International_Economics_Tenth_Edition (1)

to the closing price from the previous trading day. Because prices are expressed in terms of cents per yen, the .8986 implies that yen opened for sale at

.8986 cents per yen. Multiply this price by the size of a contract and you've calculated the full value of one contract at the open of trading for that day: .8986 cents X 12.5 million = $112,325.

The high, low, and settle columns indicate the contract's highest, lowest, and closing prices for the day. Viewed together, these figures provide an indication of how volatile the market for the yen was during the day. After opening at .8986 cents per yen, yen for March delivery never sold for more than

.9080 cents per yen and never for less than .8960 cents per yen; trading finally settled, or ended, at

.8991 cents per yen. Multiplying the size of the yen contract times the yen's settlement price gives the full value of a yen contract at the closing of the trading day: .8991 cents X 12.5 million = $112,388.

Change compares today's closing price with the closing price as listed in the previous day's paper. A plus (+) sign means prices ended higher; a minus (- ) means prices ended lower. In the yen's case, the yen for March delivery settled .0008 cents higher than it did the previous trading day.

Lifetime highand low show the volatilitythat has occurred in the trading of this particular contractan indication of risk and reward.

Open interest refers to the total number of contracts outstanding; that is, those that have not been canceled by offsetting trades. It shows how much interest there is in trading a particular contract. The months closest to March 9 generally attract the most trading activity.

The last line of Table 11.4 gives information concerning the estimated volume of trading on the current day, the actual volume on the previous trading day, the current number of contracts (open interest) across all maturity dates for this currency, and the change in the number of contracts since

the previous trading day.

~,~

IForeign-Currency Options

During the 1980s, a new feature of the foreignexchange market was developed: the option mar-

350 Foreign Exchange

States. The WallStreetJournal publishes daily listings of foreign currency options contracts, as seen in Table 11.5. The table shows quotes for calls and puts as well as the strike price on the option. It is left for more advanced textbooks to discuss the mechanics of trading foreign-currency options.

To see how exporters can use foreign-currency options to cope with exchange-rate risk, consider the case of Boeing, which submits a bid for the sale of jet planes to an airline company in Japan. Boeing must deal not only with the uncertainty of winning the bid but also with exchange-rate risk. If Boeing wins the bid, it will receive yen in the future. But what if the yen depreciates in the interim, from, say, 115 yen = $1 to 120 yen = $1? Boeing's yen holdings would convert into fewer dollars, thus eroding the profitability of the jet sale. Because Boeing wants to sell yen in exchange for dollars, it can offset this exchange-market risk by purchasing put options that give the company the right to sell yen for dollars at a specified price. Having obtained a put option, if Boeing wins the bid it has limited the exchange-rate risk. On the other hand, if the bid is lost, Boeing's losses are limited to the cost of the option. Foreign-currency options thus provide a worst-case rate of exchange for companies conducting international business. The maximum amount the company can lose by

TABLE 'I.S

Futures Options Prices of the Euro,

March 9, 2004: Chicago Mercantile Exchange

Euro (CME)

125,000 euros; cents per euro

covering its exchange-rate risk is the amount of the option price.

Exchange-Rate

Determination

What determines the equilibrium exchange rate in a free market? Let us consider the exchange rate from the perspective of the United States-in dollars per unit of foreign currency. Like other prices, the exchange rate in a free market is determined by both supply and demand conditions.

Demand for Foreign Exchange

A nation's demand for foreign exchange is derived from, or corresponds to, the debit items on its balance of payments. For example, the U.S. demand for pounds may stem from its desire to import British goods and services, to make investments in Britain, or to make transfer payments to residents in Britain.

Like most demand schedules, the U.S. demand for pounds varies inversely with its price; that is, fewer pounds are demanded at higher prices than at lower prices. This relationship is depicted by line Do in Figure 11.2. As the dollar depreciates against the pound (the dollar price of the pound rises), British goods and services become more expensive to U.S. importers. This is because more dollars are required to purchase each pound needed to finance the import purchases. The higher exchange rate reduces the number of imports bought, lowering the number of pounds demanded by U.S. residents. In like manner, an appreciation of the U.S. dollar relative to the pound would be expected to induce larger import purchases and more pounds demanded by U.S. residents.

