A Beginner's Guide to Exchange Rates and the Foreign Exchange Market

Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents each. Then we can think of the dollar-tolemon exchange rate as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly, the lemon-to-dollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return. So when we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula:

Y-to-X exchange rate = 1 / X-to-Y exchange rate

Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they work in the same fashion. On February 26, 2003 the U.S.-to-Japan exchange rate was 117 yen, so this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula:

Japan-to-U.S. exchange rate = 1 / U.S.-to-Japan exchange rate Japan-to-U.S. exchange rate = 1 / 117 = .00854
So this tells us that one Japanese yen is worth .00854 U.S. dollars, which is less than a penny. Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula:

U.S.-to-Canada exchange rate = 1/Canada-to-U.S. Exchange rate U.S.-to-Canada exchange rate = 1/0.67 = 1.4925
So one U.S. dollar can get us $1.49 in Canadian funds. To see why these relationships must hold, we'll look at the wonderful world of arbitrage. [Part 2: Exchange Rates - Arbitrage]

Suppose the Algerian dinars-to-Bulgarian leva exchange rate is 2. We would expect then that the Bulgarian-to-Algerian exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn't. Instead assume that the current market Bulgarian-to-Algerian exchange rate is 0.6. Then an investor could take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 Bulgarian leva and exchange them back for Algerian dinars. At the Bulgarian-to-Algerian exchange rate, she'd give up 10 leva and get back 6 dinars. Now she has one more Algerian dinar than she did before. This type of exchange is known as arbitrage. Since our investor gained a dinar, and since we're not creating or destroying any currency, the rest of the market must have lost a dinar. This of course is bad for the rest of the market. We would expect that the other agents in the currency exchange market will change the exchange rates that they offer so these opportunities to get exploited are taken away. Still there is a class of investors known as arbitrageurs who try to exploit these differences. Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian dinars-to-Bulgarian leva exchange rate is 2 and the Bulgarian leva-to-Chilean peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply the two exchange rates together:

A-to-C = (A-to-B)*(B-to-C)
This property of exchange rates is known as transitivity. To avoid arbitrage we would need the Algerian-to-Chilean exchange rate to be 6 and the Chilean-to-Algerian exchange rate needs to be 1/6. Suppose it was only 1/5. Then our investor could again take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 leva and get 30 Chilean pesos at the Bulgarian-to-Chilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at the Chilean-to-Algerian rate of 1/5, she'd get 6 Algerian dinars in return. Once again our investor has gained a dinar and the rest of the market has lost one. For any three currencies A, B, and C, trading A for B, B for C and C for A is known as a currency cycle. The A-to-C exchange rate not only places restrictions on the C-to-A exchange rate, but it also places restriction on the A-to-B and B-to-C pair of exchange rates. Most of the time all the exchange rates on the market will be synchronized like this, but occasionally they'll become out of sync and arbitrageurs can make a profit from currency cycles. The relative prices of currencies are not set just to ensure that profitable currency cycles do not exist. Arbitrageurs only play a small, but important, role in the value of a currency. Currencies are simply a commodity, like any other, which has a price. Since the exchange rate is simply a price, it has the same basic determinants that any other price has: supply and demand. First we'll look at supply. [Part 3: Exchange Rates - Supply]

Basic econonomic theory teaches us that if the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country's currency increases, we should see that it takes more of that currency to purchase a different currency than it did before. Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S. Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange rate would increase from $1.49 to $2.00, so each

U.S. dollar would give us more Canadian dollars than it did before, as a Canadian dollar is less valuable than it used to be. Why would the supply of a currency increase? Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. There are a few different organizations whose actions will cause a rise in the supply of the foreign exchange market:

1. Export Companies
Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a currency with limited use outside of Japan. Since the company needs to pay it's employees in the local currency, namely the South African rand, the company would sell its yen on a foreign exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will increase, and the supply of South African rands will decrease. This will cause the rand to appreciate in value (become more valuable) relative to other currencies and the yen to depreciate.

2. Foreign Investors
A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However most of their cash reserves are held in euros. The company will be forced to go to the foreign exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause Canadian dollars to appreciate and euros to depreciate. Foreign investment does not have to be in tangible goods such as land. If German investors buy Canadian stocks, such as stocks listed on the Toronto Stock Exchange or purchase Canadian dollar bonds, we will have the same situation as above.

3. Speculators
Like the stock market, there are investors who try to make a fortune (or at least a living) by buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will depreciate in the future, so it will be less valuable than other currencies than it is now. In that case, she is likely to sell her pesos on the foreign exchange market and buy a different currency instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes down. This causes pesos to depreciate, and won to appreciate. Note the self-fulfilling nature of the beliefs investors hold. If investors feel that a currency will depreciate in the future, they will try to sell it today. Since the currency is being sold by investors, the supply of it will go up, and the price of it will decrease. The investor thought that the currency would depreciate, she acted on that belief and sold her currency, and the act of selling caused the depreciation to take place. Self-fulfilling prophecies such as this one are quite common in economics.

