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CHAPTER 7
Foreign Exchange and International Financial
Markets
After studying this chapter, students should be able to:

> Describe how demand and supply determine the price of foreign exchange.
> Discuss the role of international banks in the foreign-exchange market.
> Assess the different ways that firms can use the spot and forward markets to
settle international transactions.
> Summarize the role of arbitrage in the foreign-exchange market.
> Discuss the important aspects of the international capital market.

LECTURE OUTLINE

OPENING CASE: Dollar Makes Canada a Land of the Spree

This case discusses the impact the weak Canadian dollar has had on cross-border
business between the US and Canada. As the Canadian dollar has dropped in value
against the US currency, Americans have been able to buy more and more Canadian
goods for the same amount of US dollars.

Key Points

• The Canadian dollar (known as the "loonie") has been declining in value against
the US dollar for several years, recently trading at less than 70 cents US per
Canadian dollar.

• Though the US dollar has been gaining value against several currencies,
Canada's proximity makes it an attractive shopping destination for Americans.

• American companies are able to acquire Canadian firms at better prices.

• Mail order and Internet shopping let Americans shop for Canadian bargains
without even leaving home.

• The weak Canadian dollar is good for Canadian exporters, who find it easier to
sell their goods.
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• Canadian consumers are the losers, as American imports and trips abroad have
become increasingly more expensive.

CHAPTER SUMMARY

Chapter Seven introduces the student to the practical aspects of the foreign-exchange
market. The chapter discusses how currency prices are determined, the role and
activities of international banks in the foreign-exchange markets, how the spot and
forward markets are used in international trade transactions, arbitrage in the foreign-
exchange markets, and issues relating to the international capital markets.

I. THE ECONOMICS OF FOREIGN EXCHANGE

• Foreign exchange can be defined as currencies issued by another country.


• The price of different currencies in the flexible exchange-rate system is
determined by supply and demand. Demand for a currency occurs when the residents
of a country buy foreign products, services, and assets. Discuss Figure 7.1 here.
• In order to pay for the foreign products, residents must sell their own currency
and buy the other country’s currency. In doing so, they increase the supply of their own
currency. Discuss Figure 7.2 here.

Teaching Note:
Instructors may find it worthwhile to create a scenario in which
students are asked to obtain a particular currency from another
student to see the supply and demand process in action.

• The exchange rate is the price of one currency in terms of another, at the
equilibrium price of the foreign currency. Discuss Figure 7.3 here.
• A direct quote is the price of the foreign currency in terms of the home
currency, while an indirect quote is the price of the home currency in terms of the
foreign currency. Discuss Figure 7.4 here.

Discuss Venturing Abroad: A Brief Hint


This Going Global Box helps the student better understand exchange
rates by using “laymen’s terms” to discuss the prices of currencies.
Specifically, the Box links the price of currencies with the price of
bread. The Box fits in well with a preliminary discussion of exchange rates.

II. THE STRUCTURE OF THE FOREIGN EXCHANGE MARKET

The foreign-exchange market consists of buyers and sellers of currencies, including


international banks, central banks, brokers, businesses and speculators. Foreign
exchange is traded every minute of the day, in a volume of $1.2 trillion. The majority
(83%) of transactions involve the U.S. dollar, and it is therefore known as the primary
transaction currency. Discuss Map 7.1 and Figure 7.5.
Foreign Exchange and International Financial Markets > 104

The Role of Banks

• The foreign exchange departments of large international banks play a dominant


role in the foreign exchange market.

Discuss Wiring the World:


The Biggest Online Market
The foreign exchange market does $1.5 trillion worth of business a day. It is the
world's single biggest market and is moving online to take advantage of speed and
lower cost.

• International banks operate in both the wholesale and retail markets as they
trade for their own accounts and those of customers. Commercial customers are
involved in the foreign-exchange market through their normal commercial activities.
Speculators take positions in currencies as they try to predict the direction of
currency fluctuations. In doing so, speculators deliberately assume exchange-rate
risk. Arbitrageurs try to make risk-free profits as they capitalize on the differences in
currency prices between markets. Central banks intervene in the market under fixed
exchange-rate systems to maintain par values, but may allow currencies to float
freely under flexible exchange-rate systems.
• Not all currencies can be traded in the foreign-exchange market. Those that are
tradable are call convertible or hard currencies, those that are not are called
inconvertible or soft currencies.

