DEFINITIONS

exchange rate:  the number of units of one currency needed to acquire one unit of another currency

direct quote:  when one is in a particular country, an expression of the exchange rate in terms of the number of units of the domestic currency needed to acquire one unit of a particular foreign currency (note that this is analogous to the “price” of a foreign currency)

cross rate:  an exchange rate computed from two other exchange rates  [watch the units to make sure they cancel]
SFr/$   =   SFr      $    =   SFr
DM/$         $      DM       DM

spot rate:  the exchange rate quoted for current foreign-currency transactions

forward rate:  the exchange rate quoted for transactions that call for delivery (exchange) more than two days in the future;  usually quoted for 30, 60, 90, or 180 days from the rate setting

forward discount (or premium):  the percentage difference between the spot and forward exchange rate between two currencies;  note that this reflects the market’s expectations about the future exchange rate, and can generally be related to differences in the two countries’ inflation rates, which should approximately equal the differences in the two countries’ nominal exchange rates.
Premium  =  F₀ - S₀  X360 X  100
                       S₀            N

outright forward contract:  an agreement to exchange a set amount of currency at a particular date in the future, at a particular rate.

currency swap:  an agreement to exchange a set amount of currency immediately at the spot rate and to reverse the exchange at a set rate at a set, future, date.

currency option:  an agreement that the purchaser has the right but not the obligation to exchange a set rate at some point in the future.

hard currency:  a currency that is fully convertible (no government restrictions on exchange) and relatively stable (or appreciating) against other major currencies.

devaluation (or revaluation):  official government action to reduce (or increase) the amount of foreign currency for which a fixed or pegged currency can be exchanged.

depreciation (or appreciation):  unofficial and fluctuating changes (down or up) in the market value of a floating currency, compared to the currencies of its major trading partners.

currency arbitrage:  simultaneous buying and selling of foreign currencies, in an attempt to profit from discrepancies in the direct or cross rates in different worldwide markets.

currency speculation:  holding a debt (or a credit) in a foreign currency, without a compensating account receivable or account payable.  Compare this to arbitrage:  the arbitrageur doesn't maintain a "position" in a foreign currency, but is trading simultaneously.

interest arbitrage:  lending money in currencies other than one’s own, in an attempt to profit from foreign interest rates higher than in one’s own after accounting for currency exchange rates.

1) Exchange  US$1M  for  Can$1.4M  (0.7143 US$/Can$).
2) Buy a 90-day Canadian CD at 5.5%, compared to the 5.0% for comparable U.S. instruments.
3) After 90 days, exchange  Can$1,419, 250  for  US$1,013,770, which is $1270 more than you could have made in a US instrument.
4) However, if the Canadian dollar fell by as little as 1/2 cent (50 points) during that period, to  0.7093, you would have lost $5,826 compared to a U.S. investment.
5) At the beginning of this process, you could buy a forward contract to buy US$ with Can$ in 90 days.  However, the fact that investors can do this will likely drive the forward rate to a discount.

Floating exchange rates as an instrument of trade equilibration?
First of all, recall that an export creates additional demand for the currency of the exporting country.  This is the case even if the importer pays with the importer's currency  or a "third" currency, because the factors of production in the exporting country must be paid in their currency.  Analogously, an import creates additional supply of the currency of the importing country, because at some point along the line, import country's currency is being exchanged for export country's currency.
If international trade (on the "current account") were the only reason for international currency exchange, and if exchange rates were allowed to float, then trade balances would be self-equilibrating:  a country with a persistent trade deficit (or surplus) would see international demand for its currency fall (or rise);  the international prices of its exports would fall (or rise) and the prices of its imports would rise (or fall), and it would probably end up exporting more (less) and importing less (more).  Note the domestic consequence of this is that the real incomes of factors in this country fall (rise) as a result.  Also note that this is not a bilateral relationship, but a relationship between a country and the totality of its trading partners.

However, international trade in goods and services is not the only reason for international currency exchange.  First and foremost, there is that capital account:  investment in the assets of a country (land, capital, companies) requires the currency of the country.  Thus, the two relationships, between current and capital account (trade deficits (or surpluses) mean net foreign investment into (out of) the country, remember?) should cancel each other, with respect to exchange rates.

If foreign investment in a trade-deficit country became less attractive to outside interests, then that country would be able to carry a smaller trade deficit.  If its currency floats, it will probably fall.  If its currency is not allowed to float, there will be pressure for a devaluation:  people will be selling the currency, and someone (the national government?  other governments?  international agencies?) is going to have to buy the currency at the official rate if the official rate is to be maintained.

What should influence the relative international demand for investment in (or holding of) a particular country's currency?  We'll go over this in class.
 

Of course, an additional source of demand for US dollars is the fact that many international transactions use dollars even if US goods or services are totally uninvolved -- for example, most world trade in oil and in commercial aircraft is conducted in dollars.

Interest rates as a determinant of exchange rates
So, what remains to determine exchange rates?  Well, what influences the attractiveness of investment in a country (or speculation in its currency)?  The expected return on the investment, that's what!  One simple measure of return on investment, relevant for liquid or financial investment, is the prevailing interest rate.  So, we'd expect countries with higher interest rates to have lots of external demand for their currencies, and rising currency values.

One more "but":  what an investor cares about is not the posted, or nominal, interest rate, but the real interest rate.  Since the interest rate tells me how much of "tomorrow's money" I can buy with "today's money," I care deeply about how much of tomorrow's "stuff" I can buy with tomorrow's money.  That relationship, the rate of inflation,  varies across countries.  So in comparing international alternatives for investing money, I care about the interest rates and the inflation rates in each country:  nominal interest rate minus inflation rate equals real interest rate.

In fact, the differences in nominal interest rates (for the same kind of financial instrument) of two countries (at least, two countries with open capital movements between them) is at least partially related to differences in the expected rate of inflation in the two countries:  the country with the higher nominal interest rate likely has a higher expected rate of inflation.

Based on Purchasing Power Parity, the country with the higher inflation rate should see its currency fall in value against the other country.  [Link to a page that explains and illustrates The Economist's (magazine) "Big Mac index."  What, besides currency under/over-valuation, might international differences in "Big Macs" actually reflect?].

It is from this reasoning that the International Fisher Effect predicts future changes in the spot exchange rate as a function of the differential in the two countries’ nominal interest rates.
The forward exchange rate can be interpreted as the market’s current expectation of spot exchange rates in the future.  Therefore, a well-operating market shouldn’t allow our interest-rate arbitrageur to make much money by buying a forward contract.

IMPLICATIONS
This is not a course about international financial markets and speculation.  Our major purpose (in this section of the course) is to understand international business.

Most businesses are better at making and selling products than engaging in speculation.  Therefore, most companies should hedge their exposure to exchange risk.  For an exporter, that would mean:

• negotiating a price and asking for payment upon delivery of product (no exchange risk, because the exchange rate is the exchange rate);  or
• allowing 30, 60, or 90 days for payment (as is customary), but insisting on payment in the exporter’s currency (no exchange risk despite the time delay, because you’re being paid in the currency with which you pay your bills);  or
• allowing 30, 60, or 90 days for payment in the importer’s currency (or a third currency), but immediately arranging a forward contract, swap, or option to establish the domestic-currency price you are receiving for the sale.