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FOREIGN EXCHANGE MARKET

Introduction
The concept of foreign exchange market is like any other market where various national currencies
are exchanged for other currencies. Foreign exchange market refers to the price of one currency in
terms of another. If there are two different currencies involved, there would be two different ways
of quoting foreign exchange; the price quotation system and the volume quotation system. This
book will adopt the price quotation system for its analysis.

The price quotation system defines exchange rate as the number of domestic currency per unit of
foreign currency. In other words, exchange rate is the price of a foreign currency in terms of
domestic currency. For instance, using Ghana as the home country, we say that GH₵3.7915 per
US dollar, GH₵5.8321 per British pound, GH₵4.1936 per Euro, etc.

The volume quotation system defines exchange rate as the number of units of foreign currency per
units of domestic currency. In other words, exchange rate refers to the price of domestic currency
in terms of foreign currency. Hence a reciprocal of the price quotation system. For instance, using
Ghana again as the home country, US$0.2637 per GH₵, 0.1715 British pound per GH₵, 0.2385
euros per GH₵, etc.

Other aspects of exchange rate are the depreciation and appreciation of domestic currency (x). By
exchange rate depreciation, then currency x is worth less in terms of foreign currency and as a
result, greater amount of the domestic currency (x) is required to buy one unit of the foreign
currency (y). In other words, lower amount of the foreign currency (y) is needed to buy one unit
of the domestic currency (x). Exchange rate appreciation is the opposite of exchange rate
depreciation.

Using R as the exchange rate, the following examples may be used to explain depreciation and
appreciation of currencies. The rate of depreciation (or appreciation) is the percentage change in
the value of a currency over some period.

Example 1: U.S dollar (US$) to the Canadian dollar (C$)

On January 6, 2010, rC$/US$= 1.03

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On January 6, 2009, rC$/US$= 1.19, where r denotes exchange rate

Using percentage change formula,

𝑛𝑒𝑤 𝑣𝑎𝑙𝑢𝑒 − 𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒


× 100
𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒

1.03 − 1.19
× 100
1.19

−0.16
× 100 = −13.4%
1.19

Since the percentage change in the value of US dollar in terms of the Canadian dollar is negative,
the US dollar has depreciated by 13.4 percent with respect to the Canadian dollar during the
previous year.

Example 2: U.S dollar (US$) to the Canadian dollar (C$)

On January 6, 2010, rC$/US$= 84.7

On January 6, 2009, rC$/US$= 79.1, where r denotes exchange rate

𝑛𝑒𝑤 𝑣𝑎𝑙𝑢𝑒 − 𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒


× 100
𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒

84.7 − 79.1
× 100
79.1

5.6
× 100 = 7.1%
79.1

Since the percentage change in the value of US dollar in terms of the Canadian dollar is positive,
the US dollar has appreciated by 7.1 percent with respect to the Canadian dollar during the previous
year.

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The Spot Exchange Market

The spot exchange rate refers to the exchange of two currencies on the spot (for immediate
delivery). The spot exchange market by way of arbitrage on currencies, enables one to determine
all the exchange rates by knowing one (n – 1) of them. That is, arbitrage causes actual exchange
rates to practically coincide with the values which satisfy certain simple mathematical relations
which from the theoretical point of view exist between them. Arbitrage means buying a product
when its price is low and then reselling it after its price rises in order to make profit. Hence currency
arbitrage refers to buying a currency in one market at a lower price and then reselling it later in
another market at a higher price

Considering the mathematical relations of the exchange rate of two currencies say currency x for
y and y for x; theoretically, this enables one to reduce the exchange rate from n(n  1) to n(n  1) / 2
. If we denote the exchange rate of currency i with respect to currency j in the ith financial centre
by rji ; that is, the number of units of currency i exchanged for one unit of currency j (price of

currency j in terms of currency i), the consistency conditions requires that

rji rij  1 (1.1)

Where i and j are the two currencies being used. This consistency condition (also known as
neutrality condition) means that by starting with any given quantity of currency i, exchanging it
for currency j and then exchanging the resulting amount of currency j for currency i, one must end
up with the same initial quantity of i . For instance, if x units of currency j are sold in a financial
centre for currency i, we obtain xrji , units of currency i. If the amount of currency i is resold in the

financial centre for currency k, we would obtain ( xrji )rij units of currency j. From the consistency

condition, x  ( xrji )rij must hold. This may be achieve by dividing through by x and rearranging

like terms. We then obtain equation (1.1) above and from this equation, it follows that;

rji  1/ rij , rij  1/ rji (1.2)

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This was the initial statement made (that is, by this condition, one must end up with the same initial
quantity of i or j).

