Exchange Rates between

Currencies

PROJECT FOR BUSINESS LAW
2013










COORDINATOR: STUDENT: COZMA ANDREEA
PH. D. LECTURER UNIVERSITY: TRANSILVANIA, BRASOV
DAJ ALEXIS FACULTY: ECONOMIC SCIENCES
SPECIALIZATION: BUSINESS ADMINISTRATION
YEAR: 1
GROUP: 8821

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Table of Contents
1.The Importance of Currency Markets ................................................................................................ 3
2.Appreciation and Depreciation ........................................................................................................... 4
3.Exchange Rates as Reciprocals ........................................................................................................... 5
4.Real Exchange Rates ............................................................................................................................... 5
4.1Nominal versus Real Exchange Rates ............................................................................................... 5
4.2 The Intuition Behind Real Exchange Rates ...................................................................................... 6
4.3 Calculating the Real Exchange Rate ................................................................................................. 7
4.4 The Real Exchange Rate with Aggregate Prices ............................................................................... 7
4.5 Real Exchange Rates and Purchasing Power Parity ......................................................................... 7
5.Purchasing-Power Parity ......................................................................................................................... 8
5.1 What Is the Difference Between Relative PPP and Absolute PPP? ............................................... 10
5.2.Relative PPP ................................................................................................................................... 10
5.3 PPP Conclusion .............................................................................................................................. 10
6.How Markets Use Information To Set Prices ........................................................................................ 11
6.1 The Use of Contingent Contracts ................................................................................................... 11
7.Sources.................................................................................................................................................. 16












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1.The Importance of Currency Markets

In virtually all modern economies, money (i.e. currency) is created and controlled by a central
governing authority. In most cases, currencies are developed by individual countries, though
this need not be the case. (One notable exception is the Euro, which is the official currency for
most of Europe.) Because countries buy goods and services from other countries (and sell
goods and service to other countries), it's important to think about how currencies of one
country can be exchanged for currencies of other countries.
Like other markets, foreign-exchange markets are governed by the forces of supply and
demand. In such markets, the "price" of a unit of currency is the amount of another currency
that is needed to purchase it. For example, the price of one Euro is, as of the time of writing,
about 1.25 US dollars, since currency markets will exchange one Euro for 1.25 US dollars.
These currency prices are referred to as exchange rates. More specifically, these prices are
nominal exchange rates (not to be confused with real exchange rates). Just as the price of a
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good or service can be given in dollars, in Euro, or in any other currency, an exchange rate for
a currency can be stated relative to any other currency. You can see a variety of such exchange
rates by going to various finance web sites.
A US Dollar/Euro (USD/EUR) exchange rate, for example, gives the number of US dollars
than can be bought with one Euro, or the number of US dollars per Euro. In this way, exchange
rates have a numerator and a denominator, and the exchange rate represents how much
numerator currency can be exchanged for one unit of denominator currency.
2.Appreciation and Depreciation

Changes in the price of a currency are referred to as appreciation and depreciation.
Appreciation occurs when a currency becomes more valuable (i.e. more expensive), and
depreciation occurs when a currency becomes less valuable (i.e. less expensive). Because
currency prices are stated relative to another currency, economists say that currencies
appreciate and depreciate specifically relative to other currencies.
Appreciation and depreciation can be inferred directly from exchange rates. For example, If the
USD/EUR exchange rate were to go from 1.25 to 1.5, the Euro would buy more US dollars
than it did before. Therefore, the Euro would appreciate relative to the US dollar. In general, if
an exchange rate increases, the currency in the denominator (bottom) of the exchange rate
appreciates relative to the currency in the numerator (top).
Similarly, if an exchange rate decreases, the currency in the denominator of the exchange rate
depreciates relative to the currency in the numerator. This concept can be a little tricky, since
it's easy to get backwards, but it makes sense: for example, if the USD/EUR exchange rate
were to go from 2 to 1.5, a Euro buys 1.5 US dollars rather than 2 US dollars. The Euro
therefore depreciates relative to the US dollar, since a Euro doesn't trade for as many US
dollars as it used to.
Sometimes currencies are said to strengthen and weaken rather than appreciate and depreciate,
but the underlying meanings of and intuitions for the terms are the same.

