Debre Markos University

Burie Campus
Department of Economics
International Economics-II

October, 2024
Burie, Ethiopia
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2 Chapter One: The Foreign Exchange Market
Outline
 What is a Foreign Exchange Market?
 Characteristics and Participants of the Foreign Exchange Market
 The Functions of Foreign Exchange Markets
 The Demand for and the Supply of Foreign Exchange
 The Foreign Exchange Rate
 Definition of Exchange Rate
 Spot and Forward Exchange Rates
 Nominal, Real and Effective Exchange Rates
 The Determinants of Exchange Rates
 Exchange Rate Regimes
 Fixed Exchange Rate
 Freely Floating / Flexible Exchange Rate
 Managed Float / Hybrid System
 The Interaction of Hedgers, Arbitrageurs, and Speculators

06/15/2025 Appreciation / Revaluation and Depreciation / Devaluation of Currencies
3 Foreign exchange market
 Foreign exchange market is the "place" where currencies are traded/ it is
a market in which individuals, firms, and banks buy and sell foreign
currencies or foreign exchange.
 foreign exchange market is a worldwide market and is made up primarily
of commercial banks, foreign exchange brokers and other authorized
agents trading in most of the currencies of the world.
 It is a market/situation in which international currencies are purchased
and sold or traded. The price of foreign currency is decided by the free
interface of households, firms and financial institutions.
 Foreign exchange trading takes place in many financial centers and with
substantial and growing trade volume.
 The foreign exchange market is so much integrated that no large
difference in exchange rate appears in centers.

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4 Cont’d…
 Most transactions involve exchange of foreign currency for dollars due to roles of the
US in the world economy Dollar is referred to as the vehicle currency due to its
pivotal role in so many global foreign exchange deals.
The need for demand and supply of foreign currency
 The demand for foreign currencies arises if:
 Tourists visit another country
 A domestic firm wants to import from other nations
 An individual wants to invest abroad
 The supply of a nation’s foreign currency arises from if:
 Foreign tourist expenditures in the nation
 Export earning
 Foreign investment
 Just as other prices in the economy are determined by the interaction of buyers and
sellers, exchange rates are determined by the interaction of the households, firms, and
financial institutions that buy and sell foreign currencies to make international
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payments.
5 Cont’d…
Characteristics of foreign exchange market
 Volume is enormous: over a trillion dollars a day. Banks dealing in e-market tend to be
concentrated in certain key financial cities: know which biggest. London largest, but
also, New York, Tokyo, Frankfurt and Singapore.
 Highly integrated globally: when one major market is closed usually another is open,
so people can trade around the clock, moving from one center to another. Integration
means exchange rate quotes in different centers must be the same. It is guaranteed by
arbitrage, which is defined as making a riskless profit on a financial trade.
 Vehicle currency: A vehicle currency is one that is widely used to denominate
international contracts made by parties who do not reside in the country that issues the
vehicle currency. Most foreign exchange transactions are between banks and take place
in $, even if want to change Swedish kroner for Polish zloty, not dollars. Easier to
change kroner first to $ and then $ to zlotys. Since US is so important inworld economy,
there are many people willing to trade dollars for kroner and zloty for dollars, to take the
opposite sides of your trade, rather than the opposite side of a direct kroner for zloty
trade. Euro and Yen are also used as vehicles, but less so at current time.

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6 Cont’d…
Participants of the Foreign Exchange Market
 The major participants in the foreign exchange market are commercial
banks, corporations that engage in international trade, nonbank financial
institutions such as asset-management firms and insurance companies, and
central banks. Individuals may also participate in the foreign exchange
market, for example, the tourist who buys foreign currency at a hotel's front
desk but such cash transactions are an insignificant fraction of total foreign
exchange trading.
 Commercial banks: are at the center of the foreign exchange market
because almost every sizable international transaction involves the debiting
and crediting of accounts at commercial banks in various financial centers.
Thus, the vast majority of foreign exchange transactions involve the
06/15/2025 exchange of bank deposits denominated in different currencies.
7 Cont’d…
 Corporations: Corporations with operations in several countries
frequently make or receive payments in currencies other than that of the
country in which they are headquartered.
 Nonbank financial institutions: Over the years, deregulation of
financial markets in the United States, Japan, and other countries has
encouraged nonbank financial institutions to offer their customers a
broader range of services, many of them indistinguishable from those
offered by banks. Among these have been services involving foreign
exchange transactions. Institutional investors, such as pension funds,
often trade foreign currencies.
 Central banks: Governments sometimes intervene in the foreign
exchange market to increase or decrease the supply of their currency or
purposefully affect the exchange rate in the market. Some countries
intervene to hold the value of the currency fixed at a desirable level (fixed
exchange rate).
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8 Cont’d…
Functions of the Foreign Exchange Market
 The foreign exchange market is the mechanism by which a person / firm
transfers purchasing power from one country to another, obtains or provides
credit for international trade transactions, and minimizes exposure to
foreign exchange risk.
 Transfer of Purchasing Power: Transfer of purchasing power is necessary
because international transactions normally involve parties in countries
with different national currencies. Each party usually wants to deal in its
own currency, but the transaction can be invoiced in only one currency.
 Provision of Credit: Because the movement of goods between countries
takes time, inventory in transit must be financed.
 Minimizing Foreign Exchange Risk: The foreign exchange market
provides "hedging" facilities for transferring foreign exchange risk to
someone else.
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9 Cont’d…
The Demand for and the Supply of Foreign Exchange
 The value of a nation’s money, like most goods and services,
can be analyzed by looking at its supply and demand.
 For example an increase in the demand for the dollar will raise
its price (cause an appreciation in its value), while an increase in
its supply will lower its price (cause a depreciation). These are
only tendencies, however, and depend on other factors
remaining constant.

