Exchange Rates and the Foreign Exchange Market

8/7/2019 Exchange Rates and the Foreign Exchange Market

http://slidepdf.com/reader/full/exchange-rates-and-the-foreign-exchange-market 1/42

{{

Exchange Rates andExchange Rates andthe Foreignthe Foreign

Exchange Market:Exchange Market: An Asset Approach An Asset Approach



After reading this chapter, you will be able to: After reading this chapter, you will be able to:

Relate exchange rate changes to changes in theRelate exchange rate changes to changes in therelative prices of countries exports.relative prices of countries exports.

Describe the structure and functions of the foreignDescribe the structure and functions of the foreignexchange marketexchange market

Use exchange rates to calculate and compareUse exchange rates to calculate and comparereturns on assets denominated in differentreturns on assets denominated in differentcurrencies.currencies.

Apply the interest parity condition to find equilibrium Apply the interest parity condition to find equilibriumexchange rates.exchange rates.

Find the effects of interest rates and expectationFind the effects of interest rates and expectationshift on exchange rates.shift on exchange rates.

Learning GoalsLearning Goals



Exchange rates are important because theyExchange rates are important because they

enable us to translate different counties¶ pricesenable us to translate different counties¶ pricesinto comparable terms.into comparable terms.

Exchange rates are determined in the sameExchange rates are determined in the sameway as other asset prices.way as other asset prices.

The general goal of this chapter is to show:The general goal of this chapter is to show:

How exchange rates are determinedHow exchange rates are determined

The role of exchange rates in international tradeThe role of exchange rates in international trade

Exchange Rates andExchange Rates andInternational TransactionInternational Transaction



An exchange rate can be quoted in two ways: An exchange rate can be quoted in two ways: DirectDirect

The price of the foreign currency in terms of dollarsThe price of the foreign currency in terms of dollars

IndirectIndirect

The price of dollars in terms of the foreign currencyThe price of dollars in terms of the foreign currency

Exchange Rates andExchange Rates andInternational TransactionsInternational Transactions






Domestic and Foreign PricesDomestic and Foreign Prices If we know the exchange rate between twoIf we know the exchange rate between two

countries¶ currencies, we can compute the pricecountries¶ currencies, we can compute the priceof one country¶s exports in terms of the other of one country¶s exports in terms of the other country¶s money.country¶s money.

ExampleExample: The dollar price of a: The dollar price of a ££50 sweater with a50 sweater with adollar exchange rate of $1.50 per pound is (1.50dollar exchange rate of $1.50 per pound is (1.50$/$/£)£) xx (£50) =(£50) = $75.$75.




Two types of changes in exchange rates:Two types of changes in exchange rates:

Depreciation of home country¶s currencyDepreciation of home country¶s currency

A rise in the home currency prices of a foreign A rise in the home currency prices of a foreigncurrencycurrency

It makes home goods cheaper for foreigners andIt makes home goods cheaper for foreigners andforeign goods more expensive for domesticforeign goods more expensive for domesticresidents.residents.

Appreciation of home country¶s currencyAppreciation of home country¶s currency

A fall in the home price of a foreign currency A fall in the home price of a foreign currency

It makes home goods more expensive for It makes home goods more expensive for foreigners and foreign goods cheaper for foreigners and foreign goods cheaper for domestic residents.domestic residents.




Exchange Rates and Relative PricesExchange Rates and Relative Prices

Import and export demands are influenced byImport and export demands are influenced byrelative prices.relative prices.

Appreciation of a country¶s currency: Appreciation of a country¶s currency:

Raises the relative price of its exportsRaises the relative price of its exports

Lowers the relative price of its importsLowers the relative price of its imports

Depreciation of a country¶s currency:Depreciation of a country¶s currency:

Lowers the relative price of its exportsLowers the relative price of its exports

Raises the relative price of its importsRaises the relative price of its imports







Exchange rates are determined in theExchange rates are determined in the foreignforeign

exchange marketexchange market.. The market in which international currencyThe market in which international currency

trades take placetrades take place

The ActorsThe Actors The major participants in the foreign exchangeThe major participants in the foreign exchange

market are:market are: Commercial banksCommercial banks International corporationsInternational corporations

Nonbank financial institutionsNonbank financial institutions

Central banksCentral banks

The Foreign ExchangeThe Foreign ExchangeMarketMarket



Interbank tradingInterbank trading

Foreign currency trading among banksForeign currency trading among banks

It accounts for most of the activity in the foreignIt accounts for most of the activity in the foreignexchange market.exchange market.




