a.How can this speculator use $1 million to speculate in the forward market?

b.What occurs if the franc's spot rate in 3 months is $0.40? $O.60? $O.50?

11.1The Web site of the Wells Fargo Bank provides an overview of exchange rates and international trade in its International Services section. Set your browser to this URL:

http://www.wellsfargo.com/inatlli natl.

jhtml

11.2 L.P. Bloomberg, a well-known financial-services firm, provides currency information at its Web site, including its currency calculator, key cross-country rates, and currency by region. Go to

16.You are given the following spot exchange rates: $1 = 3 francs, $1 = 4 schillings, and 1 franc = 2 schillings. Ignoring transaction costs, how much profit could a person make via three-point arbitrage?

Market Data after setting your browser to this URL:

http://www.bloomberg.com

11.3 Olsen and Associates is a leading developer of online forecasting technology for business and finance. OANDA, its Internet subsidiary, offers a currency converter that will tell you current and historical exchange rates for 192 currencies. Set your browser to this URL:

http://www.oanda.com

Speculation in the foreign-exchange market can be conducted in the spot market and the forward market. Let us examine the techniques of speculating in these markets.

Speculating in the Spot Market

Imagine that you are a currency speculator in New York, willing to risk money on your opinion about future prices of a foreign currencysay, the Swiss franc. Consider the following scenarios.

Case 1:

Speculating on a Swiss franc appreciation.

GIVEN: Today's spot price is $0.40 per franc. ASSUMPTION: In 3 months, the spot price of the franc will rise to $0.50.

PROCEDURE:

1.Purchase francs at today'sspot price of $0.40 and deposit them in a bank to earn interest.

2.In 3 months, sell the francs at the prevailing spot price of $0.50 per franc.

OUTCOME: If assumption is right, profit = $0.10 per franc. If assumption is wrong and the spot price of the franc falls instead, you incur a loss, reselling francs at a price lower than the purchase price.

Case 2:

Speculating on a Swiss franc depreciation.

GIVEN: Today's spot price is $0.40 per franc. ASSUMPTION: In 3 months, the spot price of the franc will fall to $0.25.

PROCEDURE:

1.Borrow francs today, exchange them for dollars at the prevailing spot price of

$0.40 per franc, and deposit the dollars in a bank to earn interest.

2.In 3 months, buy francs at the prevailing spot price of $0.25 per franc and use them to pay back the loan.

OUTCOME: If assumption is right, profit = $0.15 per franc. (This return is reduced by the interest paid on borrowed money, but increased by the interest received on the bank savings account). If assumption is wrong and the spot price of the franc rises in 3 months instead, you incur a loss buying francs at a higher price than the initial selling price.

Speculating in the Forward Market

Although speculation on the spot market can lead to profits, it has a serious drawback: The speculator must have a large amount of idle cash or borrowing privileges, which require interest payments. Speculation in the forward market, however, does not require cash or credit facilities. All the speculator needs to do is sign a forward contract with a bank to either purchase or sell a specified amount of foreign currency at a specified date. The bank may impose a margin requirement, requiring the speculator to put up, say, 10 percent of the value of the foreign contract as security. In practice, most speculation is done in the forward market.

Forward market speculation occurs when a speculator believes that a currency's spot price at some future date will differ from today'sforward price for that same date. For example, suppose the 30-day forward pound is selling at a 10 percent discount; this dis-

count is the market'sconsensus (average expectation) that in 30 days the spot rate of the pound will be 10 percent lower than it is today. As a speculator, however, you feel you have better information than the market. You believe that in 30 days the pound'sspot rate will be only 5 percent lower (or maybe 15 percent higher) than it is today. You are willing to bet your money that the market consensus is wrong. Your gains or losses will equal the difference between the current forward rate and the spot rate 30 days from now. Consider the following scenarios.

Case 1:

Speculating that the spot rate of the Swiss franc in 3 months will be higher than its current 3-month forward rate.

GIVEN: The current price of the 3-month forward franc is $0.40.

ASSUMPTION: In 3 months, the prevailing spot price of the franc will be $0.50. PROCEDURE:

1.Contract to purchase a specified amount of francs in the forward market, at $0.40 per franc, for 3-month delivery.

2.After receiving delivery of the francs in 3 months, resell them in the spot market at the prevailing price of $0.50 per franc.