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10 Cont’d…
Demand for foreign exchange
 Figure 1.1 Below shows the demand for US $ in Ethiopia The exchange
rate is measured on the vertical axis and quantity of the foreign currency
(US$) is measured on the X-axis. The exchange rate R is a measure of the
price of the foreign currency (US$) in terms of domestic currency
(Ethiopia Birr). An increase in R implies a decline in the value of Birr and
an increase in the value of US$.
 In other words, a movement up on the vertical axis represents an increase
in the price of foreign currency (which is equivalent to a fall in the price
of Birr). For Ethiopians, American goods are less expensive when the
Dollar is cheaper and the Birr is stronger. Hence, at the depreciated values
for the dollar, Ethiopians will switch from home-made or third-party
supplies of goods and service to American suppliers.

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11 Cont’d…

 Before they can purchase goods made in USA, however, they must first
exchange Birr for US$. Consequently, the increased demand for US goods
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is simultaneously an increase in the quantity of US $ demanded.
12 Cont’d…
Supply curve for foreign exchange
 The supply curve of foreign currency slopes up because foreign firms and
consumers are willing to buy a greater quantity of domestic goods as the
domestic currency becomes cheaper.
 The supply of US$ will increase if US and/or foreign citizens are willing
to buy a greater quantity of Ethiopia’s goods as the Ethiopian currency
becomes cheaper (i.e. as the foreigners receive more birr per USD).
 Before the foreign citizens can buy Ethiopia goods, however, they must
first convert Dollar into Birr, so the increase in quantity of Ethiopian
good demanded is simultaneously an increase in the quantity of foreign
currency supplied to the Ethiopian Economy.

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13 Cont’d…

Figure 1.2 Supply curve for foreign exchange

The market for foreign exchange

 Figure 1.3 shows (combines) the supply and demand curves of foreign
currency. The intersection of the curves in the Ethio-US foreign exchange
market determines the exchange rate R1 at which the quantity of demand
06/15/2025 and supply of foreign currency to the Ethiopian Economy are equal.,
14 Cont’d…

Figure 1.3 Market for foreign exchange

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15 The Foreign Exchange Rate
Definition of Foreign Exchange Rate
 The exchange rate, also known as the foreign exchange rate or FX
rate, is the value of one country’s currency expressed in terms of
another currency.
 An exchange rate is the price at which one currency can be
exchanged for another. It reflects how much of one currency (like the
US dollar) is needed to buy a unit of another currency (like the
Ethiopian birr).
 Exchange rates fluctuate based on supply and demand in foreign
exchange markets and are influenced by factors such as interest rates,
inflation, and economic stability
 Exchange rates play a critical role in global trade and finance,
impacting the price of goods, services, and financial instruments
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internationally.
16 Cont’d…
Methods of Expressing Exchange Rates
There are two main ways of expressing exchange rates:
 Direct quotation (domestic currency quotation) the domestic currency
units per unit of foreign currency, the exchange rate is expressed in terms
of the amount of domestic currency required to buy one unit of foreign
currency.
 For example, if you are in Ethiopia and the exchange rate between the
Ethiopian Birr (BIRR) and the (USD) is quoted as 120, it means that 1
USD costs 120 Ethiopians birr.
 In a direct quote, the foreign currency is always set to 1 unit, while the
domestic currency is variable

