Chapter 8 The Foreign- Exchange Market and Exchange Rates

However, individual country currencies are exchanged in financial markets. Two types of foreign exchange markets 1.Cash Market – Spot Market in which agents set a price to exchange cash in less than two days. 2.Derivative Market - Forward market in which agents set a price to exchange currency at some future date. Both markets are Over-the-Counter markets.

HK Dollar Exchange Rates

Exchange Rate: EX - # of foreign currency units purchased for 1 domestic currency unit. An increase in EX is an appreciation and a decrease in EX is a depreciation. Define the expected growth rate of the exchange rate as

Exchange Rates and International Trade A toaster in Hong Kong which sells at price P HK denominated in HK$ or order a toaster from Japan selling at price P JPN. (Both toasters have equivalent characteristics) The price of the Japanese toaster can be converted to HK dollars by dividing by the $HK: $Yen exchange rate. Buy HK toaster if buy Japanese toaster otherwise.

Real Exchange Rate Broaden our perspective, P HK is a broad based index of domestic prices and P JPN is a broad based index of Japanese prices. The relative price of domestic goods is the real exchange rate

LOOP, PPP, and RER The Law of One Price states that a good selling in different markets should have the same price in both markets. –If not arbitrageurs will buy in cheap markets and sell in expensive until prices are equalized. Applied to all goods LOOP implies Purchasing Power Parity. The price of goods in the domestic market should be equal to the price of goods in foreign markets divided by the exchange rate. PPP implies a constant real exchange rate.

Inflation and Exchange Rates If PPP holds, then real exchange rate is constant. This would imply that exchange rate appreciations occur when foreign inflation is higher than domestic inflation. When foreign goods cost more (in terms of foreign currency), people are willing to pay higher prices for domestic currency to buy the more competitive domestic products.

HK-US Real Exchange Rates

Real Exchange Rate Appreciation Long-run real exchange rate appreciations are caused by 1.Increases in preferences for domestic goods relative to foreign goods. 2.Trade barriers which allow domestic prices to remain relatively high. 3.Productivity Growth which increases demand and prices for non-traded goods including land which is in relatively fixed supply.

Theory and Reality PPP does not hold in the short-run. Pricing mechanism may not work that quickly to insure law of one price. Among developed countries, over long time periods, exchange rate appreciations are closely related to exchange rate differentials. Real exchange rates are roughly stationary. High growth developing countries experience long-term real exchange rate appreciations.

International Trade and Finance Level of the nominal exchange rate, affects international trade By contrast, the expected growth rate of exchange rates affects international finance.

Interest Rates Consider the decision to buy a HK bond with a yield of 1+i denominated in HK dollars or a Japanese bond denominated in Yen with a yield of 1+i f. (Assume both bonds have equivalent risk, liquidity, and information characteristics). With HK$1 you could buy a bond and receive HK$1+i after 1 period. With HK$1 dollar you could buy ¥EX, and buy a bond that would pay-off ¥(1+i f )·EX. This could then be exchanged for

Define the expected domestic Dollar return on a foreign bond as The expected domestic Dollar return on a domestic bond R = i. Given that domestic and foreign bonds have equivalent risk, liquidity and information characteristics, open international capital markets imply that they should have the same return when measured in the same currency. –If domestic interest rates (measured in domestic currency) are lower than foreign interest rates (measured in foreign currency), the market expects the domestic currency to appreciate over the life of the bonds. –If domestic interest rates are higher than foreign interest rates, the market expects the domestic currency to depreciate in value.

Long Term Interest Rate Differentials We observe long-term differences in interest rates across countries. One explanation is that there is long-term depreciation of the currency of the high interest rate country versus the low interest rate country.

Short-term Determinants of Exchange Rates Large fluctuations in exchange rates around trend between most countries currencies. The HK$-US$ exchange rate is set by the HKMA’s monetary policy. However, this is an exceptional case. Most countries monetary authorities allow an independent interest rate. The exchange rate then fluctuates to equalize returns. Many small countries set monetary policy to stabilize exchange rates.

