1. Ch 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach

2. Slide 13-2Copyright © 2003 Pearson Education, Inc. Introduction  Exchange rate is the price of one currency in terms of another currency.  Exchange rates are important because they enable us to translate different counties’ prices into comparable terms.  Exchange rates are determined in the same way as other asset (such as stock, bond, etc) prices: The Asset approach. Asset is a form of wealth which can store and transfer purchasing power (currency is one type of asset).  The general goal of this chapter is to understand: The role of exchange rates in international trade How exchange rates are determined.

3. Slide 13-3Copyright © 2003 Pearson Education, Inc. 1. Exchange Rates and International Transactions  Exchange rates play a key role in international trade. It allows us to compare prices across countries.  An exchange rate can be quoted in two ways (US perspective): Direct –The price of the foreign currency in terms of dollars Indirect –The price of dollars in terms of the foreign currency  Domestic and Foreign Prices If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s export goods in terms of the other country’s currency. –Example: The dollar price of a £50 sweater with a exchange rate of $1.50 per pound(£): (1.50 $/£) x (£50) = $75.

4. Slide 13-4Copyright © 2003 Pearson Education, Inc.  Two types of changes in exchange rates: Depreciation of home country’s currency –A fall in the value of the home currency (i.t.o. foreign currency) –A rise in the value of a foreign currency (i.t.o. home currency). –It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents. Appreciation of home country’s currency –A rise in the value of the home currency. –A fall in the value of a foreign currency –It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents. Exchange Rates and International Transactions

5. Slide 13-5Copyright © 2003 Pearson Education, Inc.  Exchange Rates and Relative Prices Import and export demands are influenced by relative prices. Appreciation of a country’s currency: –Raises the relative price of its exports –Lowers the relative price of its imports –It decreases its export and increases its imports by changing its production & consumption (as we discussed in Ch 5). Depreciation of a country’s currency: –Lowers the relative price of its exports –Raises the relative price of its imports –It will have opposite direction effects to those of appreciation. Exchange Rates and International Transactions

6. Slide 13-6Copyright © 2003 Pearson Education, Inc. 2. The Foreign Exchange Market  Exchange rates determined in the foreign exchange market. The market in which international currency trades take place.  The Actors (buyers and sellers) in the foreign exchange market Commercial banks: most international transaction entails debiting & crediting of the bank accounts. Corporations (international or multinational corporation) Non-bank financial institutions Central banks: sometimes intervene in forex market, having impact.  Inter-bank trading (a kind of wholesale trading). Foreign currency trading across banks Account for most of the transaction in the forex market.

7. Slide 13-7Copyright © 2003 Pearson Education, Inc.  Characteristics of the Market The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years. New technologies, such as internet links, are used among the major foreign exchange trading centers. –Large trade occurs in London, New York, Tokyo. The integration of financial centers implies that there can be no significant arbitrage opportunity. –The activity of buying a currency cheap and selling high. –Due to no significant difference in exchange rate quoted in different markets at a given time, few arbitrage occur. The Foreign Exchange Market

8. Slide 13-8Copyright © 2003 Pearson Education, Inc.  Vehicle currency A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Even if the goal is exchange between non-dollar currencies, indirect exchanges through the US dollar (vehicle currency) tend to be more cost effective. –Example: Around 90% of inter-bank transactions involved exchanges of foreign currencies for U.S. dollars (2001). –Euro has potential to become another vehicle currency. The Foreign Exchange Market

9. Slide 13-9Copyright © 2003 Pearson Education, Inc.  Spot Rates and Forward Rates Spot exchange rates –Apply to exchanging currencies “on the spot” –Actually, it takes two business days to clear the deal (value date). Forward exchange rates –Apply to exchanging currencies on some future date at a pre- negotiated exchange rate (value date 30, 90, 180 days) –Deals made on Apr. 1 to exchange 10000 euro for $13000 on May 1, then the 30-day forward exchange rate is $1.3 per euro. Forward and spot exchange rates, while not necessarily equal, move closely together. Why “forward exchange transaction”? –Eg. to hedge against exchange rate risk (changes), mostly accompanied with a trade in goods. The Foreign Exchange Market

10. Slide 13-10Copyright © 2003 Pearson Education, Inc. Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981-2001 The Foreign Exchange Market

11. Slide 13-11Copyright © 2003 Pearson Education, Inc.  Foreign Exchange Swaps Spot sales of a currency combined with a forward repurchase of the currency. <cf: two separate deals They make up a significant proportion of all foreign exchange trading.  Futures and Options Futures contract –The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future. –Future contract itself is traded on organized exchange <cf: forward Foreign exchange option –The right to buy (sell) a specified amount of foreign currency at a specified price at any time up to a specified expiration date. –“put option” and “call option”. –Option itself is traded on organized exchange until the expiration date, with its price changing. The Foreign Exchange Market

