In the first years of the millennium, Americans flocked to Paris to enjoy French

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1 14 chaptr Exchang Rats and th Forign Exchang Markt: An Asst Approach 320 In th first yars of th millnnium, Amricans flockd to Paris to njoy Frnch cuisin whil shopping for dsignr clothing and othr spcialtis. Whn masurd in trms of dollars, prics in Franc wr so much lowr than thy had bn a fw yars bfor that a shoppr s savings could offst th cost of an airplan tickt from Nw York or Chicago. Fiv yars latr, howvr, th prics of Frnch goods again lookd high to Amricans. What conomic forcs mad th dollar prics of Frnch goods swing so widly? On major factor was a sharp fall in th dollar pric of Franc s currncy aftr 1998, followd by an qually sharp ris starting in Th pric of on currncy in trms of anothr is calld an xchang rat. At 4 P.M. London tim on Novmbr 30, 2010, you would hav ndd dollars to buy on unit of th Europan currncy, th uro, so th dollar s xchang rat against th uro was $ pr uro. Bcaus of thir strong influnc on th currnt account and othr macroconomic variabls, xchang rats ar among th most important prics in an opn conomy. Bcaus an xchang rat, th pric of on country s mony in trms of anothr s, is also an asst pric, th principls govrning th bhavior of othr asst prics also govrn th bhavior of xchang rats. As you will rcall from Chaptr 13, th dfining charactristic of an asst is that it is a form of walth, a way of transfrring purchasing powr from th prsnt into th futur. Th pric that an asst commands today is thrfor dirctly rlatd to th purchasing powr ovr goods and srvics that buyrs xpct it to yild in th futur. Similarly, today s dollar/uro xchang rat is closly tid to popl s xpctations about th futur lvl of that rat. Just as th pric of Googl stock riss immdiatly upon favorabl nws about Googl s futur prospcts, so do xchang rats rspond immdiatly to any nws concrning futur currncy valus. Our gnral goals in this chaptr ar to undrstand th rol of xchang rats in intrnational trad and to undrstand how xchang rats ar dtrmind. To bgin, w first larn how xchang rats allow us to compar th prics of diffrnt

2 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 321 countris goods and srvics. Nxt w dscrib th intrnational asst markt in which currncis ar tradd and show how quilibrium xchang rats ar dtrmind in that markt. A final sction undrlins our asst markt approach by showing how today s xchang rat rsponds to changs in th xpctd futur valus of xchang rats. LEARNING GOALS Aftr rading this chaptr, you will b abl to: Rlat xchang rat changs to changs in th rlativ prics of countris xports. Dscrib th structur and functions of th forign xchang markt. Us xchang rats to calculat and compar rturns on assts dnominatd in diffrnt currncis. Apply th intrst parity condition to find quilibrium xchang rats. Find th ffcts of intrst rats and xpctation shifts on xchang rats. Exchang Rats and Intrnational Transactions Exchang rats play a cntral rol in intrnational trad bcaus thy allow us to compar th prics of goods and srvics producd in diffrnt countris. A consumr dciding which of two Amrican cars to buy must compar thir dollar prics, for xampl, $44,000 (for a Lincoln Continntal) or $22,000 (for a Ford Taurus). But how is th sam consumr to compar ithr of ths prics with th 2,500,000 Japans yn ( 2,500,000) it costs to buy a Nissan from Japan? To mak this comparison, h or sh must know th rlativ pric of dollars and yn. Th rlativ prics of currncis ar rportd daily in nwspaprs financial sctions. Tabl 14-1 shows th dollar xchang rats for currncis tradd in London at 4 P.M. on Novmbr 30, 2010, as rportd in th Financial Tims. An xchang rat can b quotd in two ways: as th pric of th forign currncy in trms of dollars (for xampl, $ pr yn) or as th pric of dollars in trms of th forign currncy (for xampl, pr dollar). Th first of ths xchang rat quotations (dollars pr forign currncy unit) is said to b in dirct (or Amrican ) trms, th scond (forign currncy units pr dollar) in indirct (or Europan ) trms. Housholds and firms us xchang rats to translat forign prics into domstic currncy trms. Onc th mony prics of domstic goods and imports hav bn xprssd in trms of th sam currncy, housholds and firms can comput th rlativ prics that affct intrnational trad flows. Domstic and Forign Prics If w know th xchang rat btwn two countris currncis, w can comput th pric of on country s xports in trms of th othr country s mony. For xampl, how many dollars would it cost to buy an Edinburgh Wooln Mill swatr costing 50 British pounds ( 50)? Th answr is found by multiplying th pric of th swatr in pounds, 50, by th pric of a pound in trms of dollars th dollar s xchang rat against th pound. At an xchang rat of $1.50 pr pound (xprssd in Amrican trms), th dollar pric of th swatr is (1.50$/ ) * ( 50) = $75.

3 322 PART THREE Exchang Rats and Opn-Economy Macroconomics TABLE 14-1 Exchang Rat Quotations Sourc: Data from Financial Tims, Dcmbr 1, 2010, p. 24. A chang in th dollar/pound xchang rat would altr th swatr s dollar pric. At an xchang rat of $1.25 pr pound, th swatr would cost only (1.25 $/ ) * ( 50) = $62.50, assuming its pric in trms of pounds rmaind th sam. At an xchang rat of $1.75 pr pound, th swatr s dollar pric would b highr, qual to (1.75 $/ ) * ( 50) = $ Changs in xchang rats ar dscribd as dprciations or apprciations. A dprciation of th pound against th dollar is a fall in th dollar pric of pounds, for xampl, a chang in th xchang rat from $1.50 pr pound to $1.25 pr pound. Th prcding xampl shows that all ls qual, a dprciation of a country s currncy maks its goods chapr for forignrs. A ris in th pound s pric in trms of dollars for xampl, from $1.50 pr pound to $1.75 pr pound is an apprciation of th pound against th dollar. All ls qual, an apprciation of a country s currncy maks its goods mor xpnsiv for forignrs. Th xchang rat changs discussd in th xampl simultanously altr th prics Britons pay for Amrican goods. At an xchang rat of $1.50 pr pound, th pound pric of a pair of Amrican dsignr jans costing $45 is ($45)/(1.50 $/ ) = 30. A chang in th xchang rat from $1.50 pr pound to $1.25 pr pound, whil a dprciation of th pound against th dollar, is also a ris in th pound pric of dollars, an apprciation of th dollar against th pound. This apprciation of th dollar maks th Amrican jans mor xpnsiv for Britons by raising thir pound pric from 30 to ($45)/(1.25 $/ ) = 36.