In a more practical way, using the exchange rate between Japan and USA; If the exchange rate
between the yen (¥) and the US dollar ($) is 115.20737 in Tokyo (¥ 115.20737 per $1),
mathematically; the $/¥ exchange rate in New York is 0.00868 (that is the reciprocal of the ¥/$ is
the $/¥, and as a result $0.00868 per Japanese yen). It is the arbitrage that ensures the exchange
rate between the two currencies in New York is 0.00868, given the exchange rate of 115.20737
between them in Tokyo. In this case, where two financial centres are involved, the arbitrage is
known as the two – point arbitrage.

Let us again assume that while the ¥/$ exchange rate in Tokyo is 115.20737, the exchange rate in
New York is $0.009 for ¥1. The arbitrageur can buy ¥ with $ in Tokyo and then resell them for $
in New York, obtaining a profit of $0.00032 per ¥ (the difference between the selling $0.009 and
buying $0.00868 price of one ¥). One important point to note about arbitrage is that, no cost of
financing or exchange risk is incurred. This is because arbitrage does not tie up capital since
transaction occurs simultaneously and instantaneously on computers, telephone telex and other
sources of communication. However, additional demands for yen (when there is increased supply
of the dollar) in Tokyo leads to an appreciation of the yen with respect to the dollar in Tokyo
whiles supply for the yen (when there is increased demand for the dollar) leads to a depreciation
of the yen with respect to the dollar in Tokyo. This occurs continuously as far as arbitrage is no
longer profitable (that is, when the exchange rate between two currencies in two financial centres
have been brought to the point where they satisfy the neutrality or consistency condition). In
practice, due to transaction costs, different business hours, different time zones and possible
frictions, the neutrality condition may not be satisfied.

The examples above are for the case of bilateral exchange rates. Let us now turn our focus to the
notion of indirect or cross exchange rate. The indirect exchange rate of currency i with respect to
currency j shows how may units of currency exchanged through the purchase and sale of a third
currency say m, for one unit of currency j. The indirect exchange rate between currency i and
currency j is thus written as rjm rmi . The neutrality condition would require that the indirect and

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direct rates be equal with the direct rate of currency i with respect to currency j which equals to rji

. The mathematical relation also holds;

rji  rjm rmi (1.3)

For any triplet of different indexes i, j, m. Equation (1.3) can also be expressed as equation (1.2)
above.

rij  1/ rji , rmi  1/ rmi . This follows that rji rim rmj  1 or rij rjm rmi  1 (1.4)

For example, assume the US dollar / euro ($/€) is $1.069 per €1. Assume also that the ¥/$ exchange
rate in Tokyo is ¥115.20737 per $1 in Tokyo. This gives the €/¥ cross rate in Tokyo as
¥123.1566785 (115.20737×1.069) per €1. This is still as a result of arbitrage but in the form of
three – point or triangular arbitrage since there are three currencies involved. From the
explanations given, it can readily be checked that the cross rates between any pair of currencies
say i and j are n – 2. When there are n currencies involved, it is possible to exchange currencies i
and j indirectly through any one of the other (n – 2) currencies.

The Real Exchange Rate

Generally, real magnitudes are obtained from their corresponding magnitudes after eliminating the
changes in price. However, more complications arise in the case of exchange rate since exchange
rate is intrinsically a nominal concept which is not obtained by multiplying a physical quantity by
its price. The real exchange rate is a relative price but there is no agreement on which relative price
should be called the real exchange rate as a result of the varied definitions of real exchange rate.

The most common definition of the real exchange rate is that associated with the ratio of general
price levels at home and abroad expressed in a common monetary unit or the nominal exchange
𝑝
rate adjusted for relative prices (or inflation) between the countries under consideration.𝑟𝑟 = 𝑟𝑝ℎ
𝑓

ph
rr  (1.5)
rp f

Or

5
1
ph
rr  r (1.6)
pf

Where ph and p f are the domestic and foreign price levels respectively and rr is the real
exchange rate. This definition may be linked to the Purchasing Power Parity (PPP) which would
be discussed later in the subsequent chapters.

