Chapter 2: Exchange rate and
foreign exchange market: an asset-
market based approach
Objective
This chapter reviews the concepts of the
exchange rate and foreign exchange market.
This chapter discusses the determination of
the exchange rate in the asset market
Contents
The concepts of the exchange rate
The foreign exchange market and foreign
exchange transactions
The demand for assets
The asset-based determination of the
exchange rate
1. The exchange rate and international transactions
What is the exchange rate?
Exchange rate is the price of one currencies
in terms of another currency
Ex. 1: E(VND/USD): 1 USD = 24000 VND
Ex. 2: E(USD/EUR): 1 EUR = 1.1788 USD
1. The exchange rate and international transactions
The exchange rate quotation
Direct quotation shows the value of the
foreign currency in terms of the domestic
currency
Ex. 1 USD = 24000 VND
Indirect quotation shows the value of
domestic currency in terms of foreign
currencies
Ex. 1 VND = 0.000041667 USD
1. The exchange rate and international transactions
Measuring changes in the exchange rate
The movement in the exchange rate is often
expressed in terms of the percentage change
from a benchmark value
Appreciation/revaluation: means an increase
in the value of a currency in terms of another
currency
Depreciation/devaluation refers to a fall in
the value of a currency in terms of another
currency
1. The exchange rate and international transactions
The exchange rate and international transactions I
Exchange rates make it possible to compare the price
of goods and services produced in different countries.
The price of a goods produced in one country can be
translated into the price of the same good in terms of
another country’s currency using the exchange rate
Example: a smartphone has a price: 24 millions VND in
Vietnam.
Thedollar price of this smartphone is 1000 dollars (given the
exchange rate is 24000 VND/USD).
1. The exchange rate and international transactions
The exchange rate and international transactions
A devaluation (or depreciation) of the domestic
currency reduces the price of domestic goods in terms
of the foreign currency
Ex. Given a 10% depreciation of VND, the dollar price of the
smartphone becomes: 24,000,000/26400 = 910 USD
• A revaluation (or appreciation) of the domestic
currency increases the price of domestic goods in terms
of the foreign currency
Ex. Given a 10% appreciation of VND, the dollar price of T-
shirt becomes: 24,000,000/21600 = 1110 USD
2. The Foreign Exchange Market
The actors
Commercial banks: bank acts as intermediaries in the market.
A vast majority of the foreign exchange transactions involve
the debiting and crediting of the accounts at commercial banks
Firms, individuals, and organizations: all firms, private and
public organizations and individuals that engage in
international transactions.
Non-bank financial institution: insurance companies or
investment funds can trade foreign currencies
Central banks: central banks often intervene in the foreign
exchange market to affect the demand for and the supply of
foreign exchange and the exchange rate.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market
Foreign exchange trading takes place in all countries, but
concentrates in three major financial centers (Tokyo, New York
and London)
The global foreign exchange market has been growing rapidly
since 1990.
The value of global foreign exchange trading increased from
$600 billions to $6600 billions a day between 1989 and 2019.
Large part of foreign trading is conducted through direct
phone, fax and internet.
The links through phone, fax and internet make each trading
center a part of the single world market that never sleeps.
2. The Foreign Exchange Market
Characteristics of the foreign exchange market
Most of foreign exchange transactions between two currencies
go through US dollars
US dollar serves as a vehicle currency and is widely used in
international trade and investment
Exchange rates quotes at different banks and location tend to
converge.
Any significant difference between the exchange rates quoted at
different locations will trigger arbitrage activities.
2. The Foreign Exchange Market
Arbitrages
The exchange rate between VND and USD is quoted
at two different banks as follows
Bank A (bid-ask rates): 22420-22460
Bank B (bid-ask rates): 22480-22510
Is there any opportunity for arbitrage to take place?
What is the impacts of the arbitrage on the exchange
rate between VND and USD?
2. The Foreign Exchange Market
Foreign exchange transactions
Spot transactions
Swap transactions
Forward transactions
Future contracs
Option contracts
2. The Foreign Exchange Market
Foreign exchange transactions II
Spot transactions:
Spot transactions are executed immediately
after the agreement is reached.
Spot exchange rate: Spot trading employs the
current exchange rate, which is called the spot
exchange rate.
Value date: In practice the spot trading is often
executed two days after the agreement is
reached.
The value date is the date that the parties
involved in the spot transaction actually
receive funds they have purchased.
2. The Foreign Exchange Market
Foreign exchange transactions III
Forward transactions:
The forward transactions involve trading of
foreign currencies at some date in the future.
Forward trading uses a forward exchange rate,
which is determined when the transactions is
agreed and can be different from the current
spot rate.