4 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 323 Th chang in th xchang rat from $1.50 pr pound to $1.75 pr pound an apprciation of th pound against th dollar but a dprciation of th dollar against th pound lowrs th pound pric of th jans from 30 to ( 45)/(1.75 $/ ) = As you can s, dscriptions of xchang rat changs as dprciations or apprciations can b bwildring, bcaus whn on currncy dprciats against anothr, th scond currncy must simultanously apprciat against th first. To avoid confusion in discussing xchang rats, w must always kp track of which of th two currncis w ar xamining has dprciatd or apprciatd against th othr. If w rmmbr that a dprciation of th dollar against th pound is at th sam tim an apprciation of th pound against th dollar, w rach th following conclusion: Whn a country s currncy dprciats, forignrs find that its xports ar chapr and domstic rsidnts find that imports from abroad ar mor xpnsiv. An apprciation has opposit ffcts: Forignrs pay mor for th country s products and domstic consumrs pay lss for forign products. Exchang Rats and Rlativ Prics Import and xport dmands, lik th dmands for all goods and srvics, ar influncd by rlativ prics, such as th pric of swatrs in trms of dsignr jans. W hav just sn how xchang rats allow individuals to compar domstic and forign mony prics by xprssing thm in a common currncy unit. Carrying this analysis on stp furthr, w can s that xchang rats also allow individuals to comput th rlativ prics of goods and srvics whos mony prics ar quotd in diffrnt currncis. An Amrican trying to dcid how much to spnd on Amrican jans and how much to spnd on British swatrs must translat thir prics into a common currncy to comput th pric of swatrs in trms of jans. As w hav sn, an xchang rat of $1.50 pr pound mans that an Amrican pays $75 for a swatr pricd at 50 in Britain. Bcaus th pric of a pair of Amrican jans is $45, th pric of a swatr in trms of a pair of jans is ($75 pr swatr)/($45 pr pair of jans) = 1.67 pairs of jans pr swatr. Naturally, a Briton facs th sam rlativ pric of ( 50 pr swatr)/( 30 pr pair of jans) = 1.67 pairs of jans pr swatr. Tabl 14-2 shows th rlativ prics implid by xchang rats of $1.25 pr pound, $1.50 pr pound, and $1.75 pr pound, on th assumption that th dollar pric of jans and th pound pric of swatrs ar unaffctd by th xchang rat changs. To tst your undrstanding, try to calculat ths rlativ prics for yourslf and confirm that th outcom of th calculation is th sam for a Briton and for an Amrican. Th tabl shows that if th goods mony prics do not chang, an apprciation of th dollar against th pound maks swatrs chapr in trms of jans (ach pair of jans buys mor swatrs) whil a dprciation of th dollar against th pound maks swatrs mor TABLE 14-2 $/ Exchang Rats and th Rlativ Pric of Amrican Dsignr Jans and British Swatrs Exchang rat ($/ ) Rlativ pric (pairs of jans/swatr) Not: Th abov calculations assum unchangd mony prics of $45 pr pair of jans and 50 pr swatr.

5 324 PART THREE Exchang Rats and Opn-Economy Macroconomics xpnsiv in trms of jans (ach pair of jans buys fwr swatrs). Th computations illustrat a gnral principl: All ls qual, an apprciation of a country s currncy raiss th rlativ pric of its xports and lowrs th rlativ pric of its imports. Convrsly, a dprciation lowrs th rlativ pric of a country s xports and raiss th rlativ pric of its imports. Th Forign Exchang Markt Just as othr prics in th conomy ar dtrmind by th intraction of buyrs and sllrs, xchang rats ar dtrmind by th intraction of th housholds, firms, and financial institutions that buy and sll forign currncis to mak intrnational paymnts. Th markt in which intrnational currncy trads tak plac is calld th forign xchang markt. Th Actors Th major participants in th forign xchang markt ar commrcial banks, corporations that ngag in intrnational trad, nonbank financial institutions such as asst-managmnt firms and insuranc companis, and cntral banks. Individuals may also participat in th forign xchang markt for xampl, th tourist who buys forign currncy at a hotl s front dsk but such cash transactions ar an insignificant fraction of total forign xchang trading. W now dscrib th major actors in th markt and thir rols. 1. Commrcial banks. Commrcial banks ar at th cntr of th forign xchang markt bcaus almost vry sizabl intrnational transaction involvs th dbiting and crditing of accounts at commrcial banks in various financial cntrs. Thus, th vast majority of forign xchang transactions involv th xchang of bank dposits dnominatd in diffrnt currncis. Lt s look at an xampl. Suppos ExxonMobil Corporation wishs to pay 160,000 to a Grman supplir. First, ExxonMobil gts an xchang rat quotation from its own commrcial bank, th Third National Bank. Thn it instructs Third National to dbit ExxonMobil s dollar account and pay 160,000 into th supplir s account at a Grman bank. If th xchang rat quotd to ExxonMobil by Third National is $1.2 pr uro, $192,000 (= $1.2 pr uro * 160,000) is dbitd from ExxonMobil s account. Th final rsult of th transaction is th xchang of a $192,000 dposit at Third National Bank (now ownd by th Grman bank that supplid th uros) for th 160,000 dposit usd by Third National to pay ExxonMobil s Grman supplir. As th xampl shows, banks routinly ntr th forign xchang markt to mt th nds of thir customrs primarily corporations. In addition, a bank will also quot to othr banks xchang rats at which it is willing to buy currncis from thm and sll currncis to thm. Forign currncy trading among banks calld intrbank trading accounts for much of th activity in th forign xchang markt. In fact, th xchang rats listd in Tabl 14-1 ar intrbank rats, th rats banks charg ach othr. No amount lss than $1 million is tradd at thos rats. Th rats availabl to corporat customrs, calld rtail rats, ar usually lss favorabl than th wholsal intrbank rats. Th diffrnc btwn th rtail and th wholsal rats is th bank s compnsation for doing th businss. Bcaus thir intrnational oprations ar so xtnsiv, larg commrcial banks ar wll suitd to bring buyrs and sllrs of currncis togthr. A multinational corporation wishing to convrt $100,000 into Swdish kronor might find it difficult and costly

6 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 325 to locat othr corporations wishing to sll th right amount of kronor. By srving many customrs simultanously through a singl larg purchas of kronor, a bank can conomiz on ths sarch costs. 2. Corporations. Corporations with oprations in svral countris frquntly mak or rciv paymnts in currncis othr than that of th country in which thy ar hadquartrd. To pay workrs at a plant in Mxico, for xampl, IBM may nd Mxican psos. If IBM has only dollars arnd by slling computrs in th Unitd Stats, it can acquir th psos it nds by buying thm with its dollars in th forign xchang markt. 3. Nonbank financial institutions. Ovr th yars, drgulation of financial markts in th Unitd Stats, Japan, and othr countris has ncouragd nonbank financial institutions such as mutual funds to offr thir customrs a broadr rang of srvics, many of thm indistinguishabl from thos offrd by banks. Among ths hav bn srvics involving forign xchang transactions. Institutional invstors such as pnsion funds oftn trad forign currncis. So do insuranc companis. Hdg funds, which catr to vry walthy individuals and ar not bound by th govrnmnt rgulations that limit mutual funds trading stratgis, trad activly in th forign xchang markt. 4. Cntral banks. In th prvious chaptr w larnd that cntral banks somtims intrvn in forign xchang markts. Whil th volum of cntral bank transactions is typically not larg, th impact of ths transactions may b grat. Th rason for this impact is that participants in th forign xchang markt watch cntral bank actions closly for clus about futur macroconomic policis that may affct xchang rats. Govrnmnt agncis othr than cntral banks may also trad in th forign xchang markt, but cntral banks ar th most rgular official participants. Charactristics of th Markt Forign xchang trading taks plac in many financial cntrs, with th largst volums of trad occurring in such major citis as London (th largst markt), Nw York, Tokyo, Frankfurt, and Singapor. Th worldwid volum of forign xchang trading is normous, and it has balloond in rcnt yars. In April 1989, th avrag total valu of global forign xchang trading was clos to $600 billion pr day. A total of $184 billion was tradd daily in London, $115 billion in th Unitd Stats, and $111 billion in Tokyo. Twnty-on yars latr, in April 2010, th daily global valu of forign xchang trading had jumpd to around $4.0 trillion. A total of $1.85 trillion was tradd daily in Britain, $904 billion in th Unitd Stats, and $312 billion in Japan. 1 Tlphon, fax, and Intrnt links among th major forign xchang trading cntrs mak ach a part of a singl world markt on which th sun nvr sts. Economic nws rlasd at any tim of th day is immdiatly transmittd around th world and may st off a flurry of activity by markt participants. Evn aftr trading in Nw York has finishd, Nw York basd banks and corporations with affiliats in othr tim zons can rmain activ in th markt. Forign xchang tradrs may dal from thir homs whn a latnight communication alrts thm to important dvlopmnts in a financial cntr on anothr continnt. 1 April 1989 figurs com from survys carrid out simultanously by th Fdral Rsrv Bank of Nw York, th Bank of England, th Bank of Japan, th Bank of Canada, and montary authoritis from Franc, Italy, th Nthrlands, Singapor, Hong Kong, and Australia. Th April 2010 survy was carrid out by 53 cntral banks. Rvisd figurs ar rportd in Trinnial Cntral Bank Survy of Forign Exchang and Drivativs Markt Activity in April 2010: Prliminary Global Rsults, Bank for Intrnational Sttlmnts, Basl, Switzrland, Sptmbr Daily U.S. forign currncy trading in 1980 avragd only around $18 billion.