Another definition of the real exchange rate is domestically relative price of tradable and non –
tradable goods. This can be expressed as:

pT
rr  (1.7)
p NT

Or

p NT
rr  T (1.8)
p

Where T denotes tradable goods and NT denotes non – tradable goods. The rationale of the above
definitions is that, in a two – sector model (tradables and non – tradables), the balance of trade
depends on the ratio of the prices ( PT / PNT ). This is because their relative prices measure the
opportunity cost of domestically produced tradable goods and the ex-ante balance of trade depends
on ex-ante excess supply of tradables. Equation (1.8) means that a rise in the real exchange rate
denotes an appreciation whiles a fall, denotes a depreciation.

Another widely accepted definition of real exchange rate provides a measure of external
competitiveness of a country’s goods. Using a simple export – import model of trade, the real
exchange rate may be defined in the notion of the terms of trade, used in the theory of international
trade;

px
rr    (1.9)
rpm

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Where px and pm represent export prices (in terms of domestic currency) and import prices (in
terms of foreign currency) respectively, r is the nominal exchange rate of the country being
considered. The consumer however, views  as the relative price of foreign and domestic goods
on which demand depends on. The country also views  as the amount of imports that can be
obtained in exchange for one more unit of exports. Hence, if  increases, then there is
improvement in the terms of trade since more imports can be obtained per unit of exports.  may
also be expressed as shown in equation (1.6) above

1
px
r (1.10)
pm

In this case,  may serve both domestic and foreign consumers for relevant price comparison. This
is because equation (1.9) expresses price of domestic and foreign goods in domestic currency
whiles equation (1.10) expresses the price of domestic and foreign goods in foreign currency.

The final definition of real exchange rate to be considered is that of the ratio of units of labor costs
at home (Wh) to units of labor costs abroad (Wf) which as expressed in a common monetary unit
through the nominal exchange rate (r).

W 
rr  r  f  (1.11)
 Wh 

Where rr is the real exchange rate. Here, an increase (decrease) in real exchange rate means an
improvement (deterioration) in the external competitiveness of domestic goods. Ceteris paribus,
an increase in domestic unit labor costs with respect to foreign unit labor cost is reflected (in both
perfectly and imperfectly competitive markets) in an increase of the relative price of domestic
goods with respect to foreign goods.

The Effective Exchange Rate

One must note that the concept of effective exchange rate is not the same as the real exchange rate
since the effective exchange rate can be nominal or real. Whereas the nominal or real exchange

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rate involves only two currencies, it may be desirable to have an idea of the overall external value
of currency with respect to the rest of the world and not only another country’s currency. In the
presence of a floating exchange rate, it is difficult to ascertain the behavior of the external value
of a currency, since a floating exchange rate may simultaneously cause a currency to depreciate or
appreciate with respect to various foreign currencies. When this occurs, it becomes necessary to
use an index number in which the bilateral exchange rates of one currency with respect to another
enter with suitable weights. This index number is the effective exchange rate.

Beginning with nominal effective exchange rate, the formula below may be applied;


n
rei 
j 1, j 1
w j rji , 
j 1, j 1
wj  1 (1.12)

Where; rei , rji , w j are the (nominal) effective exchange rate of currency i, nominal exchange
rate of currency i with respect to currency j and weight given to currency j in the construction of

the index respectively. However, by definition the weights must sum up to 1. rji is defined using

volume quotation system.

In most data, the effective exchange rate is given as an index number with a base of 100. It is
presented in such a way that an increase or decrease in it means an appreciation or depreciation of
the currency with respect to other currencies as a whole. Using real bilateral exchange rate for
equation (1.12), would help us obtain a real effective exchange rate which gives an overall
competiveness of domestic goods on world markets rather than with respect to another country’s
goods.

The Forward Exchange Rate

The forward exchange rate refers to the agreement for a future exchange of two currencies at an
agreed date (for instance, 6 months’ time) or the rate that appears on a contract to exchange
currencies either 30 days or 90 days in the future. The main function of the forward exchange rate
is to allow economic agents engaged in international transactions to cover themselves against
exchange risk deriving from possible future variations in the spot exchange rate (in other words,

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the forward exchange rate is used to reduce exchange rate risk). In this case, if the spot exchange
rate was rigidly fixed permanently, then any future payment in foreign currency does not incur any
exchange risk since the receiver knows how much to be paid. However in real world, the spot
exchange rate is bound to change through time so one incurs exchange risk for any future
transactions.