4. Central Bankers
The central bank of the United States is the Federal Reserve, more commonly known as "The Fed". One of the responsibilities of the Fed is to control the supply, or the amount, of currency in a country. The most obvious way to increase the supply of money is to simply print more currency, though there are much more sophisticated ways of changing the money supply. If the Fed prints more 10 and 20 dollar bills, the money supply will increase. When the government increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so the supply of U.S. dollars will increase there as well. A central bank will often directly increase the supply of money on the foreign exchange markets. Central banks like the Fed keep a supply of most (if not all) currencies in reserve and will often use them to influence the exchange rate. If the Fed decides that the U.S. dollar has appreciated in value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market, and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the yen. Of course, the Fed cannot do this as much as it would like, because it may end up running out of some currencies. As well, the Japanese central bank (named the Bank of Japan) could decide that the Fed is manipulating the price of the yen too much and the Bank of Japan could counteract the Fed by selling yen and by buying dollars. These are the organizations who will increase the supply of currency on the exchange market. Now we'll investigate the demand side of foreign exchange markets. [Part 4: Exchange Rates - Demand]

Why would the demand for a currency increase? Not surprisingly pretty much the same organizations who caused supply changes will cause demand changes. They are as follows:

1. Import Companies
A British retailer specializing in Chinese merchandise will often have to pay for that merchandise in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers and manufacturers.

2. Foreign Investors
As before a German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. So the demand for Canadian dollars will rise.

3. Speculators

If an investor feels that the price of Mexican pesos will rise in the future, she will demand more pesos today. This increased demand leads to an increased price for pesos.

4. Central Bankers
A central bank might decide that its holdings of a particular currency are too low, so they decide to buy that currency on the open market. They might also want to have the exchange rate for their currency decline relative to another currency. So they put their currency on the open market and use it to buy another currency. So Central Banks can play a role in the demand for currency. Supply and demand are often thought of as being two sides of the same coin. Here we see that this is the case, as in every transaction there is a buyer and a seller, or in other words, a demander and a supplier. Now we know what agents can cause price changes and for what reasons. We can use our knowledge to analyze what happens in the "real world". An interesting case is the Canadian-to-American exchange rate. Due to the geographical proximity and economic intergration of the two countries the Canadian-to-American exchange rate is often examined. The sharp decline in the value of the Canadian dollar relative to the American one is widely discussed in the news, so we'll discuss it now.

[Part 5: Case Study: Canada - Introduction] In January 1990 the Canada-to-U.S. exchange rate was around 85 American cents. Less than nine years later, the Canadian dollar had depreciated to 65 cents. This substantial drop in the value of the Canadian dollar has been quite upsetting to many Canadians. Almost every Canadian spends a large fraction of his/her income on American goods and many take vacations in the United States. Since the savings of most Canadians are in assets priced in Canadian dollars, their savings could now buy much fewer American goods and services. This was particularly noticable to Canadian seniors who spend much of the winter in Arizona and Florida. The following chart shows how the Canadian-to-American exchange rate has declined since 1990:

Now we can see the problem, we can investigate what caused this drop. The rapid decline of the Canadian dollar can be explained by the supply and demand framework illustrated in the previous two sections of this article. Here are three factors which caused a change in supply and/or demand and subsequently a devaluation of the Canadian dollar. [Part 6: Case Study: Canada - Commodity Prices]

Factor 1: Commodity prices. Moreso than any other industrialized country, Canada's economy relies heavily on the export of raw materials such as lumber, natural gas, and agricultural products. The Bank of Canada has developed a Commodity Price Index, which tracks changes in the prices of commodities which Canada exports. The breakdown of the elements in the Commodity Price Index is roughly:

Category Energy

Percentage 34.9

Food Metals Minerals

18.8 14.4 2.3

Forest Products 29.6

Commodities such as these represent almost 40 percent of Canadian exports. As shown in the following chart, the Commodity Price Index fell sharply several times between 1990 and 2002, particularly during the Asian crisis of 1997-1998:

Note that I divided the Commodity Price Index (CPI) by 100, so I could show both the CPI and the exchange rate on the same chart. It would appear that both the exchange rate and the Commodity Price Index suffered similar declines during 1997 and 1998. I calculated the correlation coefficient between the exchange rate and the (unscaled) Commodity Price Index between January 1997 and December 1998. The correlation coefficient between the two was a whopping 0.94, indicating a particularly strong positive relationship between the two. We cannot infer from this that the drop in the Commodity Price Index necessarily caused a drop in the exchange rate, but we can say that the two changed in the same direction most months during this period. This strong relationship did not occur before or after this period. The correlation coefficient for 1990-1996 was -0.31, and for 1999-2002 was 0.29. Now consider why this relationship might occur. After a reduction in lumber prices, an American construction company now needs less Canadian dollars to purchases its Canadian

lumber. The reduction in lumber prices will likely cause the company to increase its purchases, but their total expenditures will likely be lower than they were before. Because of this American construction companies will need to buy less Canadian dollars on the foreign exchange market to get the lumber they need. The demand for Canadian dollars will decrease, and the price of the Canadian dollar relative to all currencies including the U.S. one will go down. We would expect that all else being equal, a reduction in commodity prices will occur at the same time as a reduction in the exchange rate. This appears to have happened during the Asian crisis of 1997-1998 and possibly since then as well. This reduction in commodity prices represents only a partial explanation for the decline in the Canadian dollar. [Part 7: Case Study: Canada - Interest Rates]

