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

2. Preview The basics of exchange rates Exchange rates and the prices of goods The foreign exchange markets The demand for currency and other assets A model of foreign exchange markets –role of interest rates on currency deposits –role of expectations about the exchange rates

3. What are exchange rates (e.r.)? e.r = value of the domestic currency w.r.t another currency. e.r: quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. How much can be exchanged for 1 dollar? ¥102/$1 = e(¥ /$) How much can be exchanged for 1 yen? $0.0098/¥1=e($/¥ ) They allow us to denominate the cost or price of a good or service in a common currency. How much does a Honda cost? ¥3,000,000 In US$: ¥3,000,000 x $0.0098/¥1 = $29,400

4. Changes in the e.r. Depreciation = a decrease in the value of a currency relative to another currency. A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. $1/€1 < $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable. Or: the euro has appreciated relative to the dollar, now more valuable

5. A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive. –How much does a Honda cost? ¥3,000,000 In US$: ¥3,000,000 x $0.0098/¥1 = $29,400 If $ depreciates: ¥3,000,000 x $0.0100/¥1 = $30,000 A depreciated currency lowers the price of exports relative to the price of imports: we gain in competitiveness.

6. Appreciation = an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. $1/€1 > $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable. The euro has depreciated relative to the dollar: it is now less valuable.

7. An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive. An appreciated currency raises the price of exports relative to the price of imports: loss of competitiveness. –How much does a Honda cost? ¥3,000,000 In US$: ¥3,000,000 x $0.0098/¥1 = $29,400 If $ appreciates: ¥3,000,000 x $0.0090/¥1 = $27,000

8. $/£ Exchange Rates and the Relative Price of American Jeans and British Sweaters Exchange rate ($/£) 1.25 1.50 1.75 Relative price sweater/jeans 1.39 1.67 1.94 Price of the jeans=$45 price of sweaters=£50. Ex: (£50) x (1.25 $/£) / ($45) = 1.39 Exchange rates influence the relative prices of imports and exports, therefore their demand and supply: Depreciation of the currency improves the competitiveness of exports relative to imports (“beggar-thy-neighbor” policy). Appreciation of the currency worsens the competitiveness of exports.

9. Exchange rates determined in the Foreign Exchange (FX) Market. The main features of this market: Diffused, round-the-clock market, not an organized exchange, with most activity taking place “over the counter” The largest and most liquid market in the world, estimated turnover (by dealers alone) of over $1½ trillion a day, several times the turnover in the U.S. Government securities market (world’s 2nd largest market).

10. The participants: 1.Commercial banks and other depository institutions: transactions= buying/selling of bank deposits in different currencies for investment. 2.Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets. 3.Private firms: conduct foreign currency transactions to buy/sell goods, assets or services. 4.Central banks: conduct official international reserves transactions.

11. –Interbank trading = most of the activity in the foreign exchange market. –The worldwide volume of foreign exchange trading is enormous, and has doubled from 1990 to 2000. –Capital market integration (removal of barriers to trading, better diffusion of information, etc.) has reduced the scope for arbitrage (buying a currency ‘low’ and selling it ‘high’ at no risk). if $ cheaper in NY than in London, people will buy them in NY and stop buying them in London. The price of $ in NY rises and the price of $ in London falls, until the prices in the two markets are equal. –Especially true for exchange rates quoted in the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

12. Major trading Centers Source: B. Solnik

13. A FX transaction story Suppose a US firm needs to pay 1mln euros to a German firm. –It will go to its bank (US Bank) for payment. –The bank informs the US firm of the ask price and proceeds to acquire the funds and make the payment. Ask (sell) price=Pa= the exchange rate at which a dealer is willing to buy foreign currency Bid (buy) price=Pb= the exchange rate at which the dealer is willing to sell foreign currency

14. Quoted exchange rate=(Pa+Pb)/2 The difference (bid-ask spread) generates profits for dealers. Example: A customer wishes to purchase euros. Bank quotes: $/€: 1.2600 – 1.2620: it offers to buy euros for 1.26 dollar and to sell euros for 1.262 dollar and makes a profit of $0.002 on each dollar sold.

16. An exchange rate can be quoted in two ways: The price of foreign currency in dollars for other currencies (US$ equivalent): American terms – how much $ for 1 unit of foreign currency? in accord with the economic definition of the exchange rate: when the $ depreciates, its exchange rate rises! (Keep in mind this convention.) The price of $ in foreign currency (foreign currency per US$): Foreign (European) terms

18. Exchange-rate based transactions Spot rates = exchange rates for currency exchanges “on the spot”, or when trading is executed in the present. Forward rates = exchange rates for currency exchanges that will occur at a future (“forward”) date. –forward dates typically 30, 90, 180 or 360 days in the future. –rates negotiated between individual institutions in the present, but the exchange occurs in the future. –Allows offsetting risk of future changes in exchange rates, e.g., related to sales or purchases in trade.