For instance, suppose an importer of BMW is expecting a shipment in sixty days. Suppose that
upon arrival, the importer must pay €1,000,000 and the current spot exchange rate is 1.20$/€. If
payment was made today, it would cost $1,200,000. Suppose further that the importer is fearful of
a U.S dollar depreciation. He does not currently have the $1,200,000 but expects to earn more than
enough in sales over the next two months. If the US dollar falls in value to 1.30 $/€ within 60 days,
how much would it cost the importer in dollars to purchase the BMW shipment?

To know the amount it would cost in dollars, multiply €1,000,000 by 1.30 $/€ to get $1,300,000
since the shipment still costs €1,000,000. Note that this amount in dollars is $100,000 ($1,300,000
- $1,200,000) more for the cars since the US dollar value has changed (depreciated).

To the agent (importer), who has to make future payments in foreign currency, the risk is that
exchange rate will have depreciated at the time of payment where he will have to pay out a greater
amount of domestic currency to purchase the required amount of foreign currency. Also the
exporter who is to receive a future payment in foreign currency, the risk is that exchange rate will
have appreciated at the time of payment where he (the exporter) obtains a smaller amount of
domestic currency from the sale of the given amount of foreign currency.

It is important to note that agents who make future payment in foreign currency benefit from an
appreciation of domestic currency and agents who receive future payments in foreign currency
also benefit from a depreciation of domestic currency. However, with an exclusion of the category
of speculators, the average economic agent becomes risk averse since he is no capable of predicting
the future behavior of the exchange rate. As a result, he considers both future appreciations and
depreciations to be equally likely and as such will assign greater weight on the possibility of a loss
than a gain.

One way to avoid exchange risk is through a forward exchange market. When the forward
exchange rate is such that the forward trade costs more than the spot trade costs today, there is said

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to be a forward premium. The reverse holds, then there is a forward discount. Also, a trader may
hedge if he enters into a forward contract to protect himself from a loss. As a result, an average
operator will seek to hedge. Generally, hedging against an asset is the activity of making sure to
have a zero net position where there is no net asset nor net liability position in that asset. However,
by hedging, the trader forfeits the possibility of an upward gain.

For example: with reference to the story of the importer of BMW above, suppose the spot exchange
rate falls from 1.20 $/€ to 1.10 $/€. How much would the import pay for the shipment?

To answer this question, if the importer had waited, the €1,000,000 would only have cost
$1,100,000 (1.10 $/€ × $1,000,000). In this case, hedging protects against lost but at the same time
eliminates potential unexpected gain of $100,000 ($1,200,000 - $1,100,000)

Various Covering Alternatives; Forward Premium and Discount

Let us now consider an economic agent who makes payment at a given future data (in this case,
an importer of commodities such as the BMW car). There are various possibilities and
opportunities for cover, including the forward premium stated above. Among these possibilities
are:

i. The economic agent (the importer) may buy the foreign exchange forward where he will
not have to pay any cent now since any settlement of the forward contract would be make
in the known future date.
ii. The economic agent also has the possibility of making early payments. Here, he can
purchase the foreign exchange spot and settle his debt in advance. However, one needs to
evaluate the cost and benefit in this case. In evaluating the costs, we can count the
opportunity cost of domestic funds (forgoing the domestic interest rate on his funds for the
delay granted in payment if he owns the funds or where he pays the domestic interest rate
to borrow funds now if he does not own the funds). In evaluating the benefits, we have the
discount (here, this discount is related to the foreign interest rate) allowed by the foreign
creditor since there was an advance payment. For simplicity, we assume that the percentage
discount is the same as the full amount of foreign interest rate and that the calculation is
made using the same and exact formula;

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 1 
x  rather than the approximate commercial formula x  i f x  x(1  i f ) , where x is
 (1  i f ) 
the amount of foreign currency due in the future and if is the foreign interest rate at a given
period of time.
iii. Another possibility of the economic agent is to immediately buy the foreign exchange spot,
invest it in the foreign country from now till the maturity of the debt and pay at maturity
(spot covering). This possibility also has some costs and benefits. The costs are the same
for the second option above. The benefits however, counts the interests earned by the agent
as a result of investing the foreign exchange abroad.

