BA 282 Macroeconomics Class Notes - Part 3 Foreign Exchange BA 282 Macroeconomics Class Notes - Part 3 Foreign Exchange

Foreign Exchange Rates The exchange rate is the price of one country’s currency in terms of another country’s currency Quoted exchange rates can be either direct or indirect, one method is usually the convention Direct: home currency per unit of foreign currency Examples from US perspective: 1.676 US Dollars (USD) per British Pound (GBP) 1.152 US Dollars (USD) per Euro (EUR) Indirect: foreign currency per unit of home currency 109.58 Japanese Yen (JPY) per US Dollar (USD) 1.3664 Swiss Francs (CHF) per US Dollar (USD) Foreign Exchange

Prices in Foreign Currency Use the exchange rate in direct terms Example 1: How much does a €100 sweater cost an American if the exchange rate is 1.15 $/€? Price in $ = €100 * 1.15 $/€ = $115.00 Example 2: How much does a 100 CHF sweater cost an American if the exchange rate is 1.37 CHF/$? Price in $ = 100 CHF * (1 / 1.37 CHF/$) = $72.99 Foreign Exchange

Depreciation and Appreciation A depreciation of the local currency means that it takes more local currency to buy a unit of foreign currency An appreciation of the local currency is the opposite Example: If the $/€ exchange rate goes up from 1.10 to 1.20 the dollar has depreciated against the euro but, the euro has appreciated against the dollar. Foreign Exchange

Depreciation and the Price of Imports A depreciation of a country’s currency makes its goods cheaper for foreigners and makes foreign goods more expensive. Example: Consider a bottle of French wine that costs $20 when the $/€ exchange rate is 0.85. Now what is the $ price of the bottle of wine if the dollar depreciates to 0.95 $/€ ? Price in € before depreciation = $20 (1/0.85 $/€ ) = € 23.53 Price in $ after depreciation = € 23.53 (0.95 $/€ ) = $ 22.35 or Price in $ after depreciation = $20 (0.95/0.85) = $ 22.35 Foreign Exchange

Foreign Exchange Trading The vast majority of foreign exchange (FX) trading is done over-the-counter (OTC) Most transactions have the USD on one side Dollar is called a vehicle currency Trading is centered at major multinational banks (called dealers) such as Citibank, Bank of America, Deutsche Bank, HSBC, etc. By volume, it is the largest market in the world Average daily turnover is about 1.5 trillion USD Foreign Exchange

Foreign Exchange Trading Trading takes place 24 hours a day during the business week Trading moves around the globe: London => New York => Tokyo => London Other important participants are Corporations Nonbank financial institutions Central banks Foreign Exchange

For current rates see: http://online. wsj. com/documents/mktindex. htm Foreign Exchange

Spot vs. Forward rates Spot Rate: the exchange rate that is applicable today The settlement or value date for a spot transaction (the date on which the parties actually exchange assets) occurs two business days after the deal is made Forward Rate: the exchange rate agreed on today for a transaction at a future date. Most commonly quoted 30, 90, or 180 days in the future. The forward exchange rate is set so that no money changes hands today. Foreign Exchange

Forward Example Boeing plans to deliver a 777 to KLM in six months and receive 110 million Euros. Boeing calls Citibank and enters into a 180-day forward contract at a forward rate of 0.8700 $/€. This obligates Boeing to deliver €110m to Citibank in 180 days in exchange for € 110m * 0.8700 $/€ = $ 95.700m Foreign Exchange

Why Use Forwards Suppose that Boeing did not enter into a forward agreement. What would be the dollar proceeds from the sale if in 6 months the Euro ends up trading at: USD/EUR USD Proceeds 0.82 0.82 * 110m = $ 90.2m 0.87 0.87 * 110m = $ 95.7m 0.92 0.92 * 110m = $ 101.2m Foreign Exchange

Derivative Securities A forward contract is the simplest form of a derivative security Definition: A derivative security is a financial contract that derives its value from the price of another underlying asset. Other common examples: Swaps Put and call options Futures contracts (exchange-traded forwards) Foreign Exchange

FX Trading Statistics Foreign Exchange

FX Derivative Market Stats Foreign Exchange

JPY/USD Foreign Exchange

Trade-Weighted USD Exchange Rate The index is a weighted average of the foreign exchange values of the U.S. dollar against other major currencies. The index weights, which change over time, are derived from U.S. export shares. The index is calculated in indirect terms so higher values imply a stronger USD. Foreign Exchange

