The Foreign Exchange Market Chapter 13 The Foreign Exchange Market

Chapter Preview In the mid-1980s, American businesses became less competitive relative to their foreign counterparts. By the 2000s, though, competitiveness increased. Why? Part of the answer can be found in exchange rates. In the 1980s, the dollar was strong, and US goods were expensive to foreign buyers. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Preview By the 1990s and 2000s, the dollar weakened, so American goods became cheaper and American businesses became more competitive. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Preview In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include: Foreign Exchange Market Exchange Rates in the Long Run Exchange Rates in the Short Run Explaining Changes in Exchange Rates Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Foreign Exchange Market Most countries of the world have their own currencies: the U.S dollar., the euro in Europe, the Brazilian real, and the Chinese yuan, just to name a few. The trading of currencies and banks deposits is what makes up the foreign exchange market. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

What are Foreign Exchange Rates? Two kinds of exchange rate transactions make up the foreign exchange market: Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate. Forward transactions involve exchanges at some future date, completed at the forward rate. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Foreign Exchange Market The next slide shows exchange rates for four currencies from 1990-2006. Note the difference in rate fluctuations during the period. Which appears most volatile? The least? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Why Are Exchange Rates Important? When the currency of your country appreciates relative to another country, your country's goods prices  abroad and foreign goods prices  in your country. Makes domestic businesses less competitive Benefits domestic consumers (you) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Why Are Exchange Rates Important? For example, in 1999, the euro was valued at $1.18. On April 26, 2006, it was valued at $1.36. Euro appreciated 15% (1.36-1.18) / 1.18 Dollar depreciated 13% (0.75-0.85) / 0.85 Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18 We can see exchange rates in the WSJ. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Foreign Exchange Market: Exchange Rates Current foreign exchange rates http://www.federalreserve.gov/releases/H10/hist

How is Foreign Exchange Traded? FX traded in over-the-counter market Most trades involve buying and selling bank deposits denominated in different currencies. Trades in the foreign exchange market involve transactions in excess of $1 million. Typical consumers buy foreign currencies from retail dealers, such as American Express. FX volume exceeds $3 trillion per day. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run Exchange rates are determined in markets by the interaction of supply and demand. An important concept that drives the forces of supply and demand is the Law of One Price. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Law of One Price The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it. Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Law of One Price Law of one price  E = 100 yen/$ Copyright © 2009 Pearson Prentice Hall. All rights reserved.

PPP  Domestic price level  10%, domestic currency  10% Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels. PPP  Domestic price level  10%, domestic currency  10% Application of law of one price to price levels Works in long run, not short run Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) Problems with PPP All goods are not identical in both countries (i.e., Toyota versus Chevy) Many goods and services are not traded (e.g., haircuts, land, etc.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: PPP Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate  The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Relative price levels: a rise in relative price levels cause a country’s currency to depreciate. Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate. Productivity: if a country is more productive relative to another, its currency appreciates. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits. Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

We will illustrate this with a simple example Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets We will illustrate this with a simple example François the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets Al the American has a similar problem. He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns and Interest Parity Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets What this shows is simple. As the relative expected return on dollar assets increases (decreases), both François and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets. This leads us to our formal title for what is going on here: Interest Parity Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns and Interest Parity Interest Parity Condition $ and F deposits perfect substitutes (2) Example: if iD = 6% (US interest rate) and iF = 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns and Interest Parity Interest Parity Condition $ and F deposits perfect substitutes (2) Example: if iD = 10% and expected appreciation of $, Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Expected Returns and Interest Parity To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF. Next, we must determine the expected return in terms of dollars on dollar deposits, RD. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Deriving RF Curve RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF  Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Deriving RD Curve Points B, D, E, RD = 10%, so curve is vertical Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et  If Et < E*, RF < RD, buy $, Et  The following figure illustrates this. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exchange Rates in the Short Run: Equilibrium Figure 13.3 Equilibrium in the Foreign Exchange Market Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits. We will examine these separately, as well as changes in the money supply and exchange rate overshooting. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Shifts in RF RF curve shifts right when iF : because RF  at each Et Eet+1 : because expected appreciation of F  at each Et and RF  Occurs: 1. Domestic P ; 2. Restrictions on trade ; 3. Imports ; 4. Exports ; 5. Productivity  Figure 13.4 Shifts in the Schedule for the Expected Return on Foreign Deposits RF Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Shifts in RD RD shifts right when iD , because RD  at each Et Assumes that domestic πe unchanged, so domestic real rate  Figure 13.5 Shifts in the Schedule for the Expected Return on Domestic Deposits RD Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Factors that Shift RF and RD Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Factors that Shift RF and RD (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Response to i  Because πe  πe , Eet+1 , expected appreciation of F , RF shifts out to right iD , RD shifts to right However because πe  > iD , real rate , Eet+1  more than iD   RF shifts out > RD shifts out and Et  Figure 13.6 Effect of a Rise in the Domestic Nominal Interest Rate as a Result of an Increase in Expected Inflation Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Explaining Changes in Exchange Rates: Changes in the Money Supply Ms , P , Eet+1 , expected appreciation of F , RF shifts right Ms , i D , RD shifts left—go to point 2 and Et  In long run, i D returns to old level, RD shifts back, go to point 3 and get exchange rate overshooting Figure 13.7 Effect of a Rise in the Money Supply Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Case: Why are Exchange Rates So Volatile Expectations of Eet+1 fluctuate Exchange rate overshooting Copyright © 2009 Pearson Prentice Hall. All rights reserved.

The Dollar and Interest Rates Value of $ and real rates rise and fall together, as theory predicts No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises Daily foreign exchange rate http://quotes.ino.com/exchanges/?e=FOREX

Case: The Euro’s First Nine Years The euro debuted in 1999 at $1.18 / euro. It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of 2007. Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Reading the WSJ The figure on the next slide shows the “Currency Trading” column from the Wall Street Journal on July 11, 2007. Some highlights include: Warnings from Home Depot and other sectors that the economy is weakening – signaling possible Fed rate cuts (did that happen?) Dollar returns expected to be lower in the future – dollar expected to depreciate Copyright © 2009 Pearson Prentice Hall. All rights reserved.

The Practicing Manger: Profiting from FX Forecasts Forecasters look at factors discussed here FX forecasts affect financial institutions managers' decisions If forecast yen appreciate, yen depreciate, Sell franc assets, buy euro assets Make more euros loans, less yen loans FX traders sell yen, buy euros Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Summary Foreign Exchange Market: the market for deposits in one currency versus deposits in another. Exchange Rates in the Long Run: driven primarily by the law of one price as it affects the four factors discussed. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Summary (cont.) Exchange Rates in the Short Run: short-run rates are determined by the demand for assets denominated in both domestic and foreign currencies. Explaining Changes in Exchange Rates: factors leading to shifts in the RF and RD schedules were explored. Copyright © 2009 Pearson Prentice Hall. All rights reserved.