Learning Objectives

• Define foreign exchange market
• Describe different types of investments like foreign direct investments, portfolio investments, and hedging
• Explain how the appreciating or depreciating of currency affects exchange rates
• Identify who benefits from a stronger currency and who benefits from a weaker currency

Extraordinary Size of the Foreign Exchange Markets

The quantities traded in foreign exchange markets are breathtaking. A survey done in April 2013, by the Bank of International Settlements, an international organization for banks and the financial industry, found that $5.3 trillion per day was traded in foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2013 U.S. real GDP was $15.8 trillion per year.

Table 15.1 shows the currencies most commonly traded in foreign exchange markets. The foreign exchange market is dominated by the U.S. dollar, the currencies used by nations in western Europe—the euro, the British pound, and the Australian dollar—and the Japanese yen.

Demanders and Suppliers of Currency in Foreign Exchange Markets

In foreign exchange markets, demand and supply become closely interrelated because a person or firm who demands one currency must at the same time supply another currency, and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market: (1) firms that are involved in international trade of goods and services; (2) tourists visiting other countries; (3) international investors buying ownership, or part ownership, of a foreign firm; and (4) international investors making financial investments that do not involve ownership. Let’s consider these categories in turn.

Firms that buy and sell on international markets find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. So, a Chinese firm exporting abroad will earn some other currency—say, U.S. dollars—but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.

International tourists will supply their home currency to receive the currency of the country they are visiting. For example, an American tourist who is visiting China will supply U.S. dollars in the foreign exchange market and demand Chinese yuan.

Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories. Foreign direct investment (FDI) refers to purchasing a firm, at least 10 percent, in another country or starting up a new enterprise in a foreign country. For example, in 2008 a Belgian beer-brewing company bought a U.S. bear company for $52 billion. To make this purchase of a U.S. firm, the Belgian beer-brewing would have to supply euros, the currency of Belgium, to the foreign exchange market and demand U.S. dollars.

The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased bonds issued by the government of the United Kingdom or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.

Portfolio investment is often linked to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing bonds issued in the United Kingdom. For simplicity, ignore any interest paid by the bond, which will be small in the short term anyway, and focus on exchange rates. Say that a British pound is currently worth $1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth $1.60 in U.S. currency. Thus, as shown in Figure 15.2 (a), this investor would change $24,000 for 16,000 British pounds. In a month, if the pound is indeed worth $1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate and have $25,600—a nice profit. A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly. Say that an investor expects that the pound, now worth $1.50 in U.S. currency, will decline to $1.40. Then, as shown in Figure 15.2 (b), that investor could start off with £20,000 in British currency (borrowing the money if necessary), convert it to $30,000 in U.S. currency, wait a month, and then convert back to approximately £21,429 in British currency—again making a nice profit. Of course, this kind of investing comes without guarantees and an investor will suffer losses if the exchange rates do not move as predicted.

Figure 15.2 A Portfolio Investor Trying to Benefit From Exchange Rate Movements Expectations of the future value of a currency can drive demand and supply of that currency in foreign exchange markets.

Many portfolio investment decisions are not as simple as betting that the value of the currency will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. But you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Let’s say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against a risk from one of your investments, in this case, currency risk from the contract. Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary and you will have to pay a fee for nothing. But if the value of the euro in dollars declines, then you are protected by the hedge. Financial contracts like hedging, where parties wish to be protected against exchange rate movements, also commonly lead to a series of portfolio investments by the firm that is receiving a fee to provide the hedge.

Both FDI and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency. With portfolio investment, less than 10 percent of a company is purchased. As such, portfolio investment is often made with a short-term focus. With FDI, more than 10 percent of a company is purchased and the investor typically assumes some managerial responsibility; thus, FDI tends to have a more long-term focus. As a practical matter, portfolio investments can be withdrawn from a country much more quickly than FDIs. A U.S. portfolio investor who wants to buy or sell bonds issued by the government of the United Kingdom can do so with a phone call or a few clicks of a computer mouse. However, a U.S. firm that wants to buy or sell a company, such as one that manufactures automobile parts in the United Kingdom, will find that planning and carrying out the transaction takes a few weeks, even months. Table 15.2 summarizes the main categories of demanders and suppliers of currency.