Spot and Forward Markets

• Currencies can be traded in the spot market or in the forward market. Spot
transactions are delivered in two business days, while forward transactions are
delivered at the specified forward date of 30, 90, or 180 days. Most transactions in
the forward market are swap transactions in which the trader simultaneously buys
and sells the same currency with different delivery dates.
• Currency futures are used to obtain foreign exchange, however, unlike forward
contracts, they are designed with standard amounts for standard delivery dates.
Currency can also be obtained through currency options. A call option allows the
holder to purchase a specified quantity of foreign-exchange at a specified price by a
specified date, while a put option allows a holder to sell a specified quantity of
foreign-exchange at a specified price by a specified date. Options do not have to
be exercised. Figure 7.6, listing some options available on the Chicago Mercantile
Exchange, should be discussed here.
• Hedging is used by firms to reduce their foreign-exchange risk.
• If the forward price and the spot price of a particular currency are different, then
the currency is said to be selling at a forward discount (forward price is lower than
the spot price) or forward premium (forward price is higher than the spot price.)
Arbitrage and the Currency Market

• Arbitrage is the riskless purchase of a product in one market for immediate


resale in a second market in order to profit from a price discrepancy.
• Arbitrage of Goods--Purchasing Power Parity. The law of one price suggests
that arbitrage activities will continue until the price of the good in question is equal
in both markets. The theory of purchasing-power parity (PPP) states that the
prices of tradable goods, when expressed in a common currency, will tend to
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equalize across countries as a result of exchange-rate changes. In other words,


arbitrage activities affect the demand, and therefore the price, of currencies.
• The theory of PPP is used by international economists as they compare living
standards across countries, and by foreign-exchange analysts when they forecast
long-term exchange rate changes.

Discuss Bringing the World into Focus: Big Mac


Currencies
This Going Global Box illustrates the concept of purchasing
power parity by considering the price of Big Macs around the
world. The Box is a useful one because most students can relate to the product in
question, and may have even purchased Big Macs in other countries. The Box fits
in well with a discussion of PPP.

• Arbitrage of Money. In the financial markets, arbitrageurs attempt to make risk-


free profits by trading in foreign exchange. Two point arbitrage (also known as
geographic arbitrage) allows a trader to capitalize on differences between currency
prices in two foreign-exchange markets. Three point arbitrage involves buying
and selling three different currencies to make a risk-free profit. A currency’s cross-
rate can be calculated through the use of a third currency. Discuss Figure 7.7 here.

• Covered interest arbitrage enables a trader to capitalize on geographic


interest rate differentials, but avoid risk by covering exchange-rate exposure in the
forward market. Interest rates differ among countries as a result of the
international Fisher effect which suggests that national differences in expected
inflation rates yield differences in nominal interest rates among countries.

III. THE INTERNATIONAL CAPITAL MARKET

Major International Banks

• International banks play an important role in assisting companies with their


international transactions. International banks act both as commercial bankers and
as investment bankers. Their operations can take various forms. Discuss Table 7.1
here.
• Correspondent banking relationships involve setting up a reciprocal
relationship with a bank in another country. Under the agreement, each bank will
then act as the local bank for foreign customers. For example, a British bank may
set up a correspondent relationship with a Swiss bank in which the British bank acts
as the Swiss bank’s correspondent in Britain and the Swiss bank acts as the British
bank’s corespondent in Switzerland.
• Banks that have more extensive international operations may have a
subsidiary bank, a branch bank, or an affiliated bank. A subsidiary bank is an
operation that is incorporated separately from the parent, while a branch bank is
not. An affiliated bank involves taking an ownership position in an operation in
conjunction with a partner.
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• Commercial Banking Services. Commercial banks provide short-term


financing of international transactions, international electronic funds transfers,
transactions in the forward market, and advice about necessary documentation for
international commercial transactions.
• Investment Banking Services. Investment banking services include packaging
and locating long-term debt and equity funding, and arrangements for mergers and
acquisitions of domestic and foreign firms. In the U.S., commercial banks are not
permitted to provide investment banking services.

