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Chapter 7

The Foreign Exchange Market

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Foreign Exchange Markets

Exchange rate—price of one currency in terms of another: ETL/USD = 1.75 TL/dollar

Foreign exchange market—the financial market where exchange rates are determined

Spot transaction—immediate (two-day) exchange of bank deposits at spot exchange rate

Forward transaction—the exchange of bank deposits at some specified future date at the agreed forward exchange rate

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Foreign Exchange Markets

Appreciation—a currency rises in value relative to another currency: ETL/USD decreases.

Depreciation—a currency falls in value relative to another currency: ETL/USD increases.

Why is Exchange Rate important? When a country’s currency appreciates

(depreciates), the country’s goods abroad become more expensive (cheaper) and foreign goods in that country become cheaper (more expensive). Its exports fall (rise), imports rise (fall), trade deficit increases (falls). Rate of Inflation falls (rises).

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Foreign Exchange Markets Over-the-counter market, mainly banks

and other financial inst.’s.

Mostly deposits are traded, not paper currency.

“Average daily global foreign-exchange turnover has grown to $4.71 trillion according to a Dow Jones Newswires analysis, underscoring how currencies continue attracting liquidity and growing as an asset class despite the uncertain state of the economy…” WSJ, July 26 2011

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TL/$ exchange rate

1

10

100

1000

10000

100000

1000000

1000000002

.01.

1950

02.0

1.19

54

02.0

1.19

58

02.0

1.19

62

02.0

1.19

66

02.0

1.19

70

02.0

1.19

74

02.0

1.19

78

02.0

1.19

82

02.0

1.19

86

02.0

1.19

90

02.0

1.19

94

02.0

1.19

98

02.0

1.20

02

02.0

1.20

06

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Value of Lira against Dollar 1950 -1960: 2.82 TL / $ 1960 – August 1970: 9.08 TL / $ August 1970 – December 1971: 15.15 TL/$ December 1971 – May 1974: 14.30 TL / $ After 1980 variable (depreciations).

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Exchange Rates in the Long Run Law of one price. Price of the same good

must be the same in different countries. Assume 1 ton steel is sold at 134 TL in Turkey and 1 ton steel is sold for 100 dollar in US. According to the law of one price, exchange rate must be 1.34 TL/dollar. We assume tariffs and costs of transportation are zero.

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Exchange Rates in the Long Run

Theory of Purchasing Power Parity (PPP) Exchange Rates between any two currencies

adjusts to changes in the price levels of the two countries. PPP is a generalization of the law of one price to all goods and services

US

TURUSDTL P

PE /

PPP theory EX: The currency of the Country whose rate of

inflation is larger than the r.o.w. _______ against other currencies.

Ex: suppose 2000-2011 average rate of inflation is 10% in Turkey, 15% in Argentina, 3% in Euro area and 3% in the US. Order the rate of depreciation of each currency from largest depr. to smallest depr.

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Exchange Rates in the Long Run Btw 1973-2005, British price level rose

84% relative to the US price level. Dollar appreciated against the pound by 43%. But the theory predicts 84% appreciation?

Why does the theory of PPP cannot fully explain ER movements?

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Exchange Rates in the Long Run Why does the theory of PPP cannot fully

explain ER movements? Assumes trade barriers (tariffs and quotas) and

transportation costs are zero. Assumes all goods are tradable across borders.

But in practice many goods and especially services are not traded across borders (nontradables) like houses, haircuts, health services, etc.

Assumes all goods are identical across countries. Is Turkish steel the same as American steel?

Ignores expectations and exp. asset returns.

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Factors that Affect Exchange Rates in the Long Run Anything that increases demand for a

country’s goods, services, securities, etc. anything sold in terms of that country’s currency => increases the demand for and hence the value of that country’s currency against other currencies. If demand for TR bonds fall in London market,

TL ______ against other currencies. Interest rates on these bonds ______.

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Factors that Affect Exchange Rates in the Long Run

Relative price levels. If prices of Turkish goods or securities rise (fall) relative to foreign goods, demand for Turkish goods fall (rise), then TL depreciates (appreciates). But notice the reverse feedback correction…

Trade barriers. If import tariffs increase (decrease), then TL appreciates (depreciates). Ex: if tariffs on imported German cars decrease, demand for Turkish cars decrease, TL depreciates.

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Factors that Affect Exchange Rates in the Long Run Preferences for domestic versus

foreign goods. If Turks start to like Italian furniture more than Turkish furniture then TL depreciates.

Productivity. If Turkey’s productivity increases, then prices in Turkey decline and this causes TL to appreciate.

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1/E

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Exchange Rates in the Short Run An exchange rate is the price of domestic assets

in terms of foreign assets

Using the theory of asset demand —the most important factor affecting the demand for domestic curr. (TL) denominated assets and foreign curr.(dollar) denominated assets is the expected returns on these assets relative to each other.