USD/EUR Foreign Exchange

The Law of One Price In competitive markets free of transportation costs and other barriers to trade, identical goods sold in different countries must sell for the same price (when expressed in the same currency). Why? Foreign Exchange

The Law of One Price We can write an equation for the law of one price as, PiLC = PiFC * E where PiLC is the local currency price of good i PiFC is the foreign currency price of good i E is the dollar to euro exchange rate Or we can rearrange the equation to get E = PiLC / PiFC Foreign Exchange

Purchasing Power Parity (PPP) PPP looks just like the law of one price except the prices are for a “basket” of goods rather than for a particular good so E = PLC / PFC or PLC = PFC * E where PLC is the local currency aggregate price level PFC is the foreign currency aggregate price level Foreign Exchange

Invented in 1986 as a light-hearted guide to whether currencies are at their “correct” level, burgernomics is based on the theory of purchasing-power parity (PPP). This says that, in the long run, exchange rates should move toward rates that would equalise the prices of an identical basket of goods and services in any two countries. To put it simply: a dollar should buy the same everywhere. Our basket is a McDonald's Big Mac, produced locally to roughly the same recipe in 118 countries. The Big Mac PPP is the exchange rate that would leave burgers costing the same as in America. Comparing the PPP with the actual rate is one test of whether a currency is undervalued or overvalued. The first column of the table shows local-currency prices of a Big Mac. The second converts them into dollars. The average price of a Big Mac in four American cities is $2.71. The cheapest burgers are in China ($1.20); the dearest are in Switzerland ($4.52). In other words, the yuan is the most undervalued currency, the Swiss franc the most overvalued. The third column calculates Big Mac PPPs. Dividing the local Chinese price by the American price gives a dollar PPP of 3.65 yuan. The actual exchange rate is 8.28 yuan, implying that the Chinese currency is undervalued by 56% against the dollar. Foreign Exchange

Purchasing Power Parity (PPP) PPP asserts that all countries’ price levels are equal when measured in terms of the same currency Note: In practice the basket of goods is the same as the one used for the CPI PPP predicts that a decline (increase) in a currency’s domestic purchasing power will be associated with a proportional currency depreciation (appreciation) in the foreign exchange market Foreign Exchange

Absolute PPP vs. Relative PPP Absolute PPP (PLC = PFC * E) represents the relationship between the level of the exchange rate and the level of prices in the two economies Relative PPP states that the percentage change in the exchange rate will be equal to the difference in the percentage change in the price levels in the two countries Foreign Exchange

Absolute PPP vs. Relative PPP We can write an equation for Relative PPP as (Et - Et-1)/ Et-1 = pLC,t – pFC,t where pi,t is the inflation rate (Pi,t - Pi,t-1)/ Pi,t-1 in country i between time t-1 and t Et is the exchange rate at time t Foreign Exchange

Empirical Evidence on PPP To test absolute PPP, we measure the price level of a basket of goods in various countries. For example, The Economist’s Big Mac Index To test relative PPP we can look at the correlation between exchange rates and relative price levels Typically correlations are low Empirically, PPP theory does poorly in predicting exchange rate movements for developed countries Why is it hard to test these theories? Foreign Exchange

Problems with PPP Transport costs and trade barriers If it costs a substantial amount to transport goods, then this prevents the ability to do “arbitrage” In some industries transport costs are effectively infinite (e.g., housing). These are called nontradable goods. Governments usually have import tariffs, etc. Monopolistic or oligopolistic practices Measurement differences “Sticky” prices Foreign Exchange

Demand for Foreign Currency If we think of foreign currency as a financial asset then the demand for foreign currency will depend on the investment properties of foreign currency For example, we might consider the following properties Expected Return Risk Liquidity Inflation Foreign Exchange

Demand for Foreign Currency For now we are going to concentrate on only one of these Expected Return Notation RLC Interest rate in local currency (e.g., USD) RFC Interest rate in foreign currency (e.g., EUR) Et Actual exchange rate at time t in LC/FC Ee Expected exchange rate in one year (this is the expectation of a random variable) Foreign Exchange

