will be worth at maturity in their home
currencies.

7
 Example
A U.S importer of British goods may be obliged to pay the shipper in
sterling ninety days later. If the price of sterling falls in the interim,
because the pound is devalued, his profits from the importing
transaction are increased. But if the price of sterling rises, his profits
are reduced. He may wish to avoid taking his chances on either of
these outcomes. One solution is to purchase spot sterling now and
hold it for 90 days. This would eliminate exchange risk but would tie up
his capital and cost him an interest payment. Another is to cover his
future payment by a forward purchase of sterling. He enters a contract
to pay a specified number of dollars ninety days hence in exchange for
the sterling he will need. The dollar cost of his future payment is thus
made certain.

8
 Definitions
Covered Interest Arbitrage : A strategy in which arbitrageurs use the
forward contract to insure against exchange rate risk. A strategy in which
one enters a long position in an investment in a foreign currency and
simultaneously enters a short position in a forward contract on that
same currency. The amount one receives in the sale of the forward
contract should equal what one spends on the long investment in the
base currency.

Covered Interest Rate Parity (CIP) relates the nominal interest rate in any
economy, the United States say, to the nominal interest rate in any other
economy, Europe say, and the forward premium on the nominal
exchange rate between the two economies’ currencies:

9
 Covered Interest Arbitrage

RUSD = REUR + f
CIP states that any nominal interest rate gain of USD cash deposits over
EUR cash deposits, RUSD - REUR will be wiped out by the depreciation of the
USD against the EUR, as reflected in the forward premium f, where the
forward premium is defined as,

f = (F-E)/E = F/E – 1

Where F is the nominal forward exchange rate between the USD and the
EUR and E is the nominal spot exchange rate between the USD and the
EUR.
10
 Covered Interest Arbitrage
A five step argument, to look for an international arbitrage portfolio that is
prohibited from yielding a profit, that then presents us with CIP as a result.

1.Borrow 1 EUR on the European capital market for 30 days. After 30 days,
pay both principal and interest on this loan, (1 +REUR); to your European
lender in EUR. (Note that there is a risk because the USD/EUR exchange rate
in 30 days from now is uncertain. But the investor will get rid of the risk.)

2. Enter a forward contract. In this contract specify with your partner that
you want him to pay (1 + REUR) EUR to you in exactly 30 days from now. Also
specify that you will pay him exactly F*(1 + REUR) dollars, no more and no less,
in 30 days from now.

11
 Covered Interest Arbitrage
With the (1 + REUR) EUR that you will receive from your forward
contract partner, pay back the European lender in 30 days. (So, after
entering this contract, the investor has gotten rid of all risk, the
second dot in the no-arbitrage condition above is satisfied.)

3. Exchange the amount of EUR that you obtained (in step 1) for E
USD on the spot market.

4. Give a loan of E USD to an American for 30 days, which yields

E*(1 +RUSD) in 30 days, including both principal and interest. (Since the
investor has just borrowed the same amount from a European lender,
he has not made any net investment. So, the first dot in the no-
arbitrage above is now satisfied, too.)
12
 Covered Interest Arbitrage
5. Imagine for a moment, that the gain from this portfolio in 30
days, E*(1+RUSD), exceeded the investor’s payments to the
European lender in 30 days, F*(1+ REUR). That would be an arbitrage
for her. Unfortunately, such an arbitrage cannot exist. (Similarly,
imagine a European investor had followed the reversed steps with
an American resident, borrowing 1 USD, and so forth. Then he
would get an arbitrage if F*(1 + REUR) exceeded E*(1 +RUSD)). We can
conclude that E*(1 +RUSD) =F*(1 + REUR) must hold in equilibrium,
where there is no arbitrage, and that is CIP after some
reformulations.

13
 Covered Interest Arbitrage
The reformulations are:

E*(1 +RUSD) = F*(1 +REUR)

(1 + RUSD) = (F/E)*(1 + REUR)
(1 + RUSD) = (1 +f)*(1 + REUR) = 1 + REUR + f + f*REUR

Note that f*REUR = 0 because both f and REUR are small (percentage)
numbers. So, multiplying them makes the term negligibly small, and we
have the CIP:

RUSD = REUR + f

14
Exchange Rate Determination

15
 The Demand for Foreign Exchange

e = $/Pound As the exchange rate falls, the dollar

appreciates and the dollar price of British
goods falls. The quantity of pounds
demanded by the U.S. market increases as
U.S. consumers and firms purchase more
goods and services in Britain.