In practice, things do not go smoothly. Let us consider an agent who is to receive payment in
the future, the alternatives are:

a. The agent has to sell the foreign exchange forward


b. Allow a discount to the foreign debtor so as to obtain an advance payment and
immediately sell the foreign exchange spot
c. Discount the credit with a bank and sell the foreign exchange spot immediately.

To compare the alternatives above, we must know the exact amount of divergence between the
forward and current spot exchange rate aside the domestic and foreign interest rates. To do this,
we consider the forward premium and discount.

As already defined above, a forward premium denotes that the currency being considered is more
expensive, in terms of the foreign currency for future delivery than immediate delivery. A forward
discount however, denotes the opposite situation where the currency is cheaper for future delivery
than for immediate delivery. In foreign exchange quotations, the forward exchange rate is usually
quoted implicitly but when it is quoted explicitly as a price, it is sometimes called an outright
forward exchange rate. When the spot price of an asset exceeds its forward price, a backwardation
is said to occur. However, when the spot price falls short of its forward price, a contango is said to
occur. This makes is necessary to have clear idea of exchange rates quotations. If the price
quotation system is used, higher value of the currency forward than spot means forward exchange
rate is lower than the spot exchange rate. The reverse also is true. If the volume quotation is used
instead of the price quotation, higher value of the currency forward than spot means the forward

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exchange rate is higher than the spot and lower value of currency forward than spot means forward
exchange rate is lower than spot.

In the price quotation system, the forward premium will be measured by a negative number where
the difference between the forward minus the spot exchange rate is in fact, negative and the
forward discount would be measured by a positive number. The counterintuitive numerical
definition is presumably due to the fact that the terminologies seemed to have originated in
England where the volume quotation system is used. Hence by subtracting the spot from the
forward exchange rate, on obtains a positive or negative number in the case of premium and
discount respectively.

Adopting the price quotation system, the proportional difference between the forward and spot
exchange rate may be shown as below;

rF  r
(1.13)
r

Where r denotes the generic spot exchange rate and rF denotes the corresponding forward rate of
a currency.

The difference gives a measure of the forward premium if negative and forward discount if
positive. Since there are different maturities for forward contracts, in practice, the proportional
differences in equation (1.13) above, is given on a per annum basis by multiplying it by a suitable
factor. The reason why the forward margin (being premium or discount) is expressed in this
proportional form is to give it the dimension of an interest rate and can use it to make comparisons
with domestic and foreign interest rates. Equation (1.13) may sometimes be referred to as an
implicit interest rate in the forward transactions.

We can now make comparisons with the various alternatives of agents who have to make future
payment. To do this, we first have to show that alternative “b. and c.” are equivalent. With the
costs already being equivalent, as regard to the benefits, we can assume the discount made by the
foreign creditor for payment in (case b) is equal in percentages to the interest rate that the debtor
might earn on foreign currency invested the creditor’s country (case c).

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In order words, let ih and if denotes home and foreign interest rate respectively. Let x be the amount
of the debt in foreign currency. With alternatives b., thanks to the discount allowed by the foreign
creditor, it becomes sufficient to purchase an amount x / (1  i f ) of foreign currencies now. The

same is true with alternative c. this is because, when an amount x / (1  i f ) of foreign currency is

purchased and invested in the creditor’s country for the given period at the interest rate i f, the
 x 
amount   (1  i f )  x will be obtained at the maturity of the debt. This purchase requires
 (1  i f ) 
 x 
an immediate outlay of an amount r   of the domestic currency.
 (1  i f ) 

Considering the opportunity cost of domestic funds (referring to the period considered), the total
net cost of the operation in cases b and c (referring to the maturity date of the debt) can be obtained
by adding the opportunity cost to the sum calculated above. This gives the expression below;

 rx 
  (1  ih ) (1.14)
 (1  i f ) 

Considering case a: the economic agent will have to pay out the sum of r F x in domestic currency
when the debt falls due. It becomes obvious that alternative a will be better than, be the same or
worse than alternative b and c since b and c are equivalent:

 rx
rF x (1  ih ) (1.15)
 1 if

By dividing through by rx, we obtain:

r F  1  ih
(1.16)
r  1 if

By subtracting unity from both sides, we obtain:

r F  r  ih  i f
(1.17)
r  1 if

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The left hand side gives the forward margin: the numerator of the fraction on the right – hand side
is the interest rate differential between the domestic and foreign economy. Formula (1.17) is
mostly simplified ignoring the denominator but this is legitimate only when the foreign interest
rate (if) is very small. The condition of indifference between the alternatives occurs when the
forward margin equals the interest rate differential.