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17 Cont’d…
 Indirect quotation (foreign currency quotation) foreign
currency units per unit of domestic currency, the exchange rate
is expressed in terms of the amount of foreign currency needed
to buy one unit of the domestic currency.
 For example, if the indirect quote for the BIRR/USD is 0.0083,
it means that 0.0083 USD are required to buy 1 BIRR.
 Here, the domestic currency is set to 1 unit, while the foreign
currency is variable.
 The method of quoting exchange rates can impact the way
investors and traders view currency values, as well as the cost
of international trade. By knowing the difference, businesses,
investors, and travelers can interpret exchange rates accurately
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for their specific needs.
18 Cont’d…
Spot and Forward Exchange Rates
 Spot and Forward Exchange Rates are two primary methods
used in foreign exchange (Forex) markets to determine currency
exchange prices. They serve different purposes in international
trade, investments, and hedging against currency risk.
Spot Exchange Rate
 The Spot Exchange Rate is the current exchange rate at which
one currency can be immediately exchanged for another.
Transactions at the spot rate settle "on the spot" or, more formally,
within two business days.
 In practice, there is normally a two-day lag between a spot
purchase or sale, and the actual exchange of currencies to allow for
verification, paperwork and clearing of payments.
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19 Cont’d…
Characteristics
 Immediate Settlement: A spot rate transaction requires the
settlement of funds almost immediately. This typically means
within two business days, but certain currencies may have
different settlement periods.
 Market-Determined: The spot rate is determined by supply and
demand for the currencies in the Forex market. It changes
continuously throughout the day as new information and events
affect the market.
 Liquidity and Volatility: Spot markets tend to be more liquid and
volatile than forward markets because they respond to immediate
market conditions. Changes in interest rates, inflation, political
stability, and economic data can quickly influence the spot rate.
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20 Cont’d…
Uses
 International Trade: Companies and individuals use spot
rates for immediate currency conversion, often for purchasing
goods and services across borders.
 Travel: Travelers converting currency for immediate use often
exchange at the spot rate.
 Short-Term Investments: Traders and investors in the Forex
market may engage in spot transactions for short-term currency
speculation.
 Example: If the USD/Birr spot rate is 120, it means 1 USD can be
exchanged for 120 Birr in the spot market. If a U.S. company needs to
pay a Ethiopian supplier 10,000 Birr immediately, they can buy 10,000
Birr in the spot market at this rate.
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21 Cont’d…
Forward Exchange Rate
 The Forward Exchange Rate is an agreed-upon exchange rate for a
currency pair that will be settled at a future date, typically between 30
days and a year in the future. This rate is based on the spot rate adjusted
for differences in interest rates between the two currencies.
Characteristics
 Future Settlement: Forward contracts set an exchange rate today but
allow for the actual currency exchange at a specified future date,
protecting both parties from currency fluctuations.
 Interest Rate Differential: Forward rates incorporate the difference in
interest rates between two currencies (known as the forward premium or
discount). If the currency in question has a higher interest rate than the
base currency, the forward rate will typically be at a discount relative to
the spot rate, and vice versa.
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22 Cont’d…
 Customizable Contracts: Forward contracts are customizable
in terms of amount, duration, and settlement date, making them
flexible for corporate and institutional hedging.
Uses
 Hedging Against Exchange Rate Risk: Businesses use forward
contracts to hedge against unfavorable exchange rate movements in the
future, especially for planned imports, exports, or investments.
 Speculation: Traders can use forward contracts to speculate on the
direction of currency movements, though this can be riskier than spot
trading due to longer settlement periods.
 Long-Term Contracts and Loans: For long-term cross-border contracts
or loans, forward contracts help parties lock in a rate and minimize
exposure to currency risks.
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23 Cont’d…
 Example: If a company in the U.S. is scheduled to pay a
European supplier 10,000 EUR in six months, they may enter
into a forward contract to buy EUR at the forward rate. Suppose
the forward rate is 1.25 USD/EUR. This means the company
will need to pay $12,500 (10,000 EUR × 1.25) in six months,
regardless of what the spot rate is at that future date.

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24 Cont’d…
Differences Between Spot and Forward Rates
Aspect Spot Exchange Rate Forward Exchange Rate

Timing Immediate settlement (usually within two Future settlement

days) (customizable)
Pricing Basis Determined by current market supply and Based on spot rate plus
demand interest rate differential
Purpose Immediate needs like trade and travel Hedging, long-term
transactions, speculation
Volatility Higher, due to immediate changes Lower, due to hedging
against future uncertainty
Flexibility Less flexible, standardized in terms of More flexible, as it can be
amount and date customized to suit specific
needs
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25 Cont’d…
Key Considerations in Using Spot and Forward Rates
 Interest Rate Parity (IRP): Forward rates are influenced by the IRP theory,
which states that the difference in interest rates between two countries should
equal the difference between the spot and forward exchange rates.
 Currency Risk Management: Businesses and investors choose between spot
and forward contracts based on their tolerance for currency risk. While spot
transactions carry immediate risk exposure, forward contracts offer more
predictability.
 Speculation and Arbitrage: Forex traders often use both spot and forward
rates for arbitrage opportunities. For instance, they may buy at a low rate in
one market and sell at a higher rate in another, taking advantage of rate
differences.
 Exchange Rate Forecasting: The choice between spot and forward rates
requires understanding trends and economic indicators that could affect
currency values, such as GDP growth, political stability, and inflation.
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26 Cont’d…
 Spot and forward exchange rates are critical tools in the Forex
market, serving different purposes for various market
participants.
 Spot rates allow for quick conversions based on current rates,
while forward rates provide the stability needed for long-term
planning and risk management. Understanding the mechanics
of both rates helps individuals and organizations effectively
manage foreign exchange needs and protect against currency
risk.

