Exchange rates and the FX market

Michael Hatcher*
December 14, 2021

1 Introduction
We live in a world of global trade in goods, services and assets. Because there is no single
world currency, global trade requires the exchange of national currencies. For instance, if
Land Rover UK would like to purchase car parts from Germany, it will first have to exchange
pounds for euros in order to pay the supplier. Similarly, American investors wanting to
purchase UK government bonds will have to exchange US dollars for pounds. Thus, a world
of trade in goods, services and assets is a world of trade in currencies. We call the prices
at which currencies trade for one another exchange rates. Exchange rates are determined in
the foreign exchange market – the FOREX or FX market for short.

2 What are exchange rates?

The exchange rate is the price of one currency expressed in terms of another currency. For
example, at 12.50pm on 14 December 2020, the UK-US exchange rate was 0.75 Pounds per
Dollar. That is, $1 would buy £0.75. Equivalently, 75p could be exchanged for $1. We could
also invert the exchange rate to calculate how many dollars could be bought with £1, namely
$1.33 (=1/0.75). Since there are always two exchange rates, we must adopt a systematic
rule to avoid confusion. Our rule is as follows:
Quote the exchange rate as units of home currency per unit of foreign currency.
We assume the UK is the home country, and that the US is the foreign country. We use the
symbol E£/$ to represent the home exchange rate, expressed in terms of pounds per dollar:
E£/$ = Number of pounds needed to buy one dollar.
In our above example, the home exchange rate is E£/$ = 0.75. From this we can also infer
the foreign exchange rate using the formula:
1
E$/£ = = 1.33.
E£/$
* Department of Economics, University of Southampton. Email: [email protected].

1
Hence, if we have the exchange rate in pounds per dollar, we can easily calculate the exchange
rate in dollars per pound — the US ‘home’ exchange rate — by taking the inverse. Such
currency-based exchange rates are nominal exchange rates because they tell us how much
home currency is needed to buy one unit of foreign currency.

Figure 1: The UK exchange rate: Jan 2007–Jan 2019

Figure 1 plots the UK home exchange rate from Jan 2007 to Jan 2019. There were
large changes in the external value of the Pound over this period. For instance, in early 2007
when the exchange rate was around E£/$ = 0.50, £100 would buy $200. Fast forward to early
2017, when the exchange rate was around E£/$ = 0.80, and the same £100 would buy only
$125. This made holidays in London better value for American tourists. At the same time,
holidays in America were more expensive for British tourists. Back in late 2007, a British
tourist would have been able to get $1,000 in spending money for a holiday in Florida with
£500. Only ten years later, the same $1,000 would cost you £800 — a massive difference.

Appreciation and depreciation

We have seen that the external value of the Pound fell over the period 2007-2017: a given
number of pounds bought fewer dollars in 2017 than it did a decade earlier. Since the
purchasing power of pounds fell over this period, we say that the Pound depreciated against
the Dollar. Similarly, because the purchasing power of dollars in terms of pounds increased,
we say the Dollar appreciated against the Pound. In terms of the home exchange rate, a rise
in E£/$ is a depreciation of the Pound, whereas a fall in E£/$ is a Pound appreciation.

When the Pound depreciates against the Dollar, we have to pay more for US imports,
such as cars and computer software. A Ford Focus priced at $10,000 will cost a UK car
dealer £5,000 to import at an exchange rate of E£/$ = 0.50. If the Pound depreciates to
E£/$ = 0.80, the Ford Focus would now cost £8,000 (= 0.8 × $10, 000). The higher per-unit
cost will discourage UK firms from importing as much. UK exports, on the other hand, can
now be imported more cheaply by US firms and households: they can buy more ‘stuff’ with

2
the same amount of dollars. As they substitute from US-produced goods and services to
relatively cheaper UK exports, the turnover of UK exporters will increase.

