International Financial

Markets

Lecture 02
 Lecture 02
Introduction to Financial Markets: The FOREX market
• The Foreign Exchange Market

• The Basics of Currency Trading

• Demand and Supply of Foreign Exchange

• Arbitrage with the Spot Exchange Market

References: Krugman et al. (2022), Ch. 14; Pugel (2024), Ch. 17

2
 Learning Objectives
• Introduction to financial markets with a focus on foreign exchange
(FOREX) markets.

• To introduce the players and the features of FOREX markets.

• Spot and Forwards, Futures and Options related to FOREX Markets.

• Introduction to the basics of currency trading.

• Demand and Supply of Foreign Exchange.

• Arbitrage with the Spot Exchange Markets.

3
 Lecture 2
The FOREX market: the basics (1/3)

Foreign exchange is the act of trading different nations’ money.

Exchange rates are quoted as:

• foreign currency per unit of domestic currency (certain valuation):

1USD (domestic currency) = 0.8£ (foreign currency)

• domestic currency per unit of foreign currency (uncertain valuation):

1.25USD (domestic currency) = 1£ (foreign currency)

Changes in exchange rates are described as depreciation or

appreciations

4
 Lecture 2
The FOREX market: the basics (2/3)
Depreciation is a decrease in the value of a currency relative to another
currency. A depreciated currency is less valuable (less expensive) and
therefore can be exchanged for (can buy) a smaller amount of foreign currency.

For instance, if $1/€ → $1.20/€ → the dollar has depreciated relative to euro. It
now takes $1.20 to buy one euro, so that the dollar is less valuable.

The euro has appreciated relative to the dollar: it is now more valuable.

Appreciation is an increase in the value of a currency relative to another

currency. An appreciated currency is more valuable (more expensive) and
therefore can be exchanged for (can buy) a larger amount of foreign currency.

For instance, if $1/€ → $0.90/€ → the dollar has appreciated relative to euro. It
now takes $0.90 to buy one euro, so that the dollar is more valuable.

The euro has depreciated relative to the dollar: it is now less valuable.

5
 Lecture 2
The FOREX market: the basics (3/3)

In sum, all else equal, the appreciation/depreciation of a country’s currency

goods more expensive goods less expensive

When a country’s currency depreciates, foreigners find that its exports are
cheaper and domestic resident find that imports from abroad are more
expensive.

When a country’s currency appreciates, foreigners find that its exports are more
expensive and domestic resident find that imports from abroad are cheaper.

Yet, all else equal, an appreciation of a country’s currency raises the relative
price of its exports and lowers the relative price of its imports.

Conversely, a depreciation lowers the relative price of a country’s exports

and raises the relative price of its imports. 6
 Lecture 2
The FOREX market: the players (1/2)
The set of markets where foreign currencies and other assets are exchanged for
domestic ones: Institutions buy and sell deposits of currencies or other assets for
investment purposes.

The daily volume of foreign exchange transactions was $6.6 trillion in April
2019 ($500 billion in 1989): Most transactions exchange foreign currencies for
U.S. dollars.

The participants in the market:

• Commercial banks and other depository institutions: transactions involve
buying/selling of deposits in different currencies for investment purposes.

• Corporations (non-financial businesses) conduct foreign currency transactions

to buy/sell goods, services and assets.

• Non-bank financial institutions (mutual funds, hedge funds, securities firms,

insurance companies, pension funds) may buy/sell foreign assets for
investment.

• Central banks: conduct official international reserves transactions (recall last

lecture) 7
 Lecture 2
The FOREX market: the players (2/2)
Buying and selling in the foreign exchange market are dominated by
commercial and investment banks:

• Inter-bank transactions of deposits in foreign currencies occur in amounts of $1

million or more per transaction;

• Central banks sometimes intervene, but the direct effects of their transactions
are small and transitory in many countries.

Computer and telecommunications technology transmit information rapidly and

have integrated markets. The integration of financial markets implies that
there can be no significant differences in exchange rates across locations.

Interbank Foreign Exchange Trading

The interbank part of the market serves several functions. Participation in the
interbank (interdealer) part of the market provides a bank with a continuous
stream of information on conditions in the foreign exchange market through
communications with traders at other banks and through observing the prices
(exchange rates) being quoted. 8
 Lecture 2
Arbitrage
Arbitrage: the process of buying and selling to make a (nearly) riskless pure profit,
ensures that rates in different locations are essentially the same, and that rates and
cross-related and consistent among themselves.

But if there would be a possibility to make a profit buying and selling foreign
currencies?. Ex:

If the euro was to sell for $1.1 in New York and $1.2 in London, could buy euros in New
York (where cheaper) and sell them in London at a profit.

Opportunities for actual arbitragem of these types are rare!!! 9

 Lecture 2
Spot Rates and Forward Rates

Spot rates are exchange rates for currency exchanges “on the spot,” or
when trading is executed in the present.

