1. Copyright © 2000 Addison Wesley Longman Slide #12-1 Chapter Twelve THE FOREIGN EXCHANGE MARKET

2. Copyright © 2000 Addison Wesley Longman Slide #12-2 Foreign Exchange Rates: 1980-98 美金 / 外幣 以 1973 年 3 月為 index=100

3. Copyright © 2000 Addison Wesley Longman Slide #12-3 The Foreign Exchange Market Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Depreciation 4.Appreciation Immediate (2-day) exchange of bank deposits denominated in different currencies 注意 A 貨幣升值 x% ，則 B 貨幣會貶值，但不會剛好貶值 x%

4. Copyright © 2000 Addison Wesley Longman Slide #12-4 The Foreign Exchange Market Currency appreciates, country's goods prices  abroad and foreign goods prices  in that country 1. Makes domestic businesses less competitive 對出口不利 2. Benefits domestic consumers 對進口有利 FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies

5. Copyright © 2000 Addison Wesley Longman Slide #12-5 Law of One Price Example: American steel $100 per ton, Japanese steel, 10,000 yen per ton If E = 50 yen/$ then prices are: American Steel Japanese Steel In U.S. $100 $200 In Japan 5000 yen 10,000 yen If E = 100 yen/$ then prices are: American Steel Japanese Steel In U.S. $100 $100 In Japan 10,000 yen 10,000 yen Law of one price  E = 100 yen/$ 假設兩國鋼鐵品質相同 In the long run ∴日本人會買美國鋼鐵，不買日本鋼鐵，而美國人也會買美國鋼鐵，不買日本鋼鐵 ∴美金  日圓  或者日本人或美國人都會買美國鋼鐵運到日本來賣以賺取套利，∴美鋼價格  到 $150 ，日鋼價格會下跌到 7,500 yen

6. Copyright © 2000 Addison Wesley Longman Slide #12-6 Purchasing Power Parity (PPP) PPP  Domestic price level  10%, domestic currency 大約  10% ， foreign currency  10% 1. Application of law of one price to price levels 2. Works in long run not short run Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy 2. Many goods and services are not traded: e.g. haircuts 當日鋼價格  10% ，變成 11000yen ，則美金必須升值 10% ，變成 110yens/1 美金 ，因為要使得日本鋼鐵在美國能賣 $100 (11,000yen/110yen) ，也就是說美金升值 要剛好抵銷掉日本鋼鐵價格的上升

7. Copyright © 2000 Addison Wesley Longman Slide #12-7 PPP: U.S. and U.K

8. Copyright © 2000 Addison Wesley Longman Slide #12-8 Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 

9. Copyright © 2000 Addison Wesley Longman Slide #12-9 Expected Returns and Interest Parity RET e for Francois Al --------------------------------------------------------------------------------------------------- $ Depositsi D + (E e t+1 - E t )/E t ( 註一 )\i D F Depositsi F i F - (E e t+1 - E t )/E t ( 註二 ) -------------------------------------------------------------------------------------------------- Relative RET e i D - i F + (E e t+1 - E t )/E t i D - i F + (E e t+1 - E t )/E t Interest Parity Condition: $ and F deposits perfect substitutes i D = i F - (E e t+1 - E t )/E t Example: if i D = 10% and expected appreciation of $, (E e t+1 - E t )/E t, = 5%  i F = 15% Relative expected return on dollar deposit in terms of francs or dollars =interest rate on foreign deposit – expected appreciation of the dollar =expected return on foreign deposit in terms of dollars RET F =5%-4%=1% 因為同樣 的 risk 與 liquidity 以 及充分的 capital mobility  假設市場處在均衡狀態，當本土利率低於國外利率時，則預期本土貨幣升值，以 彌補本土利率之不足。 若 relative RET e >0 ，則大家 ( 美國人與法國人 ) 只想 hold 美金存款，而不要法國存款

10. Copyright © 2000 Addison Wesley Longman Slide #12-10 註一 ( 假設法國人將一塊法郎換成美金後存到美國銀行， 一年後再換成法郎，其報酬率為 ) ： 1/E t *(1+i D )*E e t+1 -1 = i D *(E e t+1 /E t )+(E e t+1 -E t )/E t ≈ i D +(E e t+1 -E t )/E t 註二 ( 假設美國人將一塊美金換成法郎後存到法國銀行， 一年後再換成美金，其報酬率為 ) ： [1*E t *(1+i F )/E e t+i ]-1 = (E t /E e t+1 )*(1+i F )-1 = (i F )*(E t /E e t+1 )+(E t- E e t+1 )/E e t+1 ≈ i F -(E e t+1 -E t )/E t

11. Copyright © 2000 Addison Wesley Longman Slide #12-11 Deriving RET F Curve Assume i F = 10%, E e t+1 = 10 francs/$ Point A: E t = 9.5RET F =.10 - (10-9.5)/9.5 =.048 = 4.8% B: E t = 10.0RET F =.10 - (10-10)/10 =.100 =10.0% C: E t = 10.5RET F =.10 - (10-10.5)/10.5 = 14.8% RET F curve connects these points and is upward sloping because when E t is higher, expected appreciation of F higher, RET F 

12. Copyright © 2000 Addison Wesley Longman Slide #12-12 Deriving RET D Curve Points B, D, E, RET D = 10%: so is vertical Equilibrium RET D = RET F at E* If E t > E*, RET F > RET D, sell $, E t  If E t < E*, RET F < RET D, buy $, E t  =iD=iD

13. Copyright © 2000 Addison Wesley Longman Slide #12-13 Equilibrium in the Foreign Exchange Market

14. Copyright © 2000 Addison Wesley Longman Slide #12-14 Shifts in RET F RET F curve shifts right when 1. i F  : because RET F  at each E t 2. E e t+1  : because expected appreciation of F  at each E t and RET F  Occurs: 1) Domestic P , 2) Tariffs and quotas  3) Imports , 4) Exports , 5) Productivity 

15. Copyright © 2000 Addison Wesley Longman Slide #12-15 Shifts in RET D RET D shifts right when 1. i D  ; because RET D  at each E t Assumes that domestic π e unchanged, so domestic real rate 

16. Copyright © 2000 Addison Wesley Longman Slide #12-16 Factors that Shift RET F and RET D

17. Copyright © 2000 Addison Wesley Longman Slide #12-17 Response to i  Because π e  1. π e , E e t+1 , expected appreciation of F , RET F shifts out to right 2. i D , RET D shifts to right However because π e  > i D , real rate , E e t+1  more than i D   RET F shifts out > RET D shifts out and E t  本國利率上升

18. Copyright © 2000 Addison Wesley Longman Slide #12-18 Response to M s  1. M s , P , E e t+1 , expected appreciation of F , RET F shifts right 2. M s , i D , RET D shifts left Go to point 2 and E t  3. In long run, i D returns to old level, RET D shifts back, go to point 3 and get Exchange Rate Overshooting 長期 短期

19. Copyright © 2000 Addison Wesley Longman Slide #12-19 Why Exchange Rate Volatility? 1. Expectations of E e t+1 fluctuate 2. Exchange rate overshooting

20. Copyright © 2000 Addison Wesley Longman Slide #12-20 The Dollar and Interest Rates 1. Value of $ and real rates rise and fall together, as theory predicts 2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises

21. Copyright © 2000 Addison Wesley Longman Slide #12-21 Profiting from FX Forecasts Forecasters look at factors discussed here FX forecasts affect financial institutions managers' decisions If forecast DM appreciate, franc depreciate, 1. Sell franc assets, buy DM assets 2. Make more DM loans, less franc loans 3. FX traders sell francs, buy DMs