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The foreign Exchange market and exchange rates

Lecture 18

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Introduction

In September 1997, global financial system trembled

Currency crisis rocked Asian financial markets capital flight to US fell and so did US Exports

How investors, and individuals, make transactions when people and organizations are in different countries

Determination of exchange rates and what causes them to change overtime

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Exchange Rates and Trade

1990’s markets for goods and services and financial assets were global because of imports and exports

When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!

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How is buying a domestic good different from buying a foreign good?

Buy Pakistani good, pay in Re Buy a US good, buy $ and then pay in $ Buy too many US goods, buying too many $

that raises $ value against Re1. An increase in currency’s value as compared

to that of another is Appreciation2. A fall in value is depreciation3. Change in currency’s value can affect

domestic manufacturers and workers… How?

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Example

1DM = $0.5 1DM = $0.6

Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!

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Nominal Vs. Real Exchange Rate

Nominal ER doesn’t measure real purchasing power of the currency

Nominal: Re 1 = $1/84 = $0.0012

RER = NER x P/Pf

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REAL ER

Big Mac Example Domestic Price: Rs 300 Foreign Price: $2.56 NER = $0.0012/Re

EXr = 0.0012 x 300/2.56 =

0.14 US BM/Pak BM

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EXr is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another

CPI or Inflation Rates as the ratio of P/Pf

REAL ER

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Real ER

If EXr increases, more units of foreign goods could be traded per unit of domestic goods

Relationship between EX and EXr depends on the Rates of Inflation

%Δ ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf

ΔEX/EX = ΔEXr/EXr + (πf – π)

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Foreign Exchange Market

Market forces determine exchange rates that prevail for consumers and investors

International currencies traded in forEx markets

ForEx markets are over-the-counter markets

Currencies transactions in ForEx Markets: Spot Market and Forward Market

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Determine LR Exchange rates

Forces of Demand and Supply 1$ = Rs 60 1$ = Rs 50 Rs appreciated and $ depreciate; Qd of $

increases and Qs of Rs increased!

Price level differences P > Pf

Productivity differences Prod > Prodf

Preferences (For foreign goods) Trade Barriers

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Example

DM/$

PUS > PGER

Long Run ER

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Purchasing Power Parity Theory

Law of one price: PPP Comparison of international price of identical

good, PPP holds When extend the concept to a group of

goods, it becomes PPP theory of ER determination

Assume: EXr are constant

EX = EXr x Pf / P

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Does the Theory match Reality?

Actual ER movements are just not a reflection of changing price levels

The assumption that EXr are constant is not realistic

All goods can’t be traded because of different barriers

However, PPP is a good measure for LR determination of exchange rates

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Model for SR Exchange Rate Determination

Pakistan: Domestic, US: Foreign Rs 10000 @ 5% Year End 10000(1+0.05) = Rs 10500

Suppose Re 1 = $0.0125 Rs10000 = $125 $125 @ 5%, Year End 125(1+0.05) = $ 131.25 Convert them to Rs: $0.0125*1.05 = $0.013125 / Re $131.25/0.013125 = Rs 10000

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Cont’d

Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i) Rs (1+0.05) = Rs 1.05 Re 1 invested abroad, Rs [EX (1+if)] / EXe

0.0125(1.05)/0.013125 = Re 1

Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets

1+i = EX(1+if)/EXe

Assume: Identical risks, liquidity and info characteristics

1+i = 1+ if – ΔEXe / EX

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Model: Comparing Exp Returns on domestic and foreign assets

If EX = 97 Yen/$ R > Rf

Investors should buy local assets

If EX = 105 Yen/$ R < Rf

Investors should buy foreign assets

Exp Return in DC

Yen/$ R = i

5%

100

Rf = if – ΔEXe / EX

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ER Fluctuations

Increase in domestic ‘i’

EX appreciates

As return falls, EX depreciates

Exp Return in DC

Yen/$ R0

5%

100

Rf

R1

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ER Fluctuations

Increase in Pe

i = ier + Pe

EXe appreciation falls

Rf increases and EX depreciates

Exp Return in DC

Yen/$ R0

5%

100

Rf

R1

Rf 1

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ER Fluctuations

Rf increased

EX depreciates

Rf falls, EX appreciates

Exp Return in DC

Yen/$ R0

5%

100

Rf Rf 1

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ER Fluctuations

EXe increases Rf falls

EX appreciates

Exp Return in DC

Yen/$ R0

5%

100

Rf

Rf 1

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Currency Premiums in ForEx Markets

It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency

i = if – ΔEXe / EX – hf,d