Demand

O
Quantity of Pound Sterling

16
 The Supply of Foreign Exchange

e = $/Pound Supply

As the exchange rate rises, the dollar

depreciates and the pound price of U.S.
goods falls. The quantity of pounds supplied
to the U.S. market increases as British
consumers and firms purchase more goods in
the U.S.

O
Quantity of Pound Sterling

17
Supply and Demand in the Foreign Exchange Market

e = $/Pound S

e1

O
Q1 Quantity of Pound Sterling

18
 Flexible Exchange Rates

e = $/Pound

An increase in Demand for British Pounds

R2
R1 Dollar depreciates

D2
D1
O
Q1 Q2
Quantity of Pound Sterling

e = $/Pound S1
S2

An increase in Supply for British Pounds

R1
R2 Dollar appreciates

D
O
Q1 Q2
Quantity of Pound Sterling 19
Major Determinants of an Appreciation or Depreciation
e falls : appreciation e rises : depreciation

Long run: PPP Home goods are less Home goods are more
expensive than expensive than
foreign goods foreign goods

Medium run : Home economy Home economy

Business Cycle grows more slowly grows faster than
than foreign foreign

Short run (1) : Interest Home interest rates Home interest rates
parity rise, or foreign fall, or foreign
rates fall rates rise

Short run (2): Expectations of a Expectations of a

Speculation future future
appreciation depreciation
20
 Fixed Exchange Rates
An increase in the demand for British pounds puts pressure on the exchange rate
and will cause the dollar to depreciate to e2, unless the increase in demand is
countered by an increase in supply equal to line segment AB.
e = $/Pound S1
S2

e2

e1
AB

D2

D1
O
Q1 Q2 Quantity of Pound Sterling

Fixed Exchange Rates and changes in Demand

21
 Fixed Exchange Rates
• Under a fixed exchange rate regime, the government
sets the exchange rate it wants.

– Some flexibility is allowed within a narrow trading range,

called a band.

– The official, chosen fixed rate is called the par value or

central value

22
 Fixing the Value of the Currency
• Fix to gold
– This was the way it was done a century ago.
– When all currencies are tied to the same commodity, they
are all effectively tied to each other.
• Fix to a “basket” of commodities (a commodity price index).

• Fix to another currency—from WWII until 1970 the U.S. fixed

its currency to gold and most other nations fixed their
currency to the U.S. dollar.
• Fix to a “basket” of currencies—takes advantage of averaging
to reduce volatility and to insulate the currency.

23
 The Gold Standard
Under a pure gold standard, nations keep gold as their international reserve and use
gold to settle most international obligations.

3 rules that countries must follow in order to maintain a Gold Exchange Standard.

a) The value of their currency unit must be fixed in terms of gold. E.g. Under the
Bretton Woods System, the USD was fixed at $35 per ounce. The British pound
was fixed at 12.5 pounds per ounce. Implicitly, thus, the USD and the pound were
exchanged at 2.80 USD per pound.

b) Nations keep the supply of their domestic money fixed in some constant
proportion to their supply of gold.

c) Nations must be ready and willing to provide gold in exchange for their home
currency.

24
 Defending a Fixed Exchange Rate
D1
S
D0
Exchange Rate (CAD / U.S.D)

1.20
D2

1.10

Q2 Q3 Q4 Q1

Quantity of Foreign Exchange (U.S.D.)

25
 Defending a Fixed Exchange Rate
Assume BOC fixes the exchange rate between the narrow limits CAD 1.10 to
CAD 1.20 to the USD. BOC then stabilizes the exchange rate in the face of
seasonal, cyclical and other fluctuations in demand and supply to prevent the
rate from moving outside the permitted band. When BOC buys USD its
foreign reserves rise. When it sells USD its foreign reserves fall. Consider
three situations.
1.Intersection between D0 and S in the range between 1.10 and 1.20. then BOC does
not need to intervene.

2. Demand shifts to D1. Thus, there is excess demand for USD in the foreign exchange
market. BOC sells USD from reserves to the extent of Q 1Q4 per month to prevent the
exchange rate from rising above 1.20.

3. Demand shifts to D2. Thus, there is excess supply of USD. BOC buys USD. to the
extent of Q2Q3 per month to prevent the exchange rate from falling below 1.10.
26
 Defending a Fixed Exchange Rate contd...
If demand becomes D1 permanently with fluctuations on either side.
Average drain on BOC’s foreign exchange reserves will be Q1Q4 per
month. This can only continue to the extent of the limit of the stock of
foreign-exchange reserves. Thus there are two alternatives.