Forward rates are exchange rates for currency exchanges that will occur
at a future (“forward”) date.
• Forward dates are typically 30, 90, 180, or 360 days in the future.
• Rates are negotiated between two parties in the present, but the
exchange occurs in the future.

10
 Lecture 2
Other Methods of Currency Exchange (1/2)

Foreign exchange swaps: a combination of a spot sale with a forward

repurchase.

Swaps allow parties to meet each other’s needs for a temporary amount
of time and often cost less in fees than separate transactions:
For example, suppose Toyota receives $1 million from American sales, plans to use it to pay its
California suppliers in three months, but wants to invest the money in euro bonds in the
meantime.

Swaps make up a significant proportion of all foreign exchange trading.

Futures contracts: a contract designed by a third party for a standard

amount of foreign currency delivered/received on a standard date.

Contracts can be bought and sold in markets, and only the current owner is obliged to fulfill
the contract.

11
 Lecture 2
Other Methods of Currency Exchange (2/2)

Options contracts: a contract designed by a third party for a standard

amount of foreign currency delivered/received on or before a standard
date:

• Contracts can be bought and sold in markets;

• A contract gives the owner the option, but not obligation, of buying or
selling currency if the need arises;

• A call option gives the owner the right to buy, while a put option gives
the right to sell, a specified amount of foreign currency at a specified
price at any time prior to the specified expiration date.

12
 Lecture 2
The Demand for Foreign Currency
Assets (1/6)

What influences the demand of (willingness to buy) deposits

denominated in domestic or foreign currency?

Rate of return: the percentage change in value that an asset offers

during a time period. For instance, the annual rate of return for $100
savings deposit with an interest rate of 2% is given by:

($102 − $100)
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ∗ 100% = 2%
$100

Real rate of return: inflation-adjusted rate of return, which represents the

additional amount of goods and services that can be purchased with
earnings from the asset:

The real rate of return for the above savings deposit when inflation is
1.5% is 0.5% (2%-1.5%=0.5%), approximately.
13
 Lecture 2
The Demand for Foreign Currency
Assets (2/6)
If prices are fixed, the inflation rate is 0% and (nominal) rates of return = real
rates of return (Because trading of deposits in different currencies occurs on a
daily basis, we often assume that prices do not change from day to day. A good
assumption to make for the short run).

Yet, all else equal, individuals prefer to hold those assets offering the
highest expected real rate of return.

Risk of holding assets also influences decisions about whether to buy them.

Liquidity of an asset, or ease of using the asset to buy goods and services, also
influences the willingness to buy assets.

But we assume that risk and liquidity of currency deposits in foreign exchange
markets are essentially the same, regardless of their currency denomination. Risk
and liquidity are only of secondary importance when deciding to buy or sell
currency deposits. Importers and exporters may be concerned about risk and
liquidity (small fraction of the market).

14
 Lecture 2
The Demand for Foreign Currency
Assets (3/6)

We therefore say that investors are primarily concerned about the rates of return
on currency deposits. Rates of return that investors expect to earn are determined
by interest rates that the assets will earn & expectations about appreciation
or depreciation

• A currency deposit’s interest rate is the amount of a currency that an individual

or institution can earn by lending a unit of the currency for a year.
• The rate of return for a deposit in domestic currency is the interest rate that
the deposit earns.

To compare the rate of return on a deposit in domestic currency with one in

foreign currency, consider:
• the interest rate for the foreign currency deposit;
• the expected rate of appreciation or depreciation of the foreign currency
relative to the domestic currency.

15
 Lecture 2
The Demand for Foreign Currency
Assets (4/6)

Suppose the interest rate on a dollar deposit is 2% and the interest rate on a euro
deposit is 4%. Does a euro deposit yield a higher expected rate of return?

Suppose today the exchange rate is $1/€1, and the expected rate one year in the
future is $0.97/€1.

$100 can be exchanged today for €100 yielding €104 after 1 year. These €104 are
$0.97
expected to be worth $100.88 in 1 year ∗ €104 = $100.88 . Therefore, the
€1
rate of return in terms of dollars from investing in euro deposits is 0.88%
$100.88−$100
= 0.88% . When compared this rate with the rate of return from a
$100
dollar deposit, the rate of return is simply 2%, which corresponds a gain of $2.

The euro deposit has a lower expected rate of return: thus, all investors should be
willing to dollar deposits, and none should be willing to hold euro deposits. 16
 Lecture 2
The Demand for Foreign Currency
Assets (5/6)

Note that the expected rate of appreciation of the euro was

$0.97 − $1
= −0.03(−3%).
$1

We simplify the analysis by saying that the dollar rate of return on euro deposits
approximately equals: (i) the interest rate on euro deposits plus (ii) the expected
rate of appreciation of euro deposits. (4% + −3% = 1% ≈ 0.88%).