Under this view, having a national currency with its own exchange rate may be beneficial:
the economy receives a boost when economic activity is low, as long as this is reflected in
a depreciation of the Pound.1 There is also a second reason we see many currencies in the
world economy: this enables countries to conduct independent monetary policy. To see why,
consider an economy in recession. If it has its own currency, it can counteract the recession
by having the central bank print more money or cut interest rates. By contrast, an economy
without its own currency does not have the option of expansionary monetary policy.

3 The foreign exchange market

The foreign exchange market is a collection of markets in which currencies are bought or
sold. The market price (exchange rate) and the ‘output’ (foreign currency bought and sold)
are the outcome of supply and demand decisions. At any given time, some participants in
the market will want to buy the home currency (supply of $), and others will want to sell
the home currency and buy dollars (demand for $).

How does the foreign exchange market work? The first thing to note is that the FX market
is a decentralized market: orders go through ‘market makers’ at various locations around the
world who post bid and ask prices for foreign currency.2 Thus, unlike the stocks listed on
the NYSE, currencies are not priced on a centralized exchange. Second, the FX market is
full of well-informed profit-maximizing agents, such as traders at commercial banks. These
agents are responsible for a large share of total transactions in the foreign exchange market;
by contrast, activity by uninformed actors like tourists is a small part. Lastly, the foreign
exchange market is highly liquid: there are many buyers and sellers of a given currency. Due
to its decentralized structure, the FX market cannot easily be ‘rigged’.

The price which emerges from the FX market is the exchange rate. Like other market
prices, the exchange rate is a signal : it reflects the balance of supply and demand for foreign
currency (in our case, $). A high price of foreign currency (high E£/$ ) indicates that demand
for dollars is relatively high, or that dollars have become relatively more scarce (due, say, to
tight US monetary policy). Conversely, a low foreign currency price (low E£/$ ) signals that
dollars are relatively abundant (high supply), or that demand for dollars is relatively low.

Demand for dollars comes from British businesses, consumers and investors who want to
buy US exports or assets. This could be iPods exported to the UK, Apple stocks listed on
the NASDAQ, or real estate in Chicago. When the Pound appreciates against the Dollar, US
1
Of course, the exchange rate could also be a source of instability, as in the case of currency crises or
speculation around exchange rates. We shall study these situations later on.
2
The three main FX centers are London, Tokyo and New York. Market markers are usually banks or
hedge funds. The bid-ask spread is the difference between the purchase and sale rates quoted for a currency.

3
exports look more attractive to us because they are cheaper to purchase in terms of pounds.
Hence, the demand for dollars is downward-sloping.

The supply of dollars comes from American businesses, consumers and investors who want
to purchase UK exports or assets.3 Some examples are Jaguar cars, homes in Kensington,
and UK government bonds. The supply of dollars is upward-sloping. This is because when
the Pound depreciates against the Dollar, pounds are cheaper to purchase in terms of dollars,
making UK goods, services and assets better value to Americans. Similarly, UK financial
assets tend to be more attractive when the Pound depreciates because buying pounds at a
low price (high E£/$ ) and selling at a high price (low E£/$ ) yields a capital gain.

Figure 2: Equilibrium in the foreign exchange market

Figure 2 shows how the exchange rate and the quantity of dollars bought and sold are
determined. The single market depicted here should be thought of as the aggregate of all
the decentralized markets in foreign exchange. The equilibrium exchange rate and quantity
are determined by the intersection of the demand for dollars schedule D$ , and the supply of
dollars schedule S $ (see point a). Any excess supply of dollars will be eliminated through
a falling exchange rate (Pound appreciation), and any excess demand for dollars through a
rising exchange rate (Pound depreciation). For instance, if the exchange rate is E£/$ = 0.40
so that demand orders for dollars exceed the available supply, the exchange rate will rise to
E£/$ = 0.65, bringing more suppliers of dollars into the market and eliminating the shortage.
3
Since the Dollar is global reserve currency, a non-trivial part of the supply of dollars will come from
non-US investors who hold dollars. However, not all cross-border transactions require up-front exchange of
currencies because the seller may invoice the buyer in terms of the buyer’s currency.

