8.7Summary

An exchange rate expresses the value of one currency in terms of another and

can be expressed in either direct form (the domestic currency price of one unit of

foreign currency) or indirect form (the foreign currency price of one unit of domestic

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Questions for discussion

currency). In addition to the end-users of foreign currency, arbitrageurs, speculators,

central banks and market-makers participate in forex markets. Explanations of changes

in exchange rates used to start with the demand for and supply of foreign exchange

depending on rational economic motives (market fundamentals). However, very little

of the currency traded in forex markets is used for international trade in goods and

services. Capital movements are now much more important.

To examine the market fundamentals thought likely to affect exchange rates

among currencies, we need to look at a number of important relationships. We

began with uncovered and covered interest parity. Covered interest parity concerns

the relationship between differences in interest rates between countries and the

difference between spot and forward rates of exchange. Differences in interest rates

can then be related to differences in expected ination rates (the Fisher effect),

which can, in turn, be related to changes in spot exchange rates through purchas-

ing power parity. When we put all this together, we reached the conclusion that, if

markets were fully efcient, forward exchange rates would accurately predict future

spot exchange rates. We looked at reasons why this is not so and then considered

alternative views of exchange rate determination, including the overshooting of

exchange rates. This section of the chapter concluded with an account of some of

the ideas underlying chartism, which attempts to forecast exchange rates on the

basis of past patterns.

We then moved on to look at xed exchange rate systems and their advantages

and disadvantages in comparison with oating exchange rates. The nal section of

the chapter outlined the arguments for and against monetary union and discussed

the issues surrounding the question of the UK’s future entry to the EU’s monetary

union. That is, we were concerned with whether the UK should join and, if so, when

it should join.

Questions for discussion

1	List as many items as you can of ‘news’ which would be likely to cause the value ofsterling to fall. Explain why in each case.

2	Under what circumstances might speculation in a market be regarded as a goodthing?

3	How might one use the spot markets to obtain protection against foreign exchangerisk? What advantages do the forward markets have for this purpose?

4	Under what circumstances might speculators perform the role normally played by arbitrageurs in foreign exchange markets – that of removing inconsistencies amongprices? (Note: consider the relationship between forward and future spot rates of exchange.)

5	At the close of trading on 13 June 2006 £1 sterling was worth 394.648 Hungarianforint. Did the fact that £1 was worth so many forint indicate that sterling was then avery much stronger currency than the forint? If not, what did it indicate? 4

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Chapter 8 • Foreign exchange markets

6

In 1970, £1 exchanged for over 8 deutschmarks (DMs). At the time of the formation of the euro in 1999, the exchange rate was £1 DM2.78. Why do you think this might have been the case? Did this weakening of sterling against the DM mean that in 1999 British goods were very much more competitive with German goods than they had been in 1972? If not, why not?

7	Explain the differences between being a member of the old European Monetary System before 1999 and a member of the euro area from 1999 onwards.

8	Both the UK and Denmark chose to remain outside monetary union when it was set up at the beginning of 1999. Denmark, however, chose to keep its currency within the European exchange rate mechanism while the UK did not. Why do you think the two countries made different decisions in this regard?

9	Examine the following set of exchange rates: £1 A1.458; $1 A0.753; £1 $1.886

What is wrong with these rates? If these rates did apply, how would it be possible to

make a prot by trading in these currencies? Would this be arbitrage or speculation?

Further reading

K Bain and P Howells, Monetary Economics. Policy and its Theoretical Basis (Basingstoke:

Palgrave, 2003) ch. 14

J A Frankel and K A Froot, ‘Chartists, fundamentalists and trading in the forex market’,

American Economic Review, May 1990, pp. 181–5.

P Howells and K Bain, The Economics of Money, Banking and Finance. A European Text

(Harlow: Pearson Education, 3e, 2005) ch. 18

P Williams, ‘The foreign exchange and over-the-counter derivatives markets in the United

Kingdom’, Bank of England Quarterly Bulletin, Winter 2004, pp. 470–84

For current information on foreign exchange markets see the Financial Timeswebsite,

http:/www.ft.com

For historic data on exchange rates see http://pacic.commerce.ubc.ca/xr/

Answers to exercises

8.1	(a) SFr1 £0.439; ¥100 $0.888; ¥100 a0.698; a1 £0.685.

8.2	(a) Fewer yen were needed to buy one US dollar forward and so the yen was at a forward premium;(b) one month 5.06 per cent; three months 4.95 per cent; (c) Japanese interest rates must have beenvery close to zero. In fact, they were: one month 0.125 per cent; three months 0.26 per cent.

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CHAPTER9

Exchange rate risk, derivatives

markets and speculation

Objectives

What you will learn in this chapter:

lThe nature of exchange rate risk

lThe meaning of hedging against risk

lA denition of derivatives markets

lThe nature of nancial futures markets

lHow nancial futures can be used to hedge against risk

lThe different forms of options and their use

l	A comparison of the different forms of hedging available in derivative and forward markets

l	The problems associated with derivatives markets

We looked in Chapter 8 at problems associated with volatile exchange rates and at

attempts to explain this volatility. Whatever the causes are, rms and governments

must try in some way to cope with rapidly changing exchange rates. One response,

we saw, is to develop xed exchange rate systems or to take the extra step and move

to monetary union. In the absence of any reduction in exchange rate volatility, rms

must act individually to protect themselves from the potential losses arising from

unexpected changes in exchange rates. In this chapter, we look more closely at the

nature of the risk involved and at ways of overcoming exchange rate risk. We shall

return briey to the use of forward forex markets to provide protection and go on to

consider other nancial markets that have developed and grown rapidly in the past

thirty years – markets for derivatives.

Derivatives:A nancial instrument based upon the performance of separately traded

commodities or nancial instruments.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

We introduce the major derivatives markets and look at their use both in the

protection of end-users from forex risk and in speculation. We conclude the chapter

by considering the advantages of derivatives markets and the dangers associated

with them.