Forward discount and premium: represent the
extent to which the forward rate is lesser (or
higher) the spot rate
2. The Foreign Exchange Market
Foreign exchange transactions IV
Forward transactions:
Forwards transactions is widely used to hedge against the
foreign exchange risk brought about by the movement in the
exchange rate
Hedging the future receipt of foreign exchange: a firm that
has future receipt in a foreign currency can hedge against
the exchange risk by selling the foreign currency forward.
Hedging the future payment of foreign exchange: a firm that
has future payment denominated in a foreign currency can
hedge against the exchange risk by purchasing the foreign
currency forward.
2. The Foreign Exchange Market
Foreign exchange transactions
Swap Transactions
Currency swap: the swap transaction is a spot sale of a currency
combined with a forward repurchase of the currency.
An exporter has just received one million dollars, but will have to pay
one million dollars for imported inputs in three months. The exporter
may join a swap transaction which allow it to sell one million dollars and
repurchase it three months later.
Swaps often result in lower fees or transaction
costs because they combine two transactions, and
they allow parties to meet each others needs for a
temporary amount of time.
2. The Foreign Exchange Market
Foreign exchange transactions V
Futures contracts: Foreign exchange futures are a
forward contract for a standardized volume of a
specific currency and selected calendar date
traded in an organized market.
In the futures market, only few currencies are
traded for standardized amount and at few
selected dates.
The trade of futures takes place in an organized
market with few geographical locations.
Future contracts can be sold at any time up until
maturity, but the forward contract cannot.
2. The Foreign Exchange Market
Foreign exchange transactions V
Currency option: the option contract gives the buyer the right,
but not obligation, to sell or purchase a particular currency at a
specified exchange rate and date.
The seller of the option must fulfill the contract if the buyer so desires,
but the buyer of the option can forgo the contract if it turns out
unprofitable.
The buyer of a option pays the seller a premium (the option price),
which ranges from 1% to 5% of the contract value
Put and call options: a call option specifies the right to buy a
currency, while the put option specifies the right to sell a
currency.
European and American options: An European option must be
implemented on the specified date, but the American option can
be implemented at any time before the stated date.
The amount of the option contract is standardized for the trading
that takes place in the organized market.
3. The demand for foreign currency
Demand for assets
People can hold their wealth in various forms or assets,
such as bonds, stocks, bank deposits, gold and precious
metals, cash, real estate, ...
The demand for assets depends on the following:
The return to assets: the expected return to assets
Risks
Liquidity
3. The demand for foreign currency
Rate of return to assets I
The return to an asset measures the change in the value of
the investment in the asset between two dates.
The change in the value of an assets is brought about by
the change in
(i) Its price and
(i) The interest earned during a period of time.
3. The demand for foreign currency
Rate of return to assets II
Return to an asset: examples
Example 1: An investor bought 1000 USD in early 2008 at the exchange rate 1
USD = 16000 VND. In 2010, the exchange rate was 1 USD = 19200 VND.
What is the return to the investment in US dollars.
The rate of return = (19200 - 16000)/16000 *100 = 20%
Example 2: An investor bought 1 share of the stock issued by a commercial bank
at the price of 50000 VND per share. The investor received a dividend of 2000
VND per share at the year end, and the price of the stock also rose to 58000
VND at the year end. What is the return to the stock.
The rate of return = (60000 - 50000)/50000 *100 = 20%
3. The demand for foreign currency
Rate of return to assets III
Expected return to assets
Since people do not know the return to an asset before they
buy the asset, the demand for an asset largely depends on
the expected return to the asset.
The expected return to an asset measures the change in the
expected value of the asset using its expected prices and
interest over a given period
3. The demand for foreign currency
Rate of return to assets IV
The real return to an asset
Because the value of assets measured in terms of money, the
change to the value of money has an impact on the value of
asset.
The demand for an asset depends not only on the nominal
return to the asset, but also on its real rate of return.
The expected real rate of return to an asset is the expected
nominal rate of return minus the (expected inflation during a
given period.
3. The demand for foreign currency
Rate of return to assets V
The real return to an asset
Example 1: A saver deposits 1 million VND at a bank. The
one-year interest rate is 8%, and the expected inflation over
the next year is 6%. What is the real rate of return to the
bank deposit
Example 2: A saver deposits 1 million VND at a bank. The
one-year interest rate is 10%, and the expected inflation
over the next year is 12%. What is the real rate of return to
the bank deposit
3. The demand for foreign currency
Risk and liquidity
The risk of an asset refers to the uncertainty of its expected
return.
Given all other things equal, the more risky an asset is, the lower
the demand for it.
The liquidity of an asset refers to the speed and cost of
disposing an asset. All else equal, the more liquid an asset
is, the higher the demand for it.
3. The demand for foreign currency
Perfect Asset Substitutability
Perfect asset substitutability: assets have the same degree of
risks and liquidity.
Under the assumption of perfect asset substitutability, the
rate of return is the only factor that influences the demand
for assets.
In this chapter, we consider the case of perfect asset
substitutability, i.e. we assume that domestic and foreign
assets have the same degree of risks and liquidity.