4
 The mechanism responsible for this is profit maximization. At the exchange rate of
E£/$ = 0.40 the quantity of dollars traded is limited to the supply of $100 billion. To put
this quantity on the market, sellers require £0.40 per Dollar to break even, but buyers are
willing to pay up to £0.90 per Dollar. Sellers should exploit this profit opportunity by
supplying more than $100 billion to the market. How much more?

The answer is $50 billion. On every one of those extra dollars there is a profit equal to the
vertical distance between the demand and supply curves. Once the quantity of $150 billion is
reached, the supply price exceeds the demand price, and selling dollars is no longer profitable.
Hence, profit maximization takes us to the equilibrium a, or (150, 0.65). An analogous
argument can be used to explain why, starting with a surplus of dollars at E£/$ = 0.90,
the FX market will converge on the same exchange rate of E£/$ = 0.65 and equilibrium
quantity of 150. Given that the FX market is dominated by profit-maximizing investors, we
can expect any excess demand or supply of foreign currency to be swiftly eliminated.

The diagram in Figure 2 shows us that the exchange rate is the price of foreign exchange
that balances the supply of, and demand for, foreign currency. This provides a useful frame-
work for thinking about how changes in a wide variety of factors will impact the exchange
rate. It is often more convenient, however, to think in terms of net demand for foreign
currency, which allows us to work with a single curve rather than two. By net demand we
mean the horizontal gap between the demand and supply schedules — that is, the difference
between buy orders and sell orders for foreign currency, or ND = D$ - S$ .

Figure 3: Net demand for foreign currency

The net demand curve, ND, is downward-sloping (see Figure 3). It intersects the zero
point of the x-axis at the equilibrium exchange rate £0.65 = $1, or E£/$ = 0.65. At this
price, demand and supply are equal. At exchange rates above E£/$ = 0.65, there is an excess
supply of dollars, so net demand is negative. At exchange rates below E£/$ = 0.65, there is
excess demand for dollars, and net demand is positive. In regions where ND is positive there
is pressure for the exchange rate to rise (home depreciation) because buy orders for foreign

5
currency exceed sell orders. Similarly, in regions where ND is negative, buy orders fall short
of sell orders and we expect the exchange rate to fall (home appreciation).

4 Exchange rate regimes

Thus far, we have looked at floating exchange rates. We say a currency ‘floats’ if there
is no intervention in the foreign exchange market by the government or central bank. In
this case, the exchange rate is freely determined by private agents buying and selling the
currency. Most major industrialised economies have floating exchange rates, including the
UK, Japan, Eurozone and US. The exchange rate in these economies fluctuates with shifts in
private demand and supply in the FX market. Since demand and supply depend on investor
sentiment and expectations, floating exchange rates are usually volatile exchange rates.

Despite this volatility, floating exchange rates are popular. One reason for this is that
countries with a floating exchange rate can pursue independent monetary policy – changing
money supply or interest rates as they wish in response to economic conditions. This applies
specifically when the home currency floats. In such cases, monetary policy can be devoted
to fighting inflation and recession rather than to fixing the value of the currency.

At the opposite end of the spectrum are fixed exchange rates. The exchange rate is said
to be fixed (or pegged) if the home currency maintains a fixed value against some target
currency. For example, over the decade from July 1995 to July 2005, the value of the Chinese
Yuan was fixed at around 8.3 Yuan per Dollar. In decade the Yuan was fixed against the US
Dollar, its value fluctuated somewhat against British Pounds and Canadian Dollars, for the
simple reason that these currencies fluctuated in value against the Dollar to which the Yuan
was fixed. This teaches us an important lesson: the only way to maintain a fixed exchange
rate with several currencies is by pegging a currency whose exchange rate is also fixed.4

There are several reasons a country might fix its exchange rate. One reason is to reduce
inflation. A key prediction of purchasing power parity – which we shall study later on – is
that the long run ‘inflation gap’ between two countries determines the change in the nominal
exchange rate. An economy with a fixed exchange rate against the Dollar should therefore
find, on average, that its inflation is close to US inflation. Pegging your currency to an
economy with low and stable inflation is thus a way to ‘import’ low inflation from abroad.
A second reason for fixing the exchange rate is export-led growth. If a country maintains
a relatively undervalued currency – as in the case of China – this may promote economic
growth through the expansion of export-intensive industries.