1.BOC can change the fixed exchange rate so that the band of
permissible prices straddles the the new equilibrium price.

2.Government policy can try to shift the curves so that the equilibrium
is between 1.10 and 1.20. Then government must restrict demand for
foreign exchange, through import quotas and foreign-travel restrictions
or increase supply of USD by encouraging Canadian exports.

27
 Where Does It Get The Dollars?
• If it holds U.S. Treasury bonds as reserves, it sells the bonds
on the international market in return for U.S. dollars.
• If it holds assets denominated in, say, Pound sterling, it sells
those assets for pound sterling, and then trades the pound
sterling for dollars.
• It may borrow the dollars from the IMF if it has a reserve
position with the IMF.
• It could sell gold or any other asset to raise dollars, or
another currency tradable for dollars.

28
 Four Ways to Defend the Fix
• Intervention, buying or selling in the foreign exchange
market to influence the equilibrium spot exchange rate.
• Exchange controls imposed by the government to restrict
demand and/or supply.
• Set domestic interest rates so as to influence short-term
capital flows, thus influencing the exchange rate by
changing the supply and demand in the market.
• Macroeconomic adjustments (changes in fiscal or monetary
policy) to influence supply and demand in the foreign
exchange market.
29
 Option to Surrender
Of course the country can always give up and,

•Devalue or revalue its currency

•Switch to a floating exchange rate and allow
the exchange rate to go to the market
equilibrium rate.

30
 Real Exchange Rate
Real Exchange Rate is the market rate adjusted for price differences.

Real Exchange Rate = [(Nominal exchange rate)*(Foreign price)] / Domestic Price

Example : A merchant is trying to decide whether to stock her shop with American
wine or French wine. French wine of a given quantity costs 200 Euros.
American wine of the same quantity costs 180 dollars. The merchant needs
to know the real exchange rate between French and American wine. The
nominal exchange rate is $1.20 per Euro.

Solution :
Real Exchange Rate = [(Nominal exchange rate)*(Foreign price)] / Domestic Price
= [($1.20 per Euro)*(200 Euros per case)] / ($180 per case)
= ($240 per case of French wine) / $180 per case of American wine
= 1 1/3 cases of American wine per one case of French wine

31
Current Exchange Rate Regimes

32
 Exchange Rate Structure
“If there is one exchange rate, the system is known as
unitary. If there is more than one exchange rate that may
be used simultaneously for different purposes and/or by
different entities, and if these exchange rates give rise to
differing rates for current and capital transactions, the
system is called dual or multiple.”

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

33
Classification of Exchange Rate Arrangements

34
Exchange Rate Arrangements, 2010–18 (Percentage of
IMF members as of April 30)

35
 Classification of Exchange Rate Arrangements
De Jure - The description and effective dates of the de jure exchange rate
arrangements are provided by the country authorities. Each member
country is required to notify the IMF of the exchange arrangements it
intends to apply and of any changes in the exchange arrangements.
Country authorities are requested to identify, which of the existing
categories of exchange rate arrangements most closely corresponds to the
de jure arrangement in effect.

Country authorities may also wish to describe their official exchange rate
policy, including officially announced or estimated parameters of the
exchange arrangement (e.g., parity, bands, weights, rate of crawl, and
other indicators used to manage the exchange rate). It also provides
information on the computation of the exchange rate.

36
Classification of Exchange Rate Arrangements
De Facto - IMF staff classifies the de facto exchange rate
arrangements according to the categories below. Where the
description of the de jure arrangement can be empirically confirmed
by the IMF staff over at least the previous six months, the exchange
rate arrangement will be classified in the same way on a de facto
basis.

Because the de facto methodology for classification of exchange rate

regimes is based on a backward-looking approach that relies on past
exchange rate movement and historical data, some countries are
reclassified retroactively to a date when the behavior of the exchange
rates changed and matched the criteria for reclassification to the
appropriate category.

37
 No Separate Legal Tender
Classification as an exchange rate arrangement with no separate legal
tender involves the confirmation of the country authorities’ de jure
exchange rate arrangement. The currency of another country circulates
as the sole legal tender (formal dollarization).