The Eurocurrency Market

• The Eurocurrency market involves currencies deposited outside of their


country of origin. For example, a Eurodollar is a dollar deposited in a bank outside
of the U.S. Eurodollars make up the majority (approximately two thirds) of the $6
trillion Eurocurrency market.
• The Euroloan market offers large, creditworthy borrowers an inexpensive source
of loans. Loans are inexpensive because the market is unregulated, transactions
are large and borrowers are trustworthy. Euroloans are typically quoted on the basis
of the London Interbank Offer Rate (LIBOR).
• Because U.S. banking regulations put American banks at a disadvantage vis-à-
vis their foreign counterparts in the dollar-denominated international loan market,
the Federal Reserve authorized the creation of international banking facilities.
International banking facilities are independent of a bank’s domestic operations
and thus, are not subject to U.S. regulations.

The International Bond Market

• Companies or governments seeking debt financing frequently turn to the


international bond market. Two types of bonds available are the foreign bond,
issued by a resident of country A, denominated in the currency of country B and
sold to the residents of country B, and the Eurobond, issued in the currency of
country A, but sold to residents of other countries. Discuss Figure 7.8 here.
• Global bonds are a new type of bond, which are sold in several markets
simultaneously.

Global Equity Markets

• Equity markets are more global today, reflecting the role of multinational
companies and improved telecommunications. Financial services firms, recognizing
this phenomenon, have expanded their operations to participate in the major
international financial centers. One result of the expansion has been the creation of
country funds which are mutual funds that specialize in investing in a particular
country’s firms. In recent years, investors around the world have demonstrated an
increased desire for non-U.S. stocks.
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Offshore Financial Centers

• Offshore financial centers are designed to meet the needs of nonresident


customers. They typically have a lax regulatory climate, strict secrecy laws, good
communications with other financial enterprises, and political stability.

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A Bad Case of Bahtulism

The closing case examines the events leading to the currency crisis currently affecting
the Asian economies, and immediate response to the situation.

Key Points

• Goldman Sachs & Co, a large New York investment banking house, predicted
that Thailand’s currency, the baht, could be devalued within six months. The bank,
which made the prediction on February 3, 1997, felt that several signs pointed to a
devalution of the baht including a report of a large government budget deficit,
reports that foreign investors were withdrawing short-term investments from the
country, and the impact of the rising U.S. dollar on Thailand’s exports.

• Despite Thailand’s efforts to maintain its currency’s value, Goldman Sach’s


prediction proved accurate, and on July 2, 1997 the baht fell some 20% on the
foreign exchange market throwing the Thai economy into chaos.

• Many Thai companies had borrowed dollars to fund their domestic capital
needs, and suddenly the loans became more expensive to service. Some MNCs
such as Goodyear were also hurt by the currency crisis as costs denominated in
baht rose significantly. The problems in Thailand quickly spread to neighboring
countries including Indonesia, Malaysia, and the Philippines.

• By September, the baht had fallen 26%, the Indonesian rupiah 21%, the
Malaysian ringgit 14%, and the Philippine peso 13%. South Korea also began to
experience difficulties as investors began to realize that many Korean firms were
threatened by overborrowing and devaluation-induced pricing by regional rivals.

• The crisis affected stock markets as well. For example, the average Thai stock
lost 60% of its dollar value. To halt a possible worldwide recession, the
International Monetary Fund assembled a financial aid package to bail the Asian
economies out. It is too soon to determine whether its $118 billion aid package will
restore the region’s economic health.
Foreign Exchange and International Financial Markets > 108

Case Questions

1. How can a central bank use its currency reserves to support the value of its
country’s currency in the foreign exchange market?

A country’s central bank can effectively use its reserves to support the value of its
country’s currency by buying up the currency in the foreign exchange market. This
has the effect of decreasing the supply available to others, and therefore, all else
being equal, pushes the value of the currency higher.

2. Would Thailand have been better off using a flexible exchange rate system
instead of the fixed exchange rate system that it did use?

They say that hindsight is 20/20. However, this question is still a difficult one to
answer simply because of all the possible variables that could affect the outcome.
Instructors may wish to divide a class into half and have each side prepare a case
as to why Thailand should have followed a particular scenario (either a fixed or a
flexible exchange rate system). Students can then debate which of the two
scenarios would have been the most beneficial for the country. Instructors should
prepare a list of factors (for example, interest rate changes) that could affect the
outcome of the exercise.