Demand for Foreign Currency Definition: The annual rate of depreciation of LC relative to FC is the percentage increase in E over one year, rate of depreciation = (E1 - E0) / E0 The LC rate of return on FC deposits is approximately RFC plus the rate of depreciation Today we do not know what E1 will be, only what we expect it to be (Ee). So, expected rate of return on FC = RFC + (Ee - E0) / E0 Foreign Exchange

FX Market Equilibrium Equilibrium in the foreign exchange market is defined as difference in rate of return = RLC - RFC - (Ee - E0) / E0 = 0 This is also called the interest parity condition and can be written as RLC = RFC + (Ee - E0) / E0 Foreign Exchange

Graphing Interest Parity We can rearrange this equation so that E0 = Ee / (1 + RLC - RFC) Example: Suppose R€=5.2% and Ee=0.95 $/€, what is the exchange rate today (E0) for the following USD interest rates? R$ E0 2% 4% 6% 8% Foreign Exchange

Plot the Points Exchange Rate ($/€) 0.9814 0.9615 0.9425 Expected Return on € Deposits 0.9241 2% 4% 6% 8% Rate of Return ($) Foreign Exchange

Graphical Equilibrium Exchange Rate (LC/FC) E0’’ 2 1 E0* Expected Return on FC Deposits E0’ 3 RLC Rate of Return (LC) Foreign Exchange

Changing LC Interest Rates and Exchange Rate Equilibrium Exchange Rate (LC/FC) 1 1’ E0 LC Appreciates 2 Expected Return on FC Deposits E0’ RLC R’LC Rate of Return (LC) Foreign Exchange

Changing FC Interest Rates and Exchange Rate Equilibrium Exchange Rate (LC/FC) Rise in FC Interest Rate 2 E0’ LC Depreciates 1 E0 Expected Return on FC Deposits RLC Rate of Return (LC) Foreign Exchange

Money, Interest Rates, & Exchange Rates We can combine what we learned previously about the demand for money with what we now know about exchange rates This gives a more integrated picture of how money, interest rates, and exchange rates interact For convenience let’s rotate the money market graph clockwise 90o and combine it with the FX market graph Foreign Exchange

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Money Market / Exchange Rate Linkages Foreign Exchange

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Time path of US economic variables after a permanent increase in the US money supply Foreign Exchange

FX & Currency Swaps A swap is an agreement between two parties to exchange a predefined set of cashflows for a specified period. A FX swap is the spot sale of a currency combined with a forward repurchase agreement (like a repo) A simple currency swap is when one counterparty would agree to pay €10 million each year for five years. The other counterparty would agree to pay $8 million each year for five years. Note that this currency swap is just a set of five forward contracts. Foreign Exchange

FX & Currency Swap facts Most currency swaps entail an up-front exchange of principal (unlike interest rate swaps) Like FX forwards, most FX swaps have one side in USD Currency swaps tend to be traded at longer maturities than forwards or options (> 1 year) Foreign Exchange

FX Options A call (put) option gives the owner the right but not the obligation to buy (sell) foreign currency at a prespecified exchange rate (called the strike) at a prespecified date. An option allow the owner to participate in exchange rate changes in one-direction only Consequently, options always have an upfront cost (called the premium) For a US investor, call options payoff when the USD/FCU exchange rate increases put options payoff when the USD/FCU exchange rate decreases Foreign Exchange

Calls and Puts Call Option Put Option X = Strike X = Strike C0 = Call Premium Net Payoff = max(E-X,0) - C0 Put Option X = Strike P0 = Put Premium Net Payoff = max(X-E,0) - P0 Payoff Payoff USD/FCU at Maturity X X USD/FCU at Maturity C0 P0 Foreign Exchange

Put Option Example Put options are frequently used to “hedge” foreign exchange revenues Back to Boeing example, Recall Boeing expects to receive 110 million Euros in six months. Boeing calls Citibank and buys a 180-day put option with a strike of 0.85 $/€ for a premium of $2 million today. When does Boeing exercise the put option? Would the put option premium be more or less if the strike was 0.80 $/€? Foreign Exchange

Changes in E0 and Expected Returns How does a change in E0 (all else held constant) change the LC expected return of FC deposits? Example: E0 equals 1.00$/€ and Ee equals 1.05$/€. Now suppose E0 increases to 1.03$/€ What happens to the dollar return on euros? In general, a depreciation of the local currency results in a decrease in the local currency return of foreign currency deposits Foreign Exchange