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3.Exchange Rates as Reciprocals

From a mathematical perspective, it's clear that a EUR/USD exchange rate, for example,
should be the reciprocal of a USD/EUR exchange rate, since the former is the number of Euro
that one US dollar can buy (Euro per US dollar), and the latter is the number is US dollars that
one Euro can buy (US dollars per Euro). Hypothetically, if one Euro buys 1.25 = 5/4 US
dollars, then one US dollar buys 4/5 = 0.8 Euro.
One implication of this observation is that when one currency appreciates relative to another
currency, the other currency depreciates, and vice versa. To see this, let's consider an example
where the USD/EUR exchange rate goes from 2 to 1.25 (5/4). Because this exchange rate
decreased, we know that the Euro depreciated. We can also say, because of the reciprocal
relationship between exchange rates, that the EUR/USD exchange rate went from 0.5 (1/2) to
0.8 (4/5). Because this exchange rate increased, we know that the US dollar appreciated
relative to the Euro.
It's very important to understand precisely what exchange rate you are looking at, since the
way that the rates are stated can make a big difference! It's also important to know whether you
are talking about nominal exchange rates, as introduced here, or real exchange rates, which
state directly how much of one country's goods can be traded for a unit of another country's
goods.
4.Real Exchange Rates

4.1Nominal versus Real Exchange Rates
When discussing international trade and foreign exchange, two types of exchange rates are
used. The nominal exchange rate simply states how much of one currency can be traded for a
unit of another currency. The real exchange rate, on the other hand, describes how many of a
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good or service in one country can be traded for one of that good or service in another country.
For example, a real exchange rate might state how many European bottles of wine can be
exchanged for one US bottle of wine.
This is, of course, a bit of an oversimplified view of reality- after all, there are differences in
quality and other factors between the US wine and the European wine. The real exchange rate
abstracts away these issues, and it can be thought of as comparing the cost of equivalent goods
across countries.

4.2 The Intuition Behind Real Exchange Rates

Real exchange rates can be thought of as answering the following question: If you took an item
produced domestically, sold it at the domestic market price, exchanged the money you got for
the item for foreign currency, and then used that foreign currency to purchase units of the
equivalent item produced in the foreign country, how many units of the foreign good would
you be able to buy?
The units on real exchange rates, therefore, are units of foreign good over units of domestic
(home country) good, since real exchange rates show how many foreign goods you can get per
unit of domestic good. (Technically, the home and foreign country distinction is irrelevant, and
real exchange rates can be calculated between any two countries, as shown below.)
The example above illustrates this principle- if a bottle of US wine can be sold for $20, and the
nominal exchange rate is 0.8 Euro per US dollar, then the bottle of US wine is worth 20 x 0.8 =
16 Euro. If a bottle of European wine costs 15 Euro, then 16/15 = 1.07 bottles of European
wine can be purchased with the 16 Euro. Putting all of the pieces together, the bottle of US
wine can be exchanged for 1.07 bottles of the European wine, and the real exchange rate is thus
1.07 bottles of European wine per bottle of US wine.
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The reciprocal relationship holds for real exchange rates in the same way that it holds for
nominal exchange rates. In this example, if the real exchange rate is 1.07 bottles of European
wine per bottle of US wine, then the real exchange rate is also 1/1.07 = 0.93 bottles of US wine
per bottle of European wine.
4.3 Calculating the Real Exchange Rate

Mathematically, the real exchange rate is equal to the nominal exchange rate times the
domestic price of the item divided by the foreign price of the item. When working through the
units, it becomes clear that this calculation results in units of foreign good per unit of domestic
good.
4.4 The Real Exchange Rate with Aggregate Prices