Exchange arrangements of countries that belong to a monetary or

currency union in which the same legal tender is shared by the members
of the union are classified under the arrangement governing the joint
currency. This classification is based on the behavior of the common
currency, whereas the previous classification was based on the lack of a
separate legal tender.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

38
 Currency Board
Classification as a currency board involves the confirmation of the
country authorities’ de jure exchange rate arrangement. A currency
board arrangement is a monetary arrangement based on an explicit
legislative commitment to exchange domestic currency for a specified
foreign currency at a fixed exchange rate, combined with restrictions on
the issuing authority to ensure the fulfillment of its legal obligation. This
implies that domestic currency is usually fully backed by foreign assets,
eliminating traditional central bank functions such as monetary control
and lender-of-last-resort and leaving little scope for discretionary
monetary policy.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

39
 Conventional Peg
Classification as a conventional peg involves the confirmation of the country
authorities’ de jure exchange rate arrangement. For this category the country
formally (de jure) pegs its currency at a fixed rate to another currency or
basket of currencies, where the basket is formed, for example, from the
currencies of major trading or financial partners and weights reflect the
geographic distribution of trade, services, or capital flows.

The country authorities stand ready to maintain the fixed parity through
direct intervention (i.e., via sale or purchase of foreign exchange in the
market) or indirect intervention (e.g., via exchange rate related use of
interest rate policy, imposition of foreign exchange regulations, exercise of
moral suasion that constrains foreign exchange activity, or intervention by
other public institutions). The exchange rate may fluctuate within narrow
margins of less than +/- 1% around a central rate or the maximum and
minimum value of the spot market exchange rate must remain within a
narrow margin of 2% for at least 6 months.
Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018
40
 Stabilized Arrangement
Classification as a stabilized arrangement entails a spot market
exchange rate that remains within a margin of 2% for six
months or more (with the exception of a specified number of
outliers or step adjustments) and is not floating. The required
margin of stability can be met either with respect to a single
currency or a basket of currencies, where the anchor currency
or the basket is ascertained or confirmed using statistical
techniques. Classification as a stabilized arrangement requires
that the statistical criteria are met, and that the exchange rate
remains stable as a result of official action.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

41
 Crawling Peg
Classification as a crawling peg involves the confirmation
of the country authorities’ de jure exchange rate
arrangement. In the crawling peg, the currency is
adjusted in small amounts at a fixed rate or in response
to changes in selected quantitative indicators, such as
past inflation differentials vis-à-vis major trading partners
or differentials between the inflation target and expected
inflation in major trading partners. The rate of crawl can
be set to inflation-adjusted changes in the exchange rate
or set at a predetermined fixed rate and / or below the
projected inflation differentials.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

42
 Crawl-like Arrangement
For classification as a crawl-like arrangement, the exchange rate must
remain within a narrow margin of 2% relative to a statistically identified
trend for six months or more (with the exception of a specified number of
outliers) and the exchange rate arrangement cannot be considered as
floating. Normally, a minimum rate of change greater than allowed under
a stabilized (peg-like) arrangement is required. However, an arrangement
will be considered crawl-like with an annualized rate of change of at least
–%, provided that the exchange rate appreciates or depreciates in a
sufficiently monotonic and continuous manner.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

43
Pegged Exchange Rate Within Horizontal Bands
Classification as a pegged exchange rate within horizontal bands involves
the confirmation of the country authorities’ de jure exchange rate
arrangement. The value of the currency is maintained within certain
margins of fluctuation of at least ±–% around a fixed central rate, or the
margin between the maximum and minimum value of the exchange rate
exceeds 2%. It includes arrangements of countries in the ERM of the
European Monetary System (EMS), which was replaced with the ERM II on
January 1, 1999, for those countries with margins of fluctuation wider
than ±1%. The central rate and width of the band are public or notified to
the IMF.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

44
 Floating Exchange Rate
A floating exchange rate is largely market determined, without an
ascertainable or predictable path for the rate. In particular, an exchange rate
that satisfies the statistical criteria for a stabilized or a crawl-like arrangement
will be classified as such unless it is clear that the stability of the exchange
rate is not the result of official actions. Foreign exchange market intervention
may be either direct or indirect, and such intervention serves to moderate
the rate of change and prevent undue fluctuations in the exchange rate, but
policies targeting a specific level of the exchange rate are incompatible with
floating. Indicators for managing the rate are broadly judgmental (e.g.,
balance of payments position, international reserves, parallel market
developments).

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

45
 Free Floating Exchange Rate
A floating exchange rate can be classified as free floating if
intervention occurs only exceptionally and aims to address
disorderly market conditions and if the authorities have
provided information or data confirming that intervention
has been limited to at most three instances in the previous
six months, each lasting no more than three business days.
If the information or data required are not available to the
IMF staff, the arrangement will be classified as floating.

Ref: Annual Report on Exchange Arrangements and Exchange Restrictions 2018

46