International Finance Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach

Chapter Outline The basics of exchange rates Foreign exchange markets The demand of currency A model of foreign exchange markets

The Basics of Exchange Rates An exchange rate of a currency is the price of the currency express in terms of another currency. Exchange rates quotations Direct/Indirect Pick a home currency (US$, for instance) Direct quote – $1.3385/€1 Indirect quote – €0.7471/$1 American/European American quote - $0.0101/ ¥1 European quote - ¥98.735/$1 Yahoo Finance, WSJ

The Basics of Exchange Rates (cont.) Depreciation and Appreciation of Currencies Depreciation (appreciation) is a decrease (increase) in the value of a currency relative to another currency. $0.6988/€1  $0.7122/€1  $0.7084/€1 A depreciated (appreciated) currency means that imports are more (less) expensive and domestically produced goods and exports are less (more) expensive. A depreciated (appreciated) currency lowers (raises) the price of exports relative to the price of imports.

The Basics of Exchange Rates (cont.)

Foreign Exchange Markets The set of markets where foreign currencies and other assets are exchanged for domestic ones. Institutions buy and sell deposits of currencies or other assets for investment purposes. Recently, the daily volume of foreign exchange transactions has been more than $4 trillion – up from $500 billion in 1989. Participants include commercial banks(other depository institutions), non-bank financial institutions, non-financial businesses, and central banks.

Foreign Exchange Markets (cont.) Active trading and the increasing degree of integration in forex market imply that there is no significant arbitrage between markets. Arbitrage: buying at a low price and selling at a high price for a profit. Spot rates vs. Forward rates Spot rates are the exchange rates at which currencies are traded at the present. Forward rates are the exchange rates agreed upon between two parties to trade currencies at a certain future time.

Figure 1: Dollar/Pound Spot and Forward Exchange Rates, 1983–2011 Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.

Foreign Exchange Markets Foreign exchange swaps Exchanges of loan principals and interest payments in different currencies Futures contracts a standardized contract to buy or sell a specified currency of standardized quality at a certain date in the future, at a specified price. Forward contracts vs. Futures contracts Options contracts (Call/Put) A right given to the buyer to buy or sell a currency at a specified price for a standard amount on or before a specified future date .

The Demand of Currency Deposits Factors that influence the return on assets determine the demand of those assets, including currency deposits. Rate of return: the percentage change in value that an asset offers during a time period. Real rate of return: inflation-adjusted rate of return Risk and return Inflation risk Liquidity risk Default risk Maturity risk

The Demand of Currency Deposits (Cont.) We assume that risks of currency deposits in foreign exchange markets are the same, regardless of their currency denomination. Rates of return that investors expect to earn are determined by Interest rates that the assets will earn Expectations about appreciation or depreciation

The Demand of Currency Deposits (Cont.) Suppose the interest rate on a dollar deposit is 2%. Suppose the interest rate on a euro deposit is 4% Is investment in a euro deposit more attractive than that in a dollar deposit? Suppose today the exchange rate is $1/€1, and the expected rate one year in the future is $0.97/€1. $100 can be exchanged today for €100. These €100 will yield €104 after one year. These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year. The rate of return in terms of dollars from investing in euro deposits is ($100.88-$100)/$100 = 0.88%.

The Demand of Currency Deposits (Cont.) Analyze the dollar rate of return on euro deposits: [($100 / $1/€1) x (1+4%) x $0.97/€1]/100 – 1 = (1+4%) x (0.97-1)/1 + 4% = 4% + (-3%) + 4% x (-3%) = 0.88% Considering the even smaller value of the multiplication of two small percentages, we decompose the dollar rate of return on euro deposits into two components: The interest rate on euro deposits The expected rate of appreciation of euro deposits R€ + (Ee$/€ - E$/€)/E$/€ = 4% + (-3%) = 1%  0.88%

The Demand of Currency Deposits (cont.) Compare the rate of return on dollar deposits with that on euro deposits R$ - [R€ + (Ee$/€ - E$/€)/E$/€ ] = 2% - 1% = 1% The investment in dollar deposits is more attractive.

Model of Foreign Exchange Markets If the risk of investing in dollar deposits is the same as that in euro deposits, the expected returns earned from the two kinds of deposits should be the same. An difference in expected returns would produce an arbitrage opportunity. Any arbitrage will eventually equate rate of returns between dollar deposits and euro deposits. The model of foreign exchange markets analyzes the equilibrium where deposits of all currencies offer the same expected rate of return.

Model of Foreign Exchange Markets (cont.) Interest parity. Interest parity implies that deposits in all currencies are equally desirable assets. Interest parity implies that arbitrage in the foreign exchange market is not possible. R$ = R€ + (Ee$/€ - E$/€)/E$/€ Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits.

Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/€ = $1.05 per Euro

Figure 2: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits

Figure 3: The Current Exchange Rate and the Expected Rate of Return on Dollar Deposits Expected dollar return on dollar deposits, R$ Current exchange rate, E$/€ 1.02 1.03 1.05 1.07 0.031 0.050 0.069 0.079 0.100 1.00 R$

Figure 4: Determination of the Equilibrium Dollar/Euro Exchange Rate No one is willing to hold euro deposits No one is willing to hold dollar deposits

Model of Foreign Exchange Markets (cont.) The effects of changing interest rates: an increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. This leads to an appreciation of the currency. Higher interest rates on dollar-denominated assets causes the dollar to appreciate. Higher interest rates on euro-denominated assets causes the dollar to depreciate.

Figure 5: The Effect of a Rise in the Dollar Interest Rate

Figure 6: The Effect of a Rise in the Euro Interest Rate

Figure 7: The Effect of an Expected Appreciation of the Euro increases

Covered Interest Parity Covered interest parity relates interest rates across countries and the rate of change between forward exchange rates and the spot exchange rate: R$ = R€ + (F$/€ - E$/€)/E$/€ where F$/€ is the forward exchange rate. It says that rates of return on dollar deposits and “covered” foreign currency deposits are the same. How could you earn a risk-free return in the foreign exchange markets if covered interest parity did not hold? Covered positions using the forward rate involve little risk.

Covered Interest Rate Parity Consider alternative one-year investments for $100,000: Invest in the U.S. at i$. Future value = $100,000 × (1 + i$) Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward. S$/£ F$/£ Future value = $100,000(1 + i£)× Assuming these investments have the same risk (they probably do if they are short-term bank deposits), they must have the same future value (otherwise an arbitrage would exist). S$/£ F$/£ (1 + i£) × = (1 + i$) 26

Summary An exchange rate is the price of one country’s currency in terms of another country’s currency. It enables us to translate different countries’ prices into comparable terms. Depreciation (appreciation) of a currency means that it becomes less (more) valuable and goods denominated in it are less (more) expensive: exports are cheaper (more expensive) and imports more expensive (cheaper).

Summary (cont.) 3. Commercial and investment banks that invest in deposits of different currencies dominate the foreign exchange market. Expected rates of return are most important in determining the willingness to hold these deposits. 4. Rates of return on currency deposits in the foreign exchange market are influenced by interest rates and expected exchange rates.

Summary (cont.) 5. Equilibrium in the foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity. An increase in the interest rate on a currency’s deposit leads to an increase in its expected rate of return and to an appreciation of the currency.

Summary (cont.) 7. An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and leads to an actual appreciation. Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using the forward exchange rate are the same.