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27 Cont’d…
Nominal, Real and Effective Exchange Rates
 The nominal exchange rate, real exchange rate, and effective
exchange rate are all ways of measuring the value of one currency
relative to others, but they differ in terms of the factors they account for
and the scope of their application.
Nominal Exchange Rate
 The nominal exchange rate is the rate at which one currency can be
exchanged for another in the foreign exchange (FX) market.
 It reflects the relative value of one currency in terms of another without
taking into account any differences in inflation rates or price levels
between the two countries.
 It is the direct quotation between two currencies (e.g., Birr/USD,
USD/EUR, GBP/JPY), and it’s typically expressed as the amount of
foreign currency you can get for one unit of your home currency.
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28 Cont’d…
 Example: If the exchange rate between the Ethiopian birr and
the U.S. dollar (USD) is 1 birr = 0.0083 USD, this is a nominal
exchange rate. It tells you how much of the foreign currency
you can get for one unit of your domestic currency.
Real Exchange Rate
 The real exchange rate adjusts the nominal exchange rate for
differences in price levels or inflation between two countries. It
reflects the relative purchasing power of two currencies. A
higher real exchange rate means that a country's goods and
services are more expensive relative to another country.

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29 Cont’d…
 The real exchange rate shows how much of a foreign country's
goods and services can be bought with the same amount of
domestic currency, taking into account the cost of living and
inflation. It gives a more accurate picture of a currency's
purchasing power relative to another.
 Example: If the nominal exchange rate is 1 Birr = 0.0083
USD, and the price levels (inflation rates) in the Ethiopia and
the US are different, the real exchange rate would reflect this
difference in purchasing power. If Ethiopian inflation is higher
than in the US, Ethiopian goods and services would become
relatively more expensive, meaning the real exchange rate
would adjust accordingly.

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30 Cont’d…
Effective Exchange Rate (EER)
 The effective exchange rate is a weighted average of a country's
currency relative to a basket of foreign currencies.
 It provides an indication of the value of a currency against its trading
partners as a whole, rather than just against one specific currency.
The weights are typically based on the volume of trade or economic
importance of each country.
Types of Effective Exchange Rates:
 Nominal Effective Exchange Rate (NEER): This is the weighted
average of nominal exchange rates of a country's currency against a
basket of foreign currencies.

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31 Cont’d…
 Real Effective Exchange Rate (REER): This is the weighted
average of real exchange rates against a basket of foreign
currencies. It adjusts the NEER for differences in inflation across
countries.
 The effective exchange rate gives a broader perspective on a
country's currency strength, showing how it fares in terms of trade-
weighted averages with several other countries. This is important
for understanding the overall international competitiveness of a
country's economy.
 Example: If a country has strong trade relations with the U.S., the
Eurozone, and Japan, its effective exchange rate will consider the
nominal exchange rates with each of these countries and the trade
volume with them, providing an overall view of how its currency is
performing relative to the world market.
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32 Cont’d…
Difference
 Nominal Exchange Rate: Measures the direct value of one
currency against another without adjusting for inflation.
 Real Exchange Rate: Adjusts the nominal exchange rate for
inflation differences between two countries to reflect relative
purchasing power.
 Effective Exchange Rate: A broad measure that reflects the
value of a currency relative to a basket of other currencies,
weighted by trade importance.

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33 Cont’d…
The Determinants of Exchange Rates
 Exchange rates the value of one currency relative to another are
determined by a complex set of factors. These factors can be
broadly categorized into market-based determinants and
government or policy-based determinants.
 Interest Rates: Higher interest rates in a country typically
attract foreign capital inflows because investors seek the highest
return on their investments. As a result, demand for the
domestic currency increases, leading to an appreciation of that
currency. Conversely, lower interest rates can make the
currency less attractive, leading to depreciation.
 Central banks control interest rates through monetary policy,
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making this a key tool in influencing exchange rates.
34 Cont’d…
 Inflation Rates: Countries with lower inflation rates than their trading
partners generally see their currency appreciate over time. This is because
lower inflation leads to an increase in a country’s purchasing power,
making its goods and services more attractive on the international market.
 High inflation erodes the value of a currency as it reduces purchasing
power both domestically and internationally, leading to depreciation.
 Economic Performance and Growth: A strong, growing economy tends
to attract foreign investment, which increases demand for the country’s
currency. This can lead to an appreciation of the currency.
 Conversely, economic stagnation or recession may lead to currency
depreciation, as investors pull their investments from the country in
search of better returns elsewhere.