7 326 PART THREE Exchang Rats and Opn-Economy Macroconomics Th intgration of financial cntrs implis that thr can b no significant diffrnc btwn th dollar/uro xchang rat quotd in Nw York at 9 A.M. and th dollar/uro xchang rat quotd in London at th sam tim (which corrsponds to 2 P.M. London tim). If th uro wr slling for $1.1 in Nw York and $1.2 in London, profits could b mad through arbitrag, th procss of buying a currncy chap and slling it dar. At th prics listd abov, a tradr could, for instanc, purchas 1 million in Nw York for $1.1 million and immdiatly sll th uros in London for $1.2 million, making a pur profit of $100,000. If all tradrs trid to cash in on th opportunity, howvr, thir dmand for uros in Nw York would driv up th dollar pric of uros thr, and thir supply of uros in London would driv down th dollar pric of uros thr. Vry quickly, th diffrnc btwn th Nw York and London xchang rats would disappar. Sinc forign xchang tradrs carfully watch thir computr scrns for arbitrag opportunitis, th fw that aris ar small and vry short-livd. Whil a forign xchang transaction can match any two currncis, most transactions (roughly 85 prcnt in April 2010) ar xchangs of forign currncis for U.S. dollars. This is tru vn whn a bank s goal is to sll on nondollar currncy and buy anothr! A bank wishing to sll Swiss francs and buy Israli shkls, for xampl, will usually sll its francs for dollars and thn us th dollars to buy shkls. Whil this procdur may appar roundabout, it is actually chapr for th bank than th altrnativ of trying to find a holdr of shkls who wishs to buy Swiss francs. Th advantag of trading through th dollar is a rsult of th Unitd Stats importanc in th world conomy. Bcaus th volum of intrnational transactions involving dollars is so grat, it is not hard to find partis willing to trad dollars against Swiss francs or shkls. In contrast, rlativly fw transactions rquir dirct xchangs of Swiss francs for shkls. 2 Bcaus of its pivotal rol in so many forign xchang dals, th U.S. dollar is somtims calld a vhicl currncy. A vhicl currncy is on that is widly usd to dnominat intrnational contracts mad by partis who do not rsid in th country that issus th vhicl currncy. It has bn suggstd that th uro, which was introducd at th start of 1999, will volv into a vhicl currncy on a par with th dollar. By April 2010, about 39 prcnt of forign xchang trads wr against uros lss than half th shar of th dollar, albit abov th figur of 37 prcnt clockd thr yars arlir. Japan s yn is th third most important currncy, with a markt shar of 19 prcnt (out of 200). Th pound strling, onc scond only to th dollar as a ky intrnational currncy, has dclind gratly in importanc. 3 Spot Rats and Forward Rats Th forign xchang transactions w hav bn discussing tak plac on th spot: Two partis agr to an xchang of bank dposits and xcut th dal immdiatly. Exchang rats govrning such on-th-spot trading ar calld spot xchang rats, and th dal is calld a spot transaction. 2 Th Swiss franc/shkl xchang rat can b calculatd from th dollar/franc and dollar/shkl xchang rats as th dollar/shkl rat dividd by th dollar/franc rat. If th dollar/franc rat is $0.80 pr franc and th dollar/shkl rat is $0.20 pr shkl, thn th Swiss franc/shkl rat is (0.20 $/shkl)/(0.80 $/franc) = 0.25 swiss franc/shkl. Exchang rats btwn nondollar currncis ar calld cross rats by forign xchang tradrs. 3 For a mor dtaild discussion of vhicl currncis, s Richard Ports and Hélèn Ry, Th Emrgnc of th Euro as an Intrnational Currncy, Economic Policy 26 (April 1998), pp Data on currncy shars com from Bank for Intrnational Sttlmnts, op. cit., tabl 3. For a rcnt assssmnt of th futur rols of th dollar and th uro, s th ssays in Jan Pisani-Frry and Adam S. Posn, ds., Th Euro at Tn: Th Nxt Global Currncy? (Washington, D.C.: Ptrson Institut for Intrnational Economics, 2009).

8 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 327 Forign xchang dals somtims spcify a futur transaction dat on that may b 30 days, 90 days, 180 days, or vn svral yars away. Th xchang rats quotd in such transactions ar calld forward xchang rats. In a 30-day forward transaction, for xampl, two partis may commit thmslvs on April 1 to a spot xchang of 100,000 for $155,000 on May 1. Th 30-day forward xchang rat is thrfor $1.55 pr pound, and it is gnrally diffrnt from th spot rat and from th forward rats applid to diffrnt futur dats. Whn you agr to sll pounds for dollars on a futur dat at a forward rat agrd on today, you hav sold pounds forward and bought dollars forward. Th futur dat on which th currncis ar actually xchangd is calld th valu dat. 4 Tabl 14-1 shows forward xchang rats for som major currncis. Forward and spot xchang rats, whil not ncssarily qual, do mov closly togthr, as illustratd for monthly data on dollar/pound rats in Figur Th appndix to this chaptr, which discusss how forward xchang rats ar dtrmind, xplains this clos rlationship btwn movmnts in spot and forward rats. An xampl shows why partis may wish to ngag in forward xchang transactions. Suppos Radio Shack knows that in 30 days it must pay yn to a Japans supplir for a shipmnt of radios arriving thn. Radio Shack can sll ach radio for $100 and must pay its supplir 9,000 pr radio; its profit dpnds on th dollar/yn xchang rat. At th currnt spot xchang rat of $ pr yn, Radio Shack would pay ($ pr yn) * ( 9,000 pr radio) = $94.50 pr radio and would thrfor mak $5.50 on ach radio importd. But Radio Shack will not hav th funds to pay th supplir until th radios arriv and ar sold. If ovr th nxt 30 days th dollar unxpctdly dprciats to $ pr yn, Radio Shack will hav to pay ($ pr yn) * ( 9,000 pr radio) = $ pr radio and so will tak a $3.50 loss on ach. To avoid this risk, Radio Shack can mak a 30-day forward xchang dal with Bank of Amrica. If Bank of Amrica agrs to sll yn to Radio Shack in 30 days at a rat of $0.0107, Radio Shack is assurd of paying xactly ($ pr yn) * ( 9,000 pr radio) = $96.30 pr radio to th supplir. By buying yn and slling dollars forward, Radio Shack is guarantd Exchang rats ($/ ) Spot rat 1.5 Forward rat Figur 14-1 Dollar/Pound Spot and Forward Exchang Rats, Spot and forward xchang rats tnd to mov in a highly corrlatd fashion. Sourc: Datastram. Rats shown ar 90-day forward xchang rats and spot xchang rats, at nd of month. 4 In days past, it would tak up to two days to sttl vn spot forign xchang transactions. In othr words, th valu dat for a spot transaction was actually two days aftr th dal was struck. Nowadays, most spot trads of major currncis sttl on th sam day.