Participants in the Exchange Rate Market

The foreign exchange market does not involve the ultimate suppliers and demanders of foreign exchange literally seeking each other out. For example, if Martina decides to leave her home in Venezuela and take a trip in the United States, she does not need to find a U.S. citizen who is planning to take a vacation in Venezuela and arrange a person-to-person currency trade. Instead, the foreign exchange market works through financial institutions and it operates on several levels.

Most people and firms who are exchanging a substantial quantity of currency go to a bank, and most banks provide foreign exchange as a service to customers. These banks and a few other firms, known as dealers, then trade the foreign exchange. This is called the interbank market.

In the world economy, roughly 2,000 firms are foreign exchange dealers. The U.S. economy has less than 100 foreign exchange dealers, but the largest 12 or so dealers carry out more than half the total transactions. The foreign exchange market has no central location, but the major dealers keep a close watch on each other at all times.

The foreign exchange market is huge not because of the demands of tourists, firms, or even FDI, but instead because of portfolio investment and the actions of interlocking foreign exchange dealers. International tourism is a very large industry, involving about $1 trillion per year. Global exports are about 23 percent of global GDP, which is about $18 trillion per year. FDI totaled about $1.5 trillion at the end of 2013. These quantities are dwarfed, however, by the $5.3 trillion per day being traded in foreign exchange markets. Most transactions in the foreign exchange market are for portfolio investment, relatively short-term movements of financial capital between currencies, and because of the actions of the large foreign exchange dealers as they constantly buy and sell with each other.

Strengthening and Weakening of Currency

When the prices of most goods and services change, the price is said to rise or fall. For exchange rates, the terminology is different. When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, it is referred to as appreciating or strengthening. When the exchange rate for a currency falls, so that a currency trades for less of other currencies, it is referred to as depreciating or weakening.

To illustrate the use of these terms, consider the exchange rate between the U.S. dollar and the Canadian dollar since 1980, shown in Figure 15.3 (a). The vertical axis in Figure 15.3 (a) shows the price of $1 in U.S. currency measured in terms of Canadian currency. Clearly, exchange rates can move up and down substantially. A U.S. dollar traded for $1.17 Canadian in 1980. The U.S. dollar appreciated or strengthened to $1.39 Canadian in 1986, depreciated or weakened to $1.15 Canadian in 1991, and then appreciated or strengthened to $1.60 Canadian in 2002, fell to approximately $1.20 Canadian in 2008, and then had a sharp increase and decline in 2009 and 2010. The units in which exchange rates are measured can be confusing, because the exchange rate of the U.S. dollar is being measured using a different currency—the Canadian dollar. But exchange rates always measure the price of one unit of currency by using a different currency.

Figure 15.3 Strengthen or Appreciate Versus Weaken or Depreciate Exchange rates tend to fluctuate substantially, even between bordering companies such as the United States and Canada. By looking closely at the time values—the years vary slightly on these graphs—it is clear that the values in part (a) are a mirror image of those in part (b), which demonstrates that the depreciation of one currency correlates to the appreciation of the other and vice versa. This means that when comparing the exchange rates between two countries, in this case, the United States and Canada the depreciation or weakening of one currency—the U.S. dollar for this example—indicates the appreciation or strengthening of the other currency—the Canadian dollar for this example. (Federal Reserve Bank of St. Louis, n.d.)

By looking at the exchange rate between two currencies, it is clear that the appreciation or strengthening of one currency means the depreciation or weakening of the other. Figure 15.3 (b) shows the exchange rate for the Canadian dollar measured in terms of U.S. dollars. The exchange rate of the U.S. dollar measured in Canadian dollars, shown in Figure 15.3 (a), is a perfect mirror image of the exchange rate of the Canadian dollar measured in U.S. dollars, shown in Figure 15.3 (b). A fall in the Canadian dollar/U.S. dollar ratio means a rise in the U.S. dollar/Canadian dollar, and vice versa.

