Chapter 14
Exchange Rates and the Foreign
Exchange Market: An Asset ApproachAdd
1
Learning Objectives
14.1 Relate exchange rate changes to changes in the relative prices of countries’ exports.
14.2 Describe the structure and functions of the foreign exchange market.
14.3 Use exchange rates to calculate and compare
returns on assets denominated in different currencies.Add
14.4 Apply the interest parity condition to find equilibrium exchange rates.
14.5 Find the effects of interest rates and expectation shifts on exchange rates.
Preview
• The basics of exchange rates
• Exchange rates and international relative prices
• Demand and equilibrium in the foreign exchange market
• The demand of currency and other assets
• A model of foreign exchange marketsAdd – role of interest rates on currency deposits/bonds
– role of expectations of exchange rates
– forward exchange rates and covered interest parity Definitions of Exchange Rates
• Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
– How much can be exchanged for one dollar? – How much can be exchanged for one yen?https://$0.01027.com
¥
• Exchange rates allow us to denominate the cost or price of a Add good or service in a common currency.
– How much does a Nissan cost? ¥2,500,000
– Or, ¥2,500,000 $0.01027 $25,672.50 ¥
(1 of 5)
• Depreciation is a decrease in the value of a currency relative to another currency. – A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.
– $1 € $1.20 € means that the dollar has depreciatedAdd relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.
– The euro has appreciated relative to the dollar: it is now more valuable.
(2 of 5)
• Appreciation is an increase in the value of a currency relative to another currency. – An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.
– $1 € $0.90 € means that the dollar has appreciatedAdd relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.
– The euro has depreciated relative to the dollar: it is now less valuable.
(3 of 5)
• A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.
– A Nissan costs ¥2,500,000 $0.010 27 $25,672.50
¥
– Less expensive than $27,962.50 atAdd po$0.011185¥ wcoder
• A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.
• A depreciated currency lowers the price of exports relative to the price of imports.
(4 of 5)
• An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.
– A Nissan costs ¥2,500,000 $27,962.50 atAssignment Projec $0.011185t Exam ¥¥ Help
– becomes less expensive $25,000 at$0.010
¥ Add
• An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.
• An appreciated currency raises the price of exports relative to the price of imports.
(5 of 5)
• Table 14.2 shows the relative prices implied by exchange rates of $1.25 per pound, $1.50 per pound, and $1.75 per pound.
• If the good’s money prices do not change, an appreciation of the dollar against the pound makes sweaters more expensive in terms of jeans (each pair of Add jeans buys fewer sweaters).
• All else equal, an appreciation of a country’s currency raises the relative price of its exports to its imports, while a depreciation lowers the relative price of its exports to its imports.
Table 14.2 Dollars per pound$/ £ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters
Exchange rate Dollars per pound$/ £ 1.25 1.50 1.75
Relative price of sweater in terms of
pairs of jeans Assign 1.39 ment P 1.67 roject Ex 1.94
am Help
Note: The above calculations assume unchanged money prices of $45 per pair of jeans andAdd £50 per sweater.
(1 of 4)
• 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.
dollars.
(2 of 4)
Foreign Exchange Markets
The participants:
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in different currencies for investment purposes.
2. Corporations (non-financial businesses) conduct foreign
currency transactions to buy/sell goods, services and assets.Add
(3 of 4)
• Buying and selling in the foreign exchange market are dominated by commercial and investment banks.
– Inter-bank transactions of deposits in foreign currencies occur in amounts $1 million or more per transaction.
Foreign Exchange Markets
– Central banks sometimes intervene, but the direct Add effects of their transactions are small and transitory in many countries.
(4 of 4)
• Computer and telecommunications technology transmit information rapidly and have integrated markets.
• The integration of financial markets implies that there can be no significant differences in exchange rates across locations.
– Arbitrage: buy at low price and sell at higher price for Add a profit.
– If the euro were to sell for $1.1 in New York and $1.2 in London, could buy euros in New York (where cheaper) and sell them in London at a profit.