Characteristics of the MarketCharacteristics of the Market The worldwide volume of foreign exchangeThe worldwide volume of foreign exchange

trading is enormous, and it has ballooned intrading is enormous, and it has ballooned in

recent years.recent years. New technologies, such as Internet links, areNew technologies, such as Internet links, are

used among the major foreign exchange tradingused among the major foreign exchange tradingcenters (London, New York, Tokyo, Frankfurt,centers (London, New York, Tokyo, Frankfurt,and Singapore).and Singapore).

The integration of financial centers implies thatThe integration of financial centers implies that

there can be no significantthere can be no significant arbitragearbitrage.. The process of buying a currency cheap andThe process of buying a currency cheap and

selling it dear.selling it dear.




Vehicle currencyVehicle currency A currency that is widely used to denominate A currency that is widely used to denominate

international contracts made by parties who do notinternational contracts made by parties who do notreside in the country that issues the vehiclereside in the country that issues the vehiclecurrency.currency.

ExampleExample: In 2001, around 90% of transactions: In 2001, around 90% of transactions

between banks involved exchanges of foreignbetween banks involved exchanges of foreigncurrencies for U.S. dollars.currencies for U.S. dollars.




Spot Rates and Forward RatesSpot Rates and Forward Rates

Spot exchange ratesSpot exchange rates

Apply to exchange currencies ³on the spot´ Apply to exchange currencies ³on the spot´

Forward exchange ratesForward exchange rates

Apply to exchange currencies on some future date Apply to exchange currencies on some future dateat aat a prenegotiatedprenegotiated exchange rateexchange rate

Forward and spot exchange rates, while notForward and spot exchange rates, while notnecessarily equal, do move closely together.necessarily equal, do move closely together.







Foreign Exchange SwapsForeign Exchange Swaps

Spot sales of a currency combined with aSpot sales of a currency combined with aforward repurchase of the currency.forward repurchase of the currency.

They make up a significant proportion of allThey make up a significant proportion of all

foreign exchange trading.foreign exchange trading.




Futures and OptionsFutures and Options

Futures contractFutures contract

The buyer buys a promise that a specified amountThe buyer buys a promise that a specified amountof foreign currency will be delivered on a specifiedof foreign currency will be delivered on a specifieddate in the future.date in the future.

Foreign exchange optionForeign exchange option

The owner has the right to buy or sell a specifiedThe owner has the right to buy or sell a specifiedamount of foreign currency at a specified price atamount of foreign currency at a specified price atany time up to a specified expiration date.any time up to a specified expiration date.




The demand for a foreign currency bankThe demand for a foreign currency bankdeposit is influenced by the samedeposit is influenced by the same

considerations that influence the demand for considerations that influence the demand for any other asset.any other asset.

Assets and Asset Returns Assets and Asset Returns DefiningAsset ReturnsDefiningAsset Returns

The percentage increase in value an asset offersThe percentage increase in value an asset offersover some time period.over some time period.

The Real Rate of ReturnThe Real Rate of Return The rate of return computed by measuring assetThe rate of return computed by measuring asset

values in terms of some broad representativevalues in terms of some broad representativebasket of products that savers regularly purchase.basket of products that savers regularly purchase.




Risk and LiquidityRisk and Liquidity

Savers care about two main characteristics of anSavers care about two main characteristics of anasset other than its return:asset other than its return:

RiskRisk

The variability it contributes to savers¶ wealthThe variability it contributes to savers¶ wealth

LiquidityLiquidity

The ease with which it can be sold or exchangedThe ease with which it can be sold or exchangedfor goodsfor goods




Interest RatesInterest Rates Market participants need two pieces of Market participants need two pieces of

information in order to compare returns oninformation in order to compare returns ondifferent deposits:different deposits: How the money values of the deposits will changeHow the money values of the deposits will change

How exchange rates will changeHow exchange rates will change

A currency¶s A currency¶s interest rateinterest rate is the amount of thatis the amount of thatcurrency an individual can earn by lending a unitcurrency an individual can earn by lending a unit

of the currency for a year.of the currency for a year. ExampleExample: At a dollar interest rate of 10% per year,: At a dollar interest rate of 10% per year,

the lender of $1 receives $1.10 at the end of thethe lender of $1 receives $1.10 at the end of theyear.year.

The Demand for The Demand for Foreign Currency AssetsForeign Currency Assets






Exchange Rates and Asset ReturnsExchange Rates and Asset Returns

The returns on deposits traded in the foreignThe returns on deposits traded in the foreignexchange market depend on interest rates andexchange market depend on interest rates andexpected exchange rate changes.expected exchange rate changes.