Supply of Foreign Exchange

The supply of foreign exchange refers to the amount of foreign exchange that will be offered to the market at various exchange rates, all other factors held constant. The supply of pounds, for example, is generated by the desire of British residents and businesses to import U.S. goods and services, to lend funds and make investments in the United States, to repay debts owed to u.s. lenders, and to extend transfer payments to u.s. residents.

Exchange-Rate Determinatl

-s \.r\)V\~ £. c\eYnaV'C\ -toy

b~~h ~V\V\Gtg,

In each of these cases, the British offer pounds in the foreign-exchange market to obtain the dollars they need to make payments to U.S. residents. Note that the supply of pounds results from transactions that appear on the creditside of the u.s. balance of payments; thus, one can make a connection between the balance of payments and the foreignexchange market.

The supply of pounds is denoted by schedule So in Figure 11.2. The schedule represents the number of pounds offered by the British to obtain dollars with which to buy u.s. goods, services, and assets. It is depicted in the figure as a positive function of the u.s. exchange rate. As the dollar depreciates against the pound (dollar price of the pound rises), the British will be inclined to buy more u.s. goods. The reason, of course, is that at higher and higher dollar prices of pounds, the British can get more U.S. dollars and hence more u.s. goods per

British pound. u.s. goods thus become cheaper to the British, who are induced to purchase additional quantities. As a result, more pounds are offered in the foreign-exchange market to buy dollars with which to pay u.s. exporters.

Equilibrium Rate of Exchange

As long as monetary authorities do not attempt to stabilize exchange rates or moderate their movements, the equilibrium exchange rateis determined by the market forces of supply and demand. In Figure 11.2, exchange-market equilibrium occurs at point E, where So and Do intersect. Three billion pounds will be traded at a price of $2 per pound. The foreign-exchange market is precisely cleared, leaving neither an excess supply nor an excess demand for pounds.

Given the supply and demand schedules of Figure 11.2, there is no reason for the exchange rate

352 Foreign Exchange

Jackie Murphy held up a white pair of jogging shoesfor her husband, Edward, to examine in a Nike store aisle piled high with boxes of shoes. Shesmiled when she saw the price tag.

"They'reonly $55!" said Murphy, a tourist from London, England. "Do you like them? Try them on."

Although Murphy is an experienced shopperit is one of her favorite pastimes back home-she was shocked at her purchasing power on a vacation to Orlando in 2004. The power came primarily from a currency exchange rate that had the British pound approaching twice the value of the U.S. dollar. "The exchange rate is fantastic," said Edward Murphy, who sells electronics in London. "We couldn'thave timed it better to come over on our vacation." In 2004, the dollar reached a record low against the euro and an 11-year low against the pound.

Many European and Canadian visitors followed the Murphy example, in part because of the inexpensive U.S, dollar. The American tourist industry was delighted about this situation. Because of the cheaper dollar, tourists could afford to stay longer, stay at nicer and more expensive hotels, take more tours, eat at more

restaurants, and shop with bargain-basement enthusiasm. Adding to the bonanza for Europeans, air fares to and from the United States declined.

For example, the cheap dollar encouraged 15- year-old Molly Sanders of Liverpool, England, to purchase six heavy-metal T-shirts during a visit to Orlando, and her parents decided they could afford a road trip to Miami. The family booked hotel reservations and purchased theme-park tickets in the United States rather than in Britain. By obtaining the tickets in dollars instead of pounds, they saved about $21 each day they went to the parks.

The exchange rate also led the British travel firm Virgin Holidays to renegotiate prices with the U.S. car rental companies and hotels that it uses. The new prices permitted the firm in 2004 to offer a package of airfare to Orlando, seven night' accommodations, and rental car for 399 pounds, or 130 pounds less than what it previously offered. At the prevailing exchange rate, the discounted price was equal to $718, for about $234 in savings.

Source: "Coming to America: Exchange Rate Attracts Foreign Visitors," Yakima Herald Republic, March 18, 2004, p. 6-A.

to deviate from the equilibrium level. But in practice, it is unlikely that the equilibrium exchange rate will remain very long at the existing level. This is because the forces that underlie the location of the supply and demand schedules tend to change over time, causing shifts in the schedules. Should the demand for pounds shift rightward (an increase in demand), the dollar will depreciate against the pound; leftward shifts in the demand for pounds (a decrease in demand) cause the dollar to appreciate. Conversely, a rightward shift in the supply of pounds (increase in supply) causes the dollar to appreciate against the pound; a leftward shift in the supply of pounds (decrease in supply) results in a depreciation of the dollar. What causes shifts in these schedules? This topic will be considered in Chapter 12.