Spot Rates and Forward Rates
• Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is executed in the present.
– Forward dates are typically 30, 90, 180, or 360 days in the future. Add – Rates are negotiated between two parties in the present, but the exchange occurs in the future.
Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.
(1 of 3)
• Foreign exchange swaps: a combination of a spot sale with a forward repurchase.
Other Methods of Currency Exchange
• Swaps allow parties to meet each other’s needs for a temporary amount of time and often cost less in fees than separate transactions.
– For example, suppose Toyota receives $1 million from Add American sales, plans to use it to pay its California suppliers in three months, but wants to invest the money in euro bonds in the meantime.
Other Methods of Currency Exchange
(2 of 3)
Add
(3 of 3)
– Contracts can be bought and sold in markets.
– A contract gives the owner the option, but not obligation, of buying or selling currency if the need Add arises.
Other Methods of Currency Exchange
(1 of 12)
• What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency? • Factors that influence the return on assets determine the demand of those assets.
Add
(2 of 12)
• Rate of return: the percentage change in value that an asset offers during a time period.
– The annual return for $100 savings deposit with an interest rate of 2% is $100 1.02 $102, so that the
rate of return ($102Add $100) 2%
$100
(3 of 12)
• Real rate of return: inflation-adjusted rate of return, which represents the additional amount of goods and
services that can be purchased with earnings from the asset.– The real rate of return for the above savings deposit when inflation is 1.5% is 2% 1.5% 0.5%. After accounting for the rise in the prices of goods and Add services, the asset can purchase 0.5% more goods and services after 1 year.
(4 of 12)
If prices are fixed, the inflation rate is 0% and (nominal) rates of return = real rates of return. • Because trading of deposits in different currencies occurs on a daily basis, we often assume that prices do not change from day to day.
– A good assumption to make for the short run.Add
(5 of 12)
• Risk of holding assets also influences decisions about whether to buy them.
• Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets.
Add
(6 of 12)
But we assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the
same, regardless of their currency denomination.
(7 of 12)
• We therefore say that investors are primarily concerned about the rates of return on currency deposits.
• Rates of return that investors expect to earn are determined by
– interest rates that the assets will earn – expectations about appreciation or depreciationAdd
(8 of 12)
A currency deposit’s interest rate is the amount of a currency that an individual or institution can earn by lending a unit of the currency for a year.
• The rate of return for a deposit in domestic currency is the interest rate that the deposit earns. • To compare the rate of return on a deposit in domestic Add currency with one in foreign currency, consider
– the interest rate for the foreign currency deposit
– the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency.
Since dollar and yen interest rates are not measured in comparable terms, they can move quite differently over time.
Source: Datastream. The figure shows three-month interest rates.
(9 of 12)
• Suppose the interest rate on a dollar deposit is 2%.
• Suppose the interest rate on a euro deposit is 4%. • Does a euro deposit yield a higher expected rate of return?
– Suppose today the exchange rate is$1 €1, and the expected rate one year in the future isAdd $0.97 €1.
– $100 can be exchanged today for €100.
– These €100 will yield €104 after 1 year.
The Demand of Currency Deposits
– These €1044 are expected to be worth $0.97 €1 €104
= $100.88 in 1 year.
(10 of 12)
• The rate of return in terms of dollars from investing in euro deposits is
$100.88 $100 0.88%.
$100
• Let’s compare this rate of return with the rate of return from a dollar deposit.
– The rate of return is simply the interest rate.
– After 1 year the $100 is expected to yield $102:Add
$102 $100 2%
$100 • The euro deposit has a lower expected rate of return: thus, all investors should be willing to dollar deposits and none should be willing to hold euro deposits.
(11 of 12)
The Demand of Currency Deposits
• Note that the expected rate of appreciation of the euro was
$0.97 $1 0.03 33%.%.