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35 Cont’d…
 Political Stability and Economic Policies: Countries with political stability
and sound economic policies are seen as less risky, which attracts investment
and increases demand for their currency. Political uncertainty (e.g., elections,
political crises) or poor economic management can lead to currency
depreciation as investors move their assets to more stable environments.
 Policy choices, such as fiscal policy (government spending and taxation) and
monetary policy (control of the money supply and interest rates), also
influence exchange rates.
 Government Debt and Fiscal Deficits: A high level of government debt can
lead to inflation or a risk of default, which may decrease confidence in a
country’s currency. Countries with large fiscal deficits may need to print
more money to finance debt, which could lead to currency depreciation.
 On the other hand, countries with manageable levels of debt and fiscal
discipline are more likely to experience currency appreciation due to
increased investor confidence.
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36 Cont’d…
 Current Account Balances (Trade Balance): country with a trade
surplus (exports greater than imports) typically experiences an
appreciation of its currency because foreign buyers need to purchase the
domestic currency to pay for the country’s exports.
 A trade deficit (imports greater than exports) puts downward pressure on
the currency, as the country needs to buy foreign currencies to pay for the
goods and services it imports.
Speculation and Market Sentiment: Expectations about future exchange
rates play a major role in short-term fluctuations. If investors believe a
currency will appreciate in the future, they will buy more of that currency
today, which increases its value.
 Speculative trading can cause significant volatility, especially in foreign
exchange (forex) markets. Traders, institutions, and governments often
base their actions on the perceived future direction of an economy,
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geopolitical developments, and other indicators.
37 Cont’d…
 Capital Flows: Foreign direct investment (FDI) and portfolio
investment are important drivers of capital flows. Countries that attract
substantial FDI or have favorable investment climates typically see
increased demand for their currency, leading to an appreciation.
 Similarly, if a country’s stock market or bond market is seen as attractive,
foreign investors will buy assets denominated in the local currency, raising
demand for that currency.
 Relative Strength of Other Currencies: The exchange rate of a currency
is also influenced by the strength or weakness of other currencies. For
example, the value of the U.S. dollar often moves in opposition to other
major currencies like the euro, yen, or pound, due to global trade
relationships and investor behavior.
 Changes in the strength of major currencies can lead to shifts in exchange
rates between the U.S. dollar and other currencies.
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38 Cont’d…
 Central Bank Interventions: Governments and central banks can directly
intervene in the foreign exchange market to influence the value of their
currency. For instance, a central bank might engage in foreign exchange
operations, such as buying or selling its own currency to either prop up its
value (in times of depreciation) or prevent excessive appreciation.
 Central banks can also use quantitative easing or monetary tightening to
influence the supply of money and indirectly affect exchange rates.
 Global Events and Crises: Major geopolitical events (e.g., wars,
elections, trade agreements) or global crises (e.g., the COVID-19
pandemic, financial crises) can have profound impacts on exchange rates
by altering investor confidence, disrupting trade, or shifting capital flows.
 For example, a war might lead to capital flight from the affected country,
depreciating its currency, while a financial crisis might lead to a flight to
safe-haven currencies like the U.S. dollar or Swiss franc.
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39 Cont’d…
 These determinants work together to influence the supply and
demand for a currency, which, in turn, determines the exchange
rate in the foreign exchange market. Understanding these
factors is crucial for forecasting currency movements and
assessing economic health.

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40 Cont’d…
Exchange rate regime
 An exchange rate regime refers to the system a country adopts
to determine the value of its currency in relation to other
currencies.
 It encompasses the rules, policies, and mechanisms by which a
country's exchange rate is managed, whether it's determined by
market forces or influenced or controlled by government
intervention.
 Exchange rate regimes vary based on how much flexibility is
allowed in the exchange rate and the extent to which the central
bank or government intervenes in currency markets. The main
types of exchange rate regimes are Fixed Exchange Rate (Pegged
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Exchange Rate), Floating Exchange Rate and Managed Float (Dirty Float).
41 Cont’d…
1. Fixed Exchange Rate (Pegged Exchange Rate)
 A fixed exchange rate regime, also known as a pegged
exchange rate, occurs when a country's currency is tied or
"pegged" to another major currency, like the U.S. dollar or the
euro, or a basket of currencies. The central bank or government
must maintain the currency's value within a narrow band
relative to the target currency or basket.
 The central bank intervenes in the foreign exchange market by
buying or selling the domestic currency to keep its value within
the established range.

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42 Cont’d…
Advantage
 Stability and predictability in trade and investment.
 Low inflation if pegged to a strong currency
 Easier for businesses to plan long-term due to exchange rate stability.
Disadvantage
 Requires large reserves of foreign currency to maintain the peg.
 Limits monetary policy independence since the central bank must align
domestic interest rates with the currency peg.
 Vulnerability to speculative attacks if investors believe the peg is
unsustainable.
 Example: Hong Kong Dollar and Saudi Riyal