12. Slide 13-12Copyright © 2003 Pearson Education, Inc.  The demand for a foreign currency deposit is influenced by the same considerations that influence the demand for any asset. The rate of return is the key consideration.  Assets and Asset Returns Assets: stocks, bonds, cash (domestic or foreign), real estate, gold, rare wines, etc. Defining ‘asset returns’ –The percentage increase in value an asset offers over some time period (uncertain- expected rate of return). The real rate of return <cf: dollar (nominal) rate of return –The rate of return measuring asset values in terms of some broad basket of products that savers (asset holders) regularly purchase. –To compare the rate of return of different assets, the return should be measured in the same unit. 3. The Demand for Foreign Currency Assets

13. Slide 13-13Copyright © 2003 Pearson Education, Inc.  Risk and Liquidity Savers care about two main characteristics of an asset other than its (expected real rate of) return: –Risk –The variability it contributes to savers’ wealth –Liquidity –The ease with which it can be sold or exchanged for goods. The Demand for Foreign Currency Assets

14. Slide 13-14Copyright © 2003 Pearson Education, Inc.  Interest Rates Market participants need two pieces of information in order to compare returns on different deposits: The first one is how the money value of the deposits (in different currencies) will change. –A currency’s interest rate provides this information. (differs across currency areas) –Example: At a dollar interest rate of 10% per year, the lender of $1 receives $1.10 at the end of the year. The second one is how exchange rates will change. The Demand for Foreign Currency Assets

15. Slide 13-15Copyright © 2003 Pearson Education, Inc. Figure 13-2: Interest Rates on Dollar and Deutschemark Deposits, 1975-1998 The Demand for Foreign Currency Assets

16. Slide 13-16Copyright © 2003 Pearson Education, Inc.  Exchange Rates and Asset Returns The returns on (different) foreign currency deposits depend on interest rates and expected changes in exchange rate. In order to decide whether to buy a euro deposit or a dollar deposit, one must calculate the dollar return on a euro deposit (to compare with the dollar deposit, using the same unit of measurement ).  A Simple Rule The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. The Demand for Foreign Currency Assets

17. Slide 13-17Copyright © 2003 Pearson Education, Inc. Dollar rate of return on euro deposits is (approximately) [R € + (E e $/ € - E $/€ )/E $/€ ]. Compare it with dollar interest rate R $. That is, we calculate: R $ - [R € + (E e $/ € - E $/€ )/E $/€ ]=(R $ - R € ) - (E e $/€ -E $/€ )/E $/€ (13-1) where: R $ = interest rate on one-year dollar deposits R € = interest rate on one-year euro deposits E $/€ = today’s dollar/euro exchange rate (dollar amount per euro) E e $/€ = dollar/euro exchange rate (dollar amount per euro) expected to prevail a year from today The Demand for Foreign Currency Assets

18. Slide 13-18Copyright © 2003 Pearson Education, Inc. When the difference in Equation (13-1) is positive (>0), dollar deposits yield the higher expected rate of return. When it is negative (<0), euro deposits yield the higher expected rate of return. The Demand for Foreign Currency Assets

19. Slide 13-19Copyright © 2003 Pearson Education, Inc.  Return, Risk, and Liquidity in the Forex Market The demand for foreign currency assets may depend not only on returns, but on risk and liquidity. –No consensus among economists about the importance of risk in the foreign exchange market. –Most of the market participants influenced by liquidity factors are those who are involved in international trade. –However, payments connected with international trade make up a very small portion of total foreign exchange transactions. Therefore, we ignore, for now, the risk and liquidity motives for holding foreign currencies. –Concern only on the rate of return. The Demand for Foreign Currency Assets

20. Slide 13-20Copyright © 2003 Pearson Education, Inc. 4. Equilibrium in the Foreign Exchange Market: exchange rate determination  Market clearing (equilibrium) exchange rate is the one that makes market participants content to hold existing supplies of deposits of all currencies.  The explanation of exchange rate determination in this section is only the first step. Here, we take expected future exchange rate as given. The next two chapters will cover the factors that influence the expectated future exchange rates.