Argentina is an economy that has had both fixed and floating exchange rate regimes in
recent decades (see Figure 4). Since early 1991 the Argentine Peso was fixed at 1-to-1
4
This happened on a large scale during the classical Gold Standard (1880-1914). During this period,
many countries simultaneously fixed the value of their currencies against the Dollar. This was coordinated
by having each country keep a fixed exchange rate relative to the price of an ounce of gold (expressed in $).

6
against the US Dollar under the Convertibility Plan, a currency board.5 Initially, things
went smoothly: the exchange rate was firmly fixed at one Peso per Dollar and inflation was
reduced from more than 2000% a year(!) in 1990 to 10% in 1993 and 3% by the mid 1990s.
At the same time, real GDP growth averaged around 6% per year. However, starting in
1998, things took a turn for the worse. The main problem was that the US Dollar – to which
the Peso was pegged – appreciated against other currencies, hitting Argentina’s exports and
tipping the economy into recession. It was a blow from which the economy did not recover.

In late 2001, Argentina’s peg to the Dollar was shattered in spectacular style. The Peso
depreciated from 1 Peso per Dollar at the end of 2001 to around 4 Pesos per Dollar by
mid-2002 – a 75% loss in value! At the same time, real GDP fell by more than 20% and
unemployment soared. The large depreciation of the Peso from late 2001 to early 2002 is
an example of what economists call currency crises. Currency crises are common when a
peg breaks, as the home currency is forced to immediately float and gravitates towards its
true (unmanaged) value. This accounts both for the sudden drop in the value of the Peso
in early 2002 and the sizeable fluctuations seen thereafter. The Peso depreciated further in
recent years. As of Aug 2018, the exchange rate was 38 Pesos per Dollar, and it is currently
more than 100! The brutal lesson is that fixed exchange rates are not without risk.

Figure 4: Argentina’s exchange rate: 1996-2014

Between the poles of fixed and floating, there are a range of exchange rate regimes
which are ‘softer’ versions of these strict cases. These are known as intermediate regimes.
Examples include target bands, crawling pegs, crawling bands, and managed floats. A target
band refers to a situation where the central bank attempts to keep the exchange rate within
a relatively narrow range against a target currency, such as the ±2.25% band against the
German mark that the UK pursued in the Exchange Rate Mechanism (ERM) from 1990-92.
Crawling regimes are where the target value of a peg follows an upward or downward trend.
The controlled depreciation of the Argentine Peso from mid 2008 to early 2014 has this
5
A currency board is a strict set of rules that accompany a fixed exchange rate regime. The rules are
designed to make the peg sustainable and to enhance its credibility.

7
pattern. Lastly, a managed float occurs when a currency floats freely most of the time, but
there is occasional intervention in the FX market to stabilize its value.

There are also currency arrangements which cannot be classified as fixed, floating, or
intermediate regimes. For example, a country may enter into a monetary union and thus
abandon its national currency. In this case, the country gives up the option of independent
monetary policy, as with a fixed exchange rate. Alternatively, a country may adopt another
currency without any having reached any formal agreement. This is known as dollarization.

5 Fixed exchange rates and FX intervention

The basic principles of fixed exchange rates can be understood using Figure 3. The ND
curve shows us whether supply and demand are in balance at the target fixed exchange rate.
This is crucial information as any imbalance between supply and demand will cause a change
in the exchange rate. To prevent such imbalances emerging, the central bank must stand
ready to ‘buy up’ any excess supply of foreign currency and ‘buy out’ any excess demand for
foreign currency. It buys up any excess supply of dollars by printing pounds which it then
exchanges for dollars. It ‘buys out’ excess demand by exchanging dollar reserves for pounds.
These foreign exchange transactions must be of the right size to restore net demand to zero.

