1 Slides for Krugman and Obstfeld Chapter 13 Alan G. Isaac American University
2 Preview Introduction to Exchange Rates Introductory Concepts International Financial Markets Basics exchange rate concepts Exchange rates and the cost of foreign goods The foreign exchange markets The demand for currency deposits and other assets A model of foreign exchange markets effect of interest rates on currency deposits effect of expectations of exchange rates
3 What Is An Exchange Rate? Introductory Concepts International Financial Markets Exchange Rate: The price of one currency in terms of another currency The number of units of the quote currency it takes to buy one unit of the base currency USD-EUR 0.7 USD is base currency; EUR is quote currency quote is in euros per dollar terms ( dollar terms ) EUR-USD 1.5 EUR is base currency; USD is quote currency quote is in dollars per euro terms ( European terms )
4 Direct Rate vs. Indirect Rate Introductory Concepts International Financial Markets Direct rate: domestic currency per unit of foreign currency. in US, 1.5 USD per EUR in US, EUR-USD 1.5 Indirect rate: foreign currency per unit of domestic currency in US, 0.7 EUR per USD in US, USD-EUR 0.7 We will use the direct rate.
5 Cost of Foreign Goods Introductory Concepts International Financial Markets In 2010, the Mercedes-Benz SLS AMG cost about EUR 150k. What was the dollar cost? Exchange rate (dollar terms): EUR-USD 1.3 Foreign price: EUR 150K Domestic price: (exchange rate) x (foreign price) (USD 1.3/EUR) x EUR 150k = USD 195k Exchange rates allow easier cost comparisons express prices in a common currency
6 EUR-USD Introduction to Exchange Rates Introductory Concepts International Financial Markets Source: series/exuseu?cid=95
7 Depreciation and Appreciation Introductory Concepts International Financial Markets Depreciation a fall in the exchange value of a currency. E rises (direct rate!) lowers (cet. par.) the price of our goods relative to the price of foreign goods. Appreciation a rise in the exchange value of a currency. E falls (direct rate!) raises (cet. par.) the price of our goods relative to the price of foreign goods.
8 Depreciation and Appreciation (cont.) Introductory Concepts International Financial Markets A depreciated currency is less valuable: it buys a smaller amount of foreign currency. Example: EUR-USD 1.0 -> EUR-USD 1.50 the dollar has depreciated relative to the euro. The dollar is less valuable. Equivalently, the euro has appreciated relative to the dollar: the euro is now more valuable. Given foreign prices, it can also buy fewer foreign produced goods. How much does a Honda cost? 3,000,000 3,000,000 x $0.0098/ 1 = $29,400 3,000,000 x $0.0100/ 1 = $30,000 Depreciation -> imports are more expensive and domestically produced goods and exports are relatively less expensive.
9 USD-JPY Introduction to Exchange Rates Introductory Concepts International Financial Markets Source: series/exjpus?cid=95
10 USD-CAD Introduction to Exchange Rates Introductory Concepts International Financial Markets Source: series/excaus?cid=95
11 Depreciation in Iceland Introductory Concepts International Financial Markets
12 Foreign Exchange Markets Introductory Concepts International Financial Markets 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. The daily volume of foreign exchange transactions was $4T in 2010 (vs. $3.2T in 2007) About 85% of transactions involved the USD USD-EUR transactions are just over 1/4 of the total Source:
13 Currency Composition Introductory Concepts International Financial Markets
14 Introductory Concepts International Financial Markets Foreign Exchange Market Participants 1 Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. 2 Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. 3 Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. 4 Central banks: conduct official international reserves transactions.
15 Global Foreign Exchange Turnover Introductory Concepts International Financial Markets
16 Foreign Exchange Markets (cont.) Introductory Concepts International Financial Markets 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. Central banks sometimes intervene, but the direct effects of their transactions are small and transitory in many countries.
17 Introductory Concepts International Financial Markets Arbitrage in Foreign Exchange Markets Arbitrage buying at a low price and selling at a high price for a profit. When other factors are the same, people will buy assets in New York and stop buying them in Hong Kong, so that their price in New York rises and their price in Hong Kong falls, until they are equal in the two markets. Computer and telecommunications technology transmit information rapidly and have integrated markets. The integration of markets implies that there are no significant arbitrage opportunities between markets.
18 Triangular Arbitrage Introduction to Exchange Rates Introductory Concepts International Financial Markets Suppose geographical arbitrage equates bilateral exchange rates in all centers Q: Are any arbitrage opportunities left? A: Possibly a synthetic cross rate differs. An imaginary opportunity.
19 Spot Rates and Forward Rates Introductory Concepts International Financial Markets Spot rate exchange rate for currency exchanges on the spot ; trading is executed in the present. Forward rate exchange rate for currency exchanges that will occur at a future ( forward ) date. Forward dates are typically 30, 90, 180, or 360 days in the future. Rates are negotiated between two parties in the present but the future present, exchange occurs in the future.