3. If you were a manager of an international business in Thailand in February


1997, what could you have done to protect your company against the possibility of
a devaluation of the baht?

Many Thai companies suffered because they mistakenly thought that the Bank of
Thailand would maintain a fixed rate with the U.S. dollar. Accordingly, many
companies borrowed in dollars to protect their domestic capital needs. A manager
of a company in Thailand could have avoided this costly mistake by borrowing in
baht rather than dollars. In addition, a manager could have sold off or refinanced
real estate, as this was another area that felt a substantial impact from the lower
baht.

4. There’s an old saying that “it’s an ill wind that blows no good.” Can you think of
anyone who benefited from Thailand’s currency crisis?

Certainly the immediate big winners in this situation were the speculators who
gambled on a fall of the baht and its neighboring currencies. However, the crisis
may also hold a silver lining for other players such as the MNCs who are now
snapping up factories and plants in the region at bargain basement prices. In the
end, it may be that the entire region shows a long-term benefit if it results in an
overall improvement in productivity and efficiency.
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5. What impact do you think the Asian contagion had on other emerging
economies, such as those in Latin America or in Eastern Europe?

Other regions faced at least two immediate concerns as a result of the Asian crisis.
First, their markets would be flooded with cheap products from the Asian markets,
and second, Asian markets will dried up, as consumption fell. So, goods exported
from other emerging economies had less expensive good competing with theirs.
This increased the pressure for competitive devaluations by other countries.
Furthermore, the Asian devaluations eroded confidence in the value of the currency
of other emerging economies, leading to downward pressure on the value of those
countries' currencies. The value of the Brazilian real and the Russian rubble went
down significantly in the wake of the Asian crisis.

Additional Case Application


This case provides the basis for an ongoing study of the effect of falling currencies and
reactions to the fall. Students can be asked to maintain a journal on the crisis as
additional events unfold.
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1. What determines demand for any given currency in the foreign exchange market?

Supply and demand for currencies establishes prices in the foreign-exchange market.
Demand for a country’s currency increases when foreigners buy that country’s products.
Supply of a country’s currency increases when the residents of a country buy foreign
products.

2. What determines supply of any given currency in the foreign exchange market?

The means by which equilibrium is reached in a fixed exchange system differs according to
the time frame in question. In the short-term, equilibrium is reached as central banks buy
or sell gold and/or currency from their official reserves account. In the long-run, equilibrium
is achieved as a country’s export competitiveness is affected by the inflation or deflation
that may occur when the money supply changes as a result of the short-run moves to
equilibrium. (Pages 161-163)

3. How are prices established in the foreign exchange market?

In a flexible exchange-rate system, equilibrium is reached through the market forces of


supply and demand. For example, when the supply of a currency is too high, prices will fall
until the quantity demanded equals the quantity supplied. (Pages 163-164)

4. What is the role of international banks in the foreign-exchange market?

The role of banks in the foreign-exchange market is varied. They play a major role in both
the wholesale and retail markets. In the wholesale market, international banks are
responsible for some 83% of all foreign-exchange transactions as they trade for their own
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accounts and for customers. At the retail level, international banks provide assistance to
commercial customers, speculators, and arbitrageurs that require foreign currency in the
spot or forward markets.

5. Explain the different techniques firms can use to protect themselves from future
changes in exchange rates.

There are several techniques that firms can use as they try to protect themselves from
future foreign-exchange-rate changes. In most cases, a company will contract with an
international bank to buy or sell foreign exchange on either a spot or forward basis
depending on the company’s needs. A forward contract allows a company to buy or sell
foreign-exchange with delivery at a specified future date of 30, 90, or 180 days, while a
spot transaction allows a company to buy or sell currency with delivery in two business
days.

Currency futures can also be used to obtain foreign exchange. However, because
currency futures are bought and sold in standard amounts for standard delivery, they are
not as popular as the forward market. Another method of acquiring foreign exchange is
through currency options. A call option allows a company to buy a specified quantity of
foreign-exchange at a specified price until the option expires, while a put option allows a
company to sell a specified quantity of foreign-exchange at a specified price by a specified
date. Holders of currency options are not obligated to exercise options.