Holding the foreign interest rate and expected future exchange rate constant, the return is a positive function of the current exchange rate. The higher is the exchange rate, the more foreign dollars you can get for each domestic dollar that you pay today and thus the more foreign currency bonds you can buy for 1 unit of domestic currency. Ex. The current yield on a 1 year Japanese T-bill is.03%. The HK$-¥ exchange rate hovers between 15 and 16. Assume that the expectation of the exchange rate 1 year from now is EX +1 =15. We can map this into returns as a function of the exchange rate Short-Term Foreign Bond Returns

Rise in Domestic Interest Rates An increase in domestic interest rates means that the exchange rate must be greater today than in the future. An increase in the interest rate implies a rise in the exchange rate. Intuition – A rise in domestic interest rates makes domestic bonds more attractive relative to foreign bonds. Portfolio holders purchase the domestic currency bidding up the exchange rate.

Rise in Foreign Rates An increase in domestic interest rates means that the exchange rate must be lower today than in the future. An increase in the foreign interest rate implies a fall in the exchange rate (holding the future exchange rate level constant). Intuition – A rise in foreign interest rates makes foreign bonds more attractive relative to domestic bonds. Portfolio holders purchase the foreign currency, putting downward pressure on the exchange rate.

Rise in Expected Future Exchange Rate A rise in the expected future exchange rate means that the current exchange rate must increase to equalize returns. An increase in the expected future exchange rate increases the current exchange rate. Intuition: A rise in the future exchange rate increases the foreign currency pay-off of investing in domestic currency bonds. As foreign portfolio holders buy domestic currency to take advantage, the domestic currency price is bid up.

Rise in Expected Inflation For a given real interest rate, a rise in the expected inflation rate will lead to a rise in the domestic interest rate. A rise in future prices will lead to less future demand for domestic currency and a depreciation of the future expected exchange rate and a rise in domestic currency returns of foreign currency bonds. Effect on current exchange rates are ambiguous but thought to be more likely to lead to a depreciation.

Rise inSpot Exchange Rate: EDomestic Currency Returns of Foreign Currency Bonds Domestic Interest Rate: i↑ ↑↑ Foreign Interest Rate i F ↑↓Unchanged Expected Exchange Rate E +1 ↑ ↑Unchanged Expected Domestic Inflation π ↑ Ambiguous↑

Premium Define h f,d as the premium paid by issuers of domestic bonds over foreign bonds. h f,d can be either positive or negative. 1.If domestic bonds have more attractive risk or liquidity properties, h f,d > 0. 2.If domestic bonds have less attractive risk or liquidity properties, h f,d < 0.

Currency Risk Premium and Exchange Rates Equal returns across countries presumes that the representative bonds across markets have equal characteristics (in terms of risk, liquidity, and information). This is unlikely to hold true in practice. Example: After many years of recession and political instability, bonds issued by corporations and governments in Indonesia are likely to be more risky than bonds issued by corporations and governments in Hong Kong. Example: Hong Kong banks are able to use Exchange Fund bonds as collateral for short-term loans that can be used to replenish their overnight aggregate balances. EF bonds have unique liquidity properties.

East Asian Crisis During late 1990’s, risk premiums on bonds issued in many East Asian countries rose dramatically. In Indonesia, Korea, Malaysia, Philippines, and Thailand exchange rates depreciated dramatically. (Taiwan and Singapore, to a lesser extent). In Hong Kong, exchange rates stayed the same, but interest rates rose atypically above US levels.

A Rise in the Domestic Risk Premium EX R i RFRF R F -h’ h’↓

Corrected Version of Slide 9 from Chapter 6 Q: Why does the Demand Curve for Loanable Funds Slope Down? A: If bond issuers must offer a high interest payment to borrow, the attractiveness of borrowing or financing borrowing in the bond market will drop. Q: Why does the Supply Curve for Bonds Slope Up. A: If bond issuers receive a high price for a given future face value, the attractiveness of borrowing or financing in the bond market rises.