9 328 PART THREE Exchang Rats and Opn-Economy Macroconomics a profit of $3.70 pr radio and is insurd against th possibility that a suddn xchang rat chang will turn a profitabl importing dal into a loss. In th jargon of th forign xchang markt, w would say that Radio Shack has hdgd its forign currncy risk. From now on, whn w mntion an xchang rat but don t spcify whthr it is a spot rat or a forward rat, w will always b rfrring to th spot rat. Forign Exchang Swaps A forign xchang swap is a spot sal of a currncy combind with a forward rpurchas of that currncy. For xampl, suppos th Toyota auto company has just rcivd $1 million from Amrican sals and knows it will hav to pay thos dollars to a California supplir in thr months. Toyota s asst-managmnt dpartmnt would manwhil lik to invst th $1 million in uro bonds. A thr-month swap of dollars into uros may rsult in lowr brokrs fs than th two sparat transactions of slling dollars for spot uros and slling th uros for dollars on th forward markt. Swaps mak up a significant proportion of all forign xchang trading. Futurs and Options Svral othr financial instrumnts tradd in th forign xchang markt, lik forward contracts, involv futur xchangs of currncis. Th timing and trms of th xchangs can diffr, howvr, from thos spcifid in forward contracts, giving tradrs additional flxibility in avoiding forign xchang risk. Only 25 yars ago, som of ths instrumnts wr not tradd on organizd xchangs. Whn you buy a futurs contract, you buy a promis that a spcifid amount of forign currncy will b dlivrd on a spcifid dat in th futur. A forward contract btwn you and som othr privat party is an altrnativ way to nsur that you rciv th sam amount of forign currncy on th dat in qustion. But whil you hav no choic about fulfilling your nd of a forward dal, you can sll your futurs contract on an organizd futurs xchang, ralizing a profit or loss right away. Such a sal might appar advantagous, for xampl, if your viws about th futur spot xchang rat wr to chang. A forign xchang option givs its ownr th right to buy or sll a spcifid amount of forign currncy at a spcifid pric at any tim up to a spcifid xpiration dat. Th othr party to th dal, th option s sllr, is rquird to sll or buy th forign currncy at th discrtion of th option s ownr, who is undr no obligation to xrcis his right. Imagin that you ar uncrtain about whn in th nxt month a forign currncy paymnt will arriv. To avoid th risk of a loss, you may wish to buy a put option giving you th right to sll th forign currncy at a known xchang rat at any tim during th month. If instad you xpct to mak a paymnt abroad somtim in th month, a call option, which givs you th right to buy forign currncy to mak th paymnt at a known pric, might b attractiv. Options can b writtn on many undrlying assts (including forign xchang futurs), and, lik futurs, thy ar frly bought and sold. Forwards, swaps, futurs, and options ar all xampls of financial drivativs, which w ncountrd in Chaptr 13. Th Dmand for Forign Currncy Assts W hav now sn how banks, corporations, and othr institutions trad forign currncy bank dposits in a worldwid forign xchang markt that oprats 24 hours a day. To undrstand how xchang rats ar dtrmind by th forign xchang markt, w first must ask how th major actors dmands for diffrnt typs of forign currncy dposits ar dtrmind.

10 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 329 Th dmand for a forign currncy bank dposit is influncd by th sam considrations that influnc th dmand for any othr asst. Chif among ths considrations is our viw of what th dposit will b worth in th futur. A forign currncy dposit s futur valu dpnds in turn on two factors: th intrst rat it offrs and th xpctd chang in th currncy s xchang rat against othr currncis. Assts and Asst Rturns As you will rcall, popl can hold walth in many forms stocks, bonds, cash, ral stat, rar wins, diamonds, and so on. Th objct of acquiring walth of saving is to transfr purchasing powr into th futur. W may do this to provid for our rtirmnt yars, for our hirs, or simply bcaus w arn mor than w nd to spnd in a particular yar and prfr to sav th balanc for a rainy day. Dfining Asst Rturns Bcaus th objct of saving is to provid for futur consumption, w judg th dsirability of an asst largly on th basis of its rat of rturn, that is, th prcntag incras in valu it offrs ovr som tim priod. For xampl, suppos that at th bginning of 2012 you pay $100 for a shar of stock issud by Financial Soothsayrs, Inc. If th stock pays you a dividnd of $1 at th bginning of 2013, and if th stock s pric riss from $100 to $109 pr shar ovr th yar, thn you hav arnd a rat of rturn of 10 prcnt on th stock ovr 2012 that is, your initial $100 invstmnt has grown in valu to $110, th sum of th $1 dividnd and th $109 you could gt by slling your shar. Had Financial Soothsayrs stock still paid out its $1 dividnd but droppd in pric to $89 pr shar, your $100 invstmnt would b worth only $90 by yar s nd, giving a rat of rturn of ngativ 10 prcnt. You oftn cannot know with crtainty th rturn that an asst will actually pay aftr you buy it. Both th dividnd paid by a shar of stock and th shar s rsal pric, for xampl, may b hard to prdict. Your dcision thrfor must b basd on an xpctd rat of rturn. To calculat an xpctd rat of rturn ovr som tim priod, you mak your bst forcast of th asst s total valu at th priod s nd. Th prcntag diffrnc btwn that xpctd futur valu and th pric you pay for th asst today quals th asst s xpctd rat of rturn ovr th tim priod. Whn w masur an asst s rat of rturn, w compar how an invstmnt in th asst changs in total valu btwn two dats. In th prvious xampl, w compard how th valu of an invstmnt in Financial Soothsayrs stock changd btwn 2012 ($100) and 2013 ($110) to conclud that th rat of rturn on th stock was 10 prcnt pr yar. W call this a dollar rat of rturn bcaus th two valus w compar ar xprssd in trms of dollars. It is also possibl, howvr, to comput diffrnt rats of rturn by xprssing th two valus in trms of a forign currncy or a commodity such as gold. Th Ral Rat of Rturn Th xpctd rat of rturn that savrs considr in dciding which assts to hold is th xpctd ral rat of rturn, that is, th rat of rturn computd by masuring asst valus in trms of som broad rprsntativ baskt of products that savrs rgularly purchas. It is th xpctd ral rturn that mattrs bcaus th ultimat goal of saving is futur consumption, and only th ral rturn masurs th goods and srvics a savr can buy in th futur in rturn for giving up som consumption (that is, saving) today. To continu our xampl, suppos that th dollar valu of an invstmnt in Financial Soothsayrs stock incrass by 10 prcnt btwn 2012 and 2013 but that th dollar prics of all goods and srvics also incras by 10 prcnt. Thn in trms of output that is, in ral trms th invstmnt would b worth no mor in 2012 than in With a ral rat of rturn of zro, Financial Soothsayrs stock would not b a vry dsirabl asst.