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43 Cont’d…
Floating Exchange Rate
 Under a floating exchange rate regime, the value of a currency
is determined by market forces of supply and demand in the
foreign exchange market. There is no central bank intervention
to maintain a specific value for the currency, though the central
bank may intervene occasionally to stabilize excessive
fluctuations.
 Currency values fluctuate based on changes in demand for
goods, services, capital, and investor sentiment. Exchange rates
are allowed to "float" freely and are influenced by economic
indicators such as inflation, interest rates, economic growth, and
political stability.
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44 Cont’d…
Advantage
 Allows for automatic adjustment to economic shocks (e.g., changes in trade
balance).
 Central banks can focus on other policy goals, like controlling inflation or
promoting economic growth.
 Less vulnerability to speculative attacks than fixed regimes
Disadvantage
 Can lead to high volatility, making international trade and investment more
uncertain.
 Can harm exporters if the currency fluctuates too wildly.
 May result in significant depreciation during periods of economic stress, reducing
investor confidence.
 Example: U.S. Dollar (USD), Euro (EUR), Japanese Yen (JPY), British Pound
(GBP) and recently amended Ethiopian macroeconomic policy(birr) are examples
of major currencies with floating exchange rates.
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45 Cont’d…
Managed Float (Dirty Float)
 The managed float, also known as a dirty float, is a hybrid
system where a currency primarily floats in the open market but
the central bank may intervene occasionally to stabilize or
influence the currency value.
 The value of the currency is determined by supply and demand,
but central banks or governments may enter the market to
smooth out excessive fluctuations or to prevent the currency
from appreciating or depreciating too quickly.

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46 Cont’d…
Advantage
 Allows for market forces to determine the exchange rate, but offers
flexibility for the central bank to prevent undesirable movements.
 Provides a degree of stability without the complete rigidity of a
fixed exchange rate.
Disadvantage
 Can lead to uncertainty about the future direction of the currency.
 If interventions are frequent, they might undermine confidence in
the currency or lead to speculation against it.
 Example: The Indian Rupee (INR) is managed through a
system of market-determined exchange rates, but the Reserve
Bank of India occasionally intervenes to curb extreme
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volatility.
47 Cont’d…
 Exchange rate regimes reflect a country's approach to
managing its currency value and balancing economic goals
such as inflation control, growth, and international
competitiveness.
 The choice of exchange rate regime involves trade-offs
between stability, flexibility, and policy independence. Some
countries prefer the predictability of a fixed exchange rate,
while others opt for the flexibility of a floating system.
 The ultimate goal is to maintain a stable and healthy economy,
but the best system depends on the specific economic
circumstances of the country.

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48 Cont’d…
The Interaction of Hedgers, Arbitrageurs, and Speculators
 The interaction of hedgers, arbitrageurs, and speculators in financial
markets particularly in the foreign exchange (forex) markets plays a
crucial role in shaping market behavior, price discovery, and liquidity.
 These three types of market participants engage in different strategies,
but their actions are interconnected.
Hedgers
 Hedgers are market participants who use financial instruments or
market strategies to reduce or eliminate the risk of adverse price
movements in assets they are holding or plan to acquire.
 They are typically businesses, investors, or institutions with exposure
to potential price fluctuations, and they use hedging to stabilize their
financial position.
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49 Cont’d…
Characteristics
 Risk Mitigation: Hedgers seek to lock in prices for future transactions to
avoid the uncertainty of market fluctuations. They are not seeking profit from
price movements; rather, they are attempting to minimize potential losses.
 Instruments Used: Hedging is often done through derivatives such as forward
contracts, futures contracts, options, and swaps. In the context of the foreign
exchange market, companies might hedge currency risk using these
instruments.
Arbitrageurs
 Arbitrageurs are participants who seek to exploit price discrepancies between
different markets or related financial instruments to make a risk-free profit.
Arbitrage opportunities arise when the price of an asset differs in two or more
markets or exchanges, and the arbitrageur buys the asset in the cheaper market
while simultaneously selling it in the more expensive market.

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50 Cont’d…
Characteristics:
 Risk-Free Profit: The primary goal of arbitrageurs is to
engage in risk-free profit-making. Arbitrage opportunities
often exist because of inefficiencies in the market or delays in
price adjustments between markets.
 Market Efficiency: Arbitrageurs contribute to market
efficiency by quickly exploiting pricing inconsistencies, which
helps align prices across different markets. Their actions help
correct mispricing and bring prices into equilibrium.