Is a Strong Dollar Always Good and a Weak Dollar Always Bad?

Is a strong (appreciating) dollar always good and a weak (depreciating) dollar always bad? A strengthening or weakening dollar can affect many parties, among them consumers, tourists, investors, exporters, and importers. Table 11.6 summarizes these effects.

Consider also the effects of the fluctuating dollar on U.S. firms during the 1990s. 4 In 1995, the U.S. dollar's exchange value depreciated, especially against the Japanese yen. This meant that more dollars were needed to purchase the yen; as a result,

"Tl.S, Importers Take on the Dollar's Fall." The Wall Street Journal, April 17, 1995, p. A2, and "Strong Dollar Creates Winners and Losers," The Wall Street Journal, February 6, 1997. p. A2.

1.U.s. consumers see lower prices on foreign goods.

2.Lower prices on foreign goods help keep U.S. inflation low.

3.U.S. consumers benefit when they travel to foreign countries.

1.U.s. exporting firms find it harder to compete in foreign markets.

2.U.s. firms in import-competing markets find it harder to compete with lower-priced foreign goods.

3.Foreign tourists find it more expensive to visit

the United States.

1. U.S. exporting firms find it easier to sell goods in foreign markets.

2.Firms in the United States have less competitive pressureto keep prices low.

3.More foreign tourists can afford to visit the United States.

goods imported by u.s. companies became more expensive. How did u.s. importers adjust to the dollar depreciation? Consider the following cases:

High Sierra Sport Co., a LeatherGoods Manufacturer in Illinois

As the dollar's exchange value plunged, faxes poured in from its Asian suppliers informing it of price hikes; one indicated nylon prices were going up, the next indicated zipper costs were increasing. When the firm decided to launch two new lines of handbags, Taiwanese and Korean suppliers warned it of pending increases in fabric prices. High Sierra's solution: Raise the prices of leather goods rather than absorb the higher cost of imported inputs.

Trek Bicycle Inc., a Bike Manufacturer in Wisconsin

This company manufactured bikes and also imported bikes made to its design from Taiwanese

1.U.S, consumers face higher prices on foreign goods.

2.Higher prices on foreign goods contribute to higher inflation in the United States.

3.U.s. consumers find traveling abroad more costly.

lUI

manufacturers. In both cases, from 30 percent to 50 percent of the bike components came from Japanese suppliers. Trek paid its Taiwanese bike suppliers in dollars, but these firms had to purchase Japanese components with yen. As the dollar started depreciating, Trek was initially protected because the Taiwanese were absorbing the currency variance. As negotiations for the next year's models proceeded, however, the prices of Taiwanese bikes went up. To reduce the foreign content of its bikes, Trek announced plans to build a second Wisconsin factory.

During 1996-2002, the dollar was appreciating on the foreign-exchange markets. This resulted in U.S. Treasury Secretary Robert Rubin declaring, "A strong dollar is in America's interest." The question is, which America was he talking about? As seen in the next two examples, not all Americans benefited from the rising dollar.

354 Foreign Exchange

Computer Network Technology Inc., a Producer of Network Systems in Minnesota

The dollar's climb in 1997 resulted in rising costs of its network systems to Japan. The systemsproduced by European firms thus became more competitive in the Japanese market. As a result, Computer Network Technology's sales fell and its earnings dropped by $100,000.

Sony Computer Entertainment, a U.S.-Based Unit of Sony Corp

As the dollar steadily soared against the yen, many U.S.-based subsidiaries of Japanese companies questioned whether they should pack up and head home. For example, Sony Computer Entertainment Inc., seeking to capitalize on the appreciation of the dollar against the yen, announced that it would halt production of its PlayStation home-video game in the United States and shift it back to Japan.

Indexes of the Foreign-

Exchange Value of the

Dollar: Nominal and Real

Exchange Rates

Since 1973, the value of the U.S. dollar in terms of foreign currencies has changed daily. In this environment of market-determined exchange rates, measuring the international value of the dollar is a confusing task. Financial pages of newspapers may be headlining a depreciation of the dollar relative to some currencies, while at the same time reporting its appreciation relative to others. Such events may leave the general public confused as to the actual value of the dollar.

