INTERNATIOANAL FINANCE

Exchange Rates and the Foreign Exchange Market : CHAPTER 13 An Asset Approach

Relative Concepts Exchange rate: the price of one currency in terms of another Direct quote: Indirect quote: Unit currency Direct quote Indirect quote the price of one unit foreign currency in terms of domestic currency the price of one unit domestic currency in terms of foreign currency Pricing currency domestic currency foreign currency domestic currency Quotations 直接标价法 间接标价法 汇率

Examples Direct Quotation In Shanghai USD100=CHY In Frankfort USD1=EUR Indirect Quotation In London In New York GBP1=USD 美元 人民币 欧元 英镑

Depreciation and Appreciation All else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners. All else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners. All else equal, a appreciation of a country’s All else equal, a appreciation of a country’s currency makes its goods dearer for foreigners. currency makes its goods dearer for foreigners. ___________ 贬值 与 升值

Foreign Exchange Market Defination: currencies are traded. the market in which international Major actors of the FX market: Central banks Nonbank financial institutions Commercial bank Corporations 外 汇 市 场外 汇 市 场

Framework of the Market (I) Central bank selling foreign currency buying foreign currency Corporations (importors & exporters) Nonbank financial institutionsOther users (eg.international tourists ) A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N Commercial banks Buying foreign currency with domestic currency Buying domestic currency with foreign currency

Corporations(importors & exporters) Nonbank financial institutions Central bank A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N Other users (eg.international tourists ) Commercial banks ---- Framework of the Market (II) or Retail market or Wholesale market commercial trading Intervenient trading Over-the- counter market 柜台交易市场 Interbank market 银行间市场

LondonNew YorkParisFrankfortShanghaiTokyo Sydney Hongkong Singapore Framework of FX market (III) What ’ s you spot USD JPY, pls ? /30 Buy USD1( million ) OK, done.

Characteristics of the Market Foreign exchange trading takes place in many financial centres. These major forex trading centres forms a round-o’clock market as they are linked by direct phones, fax and internet. arbitrage Most FX deals between banks involve exchanges of nondollar currencies for U.S. dollars. examples a vehical currency

Spot Rates & Forward Rates 即期汇率与远期汇率 Spot Exchange Rates: Spot Exchange Rates:  Exchange rates governing such “on-the- spot” trading. (two days after a deal is struck) Forward Exchange Rates: Forward Exchange Rates:  Exchange rates deals sometimes specify a value date farther away than 2days-- 30days, 90days,180days,or even several years.

Foreign Exchange Swaps Foreign Exchange Swaps: Foreign Exchange Swaps:  a spot sale of a currency combined with a forward repurchase of the currency

Currency Futures Futures: Futures:  a future contract means a promise that a specified amount of foreign currency will be delivered on a specified date in the future

Currency Options Options: Options:  gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at a specified expiration date

Demand for Foreign Currency Assets Asset & Asset Returns Asset & Asset Returns Interest Rates Interest Rates Exchange Rates & Asset Returns Exchange Rates & Asset Returns A Simple Rule A Simple Rule Return, Risk, and Liquidity in the Foreign Exchange Market Return, Risk, and Liquidity in the Foreign Exchange Market

Exchange Rate & Asset Returns Rate of return: The percentage increase in value it offers over some period. Rate of return: The percentage increase in value it offers over some period. Invest 100$ to buy a share of stock and the dividend is 1$. Invest 100$ to buy a share of stock and the dividend is 1$. If the price rise to 109 $ or drop to 89 $. If the price rise to 109 $ or drop to 89 $. (109 +1)/100 –1 = 10% (109 +1)/100 –1 = 10% (89 + 1)/100 –1 = – 10% (89 + 1)/100 –1 = – 10% Expected rate of return (P.334) Expected rate of return (P.334)

Equilibrium in the FX Market Interest Parity The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. 利息平价 : The basic equilibrium condition

€ E $/€ = $ € (1+R € ) = € f Asset Market Linkages $ € E $/€ $f$f E e $/€ €f€f (1+R $ ) (1+R € ) Spot FX market Future spot FX market Euro money market dollar money market $ (1+R $ ) = $ f $ f / E e $/€ = € f e.g. E $/€ = 1.2, € = $ ? € ×1.2= $ e.g. E e $/€ =1.245, $ f = € f ? $ f /1.245= € f e.g.R $ =10%, $ =$ f ? $ ×(1+10%)=$ f e.g.R € = 6%, € = € f ? € ×(1+ 6%)= € f € E $/€ (1+ R $ )/ E e $/€ = € (1+ R € ) ×1.2×(1+10%)/1.245= ×(1+ 6%)