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51 Cont’d…
Speculators
 Speculators are participants who take on risk in order to profit from
anticipated price movements in the market. Unlike hedgers, speculators do
not have an underlying exposure to a business or financial asset. Instead,
they aim to profit from the fluctuations in asset prices by buying or selling
based on their expectations of future price movements.
Characteristics:
 Risk-Taking: Speculators take on risk in the hope of making a profit.
They engage in speculative trading, betting on the direction of asset
prices (e.g., currencies, stocks, commodities) based on analysis, trends, or
market sentiment.
 Profit from Price Movements: Speculators profit from price volatility,
by correctly predicting the direction of price changes and entering or
exiting positions at the right time.
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52 Cont’d…
 Instruments Used: Speculators often use leveraged
instruments like futures contracts, options, and margin trading
to amplify potential returns (and risks). They might trade in
both spot markets and derivatives markets
 Although these three participants in the market have different
objectives and strategies, they interact with each other in
several important ways:
A. Hedgers and Speculators:
 Complementary Roles: Hedgers and speculators often
complement each other. Hedgers provide business and real-
world risk management, while speculators are willing to
assume the risks that hedgers seek to avoid.
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53 Cont’d…
 Market Liquidity: Speculators help provide liquidity to markets by
taking the opposite side of hedgers’ transactions. For example, if a
company hedges its future currency risk by selling a currency forward,
speculators are often the buyers, taking on the risk of future price
movements in exchange for the potential to profit.
 Risk Transfer: Hedgers transfer risk to speculators who are willing to
take on that risk in exchange for the potential reward of a price
movement.
B. Arbitrageurs and Speculators
 Profit from Market Inefficiencies: Arbitrageurs and speculators both
benefit from price movements, but their strategies are different.
Arbitrageurs focus on short-term price discrepancies, while speculators
look for trends or anticipate future price changes. Arbitrageurs may, in
fact, sometimes limit the opportunities for speculators by quickly
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correcting pricing inefficiencies.
54 Cont’d…
 Speculation Drives Arbitrage: Speculators’ actions—especially in large,
liquid markets like forex—can create arbitrage opportunities. For
example, speculators might push the price of a currency pair in one
market, creating a temporary price discrepancy that arbitrageurs can
exploit.
C. Hedgers and Arbitrageurs:
 Pricing and Risk Management: Hedgers and arbitrageurs can interact in
markets like currency futures or options. While hedgers use these
instruments to lock in future prices, arbitrageurs might take advantage of
price differences between related futures and the underlying spot markets
 Market Efficiency and Hedging: Arbitrageurs help ensure fair pricing
of hedging instruments. If a discrepancy arises between the spot and
futures prices, arbitrageurs can step in to correct the price misalignment,
which in turn makes hedging more accurate and reliable.
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55 Cont’d…
Summary
 Hedgers protect themselves against future price fluctuations and are
motivated by risk aversion, using hedging strategies to lock in prices and
reduce volatility.
 Arbitrageurs capitalize on price discrepancies between markets or
instruments, seeking risk-free profits by exploiting inefficiencies, thereby
contributing to market efficiency.
 Speculators take on risk in the hopes of profiting from price movements,
often using leverage to maximize their potential returns, and providing
liquidity to the market.
 These participants' actions are interconnected—hedgers rely on speculators
for risk transfer, arbitrageurs contribute to price alignment and efficiency,
and speculators bring liquidity and help drive price discovery. The
interaction between them helps markets function smoothly, making them
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more efficient, liquid, and responsive to new information.
56 Cont’d…
Appreciation / Revaluation and Depreciation / Devaluation of Currencies
 The terms appreciation, revaluation, depreciation, and devaluation refer
to the changes in the value of a currency relative to other currencies, and they
reflect the underlying economic conditions, policies, and market dynamics.
 These concepts are crucial in the context of foreign exchange (forex) markets
and exchange rate regimes.
Appreciation of a Currency
 Appreciation refers to an increase in the value of a currency relative to
another currency in the foreign exchange market, typically as a result of
market forces (in a floating exchange rate system).
 When a currency appreciates, it means that it takes fewer units of the domestic
currency to purchase a foreign currency.
 Appreciation can happen due to changes in demand or supply dynamics in the
forex market.
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57 Cont’d…
Features of Appreciation:
 Market Driven: In a floating exchange rate system, currency
appreciation is primarily driven by the forces of supply and demand
in the market. For example, if a country’s economic performance
improves or if it attracts more foreign investment, demand for its
currency may rise, leading to appreciation.
 Impact on Trade Balance: An appreciation of a country’s currency
makes its goods and services more expensive for foreign buyers
(leading to a potential reduction in exports) and cheaper for domestic
consumers to buy imported goods (leading to an increase in imports).
This can lead to a deterioration in the trade balance.
 Example: If the exchange rate of the Ethiopian birr rises from 120
Birr/USD to 1 USD/Birr, this means the Birr has appreciated relative to
the USD, as it now takes fewer birr to buy the same amount of USD.
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58 Cont’d…
Causes of Appreciation:
 Interest Rates: Higher interest rates attract foreign capital,
increasing demand for the domestic currency.
 Economic Growth: A strong economy attracts investment,
boosting demand for the domestic currency.
 Speculation: If investors believe that a currency will increase in
value, they may buy it, driving up demand and causing
appreciation.
 Trade Surplus: If a country exports more than it imports,
foreign buyers must purchase the domestic currency to pay for
goods, increasing its value.

