Overview

 

The purpose of this chapter is topresent the foreign exchange market and exchange rates, with an emphasis onspot exchange rates. Foreign exchange is the act of trading differentcountries' moneys. An exchange rate is the price of one money in terms ofanother. The spot exchange rate is the price for "immediate"exchange. The forward exchange rate is the price agreed to today for exchangesthat will take place in the future. An exchange rate is confusing because thereis no natural way to quote the price. The currency that is being priced orvalued by the rate is the currency that is in the denominator.

 

At the center of the foreignexchange market are a group of banks that use telecommunications and computersto conduct trades with their customers (the retail part of the market) and witheach other (the interbank part of the market). Most foreign exchange trades areconducted by exchanging ownership of demand deposits denominated in differentcurrencies.

 

We can picture the foreignexchange market by using demand and supply curves. Exports of goods andservices and capital outflows (as well as income payments to foreigners) createa demand for foreign currency, as payments for these items typically requirethat at some point in the payment process the home currency is exchanged forthe foreign currency to pay for the items that the home residents are buying.Imports of goods and services and capital inflows (as well as income receivedfrom foreign sources) create a supply of foreign currency, as payments forthese items typically require that at some point in the payment process theforeign currency is exchanged for the home currency to pay for the items thatthe foreign residents are buying.

 

The text explains the downwardslope of the demand curve for foreign currency through changes in the dollarprice of products that the home country might buy from the foreign country, asthe going spot exchange rate changes. (The text assumes that the supply curveslopes upward, without much discussion at this point. The details of how valuesof exports and imports respond to changes in the exchange rate are deferreduntil the last part of Chapter 23.)

In a floating exchange ratesystem without intervention by monetary authorities, the equilibrium is at theintersection of the demand and supply curves, where the curves show all private(or nonofficial) demand and supply. The floating exchange rate value changes asdemand and supply curves shift over time. In a fixed exchange rate system,government officials declare that the exchange rate should be a certain level,usually within a small band around a par value. We can still use demand andsupply to analyze this system. If the equilibrium rate that the market wouldset on its own (shown by the intersection of the private or nonofficial demandand supply curves) is outside of this band, then the officials must dosomething to prevent the actual rate from moving outside of the band. We focuson defense through official intervention—the officials must buy or sell foreigncurrency (in exchange for domestic currency) to keep the exchange rate valuewithin (or at the edge) of the band. This can be pictured as filling the gapbetween nonofficial supply and demand at the support-point exchange rate. (Theintervention could also be pictured as shifting the overall supply or demandcurve—each overall curve would include both nonofficial and official supply ordemand—so that the new intersection occurs at the support point.)

 

The chapter concludes byintroducing the two different kinds of arbitrage that can occur using the spotforeign exchange market. The simpler form is arbitrage of the same exchangerate between two locations. This arbitrage assures that, at a particular time,the same exchange rate is essentially the same value in different locations (atleast within a small range that reflects transactions costs). The morecomplicated form is triangular arbitrage—profiting from misalignments among twoexchange rates against a common currency (usually the dollar, which is thevehicle currency in the market) and the cross-rate between the other twocurrencies (for instance, pounds and Swiss francs). This type of arbitrageassures that the cross-rate essentially equals the ratio of the other two exchangerates.