Figure 5: Achieving a target exchange rate of £0.65 = $1 by printing money

Returning to Figure 3, suppose the UK government instructs the Bank of England to

maintain an exchange rate of £0.65 = $1, i.e. E£/$ = 0.65. To start with the economy is at
point a and everything is rosy: the market is delivering the target exchange rate E ∗ , so no
intervention is necessary. But now suppose the demand for dollars falls by $100 on the back
of negative US growth forecasts (see Figure 5). This lowers net demand for dollars from
N D to N D1 . If the Bank of England did not intervene, the exchange rate would appreciate
to E£/$ = 0.40 and the target exchange rate would be missed. To prevent this, the Bank
must buy the excess supply of 100 dollars. To do so, it can print £65 and purchase the $100.

8
 Now suppose the net demand for dollars is rising (Figure 6). In the absence of interven-
tion, the Pound would depreciate to E£/$ = 0.90. To prevent the peg breaking, the Bank of
England must undo the increase in the demand for dollars. How can it do this? It must hold
reserves of foreign currency — in this case dollars — which it can use to buy pounds in the
FX market. In this way it can place pound buy orders (dollar sell orders) that exactly offset
the increase in demand for dollars and hence keep the exchange rate at its target value, E ∗ .

Figure 6: Achieving a target exchange rate of £0.65 = $1 by selling FX reserves

If the Bank of England faced declining net demand for dollars, it could always achieve
the target exchange rate by printing pounds and buying up the excess supply of dollars.
However, if the net demand for dollars is rising, there is no guarantee a fixed exchange rate
can be maintained. This is because — unlike money supply — foreign exchange reserves are
limited . If the increase in demand for foreign currency is prolonged — due, say, to a lengthy
recession in the UK — the Bank of England’s reserves could run out, in which case the Pound
would be forced to float.6 The possibility that reserves will run out drives speculation that
fixed exchange rates will collapse and trigger a currency crisis; this, in turn, adds fuel to the
demand for foreign currency and means even more reserves are needed to defend the peg.
This vicious cycle has triumphed over many fixed exchange rates.7

6 Foreign exchange contracts

We conclude with a brief discussion of the different types of contracts available in the foreign
exchange market. The simplest type of transaction is a contract where two parties agree to
an immediate exchange of one currency for another. This is known as a spot contract, and
the resulting price is the spot exchange rate. All the examples we have considered so far have
involved a spot exchange rate, and this is what we mean by ‘the exchange rate’. Accordingly,
6
The Pound would be forced to float because purchases of the home currency cannot be executed without
FX reserves. Some countries have attempted to defend the exchange rate through other means such as raising
interest rates (UK, 1992) or by introducing capital controls (Malaysia, 1998), but with limited success.
7
Examples include Mexico (1994), Argentina (2001-2), and the UK (1992).

9
we use the terms ‘exchange rate’ and ‘spot rate’ interchangeably. The spot contract is the
most popular type of foreign exchange contract, appearing in almost 90% of transactions
either on its own as a single contract or in trades where it is combined with other contracts.

The other main types of foreign exchange contracts are forwards, swaps, futures and
options. These are known collectively as derivatives. With the exception of forwards and
swaps, the derivatives market is a small part of the foreign exchange market. For instance,
according to the Bank for International Settlements, the share of spot transactions in foreign
exchange is 33%, as compared to 14% for forward-only contracts, 49% for swap contracts,
and only 5% for ‘options and other products’.8

The main foreign exchange derivatives are as follows:

ˆ Forwards. The parties enter into the contract today, but the settlement date for
delivery of the currency is in the future. The time to delivery, or maturity, varies
depending on the contract. The advantage of forwards is that they eliminate risk: the
price for future exchange of currencies -– the forward rate — is known today.

ˆ Swaps. A swap contract combines a spot sale of foreign currency with a forward
repurchase of the same currency. This is cheaper than entering into separate spot and
forward contracts as broker fees and commissions are lower.