Transactors/Participants in the Foreign Exchange Market

Classification of Transactors of the foreign exchange market would be based on functional rather
than personal or institutional basis. For instance, importers and exporters who change the timing
of payments and receipts to get the benefit of an expected variation in the exchange rate are
simultaneously traders and speculators. Possible classification therefore must be based on three
categories with possible subdivisions: speculators, non – speculators and monetary authorities.

Speculators

Speculation may be defined as the purchase or sale of goods, assets, etc. with the aim of reselling
or repurchasing them as a later date. The motive behind such actions is the expectation of gaining
more which is derived from a change in the relevant prices relative to the ruling price and not a
gain accruing through their use, transformation and transfer between different markets (Kaldor,
1939). Generally, an agent who expects an increase in the price of an asset is called a bull whiles
an agent who expects a decrease in the price of an asset is called a bear. If we denote the expected
future price by ṝ, a bull in foreign currency ( r  r ) will normally buy foreign currency (have long
position) and a bear in a foreign currency ( r  r ) will normally sell foreign currency (have short
position). Both actors incur an exchange risk deliberately to profit from the expected variation in
the exchange rate. This risk is therefore accounted for by introducing a risk premium which will
the greater, the greater the dispersion of expectations and the size of commitments.

If a bull’s expected speculative capital gain in percentage terms is given by (r  r ) / r , although the
interest rate gain and loss are negligible in speculative activities, they have to be taken into account
for a precise evaluation. Hence the bull will speculate if (r  r ) / r    i f  ih , where δ is a risk

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premium. Similar considerations also show that the bear will speculate if (r  r ) / r    i f  ih .

However, there is no incentive to speculate in either direction when there exist;

r r
   ih  i f (1.18)
r

This is the speculation on spot foreign exchange besides which a forward exchange speculation
also exists. The forward exchange speculation is derived from a divergence between the current
forward rate and the expected spot rate of a currency. If the expected spot rate exceeds (or falls
short of) the current forward rate, it becomes advantageous for speculators to buy (to sell) foreign
currency forward. This is because the speculator expects that when the forward contract matures,
he will be able to resell (repurchase) the foreign currency spot at a price higher (lower) than the
price he will pay (or be paid for delivering it) at the current forward rate. In practice, the forward
exchange speculative transaction between parties involved is settled by the difference between the
forward exchange rate and the spot exchange rate existing at the time of maturity, and multiplied
by the amount of currency contemplated in the forward contract. Again, banks often require the
Transactors in forward exchange to put down a given percentage of the contract as collateral which
among other things depends on the efficiency and development of the forward market and on
possible binding instructions of central banks.

Non – Speculators

Non – speculators are defined by exclusion where such agents are neither speculators nor monetary
authorities. This functional category excludes importers and exporters of goods and services,
businesses with carry out investment abroad, individuals or institutional savers who diversify their
portfolios between national and foreign assets by making considerations of risk and yield,
arbitrageurs, etc.

Monetary Authorities

Monetary authorities refer to institutions (usually the central bank but also exchange equalization
agencies where they exist as juridical bodies that are separates from the central bank) to which the
management of the international reserves of the relative country is attributed. These authorities
intervene in exchange for their own and by taking various administrative measures such as

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exchange controls during exchange rate crisis (an example is the case of Ghana where the central
bank embarks on various alternatives and measures to help stabilize the cedis).

16
RATE OF RETURN

Introduction

Investors generally have three broad concerns when an investment is made. They care more about
how much money the investment will earn over time, how risky the investment is and how
convertible the asset is. In other words, investors care about obtaining high rate of return,
minimizing risk of default and maintaining an acceptable degree of liquidity.