With regard to the price of a typical good or service, it is clear that higher prices benefit sellers and hurt buyers whereas lower prices benefit buyers and hurt sellers. In the case of exchange rates, where the buyers and sellers are not always intuitively obvious, it is useful to trace through how different participants in the market will be affected by a stronger or weaker currency. Consider, for example, the impact of a stronger U.S. dollar on six groups of economic actors, as shown in Figure 15.4: (1) U.S. exporters selling abroad; (2) foreign exporters—that is, firms selling imports in the U.S. economy; (3) U.S. tourists abroad; (4) foreign tourists visiting the United States; (5) U.S. investors—either FDI or portfolio investment—considering opportunities in other countries; and (6) and foreign investors considering opportunities in the U.S. economy.

Figure 15.4 How Do Exchange Rate Movements Affect Each Group? Exchange rate movements affect exporters, tourists, and international investors in different ways.

For a U.S. firm selling abroad, a stronger U.S. dollar is a curse. A strong U.S. dollar means that foreign currencies are correspondingly weak. When this exporting firm earns foreign currencies through its export sales and then converts them back to U.S. dollars to pay workers, suppliers, and investors, the stronger dollar means that the foreign currency buys fewer U.S. dollars than if the currency had not strengthened and that the firm’s profits, as measured in dollars, fall. As a result, the firm may choose to reduce its exports or it may raise its selling price, which will also tend to reduce its exports. In this way, a stronger currency reduces a country’s exports.

Conversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing. Each dollar earned through export sales, when traded back into the home currency of the exporting firm, will now buy more of the home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U.S. economy or it may reduce prices, which will also lead to expanded sales. In this way, a stronger U.S. dollar means that consumers will purchase more from foreign producers, expanding the country’s level of imports.

For a U.S. tourist abroad, who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. The tourist receives more foreign currency for each U.S. dollar, and consequently the cost of the trip in U.S. dollars is lower. When a country’s currency is strong, it is a good time for citizens of that country to tour abroad. Imagine a U.S. tourist who has saved $5,000 for a trip to South Africa. In January 2008, $1 bought seven South African rand, so the tourist had 35,000 rand to spend. In January 2009, $1 bought 10 rand, so the tourist had 50,000 rand to spend. By January 2010, $1 bought only 7.5 rand. Clearly, 2009 was the year for U.S. tourists to visit South Africa. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U.S. dollar means that their own currencies are relatively weaker, so as they shift from their own currency to U.S. dollars, they have fewer U.S. dollars than previously. When a country’s currency is strong, it is not an especially good time for foreign tourists to visit.

A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. A U.S. financial investor abroad must first convert U.S. dollars to a foreign currency, invest in a foreign country, and then later convert that foreign currency back to U.S. dollars. If in the meantime the U.S. dollar becomes stronger and the foreign currency becomes weaker, then when the investor converts back to U.S. dollars, the rate of return on that investment will be less than originally expected at the time it was made.

However, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. investment. That foreign investor converts from the home currency to U.S. dollars and seeks a U.S. investment while later planning to switch back to the home currency. If in the meantime the dollar grows stronger, then when the time comes to convert from U.S. dollars back to the foreign currency, the investor will receive more foreign currency than expected at the time the original investment was made.

The preceding paragraphs all focus on the case where the U.S. dollar becomes stronger. The corresponding happy or unhappy economic reactions are illustrated in the first column of Figure 15.4. The following Work It Out feature centers the analysis on the opposite: a weaker dollar.

At this point, you should have a good sense of the major players in the foreign exchange market: firms involved in international trade, tourists, international financial investors, banks, and foreign exchange dealers. The next module shows how the tools of demand and supply can be used in foreign exchange markets to explain the underlying causes of stronger and weaker currencies—stronger and weaker addressed more in the following Clear It Up feature.