ˆ Futures. A futures contract is a promise that two parties will deliver currency to each
other on a future date at a pre-specified exchange rate, as with a forward contract.
However, futures contracts can be traded on an exchange. As a result, the two parties
involved at the delivery date need not be the same two that made the original deal.

ˆ Options. An option contract provides one party, the buyer, with the right to buy
(call) or sell (put) at a prespecified exchange rate at some future date. The other
party, the seller, must perform the trade if asked to do so by the buyer. However, the
buyer is under no obligation to trade, and they should exercise the option only if it
would improve upon a transaction at the spot price on the expiration date. In this
respect, options offer more flexibility than forwards or futures contracts.

Derivatives allow investors to trade foreign exchange at different times and with differ-
ent contingencies to spot contracts. In particular, investors may engage in risk reduction
(hedging) or risk-taking (speculation). An example of hedging is as follows. A British firm
expects to receive a payment of $1 million in 30 days. The current spot rate is E£/$ = 0.55
and it looks likely the Pound will appreciate. The firm will incur losses if the spot rate falls
below E£/$ = 0.50: it will get back too few pounds for its dollars. To insure itself against
this contingency, the firm could buy $1 million in call options on pounds at £0.50 = $1,
thus ensuring that the firm’s dollar receipts will sell for at least £0.5 million. If the spot
rate remains above E£/$ = 0.50 up until the expiry date then the call option need not be
exercised, and the firm would obtain more than £0.5 million from its dollar receipts.
8
The survey may be viewed at: https://www.bis.org/publ/rpfx16fx.pdf.

10
 Speculation refers to taking on risky bets in order to earn a profit. Suppose an investor
has £1 million at his disposal. One-year Dollar futures are priced at F£/$ = 0.50, but the
investor thinks the Dollar will appreciate to E£/$ = 1. If the investor is willing to bet on the
outcome, he should purchase £1 million of futures. If he is proved right, he will be able to
exchange the $2 million he receives for £2 million, at the spot rate of E£/$ = 1. Hence, the
investor would make a profit of £1 million. However, if the investor is proved wrong and the
Dollar depreciates to E£/$ = 0.25, he will incur losses. He again receives $2 million, but this
will exchange for only £0.5 million, implying a loss of £0.5 million.

Review Questions
1. Go to Federal Reserve Economic Data (FRED) and locate the following exchange rates:
ˆ Canada (dollar): Jan 1980-Dec 2017;
ˆ China (yuan): Jan 1999-June 2005; Aug 2005-July 2008; July 2008-June 2010.
Plot the data and make your own judgement as to whether the currency was fixed (peg
or band), crawling (peg or band), or floating against the US dollar during each period.

2. Suppose FX market participants are asked how many dollars they would like to buy
or sell each day at a given exchange rate. The (hypothetical) results are shown below.

E£/$ QD QS ND
2 700 340 .......
4 600 420 .......
6 500 500 .......
8 400 580 .......

(a) Complete the table and find the equilibrium exchange rate. What is the quantity
of pounds exchanged for dollars on a daily basis?

(b) How many dollars would the Bank of England have to sell each day if it wanted to
maintain the exchange rate at E£/$ = 4? How many days can it keep the peg in place
if it starts out with FX reserves of $5400?

3. The current 1-year forward rate is F£/$ = 0.50. An investor has £100,000 to invest and
expects the spot rate in a year’s time to be E£/$ = 1.50.

(a) If the investor is correct, could they make a profit by entering into a forward
contract? Compute the profit or loss on this investment. (You may assume the investor
holds pounds until the contract execution date and does not earn any interest.)

(b) Suppose now that the investor exchanges the £100,000 for dollars at today’s spot
rate E£/$ = 1, and deposits the dollars in a US bank account for one year at an interest
rate of 25%. The investor enters a forward contract to sell the dollars for pounds at
the 1-year forward rate F£/$ = 0.50. What is the profit or loss on this investment?

11