The rate of return therefore is the percentage change in the value of an asset over some period.
Investors would purchase an asset to save for the future. As a result, whenever an asset is
purchased, the purchaser is forgoing current consumption for future consumption with the hope to
have more money for the future consumption. Example; suppose a Picasso painting is purchased
in 1996 for $500, 000. One year later, the painting is resold for $600, 000. The rate of return is
calculated as below;

𝑛𝑒𝑤 𝑣𝑎𝑙𝑢𝑒 − 𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒


× 100
𝑜𝑙𝑑 𝑣𝑎𝑙𝑢𝑒

$600, 000 − $500,000


× 100
$500,000

$100,000
× 100 = 20%
$500,000

A positive rate of return means the investor would have gained money in dollar terms by
purchasing the Picasso painting.

The second primary objective of investors is the riskiness of assets and generally, the greater the
expected return, the higher the risk involved. For instance, investing in an oil business might get
you a 1,000 percent return on your investment. Hence a key concern to investors is how to manage
the trade – off between risk and return.

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The final objective is liquidity. Liquidity means the speed with which assets can easily be
converted to cash. For instance, insurance companies need to have assets that are fairly liquid in
the need to pay out a large number of claims. Other institutions such as banks also need to make
payouts to their depositors who might request their money back any time.

CALCULATION AND INTERPRETATION OF THE RATE OF RETURN

Suppose an investor holding US dollars must decide between two investments of equal risk and
liquidity. Suppose one potential investment is a one – year certificate of deposit (a CD is a type of
deposit that provides a higher rate of return of interest to the depositor in return for a promise to
keep the money deposited for a fixed amount of time) issued by the US bank whiles the second is
a one – year certificate of deposit issued by the British bank. Let us assume for simplicity that the
interest calculated on the certificate of deposit using a simple interest rate approach rather than a
compounding formula. We also assume that an investor wants to obtain the highest rate of return
possible given the acceptable risk and liquidity.

First we need to collect some data which is done in general terms rather than specific values.

Let r$/£= the spot exchange rate

r$/£e= the expected exchange rate one year from now

i$ is the one – year interest rate on a CD in the US

i£ is the one – year interest rate on a CD in Britain.

The rate of return on the US certificate of deposit is the interest rate on that deposit which may be
expressed as rr$ = i$. Where rr is the rate of return.

However, the rate of return on the British CD may be more difficult to obtain. If a US investor
with dollars wants to invest in the British CD, he must first exchange dollars for pounds on the
spot exchange market and then use the pounds to purchase the British CD. After a year, he must
convert the pounds back to dollars at the prevailing exchange rate. The rate of return on that
investment is the percentage change in the dollar value during the year. The procedure below may
be used to obtain the British rate of returns.

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Step 1: convert the dollars to pounds

𝑃
𝑟$/£

This is the number of pounds the investor will have at the beginning of the year

Step 2: purchase the British CD and earn interest in pounds during the year.

𝑃
(1 + 𝑖£ )
𝑟$/£

Step 3: covert the principal plus interest back into dollar in one year.

𝑃 𝑒
(1 + 𝑖£ )𝑟$/£
𝑟$/£

The rate of return in dollar terms from this British investment can be found by calculating the
expected percentage change in the value of the investor’s dollar assets over the year. This is shown
below:

𝑃 𝑒
(1 + 𝑖£ )𝑟$/£ −𝑝
𝑟
𝑟 $/£
𝑟£ =
𝑃

After factoring P out, this reduces to:


𝑒
𝑟$/£
𝑟£𝑟 = (1 + 𝑖£ ) − 1
𝑟$/£

The rate of returns therefore depends on the foreign interest rate, the spot exchange rate and the
expected exchange rate one – year in the future. Note that from the formula above, the rate of
return is positively related to the changes in the foreign interest rate and the expected foreign
currency value but negatively related to the spot foreign currency value.

Simplifying the rate of return formula above further:

Step 4: Factor out the term in parenthesis, add and subtract i₤. This mathematically does not change
in value when we add and subtract the same value.