11 330 PART THREE Exchang Rats and Opn-Economy Macroconomics Nondlivrabl Forward Exchang Trading in Asia In a standard forward xchang contract, two partis agr to xchang two diffrnt currncis at an agrd rat on a futur dat. Th currncis of many dvloping countris ar, howvr, not fully convrtibl, maning that thy cannot b frly tradd on intrnational forign xchang markts. An important xampl of an inconvrtibl currncy is China s rnminbi, which can b tradd within China s bordrs (by rsidnts) but not frly outsid of thm (bcaus China s govrnmnt dos not allow nonrsidnts unrstrictd ownrship of rnminbi dposits in China). Thus, for currncis such as th rnminbi, th customary way of trading forward xchang is not possibl. Dvloping countris with inconvrtibl currncis such as China s hav ntrd th ranks of th world s largst participants in intrnational trad and invstmnt. Usually, tradrs us th forward xchang markt to hdg thir currncy risks, but in cass such as China s, as w hav sn, a standard forward markt cannot xist. Is thr no way for forignrs to hdg th currncy risk thy may tak on whn thy trad with inconvrtibl-currncy countris? Sinc th arly 1990s, markts in nondlivrabl forward xchang hav sprung up in cntrs such as Hong Kong and Singapor to facilitat hdging in inconvrtibl Asian currncis. Among th currncis tradd in offshor nondlivrabl forward markts ar th Chins rnminbi, th Taiwan dollar, and th Indian rup. By using nondlivrabl forward contracts, tradrs can hdg currncy risks without vr actually having to trad inconvrtibl currncis. Lt s look at a hypothtical xampl to s how this hdging can b accomplishd. Gnral Motors has just sold som car componnts to China. Its contract with th Chins importr stats that in thr months, GM will rciv th dollar quivalnt of 10 million yuan in paymnt for its shipmnt. (Th yuan is th unit in which amounts of rnminbi ar masurd, just as British strling is masurd in pounds.) Th Popl s Bank of China (PBC), th cntral bank, tightly controls its currncy s xchang rat by trading dollars that it holds for rnminbi with domstic rsidnts.* Today, th PBC will buy or sll a U.S. dollar for 6.8 yuan. But assum that th PBC has bn gradually allowing its currncy to apprciat against th dollar, and that th rat it will quot in thr months is uncrtain: It could b anywhr btwn, say, 6.7 and 6.5 yuan pr dollar. GM would lik to lock in a forward xchang rat of 6.6 yuan pr dollar, which th company s chif financial officr might typically do simply by slling th xpctd 10 million yuan rcipts forward for dollars at that rat. Unfortunatly, th rnminbi s inconvrtibility mans that GM will actually rciv, not rnminbi that it can sll forward, but th dollar quivalnt of 10 million yuan, dollars that th importr can buy through China s banking systm. Nondlivrabl forwards rsult in a virtual forward markt, howvr. Thy do this by allowing non-chins tradrs to mak bts on th rnminbi s valu that ar payabl in dollars. To lock in a nondlivrabl forward xchang rat of 6.6 yuan pr dollar, GM can sign a contract rquiring it to pay th diffrnc btwn th numbr of dollars it actually rcivs in thr months and th amount it would rciv if th xchang rat wr xactly 6.6 yuan pr dollar, quivalnt to 1/6.6 dollars pr yuan = $ pr yuan (aftr rounding). Thus, if th xchang rat turns out to b 6.5 yuan pr dollar (which othrwis would b good luck for GM), GM will hav to pay out on its contract (1/6.5-1/6.6 dollars pr yuan) * (10,000,000 yuan) = ($ $ pr yuan) * (10,000,000 yuan) = $23,310. On th othr hand, by giving up th possibility of good luck, GM also avoids th risk of bad luck. If th *China s currncy rgim is an xampl of a fixd xchang rat systm, which w will study in gratr dtail in Chaptr 18. Although savrs car about xpctd ral rats of rturn, rats of rturn xprssd in trms of a currncy can still b usd to compar ral rturns on diffrnt assts. Evn if all dollar prics ris by 10 prcnt btwn 2012 and 2013, a rar bottl of win whos dollar pric riss by 25 prcnt is still a bttr invstmnt than a bond whos dollar valu riss by 20 prcnt.

12 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 331 Exchang rat (yuan pr U.S. Dollar) On month forward On yar forward Two yars forward Jun 2006 Sptmbr 2006 Dcmbr 2006 March 2007 Jun 2007 Sptmbr 2007 Dcmbr 2007 March 2008 Jun 2008 Sptmbr 2008 Dcmbr 2008 March 2009 Jun 2009 Sptmbr 2009 Dcmbr 2009 March 2010 Jun 2010 Nondlivrabl Forward Exchang Rats, China Yuan pr Dollar Sourc: Datastram. xchang rat turns out instad to b 6.7 yuan pr dollar (which othrwis would b unfavorabl for GM), GM will pay th ngativ amount ($ $ pr yuan) (10,000,000 yuan) $22,614, that is, it will rciv $22,614 from th othr contracting party. Th nondlivrabl forward contract allows GM to immuniz itslf from xchang risk, vn though th partis to th contract nd nvr actually xchang Chins currncy. Th chart abov shows daily data on nondlivrabl forward rats of yuan for dollars with valu dats on month, on yar, and two yars away. (Far longr maturitis ar also quotd.) Changs in ths rats ar mor variabl at th longr maturitis bcaus th rats rflct xpctations about China s futur xchang rat policy and bcaus th far futur is rlativly mor uncrtain than th nar futur. How hav China s xchang rat policis volvd? From July 2005 until July 2008, China followd a widly undrstood policy of gradually allowing its currncy to apprciat against th U.S. dollar. Bcaus of xpctations during this priod that th yuan/dollar rat would fall ovr tim, th forward rats at which popl wr willing to trad to covr transactions two yars away ar blow th on-yar-ahad forward rats, which in turn ar blow th on-month-ahad forward rats. China changd its policy in th summr of 2008, pgging th yuan rigidly to th dollar without any announcd nd dat for that policy. That action altrd th rlationship among th thr forward rats, as you can s in th chart. Two yars latr, in Jun 2010, China announcd its rturn to a supposdly mor flxibl xchang rat for th yuan. China s xchang rat systm and policis hav bn a focus of intrnational controvrsy in rcnt yars, and w will say mor about thm in latr chaptrs. Th ral rat of rturn offrd by th win is 15 prcnt (= 25 prcnt - 10 prcnt) whil that offrd by th bond is only 10 prcnt (= 20 prcnt - 10 prcnt). Notic that th diffrnc btwn th dollar rturns of th two assts (25 prcnt - 20 prcnt) must qual th diffrnc btwn thir ral rturns (15 prcnt - 10 prcnt). Th rason for this quality is

13 332 PART THREE Exchang Rats and Opn-Economy Macroconomics that, givn th two assts dollar rturns, a chang in th rat at which th dollar prics of goods ar rising changs both assts ral rturns by th sam amount. Th distinction btwn ral rats of rturn and dollar rats of rturn illustrats an important concpt in studying how savrs valuat diffrnt assts: Th rturns on two assts cannot b compard unlss thy ar masurd in th sam units. For xampl, it maks no sns to compar dirctly th ral rturn on th bottl of win (15 prcnt in our xampl) with th dollar rturn on th bond (20 prcnt) or to compar th dollar rturn on old paintings with th uro rturn on gold. Only aftr th rturns ar xprssd in trms of a common unit of masur for xampl, all in trms of dollars can w tll which asst offrs th highst xpctd ral rat of rturn. Risk and Liquidity All ls qual, individuals prfr to hold thos assts offring th highst xpctd ral rat of rturn. Our latr discussions of particular assts will show, howvr, that all ls oftn is not qual. Som assts may b valud by savrs for attributs othr than th xpctd ral rat of rturn thy offr. Savrs car about two main charactristics of an asst othr than its rturn: its risk, th variability it contributs to savrs walth, and its liquidity, th as with which th asst can b sold or xchangd for goods. 1. Risk. An asst s ral rturn is usually unprdictabl and may turn out to b quit diffrnt from what savrs xpctd whn thy purchasd th asst. In our last xampl, savrs found th xpctd ral rat of rturn on an invstmnt in bonds (10 prcnt) by subtracting from th xpctd rat of incras in th invstmnt s dollar valu (20 prcnt) th xpctd rat of incras in dollar prics (10 prcnt). But if xpctations ar wrong and th bonds dollar valu stays constant instad of rising by 20 prcnt, th savr nds up with a ral rturn of ngativ 10 prcnt (= 0 prcnt - 10 prcnt). Savrs dislik uncrtainty and ar rluctant to hold assts that mak thir walth highly variabl. An asst with a high xpctd rat of rturn may thus appar undsirabl to savrs if its ralizd rat of rturn fluctuats widly. 2. Liquidity. Assts also diffr according to th cost and spd at which savrs can dispos of thm. A hous, for xampl, is not vry liquid bcaus its sal usually rquirs tim and th srvics of brokrs and inspctors. To sll a hous quickly, on might hav to sll at a rlativly low pric. In contrast, cash is th most liquid of all assts: It is always accptabl at fac valu as paymnt for goods or othr assts. Savrs prfr to hold som liquid assts as a prcaution against unxpctd prssing xpnss that might forc thm to sll lss liquid assts at a loss. Thy will thrfor considr an asst s liquidity as wll as its xpctd rturn and risk in dciding how much of it to hold. Intrst Rats As in othr asst markts, participants in th forign xchang markt bas thir dmands for dposits of diffrnt currncis on a comparison of ths assts xpctd rats of rturn. To compar rturns on diffrnt dposits, markt participants nd two pics of information. First, thy nd to know how th mony valus of th dposits will chang. Scond, thy nd to know how xchang rats will chang so that thy can translat rats of rturn masurd in diffrnt currncis into comparabl trms. Th first pic of information ndd to comput th rat of rturn on a dposit of a particular currncy is th currncy s intrst rat, th amount of that currncy an individual can arn by lnding a unit of th currncy for a yar. At a dollar intrst rat of 0.10 (quotd as 10 prcnt pr yar), th lndr of $1 rcivs $1.10 at th nd of th