Suppose the U.S. dollar appreciates 10 percent relative to the yen and depreciates 5 percent against the pound. The change in the dollar's exchange value is some weighted average of the changes in these two bilateral exchange rates. Throughout the day, the value of the dollar may change relative to the valuesof any number of currenciesunder marketdetermined exchange rates. Direct comparison of the dollar's exchange rate over time thus requires a weighted average of all the bilateral changes. This

average is referred to as the dollar's exchange-rate index; it is also known as the effective exchange rate or the trade-weighted dollar.

The exchange-rate index is a weighted average of the exchange rates between the domestic currency and the nation's most important trading partners, with weights given by relative importance of the nation's trade with each of these trade partners. One popular index of exchange rates is the so-called "major currency index," which is constructed by the U.S. Federal Reserve Board of Governors. This index reflects the impact of changes in the dollar's exchange rate on U.S. exports and imports with seven major trading partners of the United States. The base period of the index is March 1973.

Table 11.7 illustrates the nominal exchangerate index of the U.S. dollar. This is the average value of the dollar, not adjusted for changes in prices levels of the United States and its trading partners. An increase in the nominal exchangerate index (from year to year) indicates a dollar appreciation relative to the currencies of the other nations in the index and a loss of competitiveness for the United States. Conversely, a decrease in the nominal exchange rate implies a dollar depreciation relative to the other currencies in the index and an improvement in U.S. international competitiveness. Simply put, the nominal exchange-rate index is based on nominal exchange rates-those published in The Wall Street Journal- which do not reflect changes in price levels in trading partners.

However, a problem arises when interpreting changes in the nominal exchange-rate index when prices are not constant. When prices of goods and services are changing in either the United States or a partner country (or both), one does not know the change in the relative price of foreign goods and services by simply looking at changes in the nominal exchange rate and failing to consider the new levelof prices within both countries. For example, if the dollar appreciated against the peso by 5 percent, we would expect that, other things constant, U.s. goods would be 5 percent less competitive against Mexican goods in world markets than was previously the case. However, suppose that, at the same time that the dollar appreciated, U.S. goods prices increased more rapidly than Mexican goods prices.

In this situation, the decrease in U.S. competitiveness against Mexican goods would be more than 5 percent, and the nominal 5 percent exchange rate change would be misleading. Put simply, overall international competitiveness of u.s. manufactured goods depends not on the behavior of nominal exchange rates, but on movements in nominal exchange rates relative to prices.

As a result, economists calculate the real exchange rate, which embodies the changes in prices in the countries in the calculation. Simplyput, the real exchange rate is the nominal exchange rate adjusted for relative price levels. To calculate the real exchange rate, we use the following formula:

Real exchange rate = Nominal exchange rate

XForeign country's price level (Home country's price level)

where both the nominal exchange rate and real exchange rate are measured in units of domestic currency per unit of foreign currency.

To illustrate, suppose that in 2002 the nominal exchange rate for the United States and Europe is 90 cents per euro; by 2004, the nominal exchange rate falls to 80 cents per euro. This is an 11 percent appreciation of the dollar against the euro [(90 - 80)/90 = .11)], leading one to expect a substantial drop in competitiveness of u.s. goods relative to European goods. To calculate the real exchange rate, we must look at prices. Let us assume that the base year is 2002, at which consumer prices are set equal to 100. By 2004, however, u.s. consumer prices increase to a level of 108 while European consumer prices increase to a levelof 102. The real exchange rate would then be calculated as follows:

In this example, the real exchange rate indicates that U.S. goods are less competitive on international markets than would be suggested by the nominal exchange rate. This result occurs because the dollar

356 Foreign Exchange

appreciates in nominal terms and U.S. prices increase more rapidly than European prices. In real terms, the dollar appreciates not by 11 percent (as with the nominal exchange rate) but by 16 percent [(75.6 - 90)/90 = .16]. Simply put, for variations in the exchange rate to have an effect on the composition of U.S. output, output growth, employment, and trade, there must be a change in the real exchange rate. That is, the change in the nominal exchange rate must alter the amount of goods and services that the dollar buys in foreign countries. Real exchange rates offer such a comparison and, therefore, provide a better gauge of international competitiveness than nominal exchange rates.