6. Discuss the major types of arbitrage activities that affect the foreign-exchange-rate
market.

The major types of arbitrage activities that affect the foreign-exchange market are two-
point arbitrage, three-point arbitrage and covered interest arbitrage. A two-point arbitrage
opportunity allows a trader to capitalize on the differences in currency prices between two
foreign-exchange markets. A three-point arbitrage opportunity exists when a trader can
buy and sell three different currencies and make a risk-free profit. Covered-interest
arbitrage allows a trader to take advantage of interest rate differentials, but avoid risk by
covering foreign-exchange exposure in the forward market.

7. Describe the various forms that banks’ overseas operations may take.

Banks’ overseas operations can take many forms. A subsidiary bank is one that is
incorporated separately from the parent company. In contrast, an operation that is not
incorporated independently of the parent company is called a branch bank. If an
international bank invests in an operation with a partner, an affiliated bank would be
created.

8. What are Eurocurrencies?

Eurocurrencies are currencies deposited in countries other than their country of issue.
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9. What are the major characteristics of offshore financial centers?

Offshore financial markets are primarily located in small island states (e.g., the Bahamas)
that provide nonresident customers with banking and other financial services. They are
attractive because their regulation is lax, they provide linkages with other financial centers,
they have strict bank secrecy laws, and they typically offer political stability.

Discussion Questions and Answers

1. Suppose the Federal Reserve Bank unexpectedly raises interest rates in the United
States. How will this impact the foreign-exchange market?

If the Federal Reserve Bank unexpectedly raises interest rates in the United States,
investors, both U.S. and foreign, will buy dollar denominated assets to capitalize on the
higher interest rates. The demand for dollars will increase, pushing the value (or price) of
the dollar upward. At the same time, the supply of other currencies will increase as holders
exchange their currencies for dollars, and other currencies will fall in value. Unless other
central banks intervene, the dollar will appreciate relative to other currencies and other
currencies will depreciate relative to the dollar.

2. How important are communications and computing technology to the smooth functioning of
the foreign-exchange market? If the technological advances of the past four decades
were eliminated--for example, no PCs or satellite telecommunications--how would the
foreign-exchange market be affected?

Communications and computing technology are critical to the smooth functioning of the
foreign-exchange market. If the technological advancements of the past four decades
were eliminated, the foreign-exchange market would probably not resemble the one we
know today. Telecommunications is the vital link in obtaining information about company
performance, stock prices, and interest rates. It is also important for monitoring changes in
different capital markets. Computers play a key role in making sense of the information
acquired. Without computers, it would be much more difficult to develop investment and
risk reduction strategies.

3. Do you expect the U.S. dollar to maintain its position as the dominant currency in the
foreign exchange market once the euro is fully established? Why or why not?

Students will probably take different perspectives in responding to this question. Some
students will suggest that the U.S. dollar cannot possibly maintain its position as the
dominant currency in the foreign exchange market because at least twelve (and possibly
more depending on the rate of expansion of the EU) countries will be sharing a single
currency, the euro. Students taking this perspective will probably suggest that the
economic power of these countries, while small when taken individually, will be enormous
when taken together, and that consequently, the role of the dollar will begin to slip. Other
students, however, will probably argue that the dollar will continue to maintain its powerful
position simply because of the overall strength of the U.S. and its role as an economic (and
military) superpower. The steady decline of the euro against the dollar since the euro's
introduction suggests that the dollar is indeed maintaining its position. However, a
downturn in the U.S. economy could significantly change the dollar's relationship to the
euro.
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4. Suppose the spot pound and the 90 day forward pound are both selling for $1.65, while
the U.S. interest rates are 10 percent and British interest rates are 6 percent. Using
covered interest arbitrage theory, describe what will happen to the spot price of the pound,
the 90-day forward price of the pound, interest rates in the U.S., and interest rates in the
UK when arbitrageurs enter this market.

Under the current situation, traders would convert their pounds to dollars at $1.65/pound,
take advantage of the higher U.S. interest, and convert the dollars back to pounds in 90
days using the forward contract rate of $1.65/pound. All this demand for dollars on the
spot market would drive the spot price for the pound down. Given its lower interest rate,
the pound should trade at a forward premium against the dollar, suggesting that the 90
forward rate for the pound will increase. Interest rates will go up in the UK and down in the
U.S.