14 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 333 yar, $1 of which is principal and 10 cnts of which is intrst. Lookd at from th othr sid of th transaction, th intrst rat on dollars is also th amount that must b paid to borrow $1 for a yar. Whn you buy a U.S. Trasury bill, you arn th intrst rat on dollars bcaus you ar lnding dollars to th U.S. govrnmnt. Intrst rats play an important rol in th forign xchang markt bcaus th larg dposits tradd thr pay intrst, ach at a rat rflcting its currncy of dnomination. For xampl, whn th intrst rat on dollars is 10 prcnt pr yar, a $100,000 dposit is worth $110,000 aftr a yar; whn th intrst rat on uros is 5 prcnt pr yar, a 100,000 dposit is worth 105,000 aftr a yar. Dposits pay intrst bcaus thy ar rally loans from th dpositor to th bank. Whn a corporation or a financial institution dposits a currncy in a bank, it is lnding that currncy to th bank rathr than using it for som currnt xpnditur. In othr words, th dpositor is acquiring an asst dnominatd in th currncy it dposits. Th dollar intrst rat is simply th dollar rat of rturn on dollar dposits. You buy th dposit by lnding a bank $100,000, and whn you ar paid back with 10 prcnt intrst at th nd of th yar, your asst is worth $110,000. This givs a rat of rturn of (110, ,000)/100,000 = 0.10, or 10 prcnt pr yar. Similarly, a forign currncy s intrst rat masurs th forign currncy rturn on dposits of that currncy. Figur 14-2 shows th monthly bhavior of intrst rats on th dollar and th Japans yn from 1978 to Ths intrst rats ar not masurd in comparabl trms, so thr is no rason for thm to b clos to ach othr or to mov in similar ways ovr tim. 5 Intrst rats (prcnt pr yar) Dollar rat Yn rat Figur 14-2 Intrst Rats on Dollar and Yn Dposits, Sinc dollar and yn intrst rats ar not masurd in comparabl trms, thy can mov quit diffrntly ovr tim. Sourc: Datastram. Thr-month intrst rats ar shown. 5 Chaptr 6 dfind ral intrst rats, which ar simply ral rats of rturn on loans, that is, intrst rats xprssd in trms of a consumption baskt. Intrst rats xprssd in trms of currncis ar calld nominal intrst rats. Th connction btwn ral and nominal intrst rats is discussd in dtail in Chaptr 16.

15 334 PART THREE Exchang Rats and Opn-Economy Macroconomics Exchang Rats and Asst Rturns Th intrst rats offrd by a dollar and a uro dposit tll us how thir dollar and uro valus will chang ovr a yar. Th othr pic of information w nd in ordr to compar th rats of rturn offrd by dollar and uro dposits is th xpctd chang in th dollar/uro xchang rat ovr th yar. To s which dposit, uro or dollar, offrs a highr xpctd rat of rturn, you must ask th qustion: If I us dollars to buy a uro dposit, how many dollars will I gt back aftr a yar? Whn you answr this qustion, you ar calculating th dollar rat of rturn on a uro dposit bcaus you ar comparing its dollar pric today with its dollar valu a yar from today. To s how to approach this typ of calculation, lt s look at th following situation: Suppos that today s xchang rat (quotd in Amrican trms) is $1.10 pr uro, but that you xpct th rat to b $1.165 pr uro in a yar (prhaps bcaus you xpct unfavorabl dvlopmnts in th U.S. conomy). Suppos also that th dollar intrst rat is 10 prcnt pr yar whil th uro intrst rat is 5 prcnt pr yar. This mans a dposit of $1.00 pays $1.10 aftr a yar whil a dposit of 1 pays 1.05 aftr a yar. Which of ths dposits offrs th highr rturn? Th answr can b found in fiv stps. Stp 1. Us today s dollar/uro xchang rat to figur out th dollar pric of a uro dposit of, say, 1. If th xchang rat today is $1.10 pr uro, th dollar pric of a 1 dposit is just $1.10. Stp 2. Us th uro intrst rat to find th amount of uros you will hav a yar from now if you purchas a 1 dposit today. You know that th intrst rat on uro dposits is 5 prcnt pr yar. So at th nd of a yar, your 1 dposit will b worth Stp 3. Us th xchang rat you xpct to prvail a yar from today to calculat th xpctd dollar valu of th uro amount dtrmind in Stp 2. Sinc you xpct th dollar to dprciat against th uro ovr th coming yar so that th xchang rat 12 months from today is $1.165 pr uro, you xpct th dollar valu of your uro dposit aftr a yar to b $1.165 pr uro * 1.05 = $ Stp 4. Now that you know th dollar pric of a 1 dposit today ($1.10) and can forcast its valu in a yar ($1.223), you can calculat th xpctd dollar rat of rturn on a uro dposit as ( )/1.10 = 0.11, or 11 prcnt pr yar. Stp 5. Sinc th dollar rat of rturn on dollar dposits (th dollar intrst rat) is only 10 prcnt pr yar, you xpct to do bttr by holding your walth in th form of uro dposits. Dspit th fact that th dollar intrst rat xcds th uro intrst rat by 5 prcnt pr yar, th uro s xpctd apprciation against th dollar givs uro holdrs a prospctiv capital gain that is larg nough to mak uro dposits th highr-yild asst. A Simpl Rul A simpl rul shortns this calculation. First, dfin th rat of dprciation of th dollar against th uro as th prcntag incras in th dollar/uro xchang rat ovr a yar. In th last xampl, th dollar s xpctd dprciation rat is ( )/1.10 = 0.059, or roughly 6 prcnt pr yar. Onc you hav calculatd th rat of dprciation of th dollar against th uro, our rul is this: Th dollar rat of rturn on uro dposits is approximatly th uro intrst rat plus th rat of dprciation of th dollar against th uro. In othr words, to translat th uro rturn on uro dposits into dollar trms, you nd to add th rat at which th uro s dollar pric riss ovr a yar to th uro intrst rat. In our xampl, th sum of th uro intrst rat (5 prcnt) and th xpctd dprciation rat of th dollar (roughly 6 prcnt) is about 11 prcnt, which is what w found to b th xpctd dollar rturn on uro dposits in our first calculation.

