8.1 The nature of forex markets

characterised the past thirty years. Both large multinational rms and governments

have sought to tap international capital markets to widen their access to funds

and/or to lower the costs of borrowing. To meet these demands, international banks

have grown hugely in size, new markets have opened up and expanded and again

new instruments have been developed.

The combination of increasing international interdependence and uncertainty

has given governments a greater interest than ever in movements in the interna-

tional value of their currencies and in the impact of capital mobility on the goals

of economic policy and the stability of the international nancial system. The post-

war world has lurched from a system of xed exchange rates to oating rates with

widely varying degrees of government intervention and, in the case of Europe, back

to xed exchange rates and then to a single currency across much of the European

Union (EU).

This world of foreign exchange and international capital markets is the subject of

the next three chapters. In this chapter we look at the foreign exchange market itself.

We consider both the expression of spot and forward rates of exchange and the market

relationships that strongly inuence them. In particular, we explain the ideas of

interest rate arbitrage – both covered and uncovered – and purchasing power parity.

We go on to look at the major arguments for and against xed rates of exchange and

the factors likely to play the major role in the determination of oating exchange

rates. This provides the background for us to examine the advantages and disadvant-

ages of monetary union. We conclude the chapter by considering the cases for and

against British membership of the euro single currency area.

8.1The nature of forex markets

Forex markets are deceptively simple. The product (foreign exchange) consists of

the currencies of the major developed countries. To the extent that the currencies

of developing countries are traded ofcially, markets are so heavily controlled by

governments that often the rates of exchange have little to do with genuine supply

and demand.

Prices (the exchange rates) are just the expression of one currency in terms of another.

As with all prices, exchange rates can be expressed in two ways – how much of the

home currency is required to buy a unit of foreign currency (direct quotation) or

how much foreign currency can be obtained for a unit of home currency (indirect

quotation). This is no different from the price of anything – one can equally ask how

much a dozen eggs costs or how many eggs can be bought for £1. It can be seen from

this example that the normal way of thinking of prices is to ask the price of one unit

of the object being bought (foreign currency, eggs) in terms of domestic currency.

In the currency market, this is direct quotation. The direct quotation of sterling in

terms of US dollars gives us how much sterling we need to buy $1.

In the foreign exchange market, however, this approach has one unfortunate con-

sequence. Consider Figure 8.1. To illustrate the direct quotation of sterling, we must

draw demand and supply curves for the foreign currency (US dollars). The vertical axis

235

..

FINM_C08.qxd 1/18/07 11:34 AM Page 236

Chapter 8 • Foreign exchange markets

Figure 8.1

then indicates how much sterling is needed to buy $1. Now assume an increase in

the demand for US dollars. The demand curve shifts out in the normal way and the

price (the exchange rate) rises. But the value of sterling has clearly fallen (it now

takes 63 pence to buy $1 rather than 62 pence). Thus, a rise in the exchange rate

of a country’s currency here means that the home currency has weakened. On the

other hand, if we follow the standard British practice of using the indirect quotation

(as we shall be doing for the most part in this book), a fall in the value of the home

currency is reected in a fall in the exchange rate. We show this in Figure 8.2.

To show the indirect quotation, we need demand and supply curves for the

domestic currency. Thus, on the vertical axis in Figure 8.2 we have the amount of

foreign currency (US dollars) needed to buy £1. In this diagram, an increase in the

demand for dollars is indicated by an increased supply of sterling on to the market.

The supply curve moves down to the right and the exchange rate falls (from £1 $1.61

to £1 = $1.59). Box 8.1 provides additional information on the expression of exchange

rates and Exercise 8.1 gives you some practice in the manipulation of rates.

	Figure 8.2
236

....

FINM_C08.qxd 1/18/07 11:34 AM Page 237