OUTCOME: If assumption is right, profit = $0.10 per franc. If assumption is wrong and the prevailing spot price in 3 months is lower than $0.40 per franc, you incur a loss.

Case 2:

Speculating that the spot rate of the Swiss franc in 3 months will be lower than its current 3-month forward rate.

GIVEN: The current price of the 3-month forward franc is $0.40.

ASSUMPTION: In 3 months, the prevailing spot price of the franc will be $0.30. PROCEDURE:

1.Contract to sell a specified amount of francs (which you do not currently have) for delivery in 3 months at the forward price of $0.40 per franc.

2.In 3 months, purchase an identical amount of francs in the spot market at $0.30 per franc and deliver them to fulfill the forward contract.

OUTCOME: If assumption is right, profit = $0.10 per franc. If assumption is wrong and the prevailing spot price in 3 months is higher than $0.40 per franc, you incur a loss.

When speculators purchase foreign currency on the spot or forward market with the anticipation of selling it at a higher future spot price, they are said to take a long position in the currency. But when speculators borrow or sell forward a foreign currency with the anticipation of purchasing it at a future lower price to repay the foreignexchange loan or fulfill the forward sale contract, they are said to take a short position (that is, they are selling what they do not currently have).

Becauseeconomists believe that the determinants of exchange-rate fluctuations are rather different in the short run (a few weeks or even days), medium run (several months), and long run (1, 2, or even 5 years), we will consider these time frames when analyzing exchange rates. In the short run, foreign-exchange transactions are dominated by transfers of financial assets (bank deposits) that respond to differences in real interest rates and to shifting expectations of future exchange rates; such transactions have the major influence on short-run exchange rates. Over the medium run, exchange rates are governed by cyclical factors such as cyclical fluctuations in economic activity. Over the long run, foreign-exchange transactions are dominated by flows of goods, services, and investment capital, which respond to forces such as inflation rates, investment profitability, consumer tastes, productivity,and government trade pol-

icy; such transactions have the dominant impact on long-run exchange rates.

Note that day-to-day influences on foreignexchange rates can cause the rate to move in the opposite direction from that indicated by longerterm fundamentals. Although today's exchange rate may be out of line with long-term fundamentals, this should not be construed as implying that it is necessarily inconsistent with short-term determinantsfor example, interest-rate differentials, which are among the relevant fundamentals at the short end of the time dimension.

Figure 12.1 highlights the framework in which exchange rates are determined.' The figure views exchange rates as simultaneously determined by

'This figure and its analysis are adapted from Michael Rosenberg, Currency Forecasting (Homewood, IL: Richard D. Irwin, 1996), pp. 3-5.

374 Exchange-Rate Determination

long-run structural, medium-run cyclical, and short-run speculative forces. The figure illustrates the idea that there exists some equilibrium level or path to which a currency will eventually gravitate. This path serves as a long-run magnet or anchor; it ensures that exchange rates will not fluctuate aimlessly without limit but rather will tend to gravitate over time toward the long-run equilibrium path.

Medium-run cyclical forces can induce fluctuations of a currency above and below its long-run equilibrium path. However, fundamental forces serve to push a currency toward its long-run equilibrium path. Note that medium-run cyclical fluctuations from a currency's long-run equilibrium path can be large at times, if economic disturbances induce significant changes in either trade flows or capital movements.

Longer-run structural forces and medium-run cyclical forces interact to establish a currency's equilibrium path. Exchange rates may sometimes move away from this path if short-run forces (for example, changing market expectations) induce fluctuations in exchange rates beyond those based on fundamental factors. Although such overshooting behavior can persist for significant periods, fundamental forces generally push the currency back into its long-run equilibrium path.

Unfortunately, predicting exchange-rate movements is a difficult job. That is because economic forces affect exchange rates through a variety of channels-some of which may induce negative impacts on a currency's value, others of which may exert positive impacts. Some of those channels may be more important in determining shortrun tendencies, whereas other channels may be more important in explaining the long-run trend that a currency follows.

To simplify our analysis of exchange rates, we divide it into two parts. First, we consider how exchange rates are determined in the long run. Then we use our knowledge of the long-run determinants of the exchange rate to help us understand how they are determined in the short run.

To gain a better understanding of these determinants, you can refer to the "Currency Trading" column that appears daily in the The Wall Street Journal; it is usually located in the third section,

"Money and Investing." The column typically discusses factors causing fluctuations in the dollar's exchange value. Table 12.1 provides an example of this column.