In practice, real exchange rates
are usually calculated for all
goods and services in an economy rather than for a single good or service. This can be
accomplished simply by using a measure of aggregate prices (such as the consumer price index
or GDP deflator) for the domestic and the foreign country in place of the prices for a particular
good or service.
Using this principle, the real exchange rate is equal to the nominal exchange rate times the
domestic aggregate price level divided by the foreign aggregate price level.
4.5 Real Exchange Rates and Purchasing Power Parity
Intuition might suggest that real exchange rates should be equal to 1, since it's not immediately
obvious why a given amount of monetary resources wouldn't be able to buy the same amount
of stuff in different countries. This principle, where the real exchange rate is, in fact, equal to 1,
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is referred to as purchasing-power parity, and there are various reasons why purchasing-power
parity need not hold in practice.
5.Purchasing-Power Parity
The idea that identical items in different countries should have the same "real" prices is very
intuitively appealing- after all, it stands to reason that a consumer should be able to sell an item
in one country, exchange the money received for the item for currency of a different country,
and then buy the same item back in the other country (and not have any money left over), if for
no other reason than this scenario simply puts the consumer back exactly where she started.
This concept, known as purchasing-power parity (and sometimes referred to as PPP), is simply
the theory that the amount of purchasing power that a consumer has doesn't depend on what
currency she is making purchases with.
Purchasing-power parity doesn't mean that nominal exchange rates are equal to 1, or even that
nominal exchange rates are constant. A quick look at an online finance site shows, for
example, that a US dollar can buy about 80 Japanese yen (at the time of writing), and this can
vary pretty widely over time. Instead, the theory of purchasing-power parity implies that there
is an interaction between nominal prices and nominal exchange rates so that, for example,
items in the US that sell for one dollar would sell for 80 yen in Japan today, and this ratio
would change in tandem with the nominal exchange rate. In other words, purchasing-power
parity states that the real exchange rate is always equal to 1, i.e. that one item purchased
domestically can be exchanged for one foreign item.
Despite its intuitive appeal, purchasing-power parity doesn't generally hold in practice. This is
because purchasing-power parity relies on the presence of arbitrage opportunities-
opportunities to risklessly and costlessly buy items at a low price in one place and sell them at
a higher price in another- to bring prices together in different countries. (Prices would converge
because the buying activity would push prices in one country up and the selling activity would
push prices in the other country down.) In reality, there are various transaction costs and
barriers to trade that limit the ability to make prices converge via market forces. For example,
it's unclear how one would exploit arbitrage opportunities for services across different
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geographies, since it's often difficult, if not impossible, to transport services costlessly from
one place to another.
Nevertheless, purchasing-power parity is an important concept to consider as a baseline
theoretical scenario, and, even though purchasing-power parity might not hold perfectly in
practice, the intuition behind it does, in fact, place practical limits on how much real prices can
diverge across countries.
The Dictionary of Economics which defines Purchasing Power Parity as:
A theory which states that the exchange rate between one currency and another is in
equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
Using this definition, we can show the link between inflation and exchange rates. To illustrate
the link, we'll take two fictional countries: Mikeland and Coffeeville. Suppose that on January
1st, 2004, the prices for every good in each country is identical. Thus a football that costs 20
Mikeland Dollars in Mikeland costs 20 Coffeeville Pesos in Coffeeville. If Purchasing Power
Parity holds then 1 Mikeland Dollar must be worth 1 Coffeville Peso, otherwise we could
make a risk free profit buying footballs in one market and selling in the other. So
here PPP requires a 1 for 1 exchange rate.
Now let's suppose Coffeville has a 50% inflation rate whereas Mikeland has
no inflation whatsoever. If the inflation in Coffeeville impacts every good equally, then the
price of footballs in Coffeeville will be 30 Coffeville Pesos on January 1, 2005. Since there is
zero inflation in Mikeland, the price of footballs will still be 20 Mikeland Dollars on Jan 1
2005.
If purchasing power parity holds and we cannot make money from buying footballs in one
country and selling them in the other, then 30 Coffeeville Pesos must now be worth 20
Mikeland Dollars. If 30 Pesos = 20 Dollars, then 1.5 Pesos must equal 1 Dollar. Thus our Peso-
to-Dollar exchange rate is 1.5, meaning that it costs 1.5 Coffeville Pesos to purchase 1
Mikeland Dollar on foreign exchange markets.
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If two countries have differing rates of inflation, then the relative prices of goods in the two
countries, such as footballs, will change. The relative price of goods is linked to the exchange
rate through the theory of Purchasing Power Parity. As we have seen, PPP tells us that if a
country has a relatively high inflation rate we should see the value of its currency decline.