(1+R $ ) € E $/€ € (1+R € ) E $/€ +E $/€ R $ = E e $/€ +E e $/€ R € E e $/€ -E $/€ =E $/€ R $ -E e $/€ R € (E e $/€ -E $/€ )/ E $/€ =R $ -E e $/€ R € / E $/€ (E e $/€ -E $/€ )/E $/€ =R $ -R € -(E e $/€ - E $/€ )/E $/€ R € ∴ (E e $/€ -E $/€ )/ E $/€ = R $ -R € or ∵ (E e $/€ - E $/€ )/ E $/€ R € is a small number R $ = R € +(E e $/€ -E $/€ )/ E $/€ ( interest parity condition ) /E e $/€ = E $/€ = E e $/€ (1+ R € )/(1+R $ ) Interest Parity Condition (E e $/€ -E $/€ )/ E $/€ = R $ -R € or R $ = R € +(E e $/€ -E $/€ )/ E $/€ The change in the expected future exchange rate is roughly equal to the difference between the two interest rates. The expected rate of return on one asset must equal that of the other asset when measured in the same currency. ________________ $ € E $/€ $f$f E e $/€ €f€f (1+R $ ) (1+R € ) E $/€ (1+R $ ) / E e $/€ = (1+R € ) 利息平价条件 Derivation of Interest Parity Condition

远期汇率与抵补的利息平价 ● The currency with a higher interest rate sells at a discount in the forward exchange market. The currency with a lowerer interest rate sells at a premium in the forward exchange market. (1+R $ ) € E $/€ € (1+R € ) E $/€ +E $/€ R $ = E f $/€ +E f $/€ R € E f $/€ -E $/€ =E $/€ R $ -E f $/€ R € (E f $/€ -E $/€ )/ E $/€ =R $ -E f $/€ R € / E $/€ (E f $/€ -E $/€ )/E $/€ =R $ -R € -(E f $/€ - E $/€ )/E $/€ R € ∴ (E f $/€ -E $/€ )/ E $/€ = R $ -R € or ∵ (E f $/€ - E $/€ )/ E $/€ R € is a small number R $ = R € +(E f $/€ -E $/€ )/ E $/€ ( covered interest parity ) Forward Exchange Rates & Covered Interest Parity /E f $/€ = ________________ $ € E $/€ $f$f E e $/€ €f€f (1+R $ ) (1+R € ) Let E e $/€ =E f $/€, expected future FX market is seen as forward FX market. / E f $/€ = (1+R € ) E $/€ (1+R $ ) E f $/€ =E $/€ (1+ R $ )/(1+R € ) Covered Interest Parity (E f $/€ -E $/€ )/ E $/€ = R $ -R € or R $ = R € +(E f $/€ -E $/€ )/ E $/€ (E f $/€ -E $/€ )/ E $/€ = R $ - R € Let P stand for 升水, then P = R $ – R €., then D = – P = R € – R $. 贴水 Let D stand for premium discount If R $ > R €, then E f $/€ > E $/€ ; If R $ = R €, then E f $/€ = E $/€ ; If R $ < R €, then E f $/€ < E $/€. E f $/€

How changes in E affect expected returns (I) R $ = R € + (E e $/€ - E $/€ )/ E $/€ R € + (E e $/€ / E $/€ -1) R $ > R € + (E e $/€ - E $/€ )/ E $/€ capital inflow E $/€ R $ = R € + (E e $/€ - E $/€ )/ E $/€ Expected dollar return Expected dollar return on euro deposits current depreciation Dollar appreciates. Interest parity condition holds again.

How changes in E affect expected returns (II) R$R$ Other things equal, depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits. R$R$ Other things equal, appreciation of a country’s currency today raises the expected domestic currency return on foreign currency deposits. > < = R € + (E e $/€ / E $/€ - 1) =

How changes in E affect expected returns (III) With fixed E e $/€ and R €, the relation between today’s E $/€ and the expected dollar return on euro deposits defines a download-sloping schedule.

How changes in E affect expected returns (IV) Given E e $/€ and R €, an appreciation of the dollar against the euro deposits, measured in terms of dollars, and vice versa.

The Equilibrium Exchange Rate R $ = R € + (E e $/€ - E $/€ )/ E $/€ Equilibrium in the FX market is at point 1, where the expected dollar return on dollar and euro deposits are equal.

Interest Rates, Expectations & Equilibrium (I) The Effect The Effect of Changing Interest Rates on the Current Exchange Rate of Changing Interest Rates on the Current Exchange Rate All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa. Conclusion:

The Effect of Changing Interest Rates on the Current Exchange Rate All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign currency, and vice versa. Interest Rates, Expectations & Equilibrium (II) Conclusion: Rise in R €

Interest Rates, Expectations & Equilibrium (III) The Effect of Changing expectations on the Current Exchange Rate Conclusion: All else equal,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

Interest Rates, Expectations & Equilibrium (IV) All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa. All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign currency, and vice versa. All else equal,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

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