In sum, the expected rate of return on a euro deposit, measured in terms of

dollars:

𝑒
𝐸$/€ − 𝐸$/€
𝑅€ +
𝐸$/€

𝑅€ - today’s interest rate on one-year euro deposits;

𝐸$/€ - today’s dollar/euro exchange rate (number of dollars per euro)
𝑒
𝐸$/€ - dollar/euro exchange rate (number of dollars per euro) expected to prevail a
year from today. 17
 Lecture 2
The Demand for Foreign Currency
Assets (6/6)

The difference in the rate of return on dollar deposits and euro deposits is

𝑒 𝑒
𝑅$ − 𝑅€ + 𝐸$/€ − 𝐸$/€ /𝐸$/€ = 𝑅$ − 𝑅€ − 𝐸$/€ − 𝐸$/€ /𝐸$/€

Expected Expected Expected Current

returns in returns in exchange exchange
dollars euros rate rate

Expected rate of
appreciation of the euro

Expected rate of return

When the difference above is positive, dollar on euro deposits
deposits yield the higher expected rate of
return; when it is negative, euro deposits yield
the higher expected rate of return. 18
 Lecture 2
Model of Foreign Exchange Markets
(1/3)

Model in equilibrium when deposits of all currencies offer the same expected rate
of return: interest parity: (i) Interest parity implies that deposits in all currencies are
equally desirable assets; (ii) Interest parity implies that arbitrage in the foreign exchange
market is not possible.

Therefore, interest parity says:

𝑒
𝐸$/€ − 𝐸$/€
𝑅$ = 𝑅€ +
𝐸$/€

Why should the interest parity condition hold?

Suppose that
𝑒
𝐸$/€ − 𝐸$/€
𝑅$ > 𝑅€ +
𝐸$/€

Then no investor would want to hold euro deposits, driving down the demand and price
of euros → all investors would want to hold dollar deposits, driving up the demand and
price of dollars → The dollar would appreciate, and the euro would depreciate, increasing
the right side until equality was achieved.
19
 Lecture 2
Model of Foreign Exchange Markets
(2/3)

How do changes in the current exchange rate

affect the expected rate of return of foreign
currency deposits?

Depreciation of the domestic currency today

lowers the expected rate of return on foreign
currency deposits → When the domestic currency
depreciates, the initial cost of investing in
foreign currency deposits increases → it
lowers the expected rate of return of foreign
currency deposits.

Appreciation of the domestic currency today

raises the expected return of deposits on foreign
currency deposits → When the domestic currency
appreciates, the initial cost of investing in
foreign currency deposits decreases → it
An appreciation of dollar
lowers the expected rate of return of foreign (descending direction) →
currency deposits. higher dollar return on euro
deposits and vice-versa

20
 Lecture 2
Model of Foreign Exchange Markets
(3/3)

The effects of changing interest rates:

• An increase in the interest rate paid on deposits denominated in a particular
currency will increase the rate of return on those deposits.
• This leads to an appreciation of the currency.
• Higher interest rates on dollar-denominated assets cause the dollar to
appreciate.
• Higher interest rates on euro-denominated assets cause the dollar to
depreciate.

• A rise in the interest rate offered by dollar deposits

from 𝑅$1 to 𝑅$2 causes the dollar to appreciate from
1 2
𝐸$/€ to 𝐸$/€

21
 Lecture 2
Forward Exchange Rates and Covered
Interest Parity (1/2)
Covered interest parity (CIP) relates interest rates across countries and the rate of change
between forward exchange rates and the spot exchange rate:

𝐹$/€ − 𝐸$/€
𝑅$ = 𝑅€ +
𝐸$/€
Where 𝐸$/€ is the forward exchange rate.

It says that rates of return on dollar deposits and “covered” foreign currency deposits are
the same, How could you earn a risk-free return in the foreign exchange markets if covered
interest parity did not hold? Covered positions using the forward rate involve little risk.

For example, suppose the 1-year forward price of euros in terms of dollars is 𝐹$/€ = $1.113 and
the spot exchange rate is 𝐸$/€ = $1.05 per euro. If 𝑅€ = 0.04, compare the rate of return on a
covered euro deposit of 10% rate of return on a dollar deposit (𝑅$ = 0.10):

• A €1 deposits costs $1.05 and is worth €1.04 after 1 year.

• Selling €1.04 forward today at the forward exchange rate $1.113 per euro yield a dollar value
after 1 year of ($1.113 per euro)*(€1.04)=$1.1158
• The rate of return on the covered purchase of a euro deposit is (1.158-1.05)/1.05 = 0.103
(10.3%), which is greater than a 10% rate of return on a dollar deposit and covered interest
parity fails.
22
 Lecture 2
Forward Exchange Rates and Covered
Interest Parity (2/2)

The forward premium on euros against dollars (also called the forward discount
on dollars against euros) is
𝐹$/€ − 𝐸$/€
𝐸$/€
Using this terminology, the covered interest parity condition becomes: The
interest rate on dollar deposits equals the interest rate on euro deposits
plus the forward premium on euros against dollars.

23