In order to decide whether to buy a euro or aIn order to decide whether to buy a euro or adollar deposit, one must calculate the dollar dollar deposit, one must calculate the dollar

return on a euro deposit.return on a euro deposit.




A Simple Rule A Simple Rule

The dollar rate of return on euro deposits isThe dollar rate of return on euro deposits isapproximately the euro interest rate plus theapproximately the euro interest rate plus the raterate

of depreciationof depreciation of the dollar against the euro.of the dollar against the euro.

TheThe rate of depreciationrate of depreciation of theof the dollar against thedollar against theeuro is the percentage increase in the dollar/euroeuro is the percentage increase in the dollar/euroexchange rate over a year.exchange rate over a year.




The expected rate of return difference between dollar andThe expected rate of return difference between dollar andeuro deposits is:euro deposits is:

R R $ $ -- [[R R ¼ ¼ ++ ((E E ee$ $ // ¼ ¼ -- E E $ $ //¼ ¼ )/)/E E $ $ //¼ ¼ ]=]= R R $ $ -- R R ¼ ¼ -- ((E E ee$/ $/¼ ¼ --E E $ $ //¼ ¼ )/)/E E $ $ //¼ ¼

(13(13--1)1)

where:where:R R $ $ == interest rate on oneinterest rate on one--year dollar year dollar

depositsdepositsR R ¼ ¼ = today¶s interest rate on one= today¶s interest rate on one--year euroyear euro

depositsdepositsE E

$ $ //¼ ¼ = today¶s dollar/euro exchange rate= today¶s dollar/euro exchange rate(number of (number of dollars per euro)dollars per euro)E E ee$/ $/¼ ¼ == dollar/euro exchange rate (number of dollar/euro exchange rate (number of

dollars per dollars per euro) expected to prevail aeuro) expected to prevail ayear from todayyear from today




When the difference in Equation (13When the difference in Equation (13--1) is1) ispositive, dollar deposits yield the higher positive, dollar deposits yield the higher expected rate of return. When it is negative, euroexpected rate of return. When it is negative, eurodeposits yield the higher expected rate of return.deposits yield the higher expected rate of return.







Return, Risk, and Liquidity in the Foreign ExchangeReturn, Risk, and Liquidity in the Foreign ExchangeMarketMarket

The demand for foreign currency assets dependsThe demand for foreign currency assets depends

not only on returns but on risk and liquidity.not only on returns but on risk and liquidity. There is no consensus among economists about theThere is no consensus among economists about the

importance of risk in the foreign exchange market.importance of risk in the foreign exchange market.

Most of the market participants that are influenced byMost of the market participants that are influenced byliquidity factors are involved in international trade.liquidity factors are involved in international trade.

Payments connected with international trade make upPayments connected with international trade make upa very small fraction of total foreign exchangea very small fraction of total foreign exchange

transactions.transactions. Therefore, we ignore the risk and liquidity motivesTherefore, we ignore the risk and liquidity motives

for holding foreign currencies.for holding foreign currencies.




Interest Parity: The Basic Equilibrium ConditionInterest Parity: The Basic Equilibrium Condition

The foreign exchange market is in equilibrium whenThe foreign exchange market is in equilibrium whendeposits of all currencies offer the same expecteddeposits of all currencies offer the same expected

rate of return.rate of return.

Interest parity conditionInterest parity condition

The expected returns on deposits of any twoThe expected returns on deposits of any twocurrencies are equal when measured in the samecurrencies are equal when measured in the samecurrency.currency.

It implies that potential holders of foreign currencyIt implies that potential holders of foreign currency

deposits view them all as equally desirable assets.deposits view them all as equally desirable assets. The expected rates of return are equal when:The expected rates of return are equal when:

R R $ $ == R R ¼ ¼ ++ ((E E ee$ $ //¼ ¼ -- E E $ $ //¼ ¼ )/)/E E $ $ //¼ ¼

(13(13--2)2)

Equilibrium in theEquilibrium in theForeign Exchange MarketForeign Exchange Market



How Changes in the Current Exchange RateHow Changes in the Current Exchange Rate

Affect Expected Returns Affect Expected Returns Depreciation of a country¶s currencyDepreciation of a country¶s currency todaytoday

lowers the expected domestic currency return onlowers the expected domestic currency return onforeign currency deposits.foreign currency deposits.

Appreciation of the domestic currency today Appreciation of the domestic currency todayraises the domestic currency return expected of raises the domestic currency return expected of foreign currency deposits.foreign currency deposits.