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Comparing Expected Returns

TL denominated assets pay a real interest rate of iD

Dollar (foreign curr.) denominated assets pay real interest rate of iF

Expected depreciation of TL against dollar is

where Et is TL/dollar exchange rate at time t. This is also exp. appreciation of dollar against lira.

t

tte

E

EE 1

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Comparing Expected Returns From a Turkish investor’s perspective,

expected return from holding dollar assets is equal to

Expected return from holding TL assets in terms of liras is iD.

t

tte

FF

E

EEiR

1

liras of in terms

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Comparing Expected Returns II

D

t

tte

FF iE

EEiR

1

liras of in terms Relative

So expected relative return from holding dollar assets is equal to

•For example, if iD is 9%, iF is 3%, and TL is exp. to depreciate 5% against dollar next year, then relative return from holding dollar assets is -1% (1% loss). Relative return from holding TL assets is +1%. (Note: assume inflation is zero)

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Comparing Expected Returns III Now think of holding TL assets from an

American (or int’l) investor’s perspective. Return on TL assets for him is

If the American holds dollar assets instead of TL, then loses the above return, but gains iF.

t

tte

DD

E

EEiR

1

dollars of in terms

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Comparing Expected Returns III If the American holds dollar assets, then

his return is iF . But he loses the return he could have earned by holding TL assets. Exp. Return of holding dollars relative to TL assets is

t

tte

DFF

E

EEiiR

1

dollars of in terms Relative

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Comparing Expected Returns III

Result: Regardless of where the investor is from or which currency you start with, exp. relative returns from holding dollar assets (which is the negative of the exp. relative return from holding TL assets) ARE EQUAL.

If exp. relative returns from holding TL assets increase, both Turkish and American investors will “buy” or “hold more” TL assets and “sell” or “hold less” dollar assets. This causes lira to appreciate, dollar to depreciate.

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Interest Parity Condition

An equilibrium condition: If both domestic and foreign assets are held in eqbm, then expected returns must be the same on both domestic and foreign assets. Otherwise everybody would hold the one with positive exp. relative return. Nobody will hold the other asset.

In other words relative returns from holding each currency should be zero.

t

tte

FD

E

EEii

1

Interest Parity Condition Capital mobility with similar risk and

liquidity the assets are perfect substitutes.

The domestic (real) interest rate equals the foreign interest rate plus the expected depreciation of the domestic currency

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Interest Parity Condition But in an actual economy, we do not fully observe

the interest parity because of “country risk premium”. Country risk p. is the uncertainty regarding what is going to happen in Turkey in the future, like political instability.

For example, Garanti Bankası pays TL account %9, pays dollar %2. But does this mean people expect that TL will depreciate against dollar %7 during the next year? Not necessarily, part of the difference is due to the higher risk perceived of TL due to the bigger uncertainty in Turkish economy. This is called “country risk p.”.

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Demand for Domestic (curr. denom.) Assets

Demand increases if relative expected return increases.

Suppose Eet+1 = 1,45 . In which case is your TL

demand higher? İf Et= 1,31 TL/dollar now or if Et= 1,80 TL now?

At lower current values of TL (everything else equal), the quantity demanded of TL assets is higher

t

tte

FDD

E

EEiiR

1

Relative

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Demand for Domestic Assets

D

1/1,80

Quantity of TL assets

1/1,5

1/E ($/TL)

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Supply of Domestic Assets Supply

The amount of bank deposits, bonds, and equities, all securities denom. in TL. This amount does not depend on the current exchange rate.

Vertical supply curve

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EQUILIBRIUM

1/1,5

D

1/1,60

Quantity of TL assets

S1/E ($/TL)

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IF REAL INTEREST RATE (iD) INCREASES for TL-denom assets

1/1,5

D

1/1,60

S

D’

1/1,20

Quantity of TL assets

1/E ($/TL)

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IF EXPECTED INFLATION INCREASES IN TURKEY

1/1,5

D’

1/1,60

S

D

1/1,20

Quantity of TL assets

1/E ($/TL)

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IF FED INCREASES INTEREST RATE

1/1,5

D’

1/1,60

S

D

1/1,20

Quantity of TL assets

1/E ($/TL)

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IF EXPECTED FUTURE EXCHANGE RATE APPRECİATES

1/1,5

D

1/1,60

S

D’

1/1,20

Quantity of TL assets

1/E ($/TL)

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IF CBRT INCREASES MONEY SUPPLY When the CB increases the money supply,

the long run price level will increase. This means TL will depreciate in the long run, due to purchasing power parity theory. Since the expected value of TL next year is smaller, current demand for TL assets decline. Causes TL to depreciate. (first effect)

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Exchange Rate Overshooting Monetary Neutrality in the long run

In the long run, a one percent increase in the money supply is matched by the same one percent increase in the price level

But in the short run, price level cannot increase immediately. Prices are “sticky”. So, M/P (real money supply) increases. This causes domestic real interest rate to fall (liquidity preference theory). Demand for TL declines further. (second effect)

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Exchange Rate Overshooting

Time

1/1,5

1/1,60

1/E ($/TL)

1/2

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1/1,5

D’

1/1,60

S

D

1/1,20

Qty of TL assets

Exchange Rate Overshooting

D’’

1/E ($/TL)

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Exchange Rate Overshooting But in the long-run, prices increase, M/P

decreases back to original level and interest rate goes up again. This increases demand for TL assets. But not completely because prices are higher than before.

The exchange rate depreciates more in the short run than in the long run Helps to explain why exchange rates exhibit so

much volatility

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The EURO’S FIRST SEVEN YEARS Euro initially depreciated in 1999&2000.

Strong US growth and poor growth & low real interest rates in Europe. But after 2001, euro started to appreciate because of the recession and low interest rates (1%) in the US.The recession still did not finish completely today.

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