20 Introductory Concepts International Financial Markets Fig. 13-1: Spot and Forward Exchange Rates GBP-USD day forward and spot exchange rates (end of month). Source: KO Figure 13-1 (Data Source: Datastream).
21 Covered Introductory Concepts International Financial Markets R = R* + (F - E)/E where E is the spot (direct) exchange rate, F is the forward exchange rate, R is the domestic interest rate, and R* is the foreign interest rate. Covered interest parity relates interest rates across countries and the rate of change between forward exchange rates and the spot exchange rate: 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.
22 Introductory Concepts International Financial Markets Other Methods of Currency Exchange Foreign exchange swaps: a combination of a spot sale with a forward repurchase. Swaps often result in lower fees or transactions costs because they combine two transactions, and they allow parties to meet each others needs for a temporary amount of time. Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date. Contracts can be bought and sold in markets, and only the current owner is obliged to fulfill the contract.
23 Introductory Concepts International Financial Markets Other Methods of Currency Exchange Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. 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 arises.
24 Nondeliverable Forward Contracts Introductory Concepts International Financial Markets Non-deliverable forward (NDF) contract: counterparties settle the difference cash settled : only difference flows contracted price vs. fixing price fixing price is usu. realized spot rate traded over-the-counter (OTC) direct trade between two parties (vs. trading on an exchange) offshore nondeliverable forward markets: NY (esp Latin America), London, Hong Kong, Singapore
25 Nondeliverable Forward Exchange Introductory Concepts International Financial Markets NDF market grew significant in early 1990s Initally mostly Latin American currencies NDFs are often a response to capital controls Some countries restrict foreign ownership of domestic deposits E.g., China restricts foreign ownership of renminbi deposits ISO: CNY; common: RMB; Latinized symbol:
26 CNY Nondeliverable Forwards Introductory Concepts International Financial Markets
28 Example: CNY NDF Introduction to Exchange Rates Introductory Concepts International Financial Markets 10 Sep 2010 PBoC fixes mid-point at USD-CNY Sep 2010 USD-CNY (spot) vs predicted by the NDF market a year before USD-CNY (12 month NDF) 12-month implied yuan appreciation: 1.74% ( )/ = -1.74% CCN%2B12M:IND#chart
29 Rate of Return Introduction to Exchange Rates Rate of return the percentage change in value that an asset produces during a time period. Real rate of return inflation-adjusted rate of return, approximately (interest rate - inflation) the addition to purchasing power (control over goods & services) Example: $1000 saving deposit, R=2%/yr, inflation = 1%/yr After 1 year the deposit is worth $1000 x 1.02 = $1020 So its rate of return is ($ $1000)/$1000 = 2%/yr The real rate of return is (approximately): 2% - 1.0% = 1.0%
30 The Demand for A rise in P reduces the goods and services controlled by a given nominal wealth. Suppose the inflation rate is 0%. Then prices are fixed, 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 reasonable assumption to make for the short run.
31 The Demand of (cont.) Other factors influence the demand for assets: Risk The volatility of real wealth Liquidity the ease with which one can turn the asset into goods and services We assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination. That is, risk and liquidity are of secondary importance to individuals deciding to buy or sell currency deposits. Investors in currency deposits are primarily concerned about the rates of return.
32 The Demand for (cont.) Rates of return that investors expect to earn are determined by interest rates that the assets will earn expectations about appreciation or depreciation Domestic currency assets: expected return is just R Foreign currency assets: expected return is R* + expected depreciation of the domestic currency To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider the interest differential the expected rate of depreciation (or appreciation) of the domestic currency.
33 Summary: Demand for Influences on the demand for deposits Deposits Risk Liquidity Expected rate of return we will emphasis this for now bear interest (at annual rate) denominated in domestic or foreign currency Foreign currency deposits additionally have capital gains or losses Exchange-rate risk
34 Dollar and Yen Interest Rates (3 month rates, annualized) Source: KO Fig 13-2 (Original Data Source: Data Stream)
35 The Demand for (cont.) Suppose R = 1%/yr and R* = 2%/yr. Does a euro deposit yield a higher expected rate of return? To answer this, we must consider the expected change in the value of a euro. Suppose today the exchange rate is EUR-USD 1.5, and the expected rate one year in the future is EUR-USD 1.3. USD 150 can be exchanged today for EUR 100. These EUR 100 will yield EUR 102 after one year. These EUR 102 are expected to be worth (1.3 USD/EUR) EUR 102 = USD in one year. Clearly USD from investing at home is better than USD from investing abroad. The return is higher on domestic assets, despite the higher interest rate abroad.
36 The Demand for (cont.) Recap R = 1%. R* = 2% E = 1.50 Ee = 1.30 The rate of return from investing domestically is simply the interest rate, R=0.01=1%. The expected rate of return from investing abroad ( )/150 = = -11.6%. The euro deposit has higher interest rate but a lower expected rate of return. All investors should be willing to hold dollar deposits and none should be willing to hold euro deposits.