5.1 What Is the Difference Between Relative PPP and Absolute PPP?
Absolute purchasing power parity is the kind discussed in A Beginner's Guide to Purchasing
Power Parity Theory (PPP Theory). Specifically, it implies that "a bundle of goods should cost
the same in Canada and the United States once you take the exchange rate into account". Any
deviations from this (if a basket of goods is cheaper in Canada than in the United States), then
we should expect relative prices and the exchange rate between the two countries to move
towards a level at which the basket of goods have the same price in the two countries.
The idea is expressed in more detail at A Beginner's Guide to Purchasing Power Parity Theory
(PPP Theory).
5.2.Relative PPP
Relative PPP describes differences in the rates of inflation between two countries. Specifically,
suppose the rate of inflation in Canada is higher than that in the US, causing the price of a
basket of goods in Canada to rise. Purchasing power parity requires the basket be the same
price in each country, so this implies that the Canadian dollar must depreciate vis-a-vis the
U.S. dollar. The percentage change in the value of the currency should then equal the
difference in the inflation rates between the two countries.
5.3 PPP Conclusion
I hope this helps clarify the issue. Both forms of purchasing power parity evolve from the same
premise - that large disparities in the prices of goods between two countries is unsustainable,
since it creates arbitrage opportunities to move goods across borders.
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6.How Markets Use Information To Set Prices
6.1 The Use of Contingent Contracts
Markets, when they operate efficiently, can provide a great deal of information on the beliefs
of the people who participate in that market. Prices, and changes in prices, convey a lot of
information on what traders think is currently happening and what they believe will happen in
the future. To see how this works, we'll look the at the pricing of a simple asset known as a
"contingent contract".
A contingent contract in finance generally refers to a contract in which the amount of money
one agent pays to another in the future will differ depending on the realization of some future
event. A simple example of a contingent contract would be a contract which gave the bearer of
that contract nothing if it rains next Thursday but one dollar if it does not rain. These kinds of
contracts are more common than you might believe at first glance. A farmer's crop may depend
rather heavily or whether or not it rains. If it does rain, he has a healthy crop which he can sell
on the market. If it does not rain the crop will be ruined and the farmer will having nothing.
The farmer can minimize this risk by buying many of these contingent contracts. If the farmer
buys the contingent contracts and it does not rain, his crop will be worthless but he will get $1
for each contract he holds. Of course, if it does rain his crop will be valuable, but he'll also
have paid money for contingent contracts which are now worthless. If the farmer buys enough
of the contracts, he can insure that he receives the same amount of money no matter what the
weather does. This sort of risk-minimization is known as hedging and is used quite frequently,
particularly in finance.
From an informational standpoint, contingent contracts (also known as "contingent claims")
are very nice because they tell how likely the market thinks some event will happen. Suppose
our $1 if it doesn't rain and $0 if it does rain contingent contract is selling for 70 cents. This
implies that the market believes that there is a 70% chance it will not rain and a 30% chance
that it will. This is because we believe that 70% of the time the contingent contract will be
worth $1 and 30% of the time the contingent contract will be worth nothing. So on average,
we'd expect the contingent contract to be worth 70 cents. Now suppose a number of people in
the "rain" market got a new piece of information (say satellite photos) and now believed that
the chance of it not raining on Thursday is now 90%. This would cause them to value the
contract at 90 cents, but the price is currently at 70 cents. So they would buy these contingent
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contracts as they'd expect to make 20 cents on average. The increase in demand for the
contracts will cause the price to rise and if enough people in the market believed the chance of
a lack of precipitation was 90%, we'd expect to see the value of the contingent contract to rise
to 90 cents.
To see a good example of price changes and contingent contracts, we'll look at the world of
baseball.
While often used for serious purposes, contingent contracts can also be used as a form of
entertainment. An Irish based website named TradeSports.com allows people to gamble on
sports events using contingent contracts as a basis. You can buy contracts on all sorts of events,