$1
• We simplify the analysis by saying that the dollar rate of return on euro deposits approximately equals
– the interest rate on euro depositsAdd
– plus the expected rate of appreciation of euro deposits
– 4% 3% 1% 0 88%
Eee$/€$/€ E$/€$/€
– R€€ + E$/€$/€
(12 of 12)
• The difference in the rate of return on dollar deposits and euro deposits is
Model of Foreign Exchange Markets
(1 of 6)
• Construct model of foreign exchange markets using:
– the demand of (rate of return on) dollar-denominated deposits
– and the demand of (rate of return on) foreign currency– denominated deposits
Add
Table 14.3 Comparing Dollar Rates of Return on Dollar and Euro Deposits
Blank Dollar Interest Rate Euro Interest Rate Expected Rate of
Dollar Depreciation
Against Euro Rate of Return
Difference between
Dollar and Euro Deposits
Case RRR sub $$$ Assign
RR sub euro €€ menE Et
Proj$/€$/€ee $/€$/€ect Exam HelpE
$/€$/€ee $/€$/€
E
start fraction upper E to the lower e power, sub $ per euro minus upper E sub $ per euro over upper E sub $ per euro end fraction $/€$/€ R R$$ R sub $ minus R sub euro minus start fraction upper E to the lower e power, sub $ per euro minus upper E sub $ per euro over upper E sub $ per euro end fraction€€
EE$/€$/€
0.00 .com 0.04
po0.04 wcoder 0.00
3 0.10 0.06 0.08 0.04Negative 0.04
4 0.10 0.12 0.04Negative 0.04
0.02
(2 of 6)
• Model in equilibrium when deposits of all currencies offer the same expected rate of return: 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.Add • Interest parity says:
Model of Foreign Exchange Markets
Ee$/€ E R R$ €
$/€
E$/€
Model of Foreign Exchange Markets
(3 of 6)
• Why should the interest parity condition hold?
– Suppose it did not. Suppose
Eee$/€$/€ E$/€$/€
R >R$$ €
E$/€$/€
– Then no investor would want to hold euro deposits, driving down the demand and price of euros.Add – Then all investors would want to hold dollar deposits, driving up the demand and price of dollars. – The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved.
(4 of 6)
• How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits?
Model of Foreign Exchange Markets
• Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. – When the domestic currency depreciates, the initial cost of investing in foreign currency deposits Add increases, thereby lowering the expected rate of return of foreign currency deposits.
(5 of 6)
• Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. – When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby increasing the expected rate of return of foreign currency deposits.
Add
Figure 14.3 The Relation Between the Current Dollar/Euro
Exchange Rate and the Expected Dollar Return on Euro Deposits
Given that E$$ee//€€ 1.05 and R€€ 0.050 05 an appreciation of the dollar against the euro raises the expected return on euro deposits, measured in terms of dollars.
Figure 14.4 Determination of the Equilibrium Dollar/Euro Exchange Rate
Equilibrium in the foreign exchange market is at point 1, where the expected dollar returns on dollar and euro deposits are equal.
Model of Foreign Exchange Markets (6 of 6)
• 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 Add cause the dollar to appreciate.
– Higher interest rates on euro-denominated assets cause the dollar to depreciate.
Figure 14.5 Effect of a Rise in the Dollar Interest Rate
A rise in the interest rate offered by dollar deposits from R R$1to $$22 causes the dollar to appreciate from E$1/€(point 1) to E$2/€(point 2).
Figure 14.6 Effect of a Rise in the Euro Interest Rate
A rise in the interest rate paid by euro deposits causes the dollar to depreciate from
E$$11//€€(point 1) to E$$22//€€(point 2). (This figure also describes the effect of a rise in the expected future $ € € exchange rate.)
The Effect of Changing Expectations on the Current Exchange Rate
• If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods.
– The expected rate of return on euros therefore increases.
– An expected appreciation of a currency leads to an Add actual appreciation (a self-fulfilling prophecy).
– An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy). What Explains Carry Trade?
• International investors frequently borrow low-interest currencies and buy high-interest currencies, with results that can be profitable over long periods—this activity is called carry trade.
• The extent of carry trade positions can become very large when sizable international interest differentials open up. Is the prevalence of the carry trade evidence that interest parity is wrong?
