16. THE FOREIGN-CURRENCY EXCHANGE RATE MARKETS
Many countries across the world use a flexible exchange rate regime. Consequently, this
chapter builds upon a market's currency exchange rates, and explains how investors can
calculate a cross exchange rate for two countries that rarely engage in trade. Moreover, investors
can profit from arbitrage, when currency exchange rates differ between two or more markets.
Then, students learn the supply and demand analysis to predict changes in a currency’s
exchange rate because a country’s income, inflation, interest rates, etc. influence exchange rates.
Finally, we expand the supply and demand analysis to include a pegged exchange rate and
explain how a central bank devaluing its currency can trigger capital flight and a financial crisis.
Foreign Exchange Rates
Foreign-currency exchange market is traders exchange currency of one country for
another country’s currency. Consequently, five parties need foreign currency. First, international
banks specialize in foreign currencies. They transfer billions in foreign currencies with other
banks. Second, any person or business engaged in international trade and commerce, especially
imports and exports. Third, international travelers need foreign currency to pay for food,
lodging, and entertainment in a foreign country. Fourth, central banks and governments use a
cache of foreign currencies to finance balance-of-payments deficits or to manipulate their
exchange rate. Finally, international investors invest in foreign countries, seeking greater profits
in foreign countries.
Some international investors use hedging, where they invest in several countries to reduce
their risk, while other investors use speculation, where they buy currency for a low price and
sell for a high price. Speculation is a form of gambling because speculators gamble on future
prices. Furthermore, investors could use arbitrage. Investors see a price difference of the same
currency in two separate markets; thus, they buy currency for a low price and sell it for a higher
price in the other market, reducing the price difference to zero between the markets.
Foreign exchange market is the largest market in the world, and traders exchanged nearly
$3.2 trillion daily in 2007. Most transactions are electronic transfers between international
banks, whereas transactions occur 24 hours per day, 7 days per week. Foreign exchange market
has retail and wholesale markets. Retail market is a small market, where agents buy and sell
foreign currencies, usually at booths at shopping malls, airports, and train and bus stations.
Retailers display two exchange rates: Selling and buying price. Retailer always sells currency
for a higher price than the buying price. Hence, the price spread reflects the retailers’
commission. On the other hand, the wholesale market comprises of a network of about 2,000
banks and brokerage firms. They buy and sell currencies with each other or with large
corporations. Wholesale market uses an international clearing system where they exchange
electronic deposits. International clearing system is similar to a clearinghouse for checks.
Supply and demand analysis for foreign currencies assumes no government interference and
flexible exchange rates. For example, one U.S. dollar equals 3.0 Malaysian ringgits (or $1 = 3