from who will win tomorrow's Blue Jays vs. Red Sox game to who will win the next
Superbowl. The contingent contracts work in a similar fashion as the one in the previous
section. If you buy a $1 Blue Jay contingent contract and the Blue Jays win you get $1 but if
they do not win the contract pays nothing. At the time of writing, the last trade price of the
Tiger Woods contract for the 2003 British Open was 22 cents, meaning that the market
believes that Tiger has a 22% chance of winning the tournament.
The 2003 Major League Baseball All-Star Game was expected to be a match between two
equally capable teams. Before the game begin, the price of the American League contract had
been hovering around 50 cents, so the market believed that the American League seemed
equally as likely to win the game as the National League team. When the game began, the price
was still around 50 cents, as investors had not learned any information which would cause
them to change their beliefs about the outcome of the game. After an uneventful inning and a
half, the American League started to make some noise. With two out in the inning, American
Leaguer Edgar Martinez was hit by a pitch, then teammate Hideki Matsui hit a single, putting 2
men on base for Troy Glaus. Although there were two out, it looked like the American side had
a chance to score some runs, which would obviously improve their chances of winning the
game. During the inning the price of the American League contract rose from 48 cents to 55
cents as investors felt that having 2 men on base and 2 outs in a tie game in the 2nd inning
raised the American League's chances to win to 55%. Glaus struck out swinging and the price
of the contingent contract fell almost immediately to 50 cents. A piece of new information (the
Glaus strikeout) caused the price of the contingent contract to fall 10%, despite the fact that the
game was nowhere near completion.
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The National League side was unable to do much against American league pitcher Roger
Clemens, but a single by Ichiro Suzuki, a wild pitch by National League pitcher Randy Wolf,
and a single by Carlos Delgado put the American League up 1-0 and the price of the contingent
contract up to around 65 cents. With Delgado on first and 2 outs, Alex Rodriguez grounded out
to third base, and the price of the contingent contract slid to 60 cents.
Everything fell apart for the American League during the 5th inning. The first National League
batter of the inning got to first base on a walk, and the second, Todd Helton, made the score 2-
0 on a homerun. After the third batter of the inning, Scott Rolen, hit a single, the price of the
contingent contract was down to 33 cents. The next two batters for the National League got out
sending the price up to 38 cents, but a double by Andrew Jones and a single by Albert Pujols
sent the score to 5-1 and the price to around 16 cents. The price did not seem to recover any
after Barry Bonds struck out.
By the bottom of the 6th inning, the market believed that the American Leauge only had a 10%
chance of winning. A two run homerun by Garret Anderson caused the price to double to
twenty cents, but the price hike was short lived as a 7th inning homerun by Andruw Jones for
the National League sent the price back down to 10 cents. Although the score was only 6-3,
Fox, the network carrying the game, said that the American league did not stand much of a
chance of winning since the National League's closers were unbeatable. Even a homerun by
Jason Giambi sending the score to 6-4 only moved up the contingent contract price to 15 cents.
Things were looking pretty dire for the American League as they had to face Eric Gagne in the
8th inning and John Smoltz in the 9th inning while they had a 2 run deficit. With one out in the
8th, Garret Anderson hit a double, sending the contingent contract price up to 22 cents. Earlier
in the game a hit that did not score a run would not have had much effect on the price, but
since it was late in the game and the score was close, investors knew that even a small change
in circumstances could change the outcome. As a result, the price changes became more
dramatic near the end of the game. A ground-out by Carl Everett sent the price down to 19
cents, but a run-scoring double by Vernon Wells sent the game to 6-5, and caused the price to
rise to 52 cents. Although the American League was still losing, investors believed that with a
runner on 2nd and 2 outs, they were slightly more likely to win the game than the National
League side. Hank Blalock, the next hitter, hit a towering homerun which caused the American
league to take a 7-6 lead very late in the game, and caused the price to escalate all the way to
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85 cents. In a matter of 10 minutes, the value of the contingent contract had increased 8-fold,
and investors who bought at 10 cents suddenly had a very valuable asset. With the 8th inning