16 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 335 W summariz our discussion by introducing som notation: R = today s intrst rat on on-yar uro dposits, = today s dollar/uro xchang rat (numbr of dollars pr uro), = dollar/uro xchang rat (numbr of dollars pr uro) xpctd to prvail a yar from today. (Th suprscript attachd to this last xchang rat indicats that it is a forcast of th futur xchang rat basd on what popl know today.) Using ths symbols, w writ th xpctd rat of rturn on a uro dposit, masurd in trms of dollars, as th sum of (1) th uro intrst rat and (2) th xpctd rat of dollar dprciation against th uro: R + ( - )/. This xpctd rturn is what must b compard with th intrst rat on on-yar dollar dposits, R $, in dciding whthr dollar or uro dposits offr th highr xpctd rat of rturn. 6 Th xpctd rat of rturn diffrnc btwn dollar and uro dposits is thrfor qual to lss th abov xprssion, R $ R $ - [R + ( - )/ ] = R $ - R - ( - )/. (14-1) Whn th diffrnc abov is positiv, dollar dposits yild th highr xpctd rat of rturn; whn it is ngativ, uro dposits yild th highr xpctd rat of rturn. Tabl 14-3 carris out som illustrativ comparisons. In cas 1, th intrst diffrnc in favor of dollar dposits is 4 prcnt pr yar (R $ - R = = 0.04), and no chang in th xchang rat is xpctd [( - )/ = 0.00]. This mans that th xpctd annual ral rat of rturn on dollar dposits is 4 prcnt highr than that on uro dposits, so that, othr things qual, you would prfr to hold your walth as dollar rathr than uro dposits. TABLE 14-3 Dollar Intrst Rat Comparing Dollar Rats of Rturn on Dollar and Euro Dposits Euro Intrst Rat Expctd Rat of Dollar Dprciation Against Euro Rat of Rturn Diffrnc Btwn Dollar and Euro Dposits E Cas R $ R $/ - R $ R (E $/ ) 6 If you comput th xpctd dollar rturn on uro dposits using th xact fiv-stp mthod w dscribd bfor introducing th simpl rul, you ll find that it actually quals This xact formula can b rwrittn, howvr, as R + ( (1 + R ) ( / ) )/ + R * ( - )/. Th xprssion abov is vry clos to th formula drivd from th simpl rul whn, as is usually th cas, th product R * ( - )/ is a small numbr.

17 336 PART THREE Exchang Rats and Opn-Economy Macroconomics In cas 2 th intrst diffrnc is th sam (4 prcnt), but it is just offst by an xpctd dprciation rat of th dollar of 4 prcnt. Th two assts thrfor hav th sam xpctd rat of rturn. Cas 3 is similar to th on discussd arlir: A 4 prcnt intrst diffrnc in favor of dollar dposits is mor than offst by an 8 prcnt xpctd dprciation of th dollar, so uro dposits ar prfrrd by markt participants. In cas 4, thr is a 2 prcnt intrst diffrnc in favor of uro dposits, but th dollar is xpctd to apprciat against th uro by 4 prcnt ovr th yar. Th xpctd rat of rturn on dollar dposits is thrfor 2 prcnt pr yar highr than that on uro dposits. So far w hav bn translating all rturns into dollar trms. But th rat of rturn diffrntials w calculatd would hav bn th sam had w chosn to xprss rturns in trms of uros or in trms of som third currncy. Suppos, for xampl, w wantd to masur th rturn on dollar dposits in trms of uros. Following our simpl rul, w would add to th dollar intrst rat R $ th xpctd rat of dprciation of th uro against th dollar. But th xpctd rat of dprciation of th uro against th dollar is approximatly th xpctd rat of apprciation of th dollar against th uro, that is, th xpctd rat of dprciation of th dollar against th uro with a minus sign in front of it. This mans that in trms of uros, th rturn on a dollar dposit is R $ - ( - )/. Th diffrnc btwn th xprssion abov and R is idntical to xprssion (14-1). Thus, it maks no diffrnc to our comparison whthr w masur rturns in trms of dollars or uros, as long as w masur thm both in trms of th sam currncy. Rturn, Risk, and Liquidity in th Forign Exchang Markt W obsrvd arlir that a savr dciding which assts to hold may car about th assts riskinss and liquidity in addition to thir xpctd ral rats of rturn. Similarly, th dmand for forign currncy assts dpnds not only on rturns but also on risk and liquidity. Evn if th xpctd dollar rturn on uro dposits is highr than that on dollar dposits, for xampl, popl may b rluctant to hold uro dposits if th payoff to holding thm varis rratically. Thr is no consnsus among conomists about th importanc of risk in th forign xchang markt. Evn th dfinition of forign xchang risk is a topic of dbat. For now w will avoid ths complx qustions by assuming that th ral rturns on all dposits hav qual riskinss, rgardlss of th currncy of dnomination. In othr words, w ar assuming that risk diffrncs do not influnc th dmand for forign currncy assts. W discuss th rol of forign xchang risk in gratr dtail, howvr, in Chaptr Som markt participants may b influncd by liquidity factors in dciding which currncis to hold. Most of ths participants ar firms and individuals conducting intrnational trad. An Amrican importr of Frnch fashion products or wins, for xampl, may find it convnint to hold uros for routin paymnts vn if th xpctd rat of rturn on uros is lowr than that on dollars. Bcaus paymnts connctd with intrnational trad 7 In discussing spot and forward forign xchang transactions, som txtbooks mak a distinction btwn forign xchang spculators markt participants who allgdly car only about xpctd rturns and hdgrs markt participants whos concrn is to avoid risk. W dpart from this txtbook tradition bcaus it can mislad th unwary: Whil th spculativ and hdging motivs ar both potntially important in xchang rat dtrmination, th sam prson can b both a spculator and a hdgr if sh cars about both rturn and risk. Our tntativ assumption that risk is unimportant in dtrmining th dmand for forign currncy assts mans, in trms of th traditional languag, that th spculativ motiv for holding forign currncis is far mor important than th hdging motiv.

18 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 337 mak up a vry small fraction of total forign xchang transactions, w ignor th liquidity motiv for holding forign currncis. W ar thrfor assuming for now that participants in th forign xchang markt bas thir dmands for forign currncy assts xclusivly on a comparison of thos assts xpctd rats of rturn. Th main rason for making this assumption is that it simplifis our analysis of how xchang rats ar dtrmind in th forign xchang markt. In addition, th risk and liquidity motivs for holding forign currncis appar to b of scondary importanc for many of th intrnational macroconomic issus discussd in th nxt fw chaptrs. Equilibrium in th Forign Exchang Markt W now us what w hav larnd about th dmand for forign currncy assts to dscrib how xchang rats ar dtrmind. W will show that th xchang rat at which th markt sttls is th on that maks markt participants contnt to hold xisting supplis of dposits of all currncis. Whn markt participants willingly hold th xisting supplis of dposits of all currncis, w say that th forign xchang markt is in quilibrium. Th dscription of xchang rat dtrmination givn in this sction is only a first stp: A full xplanation of th xchang rat s currnt lvl can b givn only aftr w xamin how participants in th forign xchang markt form thir xpctations about th xchang rats thy xpct to prvail in th futur. Th nxt two chaptrs look at th factors that influnc xpctations of futur xchang rats. For now, howvr, w will tak xpctd futur xchang rats as givn. Intrst Parity: Th Basic Equilibrium Condition Th forign xchang markt is in quilibrium whn dposits of all currncis offr th sam xpctd rat of rturn. Th condition that th xpctd rturns on dposits of any two currncis ar qual whn masurd in th sam currncy is calld th intrst parity condition. It implis that potntial holdrs of forign currncy dposits viw thm all as qually dsirabl assts, providd thir xpctd rats of rturn ar th sam. Lt s s why th forign xchang markt is in quilibrium only whn th intrst parity condition holds. Suppos th dollar intrst rat is 10 prcnt and th uro intrst rat is 6 prcnt, but that th dollar is xpctd to dprciat against th uro at an 8 prcnt rat ovr a yar. (This is cas 3 in Tabl 14-3.) In th circumstancs dscribd, th xpctd rat of rturn on uro dposits would b 4 prcnt pr yar highr than that on dollar dposits. W assumd at th nd of th last sction that individuals always prfr to hold dposits of currncis offring th highst xpctd rturn. This implis that if th xpctd rturn on uro dposits is 4 prcnt gratr than that on dollar dposits, no on will b willing to continu holding dollar dposits, and holdrs of dollar dposits will b trying to sll thm for uro dposits. Thr will thrfor b an xcss supply of dollar dposits and an xcss dmand for uro dposits in th forign xchang markt. As a contrasting xampl, suppos that dollar dposits again offr a 10 prcnt intrst rat but uro dposits offr a 12 prcnt rat and th dollar is xpctd to apprciat against th uro by 4 prcnt ovr th coming yar. (This is cas 4 in Tabl 14-3.) Now th rturn on dollar dposits is 2 prcnt highr. In this cas no on would dmand uro dposits, so thy would b in xcss supply and dollar dposits would b in xcss dmand. Whn, howvr, th dollar intrst rat is 10 prcnt, th uro intrst rat is 6 prcnt, and th dollar s xpctd dprciation rat against th uro is 4 prcnt, dollar and uro