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59 Cont’d…
Revaluation of a Currency
 Revaluation refers to the deliberate increase in the value of a currency
that is set under a fixed exchange rate system or pegged exchange rate
system. Unlike appreciation, which occurs through market forces, revaluation
is a decision made by a country's central bank or government to increase the
currency’s value relative to another currency or a basket of currencies.
Features of Revaluation:
 Government Action: Revaluation occurs when a country's central bank or
monetary authority adjusts the fixed value of its currency upwards, often in
response to economic conditions such as a trade surplus or increased foreign
exchange reserves.
 Fixed or Pegged Systems: Revaluation is only possible in countries that have
a fixed exchange rate or pegged exchange rate regime, where the
currency's value is directly linked to a benchmark, such as another currency
(e.g., the U.S. dollar or euro).
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60 Cont’d…
 Example: If a country has pegged its currency to the U.S. dollar at a rate
of 10 units of its currency per USD, and the central bank decides to change
the peg to 9 units per USD, this is a revaluation of the currency.
Causes of Revaluation:
 Improved Economic Fundamentals: If a country’s economy improves
(e.g., through higher exports or increased foreign investment), the
government may choose to revalue the currency to reflect the country's
improved economic position.
 External Pressures: In some cases, a country might be forced to revalue
its currency to maintain balance in international trade or to prevent
excessive inflation.

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61 Cont’d…
Depreciation of a Currency
 Depreciation refers to a decrease in the value of a currency relative to
another currency in the foreign exchange market, typically due to market
forces in a floating exchange rate system. Depreciation means that a
currency is losing value and now takes more of the domestic currency to
purchase the same amount of a foreign currency.
Features of Depreciation:
 Market Driven: Depreciation happens when the supply of a currency
exceeds its demand in the market. Factors that can lead to depreciation
include weaker economic performance, lower interest rates, or reduced
investor confidence.
 Impact on Trade Balance: A depreciated currency makes a country's goods
and services cheaper for foreign buyers, potentially boosting exports.
However, it makes imports more expensive for domestic consumers, which
06/15/2025 could lead to a trade deficit if imports increase significantly.
62 Cont’d…
 Example: If the exchange rate of the Ethiopian birr (ETB) moves
from 120 Birr/USD to 130 Birr/USD, the Birr has depreciated relative
to the dollar, meaning it now takes more Birr to buy the same amount
of dollars.
Causes of Depreciation:
 Declining Interest Rates: Lower interest rates can make a currency
less attractive to investors, reducing demand and leading to
depreciation.
 Weak Economic Performance: A country with weak economic
growth, high inflation, or a large fiscal deficit may experience
depreciation as foreign investors withdraw their capital.
 Trade Deficit: If a country imports more than it exports, there is
increased demand for foreign currencies, putting downward pressure
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on the domestic currency.
63 Cont’d…
Devaluation of a Currency
 Devaluation refers to the deliberate decrease in the value of a currency
under a fixed exchange rate system or pegged exchange rate system.
Devaluation is the opposite of revaluation and occurs when a country's
central bank or government intentionally lowers the value of its currency
relative to other currencies or a basket of currencies.
Features of Devaluation:
 Government Action: Devaluation occurs when the country’s government
or central bank adjusts the value of its currency downward. This is often
done to address trade imbalances, stimulate exports, or correct an
overvalued currency.
 Fixed or Pegged Systems: Like revaluation, devaluation only applies to
countries with a fixed or pegged exchange rate system. It cannot occur in
a floating exchange rate system since the market determines the value of
06/15/2025 the currency in such a system.
64 Cont’d…
 Example: If a country has pegged its currency to the U.S. dollar at a rate
of 1 unit of its currency per USD, and the central bank changes the peg to
1.2 units per USD, the currency has been devalued.
Causes of Devaluation:
 Trade Imbalance: A country facing persistent trade deficits (importing
more than it exports) may choose to devalue its currency to make its
exports cheaper and imports more expensive.
 Debt and Inflation: Countries with high levels of external debt or
inflation may devalue their currency as a way to reduce the real value of
their debt and stimulate economic growth by making exports more
competitive.
 Confidence Loss: Devaluation can be a response to a loss of confidence
in the currency, particularly if the currency has been overvalued or if
foreign exchange reserves are insufficient to maintain the peg.
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65 Cont’d…
Differences Between Appreciation/Depreciation and Revaluation/Devaluation
Aspect Appreciation/Depreciation Revaluation/Devaluation
Nature Caused by market forces in a floating Caused by government action in a
exchange rate system fixed or pegged exchange rate system

Direction Appreciation is an increase in value; Revaluation is a deliberate increase in

Depreciation is a decrease value;
Devaluation is a deliberate decrease

Market Impact Driven by supply and demand in forex Caused by central bank or government
markets decisions

Example if the dollar appreciates against the euro A country pegging its currency to the
due to increased demand for USD dollar might revalue the currency from
10 to 9 units per USD

Currency Floating exchange rate system (market- Fixed or pegged exchange rate system
Regime driven) (policy-driven)
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66 Cont’d…
Summary
 Appreciation and depreciation refer to the rise or fall in the
value of a currency due to market forces (supply and demand)
in a floating exchange rate system.
 Revaluation and devaluation refer to the deliberate increase
or decrease in the value of a currency by a central bank or
government in a fixed or pegged exchange rate system.
 Appreciation and revaluation both increase the value of a
currency, while depreciation and devaluation both decrease the
value of a currency, but revaluation and devaluation are
controlled by government policy, whereas appreciation and
depreciation are determined by market conditions.
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