In addition to constructing a nominal exchange rate index, economists construct a real exchange rate index for a broad sample of U.S. trading partners. Table 11.7 also shows the real exchange rate index of the U.S. dollar. This is the average value of the dollar based on real exchange rates. The index is constructed so that an appreciation of the dollar corresponds to higher index values. The importance that monetary authorities attach to the real exchange-rate index stems from economic theory, which states that a rise in the real exchange rate will tend to reduce the international competitiveness of U.S. firms; conversely, a fall in the real exchange rate tends to increase the international competitiveness of u.s. firms.'

I Arbitrage

We have seen how the supply and demand for foreign exchange can set the market exchange rate. This analysis was from the perspective of the U.S. (New York) foreign-exchange market. But what about the relationship between the exchange rate in the u.s. market and that in other nations? When restrictions do not modify the ability of the foreignexchange market to operate efficiently, normal market forces result in a consistent relationship among the market exchange rates of all currencies.

"For discussions of the nominal and real exchange-rate indexes see "New Summary Measures of the Foreign-Exchange Value of the Dollar," Federal Reserve Bulletin, October 1998, pp. 811-818, and "Real Exchange Rate Indexes for the Canadian Dollar," Bank of Canada Review, Autumn, 1999, pp. 19-28.

That is to say, if £1 = $2 in New York, then $1 = £0.5 in London. The prices for the same currency in different world locations will be identical.

The factor underlying the consistency of the exchange rates is called exchange arbitrage. Exchange arbitrage refers to the simultaneous purchase and sale of a currency in different foreignexchange markets in order to profit from exchange-rate differentials in the two locations. This process brings about an identical price for the same currency in different locations and thus results in one market.

Suppose that the dollar/pound exchange rate is £1 =$2 in New York but £1 =$2.01 in London. Foreign-exchange traders would find it profitable to purchase pounds in New York at $2 per pound and immediately resell them in London for $2.01. A profit of 1 cent would be made on each pound sold, less the cost of the bank transfer and the interest charge on the money tied up during the arbitrage process. This return may appear to be insignificant, but on a $1 million arbitrage transaction it would generate a profit of approximately $5,000-not bad for a few minutes' work! As the demand for pounds increases in New York, the dollar price of a pound will rise above $2; as the supply of pounds increases in London, the dollar price of the pound will fall below $2.01. This arbitrage process will continue until the exchange rate between the dollar and the pound in New York is approximately the same as it is in London. Arbitrage between the two currencies thus unifies the foreign-exchange markets.

The preceding example illustrates two-point arbitrage, in which two currencies are traded between two financial centers. A more intricate form of arbitrage, involving three currencies and three financial centers, is known as three-point arbitrage, or triangular arbitrage. Three-point arbitrage involves switching funds among three currencies in order to profit from exchange-rate inconsistencies, as seen in the following example.

Consider three currencies-the u.s. dollar, the Swiss franc, and the British pound, all of which are traded in New York, Geneva, and London. Assume that the rates of exchange that prevail in all three financial centers are as follows: (1) £1 = $1.50; (2) £1 =4 francs; (3)1 franc =$0.50. Because the same exchange rates (prices) prevail in all three

financial centers, two-point arbitrage is not profitable. However, these quoted exchange rates are mutually inconsistent. Thus, an arbitrager with $1.5 million could make a profit as follows:

1.Sell $1.5 million for £1 million.

2.Simultaneously, sell £1 million for 4 million francs.

3.At the same time, sell 4 million francs for $2 million.

The arbitrager has just made a risk-free profit of $500,000 ($2 million - $1.5 million) before transaction costs!

These transactions tend to cause shifts in all three exchange rates that bring them into proper alignment and eliminate the profitability of arbitrage. From a practical standpoint, opportunities for such profitable currency arbitrage have decreased in recent years, given the large number of currency traders-aided by sophisticated computer information systems-who monitor currency quotes in all financial markets. The result of this activity is that currency exchange rates tend to be consistent throughout the world, with only minimal deviations due to transaction costs.