37 The Demand for (cont.) We simplify the analysis by saying that the dollar rate of return on euro deposits approximately equals: the interest rate on euro deposits plus the expected rate of appreciation of euro deposits 2% % = -11.3% (which is approximately our -11.6%) Return on foreign currency deposits: R* + (Ee - E)/E
38 The Demand for (cont.) The expected rate of return on euro deposits is R + E e E E interest rate on euro deposits, plus expected rate of depreciation of the dollar expected exchange rate current exchange rate
39 Model of Foreign Exchange Markets (cont.) How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits?
40 Model of Foreign Exchange Markets (cont.) Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why? When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits. Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. Why? When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby raising the expected rate of return of foreign currency deposits.
41 Exchange Rate and Asset Return Case E E e E E R + E e E E % -3.0% % -1.0% % 1.0% % 3.0% % 5.0% Constants: R = 1.0%, E e =1.33
42 The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits Current Exchange Rate Expected USD Return on EUR Currency when E e = 1.33 Compare with KO 8 Fig. 13-3
43 Equilibrium in the FX Market Equilibrium in the market for foreign exchange requires equal desirability of competing assets. Interest parity comparable assets must bear comparable rates of return R = R* + (Ee-E)/E where expected return on dollar denominated deposits: R expected return on foreign currency denominated deposits: R* + (Ee-E)/E Interest parity implies that deposits in various currencies are equally desirable. Interest parity is the basic component of our first model of foreign exchange markets.
44 Model of Foreign Exchange Markets (cont.) Interest parity says: R = R* + (Ee - E)/E Why should this condition hold? Suppose it didn t. Suppose R > R* + (Ee - E)/E Then no investor would want to hold euro deposits, driving down the demand and price of euros. 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:
45 Equilibrium in the FX Market E E 1 R returns Note: compare KO 8 Fig 13-4
46 Equilibrium in the FX Market E E 1 R + Ee E E R returns Note: compare KO 8 Fig 13-4
47 Equilibrium in the FX Market E E 1 R + Ee E E R returns Note: compare KO 8 Fig 13-4
48 Model of Foreign Exchange Markets Effect of changing R: 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 causes the dollar to appreciate. Higher interest rates on euro-denominated assets causes the dollar to depreciate
49 Effect of a Rise in the Domestic Interest Rate E E 1 E 2 R + Ee E E R 1 R 2 returns Note: compare KO 8 Fig 13-5
50 A Rise in the R* Introduction to Exchange Rates E E 2 R 2 + Ee E E E 1 R R 1 + Ee E E returns Note: compare KO 8 Fig 13-6
51 Appreciation of the Expected Euro 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 actual appreciation (a self-fulfilling prophecy). An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy).
52 A Rise in the Ee Introduction to Exchange Rates E E 2 R 1 + Ee 2 E E E 1 R R 1 + Ee 1 E E returns
53 Summary Introduction to Exchange Rates exchange rate (direct rate) the domestic-currency price of foreign exchange. foreign exchange interest-bearing deposits foreign currencies. (for the most part) spot exchange rate a contracted rate at which foreign exchange will be bought on sold on the spot. forward exchange rate a contracted rate at which foreign exchange will be bought on sold on a future date. By foreign exchange we primarily mean interest-bearing deposits foreign currencies.
54 Summary (cont) Introduction to Exchange Rates Depreciation (of the domestic currency) E (direct rate) rises; the currency becomes less valuable. Goods priced in it (e.g., our exports) become relatively less expensive. Imports become relatively expensive. A depreciation hurts consumers (who buy imports) but helps exporters. Appreciation (of the domestic currency) E (direct rate) falls; the currency becomes more valuable. Goods priced in it (e.g., our exports) become relatively expensive. Imports become relatively cheap. An appreciation helps consumers (who buy imports) but hurts exporters.
55 Summary (cont) Introduction to Exchange Rates The primary players in the market for foreign exchange are commercial and investment banks. Their arbitrage activities ensure interest parity holds: comparable assets should bear comparable rates of return. This implies covered interest parity. Ignoring risk factors, this implies uncovered interest parity.
56 Summary (cont) Introduction to Exchange Rates Covered interest parity R = R* + (F - E)/E the rate of return on domestic currency deposits must equal the rate of return on covered foreign currency deposits. Foreign currency deposits can be covered with a forward exchange contract. Uncovered interest parity R = R* + (Ee - E)/E Expected rates of return on foreign and domestic currency deposits are equal Expected rates of return on currency deposits and determined by interest rates and expected exchange rates.
57 Summary (cont) Introduction to Exchange Rates An increase in the domestic interest rate (an increase in its expected rate of return) leads to an appreciation of the domestic currency. An increase in the expected future exchange rate lead to a depreciation of the domestic currency.
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