19
𝑒 𝑒
𝑟$/£ 𝑟$/£
𝑟£𝑟 = + 𝑖£ − 1 + 𝑖£ − 𝑖£
𝑟$/£ 𝑟$/£

𝑟
Step 5: change the (-1) in the expression to its equivalent, − 𝑟$/£ . Also change -i£ to its equivalent
$/£

𝑟 𝑟
as well to obtain: −𝑖£ 𝑟$/£ . This is because 𝑟$/£=1
$/£ $/£

𝑟𝑒 𝑟𝑒 𝑟 𝑟
We now obtain: 𝑟 𝑟 £ = 𝑟$/£ + 𝑖£ 𝑟$/£ − 𝑟$/£ + 𝑖£ − 𝑖£ 𝑟$/£
$/£ $/£ $/£ $/£

Step 6: rearranging the expression above gives;


𝑒 𝑒
𝑟$/£
𝑟$/£ 𝑟$/£ 𝑟$/£
𝑟£𝑟 = 𝑖£ + − + 𝑖£ − 𝑖£
𝑟$/£ 𝑟$/£ 𝑟$/£ 𝑟$/£

Step 7: simplify by combining terms with common denominators and factor out the percentage
change in the exchange rate term to obtain:
𝑒
𝑟$/£ − 𝑟$/£
𝑟£𝑟 = 𝑖£ + (1 + 𝑖£ )
𝑟$/£

From this formula, the expected rate of return on the British asset depends on the British interest
𝑒
𝑟$/£ −𝑟$/£
rate and the expected percentage change in the value of the pound. If was a positive
𝑟$/£

number, then it corresponds to the expected rate of appreciation of the pound during the following
year and if it is a negative number, then it corresponds to the expected depreciation of the pound
during the subsequent year.

A positive rate of return means that the investor would have gained money in dollar terms by
purchasing the British asset and a negative rate of return means that the investor would be lost
money in dollar terms by purchasing the British asset.

In order to make sense of the expressions above, let us consider a series of simple numerical
examples;

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Given the following values in the table below;

i£ 5% per year

𝑒
𝑟$/£ 1.1$/£

𝑟$/£ 1.0$/£

Plugging these into the rate of return formula yields

1.10 − 1.00
𝑟£𝑟 = 0.05 + (1 + 0.05)
1.00

𝑟£𝑟 = 0.05 + (1 + 0.05)(0.10)

𝑟£𝑟 = 0.155 𝑜𝑟 15.5%

Because the exchange rate changes, the rate of return on the British assets is considerable higher
than the 5% interest rate

APPLYING THE RATE OF RETURN FORMULARS

This section uses data from the various tables below to calculate in which country it would have
been best to purchase a one – year interest – bearing asset.

Example 4.1: Consider the following data for interest rates and exchange rates in the United States
and Britain

i$ 2.37% per year

i£ 4.83% per year

04 1.96$/£
𝑟$/£
05 1.75$/£
𝑟$/£
1.75 − 1.96
𝑟£𝑟 = 0.0483 + (1 + 0.0483)
1.96

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−0.21
𝑟£𝑟 = 0.0483 + (1 + 0.0483)
1.96

𝑟£𝑟 = −0.064 𝑜𝑟 − 6.4%

A negative rate of return means that the investor would have lost money in dollar terms by
purchasing the British asset. Since 𝑟$𝑟 = 2.37% > 𝑟£𝑟 = -6.4%, the investor seeking the highest rate
of return should have deposited her money in the U.S account

Example 4.2: Consider the following data for interest rates and the exchange rates in the United
States and Japan

i$ 2.37% per year

i¥ 0.02% per year

04 104¥/$
𝑟¥/$
05 120¥/$
𝑟¥/$

Imagine that the decision to be made in 2004, looking forward into 2005. However, we calculate
this in hindsight after we know what the 2005 exchange rate is. Thus we plug in the 2005 rate for
the expected exchange rate and use the 2004 rate as the current spot rate. Note again that the
interest rate in Japan really was 0.02% which is virtually zero.

It is necessary to convert the exchange rate to the yen equivalent rather than the dollar equivalent
before we calculate the rate of return.

04 1
𝑟¥/$ = = 0.0096
104

05 1
𝑟¥/$ = = 0.0083
120

0.0083 − 0.0096
𝑟£𝑟 = 0.0002 + (1 + 0.0002)
0.0096

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𝑟£𝑟 = 0.0002 + (1 + 0.0002)(−0.1354)

𝑟£𝑟 = −0.1352 𝑜𝑟 − 13.52%

A negative rate of return means that the investor would have lost money in dollar terms by
purchasing the British asset. Since 𝑟$𝑟 = 2.37% > 𝑟£𝑟 = -13.52%, the investor seeking the highest
rate of return should have deposited her money in the U.S account.

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