Topic 1: Foreign Exchange Rates


From a macroeconomic point of view, the main thing that distinguishes countries from regions within countries is the fact that countries almost always have separate monetary units---the pound in England, the yen in Japan, the deutschmark in Germany, the French franc, the U.S. dollar, the New Zealand dollar, and so forth. International exchange of goods, services and securities requires that national currencies be exchanged in the process. Japanese yen received for a sale of Canadian lumber to Japan, for example, are of no use to a Canadian exporter who must pay his employees in Canadian dollars.

Every time a U.S. resident buys something---be it a commodity a service, or an asset---from a Japanese resident, one or other of them has to convert U.S. dollars into Japanese yen. The U.S. importer must pay in yen or persuade the Japanese exporter to accept dollars. In the latter case, the Japanese exporter has to convert the dollars to yen before the funds can be used to cover her domestic costs. Similarly, every time a Japanese resident wants to buy something in the United States either she or the U.S. exporter must convert yen into dollars.

Sometimes exporters in smaller countries prefer to accept U.S. dollars in payment even when they are not trading with a U.S. resident and importers are willing to pay in U.S. dollars even though they are not U.S. residents. In this case the dollar is serving as a vehicle currency or as international money in the same way that the yen serves as money within Japan. The transactors on both sides, of course, have to convert between their local currency and U.S. dollars.

When a country's residents make payments to foreigners, a supply of the domestic currency and demand for the foreign currency is created. Similarly, payments to domestic residents from abroad create a supply of the foreign currency and a demand for the domestic currency. The foreign exchange market is where these buyers and sellers of national currencies come together---it operates through a world-wide electronic network. The price of foreign currency in terms of domestic currency is the foreign exchange rate, which could equally well be defined alternatively as the foreign currency price of domestic currency.

Since an exchange rate exists between each country's currency and the currency of every other country, there are many more foreign exchange rates than there are currencies. These rates of exchange must all be consistent with each other. For example, one should not be able make a profit by converting pounds into yen at the market exchange rate of yen for pounds, then the yen into dollars at the market rate of dollars for yen, and then the dollars back into pounds at the market rate of exchange of pounds for dollars. Any such profits---called arbitrage profits---are immediately eliminated by arbitrage.

To understand the nature of arbitrage, suppose that the exchange rates between the pound, the yen and the dollar at a particular point in time are as follows:

one pound = 370 yen      one yen = 0.005 dollars      one dollar = 0.54795 pounds.

A British foreign exchange trader (the term foreign exchange is used to refer to any foreign currency purchased with or sold for a domestic currency) can sell 100 million pounds for 37000 million yen, then sell these yen for 185 million dollars which can be then be converted back into 101.37 million pounds for a realized net profit of 1.37 million pounds. Moreover, this arbitrage profit is virtually a sure thing. The only way the trader could lose is for the exchange rates to change in the minute or two it takes to make the three transactions. This is different from a speculative profit. Speculation is an attempt to profit from expected future changes in exchange rates while arbitrage is an attempt to profit from simultaneous transactions at existing rates. Speculative profits occur when foreign exchange rates move as the speculator expects they will move. Arbitrage profits occur as long as the exchange rate does not move significantly while the arbitrage transactions are being made.

When an arbitrage opportunity presents itself, traders all over the market will attempt to take advantage of it. In the situation outlined above, everyone will try to buy yen with pounds, dollars with yen, and pounds with dollars. The price of the yen in terms of the pound will rise, with the result that less yen will exchange for a pound, and the price of dollars in terms of yen will rise, so that less dollars will be obtained for a yen. These exchange rate adjustments will continue until all three exchange rates are consistent with each other.

Suppose, to continue the example, that the yen price of the pound falls from 370 to 368, and the dollar price of the yen falls from .005 to .0049592. The three rates will then be as follows:

one pound = 368 yen      one yen = 0.0049592 dollars      one dollar = 0.54795 pounds.

An arbitrager could no longer make a profit. An initial investment of 100 million pounds would yield only (36800)(.0049592)(.54795) = 100.002 million pounds, which we will assume to be an insufficient gain to cover transaction costs.

As a result of the actions of arbitragers, any inconsistencies across exchange rates will be eliminated so quickly that only traders sitting right at their computer terminals would have any chance of profiting from them.

It is time for a test. Be sure to think up your own answers before looking at the ones provided.

Question 1
Question 2

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