3. The demand for foreign currency
Domestic and foreign deposits
Domestic currency deposits
The interest rate is the rate of return to the deposit at the
bank. When you deposit money, you are buying the asset
‘deposit’
The rate of return to domestic currency deposits is the interest rate
offered on the deposits.
Example: A saver deposits 10 millions VND at a
commercial bank with annual interest rate of 7%. After one
year, he will receive 700000 VND in interest. The rate of
return is 7%
3. The demand for foreign currency
Domestic and foreign deposits
The exchange rate and foreign assets
The return to the foreign currency deposit consists of not
only the interest rate, but also the expected change in the
exchange rate.
Example: Suppose the annual interest rate offered on the
dollar deposit is 2%. Vietnamese dong is expected to
depreciate by 3% against US dollar over next year. What is
the expected rate of return on the dollar deposit?
3. The demand for foreign currency
The rate of return to foreign assets
The rate of return to a foreign-currency
denominated asset is (approximately) equal to
the interest offered by the foreign asset plus
the expected depreciation of domestic
currency.
Rate of return to foreign deposit
Rate of Return= R* + (Ee – E)/E
Where R* is the interest rate offered to
foreign currency deposits, E is the
current exchange rate, Ee is the
expected exchange rate
4. Equilibrium in the foreign exchange market
Equilibrium in the foreign exchange market
The foreign exchange market is in equilibrium when bank
deposits of all currencies offer the same rate of return.
If the dollar deposit offers a higher rate of return as
compared to the dong deposit, investors will move from
dong deposit to dollar deposit, and thus creating excess
demand for dollar.
If the dollar deposit offers a lower rate of return as
compared to the dong deposit, investors will move toward
dong deposit from dollar deposit, and thus creating excess
demand for dong.
4. Equilibrium in the foreign exchange market
Interest parity condition (UIP)
The interest parity condition establish an equality
between the rates of return on domestic-currency
deposits and foreign currency deposits (uncovered
interest parity – UIP)
R = R* + (Ee – E)/E
Here R is the interest rate on domestic-currency deposits
The UIP shows the difference in interest rates equals to
the expected rate of depreciation of domestic currency.
R – R* = (Ee – E)/E
When the interest parity condition holds, the foreign
exchange market is in equilibrium
4. Equilibrium in the foreign exchange market
Adjustment to equilibrium
If the UIP condition does not hold, the exchange rate will adjust
to bring about the equilibrium in the foreign exchange market
Question 1: what would happen if the rate of return on foreign
currency deposits is higher than that of domestic currency deposits?
R < R* + (Ee – E)/E
Question 2: What would happen if the rate of return on foreign
currency deposits is lower than that of domestic currency deposits
R > R* + (Ee – E)/E
4. Equilibrium in the foreign exchange market
Graph Presentation
Expected return on Exchange FCD
foreign currency curve rate return
In the graph, the vertical
schedule indicates the
current exchange rate,
and the horizontal
schedule indicates the
rate of return on
domestic and foreign
deposits measured in
terms of domestic
currency. The return to
FC deposits is described
by a downward-sloping
curve. Expected
rate of
return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange
The equilibrium DCD
rate FCD return
return
exchange rate
The return to domestic
currency deposit if
.
indicated with a vertical B
line. The equilibrium in
the foreign exchange E A
market is reached at point 1
A where the expected .
C
return on domestic
currency deposits and
foreign currency deposits R
Expected
are equal. 1
rate of
return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange DCD
Adjustment to rate FCD return
return
equilibrium
The exchange
rate will adjust E .
B
to maintain the 2
equilibrium in E A
the foreign 1
.
exchange market E C
3
R
Expected
1
rate of
return
4. Equilibrium in the foreign exchange market
Graph Presentation
Home interest rate Exchange DCD
rate FCD return
return
and the current
exchange rate
An increase in the
.
interest rate on
domestic currency
deposit raises the E A
rate of return on DC 1
B
deposits, causing an E
appreciation of 2
domestic currency.
R R
Expected
1 2
rate of
return
4. Equilibrium in the foreign exchange market
Graph Presentation
Exchange
Foreign interest rate
DCD
return
rate and the
exchange rate B
E
A higher foreign 2 .
interest rate raises
the rate of return on
E A
foreign currency 1
deposits (R* + (Ee FCD return
– E)/E), causing a
depreciation of
domestic currency. R R
Expected
1 2
rate of
return
5. Equilibrium in the foreign exchange market
Graph Presentation
Exchange
The expected rate
DCD
return
exchange rate and
the current exchange
E B
rate 2 .
A rise in the
expected exchange
rate raises the rate of E A
1
return on foreign
FCD return
currency deposits
(R* + (Ee – E)/E),
causing the current R R
exchange rate to rise. Expected
1 2
rate of
return