19. $/£ spot and 3-month forward rates

20. Spot rate 3-month forward 6-month forward Source: Datastream $/£ spot and 3 and 6-month forward rates

21. ¥/$ spot and forward exchange rates Spot rate 3-month forward6-month forward Source: Datastream

22. Foreign exchange swaps: spot sale of a currency combined with a forward repurchase, both negotiated between individual institutions. –swaps often result in lower fees or transactions costs because they combine two transactions. They cover a significant share of foreign exchange trading. –Ex: A company receives $1mln that it will pay another in 3 months. Wants to place $1mln for 3 months in euros. It purchases a 3-month swap of $ into ero.

23. Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date. –contracts can be bought and sold in markets, and only the current owner is obliged to fulfill the contract.

24. Futures (clients: speculators)Forward (clients: hedgers) Traded in securitized form An agreement between two parties Can sell at an organized futures market, get a profit or loss right away: marking to market Binding on fulfilling the contract until expiration. Locked in. Trading subject to “margin requirements” Clearing house; standardized contract Deal with bank.

25. Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. –contracts can be bought and sold in markets. –a contract gives the owner the option, but not obligation, of buying or selling currency if the need arises. The buyer of an option has the right to buy (‘call’) or sell (‘put’) a given amount of foreign currency at a specified (‘strike’) price at any time up to a specified expiration date.

26. Demand for currency deposits What influences the demand for (willingness to buy) deposits denominated in domestic or foreign currency? =Factors that influence the return on assets: (Note: Rate of return (ror): the % change in value that an asset offers during a time period. Ex: The annual return for $100 savings account with an interest rate of 2% = $100 x (1+0.02) = $102, so ror = ($102 - $100)/$100 = 2%= Interest rate. Real rate of return =inflation adjusted nominal return=ror-inflation rate).  interest rates that the assets earn  expectations about appreciation or depreciation Risk of holding assets and liquidity of an asset, or ease of using the asset to buy goods and services, also influence the willingness to buy assets. But difficult to measure, and often not significant. We will ignore these.

27. A currency’s interest rate (i.r.) = the amount of a currency an individual can earn by lending a unit of the currency for a year. The ror for a deposit in domestic currency = i.r. that the bank deposit earns. To compare the ror on a deposit in domestic currency with one in foreign currency, consider –the i.r. for the foreign currency deposit –the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency.

28. Interest Rates on $ and DM Deposits: Their movements are correlated but they can be quite far apart

29. Compare ROR from investing $100 on a $ deposit at 2% and on a € deposit at 4%. Which return is higher? ROR from a $ deposit=$R= [$100(1+0.02)-$100]/$100=2%. After 1 year $100 gives $102. ROR from a € deposit: 1.Convert $100 into € =$100/E($/ €). 2.Purchase the European CD and earn interest in € during the year =[$100/E($/ €)](1+0.04). If the spot E($/ €)=1, then the € return in 1 year = €104. 3.Convert the amount (principal+interest) back into $ at the expected exchange rate in 1 year: €100(1+i*) E e ($/ € ) = €104.E e ($/ € ). 4.Suppose the expected rate 1 year in the future E e ($/€) = $0.97/€1. Then the expected return in 1 year from investing in € deposits is: €104. ($0.97/ €1 ) = $100.88 5.The $ROR from investing in € deposits =($100.88-$100)/$100 = 0.88%. The € deposit has a lower expected rate of return: all investors will prefer $ deposits and none are willing to hold € deposits. Example

30. where P=principal.

31. Note: the expected rate of appreciation of the € = ($0.97- $1)/$1 = -0.03 = -3%. X=(E e -E)/E –X>0 $ is expected to depreciate w.r.t €, or € expected to appreciate w.r.t $. –X<0 $ is expected to appreciate w.r.t. €, or € expected to depreciate w.r.t $. Simplify the ROR comparison by saying that $ ROR on € deposits approximately equals the interest rate on € deposits =R € plus the expected rate of appreciation on € deposits X ROR € = R € + (E e $/€ - E $/€ )/E $/€ =4%+(-3%)=1% ≈0.88%

32. Ror € = R € + (E e $/€ - E $/€ )/E $/€ The expected dollar rate of return on euro deposits is equal to the interest rate on euro deposits plus the expected rate of depreciation of the dollar against the euro. Ror € = R € + (E e $/€ - E $/€ )/E $/€ expected rate of return on euro deposits expected rate of appreciation of the euro

33. Therefore, the difference in expected returns is: R $ - R € - (E e $/€ -E $/€ )/E $/€ (1) When (1) is positive, dollar deposits yield a higher expected rate of return, demand for $ rises, $ appreciates. When (1) is negative, dollar deposits yield a lower expected rate of return, demand for € rises, $ depreciates.

34. Comparing Dollar Ror on $ and € Deposits