IThe Forward Market

Foreign-exchange markets, as we have seen, may be spot or forward. In the spot market, currencies are bought and sold for immediate delivery (generally, two business days after the conclusion of the deal). In the forward market,currencies are bought and sold now for future delivery, typically 1 month, 3 months, or 6 months from the date of the transaction. The exchange rate is agreed on at the time of the contract, but payment is not made until the future delivery actually takes place. Only the most widely traded currencies are included in the regular forward market, but individual forward contracts can be negotiated for most national currencies.

The Forward Rate

The rate of exchange used in the settlement of forward transactions is called the forward rate. This rate is quoted in the same way as the spot rate: the price of one currency in terms of another curren-

Forward Exchange Rates: Selected Examples

EXCHANGE RATES

Tuesday. March 9, 2004

TheNewYork foreign-exchange mid-range rates belowapplyto tradingamongbanks in amounts of $1 million and more, as quoted at 4 P.M. Eastern time by Reuters and other sources, Retail transactions provide fewer units offoreign currency per dollar.

358 Foreign Exchange

If the result is a negative forward premium, it means that the currency is at a forward discount.

According to Table 11.8, on Tuesday the 1- month forward Swiss franc was selling at $0.7803, whereas the spot price of the franc was $0.7797. Because the forward price of the franc exceeded the spot price, the franc was at a 1- month forward premium of 0.06 cents, or at a 0.92 percent forward premium per annum against the dollar:

Premium = $0.7803 - $0.7797 X 12 = .0092

$0.7797 1

Similarly, the franc was at a 3-month premium of 0.17 cents, or at a 0.87 percent forward premium per annum against the dollar:

Premium = $0.7814 - $0.7797 X 12 = 0.0087

$0.7797 3

As for the British pound, the 6-month forward pound was at a discount of 3.25 percent per annum against the dollar:

Discount =$1.7953 - $1.8250 X 12 =-0.0325

$1.8250 6

Forward Rate Differs from the Spot Rate

What determines the forward rate? Why might it be at a premium or discount compared to the spot rate? The reason is that forward rates are strictly a mathematical calculation based on interest-rate differentials between countries. When a country's interest rates are higher than those of the United States, its currency tends to be at a forward dis- count in terms of the dollar; when a country's interest rates are lower than those of the United States, its currency tends to be at a forward premium.

To illustrate, suppose that the interest rate is 8 percent in New York and 3 percent in Zurich. Also assume that both the spot and forward exchange rates equal $.50 per franc. In this situation, a Swiss investor will obviously send his funds to New York. However, other investors will realize this opportunity and move their funds to New York as well. In the process, investors will sell francs on the spot market and buy them on the forward market; the francs purchased on the

forward market eventually will return to Switzerland when the investment is liquidated. This will decrease the franc on the spot market to say, $.49 per franc, or by 2 percent. However, on the forward market, the franc will increase to $.515 per franc, or by 3 percent. Therefore, the franc will move to a 5 percent forward premium and the funds will not move between financial centers. The interest rate differential in favor of New York, 5 percent, will be exactly offset by the 5 percent forward premium on the franc. We conclude that when a country's interest rates are louier than those of the United States, its currency tends to be at a forward premium. This topic will be further examined later in this chapter.

Forward Market Functions

The forward market can be used to protect international traders and investors from the risks involved in fluctuations of the spot rate. The process of avoiding or covering a foreignexchange risk is known as hedging. People who expect to make or receive payments in a foreign currency at a future date are concerned that if the spot rate changes, they will have to make a greater payment or will receive less in terms of the domestic currency than expected. This could wipe out anticipated profit levels.

In 1997, many Asian companies lost large sums when Asian currencies sharply depreciated against the U.S. dollar. For example, Siam Cement PCl, a chemicals giant in Thailand, was forced to absorb an extraordinary loss of $517 million in the third quarter of 1997. The company had $4.2 billion in foreign borrowing, and none of it was hedged. The foreign-exchange loss wiped out all of the profits that Siam Cement had chalked up between 1994 and 1996! Prior to 1997, few Asian economies bothered to hedge their foreign-exchange risks because most Asian currencies were tied to the dollar. The ties were broken, however, as a result of the Asian financial crises of 1997, and this caught many Asian managers by surprise; they were unprepared for the adverse effects of volatile currencies.

How can firms and investors insulate themselvesfrom volatile currency values? They can deal in the forward market, as shown in the following examples.