Factor 2: Interest Rates During the early 1990s, the Bank of Canada (BoC), Canada's central bank, embarked on a policy to lower interest rates, particularly interest rates on government bonds. The BoC succeeded and Canadian interest rates dropped much faster than American rates. The Canadian prime rate of interest was around 14% during 1990 while the American prime rate was around 10%. We usually compare interest rates by basis points, where 100 basis points a difference of 1%, say between 5% and 6% or between 17% and 18%. So here we have a 400 point difference in rates. By 1997 the Canadian prime rate of interest was 375 points lower than the American one. The following chart shows the difference between the Canadian rate and the American one:

Changes in interest rates can have a drastic effect on exchange rates. Investors interested in purchasing a security that pays interest, such as a bond, will buy the bond that gives them the highest interest rate, all else being equal. Since Canadian bonds had a lower interest rate than American bonds, investors were more interested in purchasing American bonds, and less interested in Canadian ones. In order to purchase American bonds, they would need to buy American dollars on the foreign exchange market, causing a reduction in the supply of U.S. dollars and a rise in their value relative to other currencies such as the Canadian one. If Canadians are buying U.S. bonds, they'll be selling Canadian dollars and buying American ones, so we'll see an increase in the supply of Canadian dollars and a decline in their value. We should then expect to see periods where the exchange rate and the interest rate move in the same direction. Visually it would be helpful to plot them both on the same set of axes. To do this I had to perform a scaling operation on the interest rate gap. By taking the gap, dividing it by 50 then adding 0.7 to this figure, I was able to plot both on the same chart:

The exchange rate is the blue line which starts higher and the interest rate gap is the purple line which starts lower. Note how both decline until 1997. The correlation coefficient for the interest rate gap and the exchange rate from January 1990 to December 1996 is 0.73; the two were highly positively related during this period. However during the Asian crisis of 1997-1998 the two went in opposing directions and the correlation coefficient was -0.91. Changes in the interest rates gap have not gone in the same direction as changes in the exchange rate since 1998 as the correlation coefficient is -0.75. It would appear that if we're looking for reasons why the Canadian dollar may have been weak since 1998, we'll have to look elsewhere for an answer.

[Part 8: Case Study: Canada - International Factors] Factor 3: International Factors and Speculation
More of this Feature Part 1: Exchange Rates - What are they? Part 2: Exchange Rates - Arbitrage Part 3: Exchange Rates - Supply Part 4: Exchange Rates - Demand Part 5: Case Study: Canada Introduction Part 6: Case Study: Canada Commodity Prices Part 7: Case Study: Canada Interest Rates Part 8: Case Study: Canada International Factors

During 1997 and 1998, the economies of most Asian countries went into steep decline which became known as the Asian Crisis. The Asian crisis had a far greater impact on Canada than it did on the United States. Exports take up a much smaller portion of the U.S. economy than they do of the Canadian economy. So the American dollar is much more insulated to international events than the Canadian dollar. Canada also exports a large amount of construction materials to Asian countries, so when the economies of these countries went into severe decline, new construction became nonexistent so raw materials were no longer demanded. This drop in the demand for commodities caused a decline in the price of the Canadian dollar relative to other non-Asian currencies. Understandably most investors are somewhat risk-averse, so they will avoid unnecessary risk. Investors during times of international turmoil prefer to invest in large countries that are more insulated from turmoil in other counries. The United States is a haven for investors trying to avoid this type of uncertainty, whereas smaller open economies like Canada are not. So not surprisingly the Canadian dollar declined during the Asian crisis. This still doesn't explain why the Canadian dollar declined from 1998 to 2002. Unfortunately I can't provide any solid evidence of why this happened, but here are three possibilities. 1. The Bush Election win: The Republicans are seen as a party which will create an environment positive for investors. It is conceivable that many international investors moved their money from Canada to the United States when the White House went from Democratic to Republican control. 2. International Uncertainty: As mentioned before investors will flock to a country like the United States during time of unrest. Investors have been worried that a global recession might occur during the beginning of this decade. Terrorist threats and military actions in Afghanistan and Iraq may have caused investors to put their money into large countries like the United States. 3. The Beliefs of Currency Speculators: Many currency speculators felt that the Canadian dollar would continue to decline in the future. Many investors did not want to be part of a sinking ship, so they sold their holdings of Canadian dollars, further reducing the price. If investors feel that the Canadian dollar will improve in the near future, they will jump back on the bandwagon by buying Canadian dollars and the value of the Canadian dollar will rise. It appears this is what has been happening in the beginning of 2003. Next week I'll be adding pages on Purchasing Power Parity, Fixed vs. Floating Rates, and Currency Unions. As always please e-mail me if you have any questions, comments, criticism, or suggestions.