over, the American League needed just three more outs to win the game. They would get those
three outs and not score any runs. During the 9th inning the price of the contract rose from 85
cents to 1 dollar, the price it eventually paid to the holder.
The effect of the All-Star game was seen in other contracts. A day before the All-Star game,
the contract which paid $1 if the Yankees won the World Series was selling for 20 cents. The
league that won the All-Star Game would win home field advantage in the World Series.
Teams win more often than not when they have the homefield advantage, so the outcome of the
game was important. The Yankees, seen as the most likely American League team to make it
to the World Series, were seen as slightly more likely to win the World Series by investors. A
contract which pays $1 if the Yankees win the series was selling for 20 cents the day before the
All-Star Game, but had climed in price to 21 cents the day after. Investors took their new
knowledge about homefield advantage in the World Series, and slightly upgraded the value of
all the contingent contracts for American League teams and slightly downgraded the value of
the National League teams.
Next we'll look at some more practical applications of how information causes prices changes
and how we can extract information from price changes.
The effect of new information and changed beliefs are apparent in contingent contracts, but
they also show up in the price of any asset. In quite a few articles, such as Canadian Dollar
Slides Following Surprise Bank of Canada Interest Rate Cut I discuss the link between the
differences in the interest rates in two countries and the exchange rate. In short, if the interest
rate in country A falls and the rate in country B stays the same, we'd expect to see A's currency
become less valuable relative to B's, all else being equal. As an investor, if I know that country
A will be lowering its interest rate, I would expect that the A's currency would soon become
less valuable than B's. So I'd do well for myself if I sold A's currencies and bought B's on the
open market. Of course, if everyone believes the interest rate drop is coming, they'll sell
currency A and buy currency B, until the price of currency A falls to the level at which it
would be after the interest rate drop was announced. So if we all expect that the central bank of
country A will drop rates by 25 points, then they do, we should not expect to see any changes
in the exchange rate at the time of the annoucement. However, if they announce
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they're notgoing to cause the interest rate to decline, we should see currency A rise back up to
it's former value, despite the fact that nothing tangible has changed. To the naive observer, it
may even look like the drop in the exchange rate is causing the central bank of country A to
lower its interest rate a few days later, an idea I look at in length in "Do changes in stock prices
cause recessions?"
By looking closely at these price changes we can also learn a great deal about what the market
expects. Suppose we know that Alan Greenspan is going to make an announcement next
Tuesday. This situation is not unusual, as it is usually known weeks in advance when the
Federal Reserve Chairman is going to give a speech or make an announcement. We can tell
what investors' best predictions on the content of the announcement is going to be by looking
at exchange rates. If the exchange rate drops or rises, we should expect to see a change in the
interest rate, while if the exchange rate stays the same, it's likely that no change will be made.
Of course this is an oversimplification as announcements by the Federal Reserve influence all
sorts of variables, not just the exchange rate. However it is apparent that if we watch how
prices change we can determine what the investment community feels will happen in the
future.
In a country with a free market economy, prices are not set by a central planning bureau: they
are set by supply and demand. Because supply and demand reflect the information and beliefs
of investors in those markets, they contain the sum total of all the information and beliefs the
investors have in a market. While we might not have the power to change people's actions or
beliefs, the price mechanism gives us the power to observe those actions and beliefs. Prices are
far more than just what you have to pay for something, they are also a source of great
knowledge if interpreted correctly.







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7.Sources

www.investopedia.com/articles/basics/04/050704.asp
https://en.wikipedia.org/wiki/Exchange_rate
epp.eurostat.ec.europa.eu/statistics.../Exchange_rates_and_interest_rates
www.imf.org/external/pubs/ft/fandd/basics/realex.htm l
www.marketwatch.com/investing/currencies/tools
economics.about.com ... Exchange Rates Purchasing Power Parity