Determining Long-Run

Exchange Rates

Changes in the long-run value of the exchange rate are due to reactions of traders in the foreignexchange market to changes in four key factors: relative price levels, relative productivity levels, consumer preferences for domestic or foreign goods, and trade barriers. Note that these factors underlie trade in domestic and foreign goods and thus changes in the demand for exports and imports. Table 12.2 on page 376 summarizes the effects of these factors.

To illustrate the effects of these factors, refer to Figure 12.2 on page 377, which shows the demand and supply schedules of pounds. Initially, the equilibrium exchange rate is $1.50 per pound. We will examine each factor by itself, assuming that all other factors remain constant.

Relative Price Levels

Referring to Figure 12.2(a), suppose the domestic price level increases rapidly in the United States and remains constant in the United Kingdom. This causes Ll.S, consumers to desire relatively low-priced British goods. The demand for pounds thus increases to D I in the figure. Conversely, as the British purchase less relatively high-priced U.S. goods, the supply of pounds decreases to 51' The increase in the demand for pounds and the decrease in the supply of pounds result in a depreciation of the dollar to $1.60 per pound. This analysis suggests that an increase in the U.S. price level relative to price levels in other countries causes the dollar to depreciate in the long run.

Relative Productivity Levels

Productivity growth measures the increase in a country's output for a given level of input. If one country becomes more productive than other countries, it can produce goods more cheaply than its

V.$ " .

foreign competitors can. If productivity gains are passed forward to domestic and foreign buyers in the form of lower prices, the nation's exports tend to increase and imports tend to decrease.

Referring to Figure 12.2(b), suppose U.S. productivity growth is faster than that of the United Kingdom. As U.S. goods become relatively less expensive, the British demand more U.S. goods,

which results in an increase in the supply of pounds to 52' Also, Americans demand fewer British goods, which become relatively more expensive, causing the demand for pounds to decrease to D2. Therefore, the dollar appreciates to $1.40 per pound. Simply put, in the long run, as a country becomes more productive relative to other countries, its currency appreciates.

Preferences for Domestic or Foreign Goods

Referring to Figure 12.2(c), suppose that U.S. consumers develop stronger preferences for Britishmanufactured goods such as automobiles and CD players. The stronger demand for British goods results in Americans' demanding more pounds to purchase these goods. As the demand for pounds rises to D]> the dollar depreciates to $1.55 per pound. Conversely, if British consumers demanded additional American computer software, machinery, and apples, the dollar would tend to appreciate against the pound. We conclude that an increased demand for a country's exports causes its currency to appreciate in the long run; conversely, increased demand for imports results in a depreciation in the domestic currency.

Trade Barriers

Barriers to free trade also affect exchange rates. Suppose that the u.s. government imposes tariffs on British steel. By making steel imports more expensive than domestically produced steel, the tariff discourages Americans from purchasing British steel. In Figure 12.2(d), this causes the demand for pounds to decrease to Dz, which results in an appreciation of the dollar to $1.45 per pound. Simply put, trade barriers such as tariffs and quotas cause a currency appreciation in the long run for the country imposing the barriers.

Inflation Rates, Purchasing

Power Parity, and Long-

Run Exchange Rates

The determinants discussed earlier are helpful in understanding the long-run behavior of exchange rates. Let us now focus on the purchasing-power- parity approach and see how it builds on the relative price determinant of long-run exchange rates.

Law of One Price

The simplest concept of purchasing power parity is the law of one price. It asserts that identical goods should cost the same in all nations, assuming that it is costless to ship goods between nations and there are no barriers to trade.

Before the costs of goods in different nations can be compared, prices must first be converted into a common currency. Once converted at the going market-exchange rate, the prices of identical goods from any two nations should be identicaL After converting francs into dollars, for example, machine tools purchased in Switzerland should cost the same as identical machine tools bought in the United States.

In theory, the pursuit of profits tends to equalize the price of identical products in different nations. Assume that machine tools bought in Switzerland are cheaper than the same machine tools bought in the United States, after convert-

ing francs into dollars. Swiss exporters could realize a profit by purchasing machine tools in Switzerland at a low price and selling them in the United States at a high price. Such transactions would force prices up in Switzerland and force

prices down in the United States until the price of the machine tools would eventually become equal in both nations, whether prices are expressed in francs or dollars. As a result, the law of one price would prevail.