Expected dollar return on

euro deposits, R ¼ + (E e$ /¼ -

E $ /¼ )/(E $ /¼ )

Today¶s dollar/euro

exchange rate, E $ /¼

1.02

1.03

1.05

1.07

0.031 0.050 0.069 0.079 0.100

1.00



The Equilibrium Exchange RateThe Equilibrium Exchange Rate Exchange rates always adjust to maintainExchange rates always adjust to maintain

interest parity.interest parity.

Assume that the dollar interest rate Assume that the dollar interest rate R R $$, the euro, the eurointerest rateinterest rate R R ¼ ¼, and the expected future, and the expected future

dollar/euro exchange ratedollar/euro exchange rate E E ee$/$/¼ ¼, are all given., are all given.





R $

Return on

dollar deposits

E 2$ /¼ 2

1E 1$ /¼

E 3$ /¼ 3

Expected return

on euro deposits

Rates of return

(in dollar terms)

Exchange rate,E $ /¼



The Effect of Changing Interest Rates on theThe Effect of Changing Interest Rates on the

Current Exchange RateCurrent Exchange Rate An increase in the interest rate paid on deposits An increase in the interest rate paid on deposits

of a currency causes that currency to appreciateof a currency causes that currency to appreciateagainst foreign currencies.against foreign currencies.

A rise in dollar interest rates causes the dollar to A rise in dollar interest rates causes the dollar toappreciate against the euro.appreciate against the euro.

A rise in euro interest rates causes the dollar to A rise in euro interest rates causes the dollar todepreciate against the euro.depreciate against the euro.

Interest Rates, Expectations,Interest Rates, Expectations,and Equilibriumand Equilibrium




R 1$ Rates of return

(in dollar terms)

Exchange rate, E $ /¼

2E 2$ /¼

1'1E 1$ /¼

Expected

euro return




Dollar return

R $ Rates of return

(in dollar terms)

Exchange rate, E $ /¼

1E 1$ /¼

2E 2$ /¼

Rise in euro

interest rate

Expected

euro return



The Effect of Changing Expectations on theThe Effect of Changing Expectations on theCurrent Exchange RateCurrent Exchange Rate

A rise in the expected future exchange rate A rise in the expected future exchange ratecauses a rise in the current exchange rate.causes a rise in the current exchange rate.

A fall in the expected future exchange rate A fall in the expected future exchange rate

causes a fall in the current exchange rate.causes a fall in the current exchange rate.




An An Exchange rateExchange rate is the price of one countrysis the price of one countryscurrency in terms od another countrys currency.currency in terms od another countrys currency.

Exchange rates are determined in the foreignExchange rates are determined in the foreignexchange market.exchange market.

Because the exchange rate is the relative priceBecause the exchange rate is the relative priceof two assets, it is most appropriately thought of of two assets, it is most appropriately thought of as being an asset price itself.as being an asset price itself.

SummarySummary



An important category of foreign exchange An important category of foreign exchangetrading is forward trading.trading is forward trading.

The exchange rate is most appropriatelyThe exchange rate is most appropriatelythought of as being an asset price itself.thought of as being an asset price itself.

The returns on deposits traded in the foreignThe returns on deposits traded in the foreignexchange market depend on interest rates andexchange market depend on interest rates andexpected exchange rate changes.expected exchange rate changes.

SummarySummary



Equilibrium in the foreign exchange marketEquilibrium in the foreign exchange marketrequires interest parity.requires interest parity. For given interest rates and a given expectationFor given interest rates and a given expectation

of the future exchange rate, the interest parityof the future exchange rate, the interest paritycondition tells us the current equilibriumcondition tells us the current equilibriumexchange rate.exchange rate.

A rise in dollar (euro) interest rates causes the A rise in dollar (euro) interest rates causes the

dollar to appreciate (depreciate) against thedollar to appreciate (depreciate) against theeuro.euro.

Today¶s exchange rate is altered by changes inToday¶s exchange rate is altered by changes inits expected future level.its expected future level.

SummarySummary



Appreciation liquidity Appreciation liquidity

Arbitrage rate of Arbitrage rate of appreciationappreciation

Depreciation rate of Depreciation rate of depreciationdepreciation

Exchange rate rate of returnExchange rate rate of return

Foreign exchange market real rate of returnForeign exchange market real rate of return

Forward ewchange rate riskForward ewchange rate risk

Interbank trading spot exchangeInterbank trading spot exchangeraterate

Interest parity condition vehicle currencyInterest parity condition vehicle currency

Interset rateInterset rate

Key TermsKey Terms



Documents

Exchange Rates and the Foreign Exchange Market