19 338 PART THREE Exchang Rats and Opn-Economy Macroconomics dposits offr th sam rat of rturn and participants in th forign xchang markt ar qually willing to hold ithr. (This is cas 2 in Tabl 14-3.) Only whn all xpctd rats of rturn ar qual that is, whn th intrst parity condition holds is thr no xcss supply of som typ of dposit and no xcss dmand for anothr. Th forign xchang markt is in quilibrium whn no typ of dposit is in xcss dmand or xcss supply. W can thrfor say that th forign xchang markt is in quilibrium whn, and only whn, th intrst parity condition holds. To rprsnt intrst parity btwn dollar and uro dposits symbolically, w us xprssion (14-1), which shows th diffrnc btwn th two assts xpctd rats of rturn masurd in dollars. Th xpctd rats of rturn ar qual whn R $ = R + ( - )/. (14-2) You probably suspct that whn dollar dposits offr a highr rturn than uro dposits, th dollar will apprciat against th uro as invstors all try to shift thir funds into dollars. Convrsly, th dollar should dprciat against th uro whn it is uro dposits that initially offr th highr rturn. This intuition is xactly corrct. To undrstand th mchanism at work, howvr, w must tak a carful look at how xchang rat changs lik ths hlp to maintain quilibrium in th forign xchang markt. How Changs in th Currnt Exchang Rat Affct Expctd Rturns As a first stp in undrstanding how th forign xchang markt finds its quilibrium, w xamin how changs in today s xchang rat affct th xpctd rturn on a forign currncy dposit whn intrst rats and xpctations about th futur xchang rat do not chang. Our analysis will show that, othr things qual, dprciation of a country s currncy today lowrs th xpctd domstic currncy rturn on forign currncy dposits. Convrsly, apprciation of th domstic currncy today, all ls qual, raiss th domstic currncy rturn xpctd of forign currncy dposits. It is asist to s why ths rlationships hold by looking at an xampl: How dos a chang in today s dollar/uro xchang rat, all ls hld constant, chang th xpctd rturn, masurd in trms of dollars, on uro dposits? Suppos that today s dollar/uro rat is $1.00 pr uro and that th xchang rat you xpct for this day nxt yar is $1.05 pr uro. Thn th xpctd rat of dollar dprciation against th uro is ( )/1.00 = 0.05, or 5 prcnt pr yar. This mans that whn you buy a uro dposit, you not only arn th intrst R but also gt a 5 prcnt bonus in trms of dollars. Now suppos that today s xchang rat suddnly jumps up to $1.03 pr uro (a dprciation of th dollar and an apprciation of th uro) but that th xpctd futur rat is still $1.05 pr uro. What happns to th bonus you xpctd to gt from th uro s incras in valu in trms of dollars? Th xpctd rat of dollar dprciation is now only ( )/1.03 = 0.019, or 1.9 prcnt instad of 5 prcnt. Sinc R has not changd, th dollar rturn on uro dposits, which is th sum of R and th xpctd rat of dollar dprciation, has falln by 3.1 prcntag points pr yar (5 prcnt 1.9 prcnt). In Tabl 14-4 w work out th dollar rturn on uro dposits for various lvls of today s dollar/uro xchang rat, always assuming that th xpctd futur xchang rat rmains fixd at $1.05 pr uro and th uro intrst rat is 5 prcnt pr yar. As you can s, a ris in today s dollar/uro xchang rat (a dprciation of th dollar against th uro) always lowrs th xpctd dollar rturn on uro dposits (as in our xampl), whil a fall in today s dollar/uro xchang rat (an apprciation of th dollar against th uro) always raiss this rturn.

20 CHAPTER 14 Exchang Rats and th Forign Exchang Markt: An Asst Approach 339 TABLE 14-4 Today s Dollar/Euro Exchang Rat Today s Dollar/Euro Exchang Rat and th Expctd Dollar Rturn on Euro Dposits Whn = $1.05 pr Euro Intrst Rat on Euro Dposits Expctd Dollar Dprciation Rat Against Euro Expctd Dollar Rturn on Euro Dposits R R It may run countr to your intuition that a dprciation of th dollar against th uro maks uro dposits lss attractiv rlativ to dollar dposits (by lowring th xpctd dollar rturn on uro dposits) whil an apprciation of th dollar maks uro dposits mor attractiv. This rsult will sm lss surprising if you rmmbr w hav assumd that th xpctd futur dollar/uro rat and intrst rats do not chang. A dollar dprciation today, for xampl, mans th dollar now nds to dprciat by a smallr amount to rach any givn xpctd futur lvl. If th xpctd futur dollar/uro xchang rat dos not chang whn th dollar dprciats today, th dollar s xpctd futur dprciation against th uro thrfor falls, or, altrnativly, th dollar s xpctd futur apprciation riss. Sinc intrst rats also ar unchangd, today s dollar dprciation thus maks uro dposits lss attractiv compard with dollar dposits. Put anothr way, a currnt dollar dprciation that affcts nithr xchang rat xpctations nor intrst rats lavs th xpctd futur dollar payoff of a uro dposit th sam but raiss th dposit s currnt dollar cost. This chang naturally maks uro dposits lss attractiv rlativ to dollar dposits. It may also run countr to your intuition that today s xchang rat can chang whil th xchang rat xpctd for th futur dos not. W will indd study cass latr in this book whn both of ths rats do chang at onc. W nonthlss hold th xpctd futur xchang rat constant in th prsnt discussion bcaus that is th clarst way to illustrat th ffct of today s xchang rat on xpctd rturns. If it hlps, you can imagin w ar looking at th impact of a tmporary chang so brif that it has no ffct on th xchang rat xpctd for nxt yar. Figur 14-3 shows th calculations in Tabl 14-4 in a graphic form that will b hlpful in our analysis of xchang rat dtrmination. Th vrtical axis in th figur masurs today s dollar/uro xchang rat and th horizontal axis masurs th xpctd dollar rturn on uro dposits. For fixd valus of th xpctd futur dollar/uro xchang rat and th uro intrst rat, th rlation btwn today s dollar/uro xchang rat and th xpctd dollar rturn on uro dposits dfins a downward-sloping schdul. Th Equilibrium Exchang Rat Now that w undrstand why th intrst parity condition must hold for th forign xchang markt to b in quilibrium and how today s xchang rat affcts th xpctd rturn on forign currncy dposits, w can s how quilibrium xchang rats ar dtrmind. Our main conclusion will b that xchang rats always adjust to maintain intrst parity. W continu to assum that th dollar intrst rat R $, th uro intrst rat R, and th xpctd futur dollar/uro xchang rat ar all givn.

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