21. Slide 13-21Copyright © 2003 Pearson Education, Inc. Equilibrium in the Foreign Exchange Market: exchange rate determination (cont’d)  Interest Parity: The Basic Equilibrium Condition The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Interest parity condition –The expected returns on deposits of any two currencies are equal when measured in the same currency. –It implies that potential holders of the foreign currency deposits view them as equally desirable assets. –The expected rates of return are equal when: R $ = R € + (E e $/€ - E $/€ )/E $/€ (13-2)

22. Slide 13-22Copyright © 2003 Pearson Education, Inc.  As a first step, we want to know “the relationship between exchange rate and expected dollar rate of return on euro deposit.” That is, how the changes in the current exchange rate affect the expected rate of returns on euro deposit? –While euro interest rate & expected exchange rate being fixed. Depreciation of dollar today lowers the expected dollar return on foreign currency (eg. euro) deposits. Appreciation of dollar today raises the dollar return expected of foreign currency (eg. euro) deposits. Do those relationships run counter to the intuition? –The key here is that the expected future exchange rate is fixed. Can today’s exchange rate change, while the expected future exchange rate is fixed? Consider “temporary” change. Equilibrium in the Foreign Exchange Market (cont’d)

23. Slide 13-23Copyright © 2003 Pearson Education, Inc. Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When E e $/€ = $1.05 per Euro Equilibrium in the Foreign Exchange Market (cont’d_

24. Slide 13-24Copyright © 2003 Pearson Education, Inc. Figure 13-3: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits Expected dollar return on euro deposits, R € + (E e $/€ - E $/€ )/(E $/€ ) Today’s dollar/euro exchange rate, E $/€ 1.02 1.03 1.05 1.07 0.0310.0500.0690.0790.100 1.00 Equilibrium in the Foreign Exchange Market

25. Slide 13-25Copyright © 2003 Pearson Education, Inc.  The Equilibrium Exchange Rate Main conclusion: exchange rates always adjust to maintain interest parity. Assume that the dollar interest rate R $, the euro interest rate R €, and the expected future dollar/euro exchange rate E e $/€, are all given. –Then, the equilibrium exchange rate is determined where the interest parity condition holds. See the following Figure. –Suppose initial situation is at point 2 or 3. Equilibrium in the Foreign Exchange Market

26. Slide 13-26Copyright © 2003 Pearson Education, Inc. R$R$ Return on dollar deposits Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate Rates of return (in dollar terms) Exchange rate, E $/€ E2$/€E2$/€ 2 1 E1$/€E1$/€ E3$/€E3$/€ 3 Expected return on euro deposits Equilibrium in the Foreign Exchange Market

27. Slide 13-27Copyright © 2003 Pearson Education, Inc.  The Effect of Changing Interest Rates on the Current Exchange Rate Effect of changes in the factors which were assumed to be fixed. –Changes in interest rate & expected future exchange rate. An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies. –A rise in dollar interest rates causes the dollar to appreciate against the euro. –A rise in euro interest rates causes the dollar to depreciate against the euro. 5. Interest Rates, Expectations, and Equilibrium

28. Slide 13-28Copyright © 2003 Pearson Education, Inc. Dollar return R2$R2$ R1$R1$ Figure 13-5: Effect of a Rise in the Dollar Interest Rate Rates of return (in dollar terms) Exchange rate, E $/€ 2 E2$/€E2$/€ 1'1' 1 E1$/€E1$/€ Expected euro return Interest Rates, Expectations, and Equilibrium

29. Slide 13-29Copyright © 2003 Pearson Education, Inc. Dollar return R$R$ Figure 13-6: Effect of a Rise in the Euro Interest Rate Rates of return (in dollar terms) Exchange rate, E $/€ 1 E1$/€E1$/€ 2 E2$/€E2$/€ Rise in euro interest rate Expected euro return Interest Rates, Expectations, and Equilibrium

30. Slide 13-30Copyright © 2003 Pearson Education, Inc.  The Effect of Changing Expectations on the Current Exchange Rate Effect of another factor assumed to be fixed. The above Fig. 13-6 can be used as well. A rise in the expected future exchange rate causes a rise in the current exchange rate. –If depreciation is expected for dollar, the dollar depreciates now. –Through the expected depreciation of dollar & subsequent rise in the expected return of euro deposit, leading to the sales of dollar for more euro deposit. A fall in the expected future exchange rate causes a fall in the current exchange rate. Interest Rates, Expectations, and Equilibrium

31. Slide 13-31Copyright © 2003 Pearson Education, Inc. Summary  Exchange rates play a role in spending decisions because they enable us to translate different countries’ prices into comparable terms.  A depreciation (appreciation) of a country’s currency against foreign currencies makes its exports cheaper (more expensive) and its imports more expensive (cheaper).  Exchange rates are determined in the foreign exchange market.

32. Slide 13-32Copyright © 2003 Pearson Education, Inc. Summary  An important category of foreign exchange trading is forward trading.  The exchange rate is most appropriately thought of as being an asset price itself.  The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.

33. Slide 13-33Copyright © 2003 Pearson Education, Inc. Summary  Equilibrium in the foreign exchange market requires interest parity. For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate.  A rise in dollar (euro) interest rates causes the dollar to appreciate (depreciate) against the euro.  Today’s exchange rate is altered by changes in its expected future level.