• While interest parity does not hold exactly in practice, in part Add because of the risk and liquidity factors mentioned earlier, economists are still trying to understand if the carry trade requires additional explanation.
Australian Dollars Compared with Japanese Yen, 2006–
The Australian dollar-yen carry trade has been profitable on average but is subject to sudden large reversals, as in 2008.
Source: Quarterly Japanese yen/Australian dollar exchange rate, 90-day Australia bank bill rate, and 90-day
Japan certificate of deposit rate from F R E D database. The chart compares the cumulative value over time of a ¥100 investment in Japanese interest-bearing 90-day bonds, rolled over every quarter, with the same yen investment converted into Australian dollars, invested in 90-day Australian bonds and rolled over every quarter, and then converted back into yen at the end of the investment period.
(1 of 5) • Covered interest parity (C I P) 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.Add
• 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.
(2 of 5)
• For example, suppose the 1-year forward price of euros in terms of dollars is F$/ €$/ € $1.113 and the spot exchange rate is E$/€$/ = $1.05 per euro.
• If RR€€ 0.040.04,, compare the rate of return on a covered euro deposit to a 10%
rate of return on a dollar deposit (R$$ 0.10).
– A €1€1 deposit costs $1.05 today and is worth €1.04 after 1 year.
– Selling €1.04 forward today at the forward exchange rate $1.113 perAdd euro yield a dollar value after 1 year of $1.113 per euro €1.04 $1.158.
– The rate of return on the covered purchase of a euro deposit is 1.158 1.05 1.05 0.103. or 10.3%, is greater than a 10% rate of return on a dollar deposit and covered interest parity fails. (3 of 5)
• The forward premium on euros against dollars (also called the forward discount on dollars against euros) is
F E$/€ $/€
E$/€$/€
• Using this terminology, the covered interest parity Add condition becomes:
– The interest rate on dollar deposits equals the interest rate on euro deposits plus the forward premium on euros against dollars. (4 of 5)
• Figure 14-8 graphs the difference between dollar interbank interest rates and the covered return to investing in three foreign interbank markets.
– Big deviations from C I P emerged around the time of the worldwide banking crisis in 2007–2008. C I P did not reestablish itself after the crisis passed.
– The deviations from C I P tend to be negative, implying that Add it would be profitable to arbitrage by borrowing dollars, selling them for foreign currencies, and then investing the proceeds in foreign money markets while selling the proceeds forward to complete the round trip out of dollars and back
Figure 14.8 U.S. Dollar Three-Month Interest Rate Less
Covered Rate on Three-Month Foreign Bank Deposits
Covered interest parity held well up until the financial crisis that started in 2008, but it has not held closely since then. The three non-U.S. investment currencies shown are the euro, pound, and yen.
Forward Exchange Rates and Covered Interest Parity (5 of 5)
• By comparing the uncovered interest parity (UIP) condition,
Eee$/€ E R R$$ €€ $/€ E$/€$/€
with the covered interest parity condition, you will find that both conditions can be true at the same time only if the 1-year forward rate quoted today equals the spot exchange rateAdd people expect to materialize a year from today: F$/€$/€ E$/€$/€ee
• Covered transactions do not involve exchange rate risk, whereas uncovered transactions do. (1 of 4)
1. An exchange rate is the price of one country’s currency in terms of another country’s currency.
Summary
– It enables us to translate different countries’ prices into comparable terms.
2. Depreciation of a currency Add means that it becomes less valuable and goods denominated in it are less expensive: exports are cheaper and imports more expensive.
3. Appreciation of a currency means that it becomes more valuable and goods denominated in it are more expensive: exports are more expensive and imports cheaper.
Summary
(2 of 4)
4. 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.
Add
5. Rates of return on currency deposits in the foreign exchange market are influenced by interest rates and expected exchange rates. (3 of 4)
6. 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.
Summary
7. 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.Add
(4 of 4)
8. An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and thus leads to an actual appreciation.
9. Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using the forward exchange rate are Add the same.