5. How important is the creation of international banking facilities to the international


competitiveness of the U.S. banking industry?

The creation of international banking facilities is very important to the international


competitiveness of the U.S. banking industry. In the 1970s U.S. banks believed they were
at a disadvantage competitively because of the reserve requirements and other regulations
imposed on them. In fact, regulations kept U.S. banks from keeping up with their
European and Asian counterparts in the issuance of dollar denominated loans. In 1981,
U.S. banks won some reprieve when the Federal Reserve authorized international banking
facilities. A bank can establish an IBF and be free of many domestic banking regulations,
and thus better compete in the Eurodollar market. The IBF must be legally separate from
the bank’s domestic operations.

6. What would be the impact on world trade and investment if there were one currency based
on the SDR?

If there were one currency based on the SDR, the main impact on world trade and
investment would be stability. If all countries had the same currency, the SDR, there would
be no need for foreign-exchange markets as we know them today, because there would be
no demand for foreign exchange. Companies could make strategic business decisions
without factoring in the effect of exchange rates; opportunities for foreign-exchange
arbitrage would be eliminated and countries would be free to focus on domestic policies
without having to worry about coordinating them with other nations.
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Essence of the exercise


This exercise asks students to determine what the value of the Polish currency, the zloty, will
be in 90 days, 180 days, and 365 days. The exercise is a difficult one because, at present,
there is no forward market for the currency. Consequently, students will have to develop an
alternative method of forecasting where the currency is likely to go.
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Essence of exercise
This exercise allows the student to test his/her knowledge of exchange rates and the forward
market. It involves simple mathematical calculations as well as more thought provoking
exercises that require the student to extend the basic mathematical calculations and
observations to draw conclusions about the implications of flexible exchange rates.

Answers to the follow-up questions (based on Figure 7.4, on page 191).

1. What is the spot rate for the British pound on Wednesday in terms of the U.S. dollar? Or
stated differently, how many dollars does a pound cost? Or, from the U.S. perspective,
what’s the direct quote on pounds?

The spot rate for the British pound on Wednesday in terms of U.S. dollars is 1.4429.

2. What is the spot price for the dollar on Wednesday in terms of the Swiss franc? (Or, from
the U.S. perspective, what is the indirect rate on Swiss francs?)

The spot rate for the dollar on Wednesday in terms of Swiss Francs is 1.6885.

3. Calculate the cross rate of exchange between the British pound and the Swiss franc.

The cross rate of exchange between British pounds and Swiss francs (using Wednesday's
rates) is 2.447 Swiss francs per British pound (or, conversely, 0.487 British pounds per
Swiss franc).

4. Calculate the annualized forward premium or discount on the 180-day yen.

The annualized forward premium on the yen (using Wednesday's spot rate) is 4.87%.

5. If you’re planning to go to Japan this summer, should you buy your yen today? Why or
why not?

The answer depends on the difference between the interest rate you would get on your
dollars (if you waited to convert them to yen until your trip) and the interest rate you could
get on the yen (if you converted you dollars to yen today). It is probably safe to assume
there is not an arbitrage opportunity, meaning that it doesn't matter one way or another.
However, students should recognize that the "forward yen" is more expensive than the spot
(today's price) yen.

6. According to covered-interest arbitrage theory, is the United States or Japan expected to


have higher interest rates?

The U.S. is expected to have higher interest rates.


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7. According to covered-interest arbitrage theory, what is the expected difference between


interest rates in the United States and Japan?

The expected difference between the interest rates should be equivalent to the annualized
premium on the yen, or roughly 4.87%.

8. According to the international Fisher effect, is the expected inflation rate higher in Japan or
in the United States?

The expected inflation rate in the U.S. should be higher than the inflation expected in
Japan.

9. Did the value of the Canadian dollar rise or fall between Tuesday and Wednesday?

The value of the Canadian dollar rose. On Tuesday the Canadian dollar was worth
$0.6493 U.S. On Wednesday the Canadian dollar's value went up to $0.6509 U.S.

Other Applications
Students may find it interesting to “track” a particular currency over a three-year period by
looking up the exchange rates in the Wall Street Journal for the first day of each month
during the three year time period. Students then get an idea of how rates change and this
can provide a basis for a discussion on why they changed.