Asset Market Approach : PAKISTAN

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Chapter 13

Asset-Market Approach to the

Exchange Rate

To understand short-run exchange rate behavior, it is important to recognize that foreign-exchange

market activity is dominated by investors in assets such as Treasury securities, corporate bonds,

bank accounts, stocks and real property. Today, only about 2 percent of all foreign exchange transac-

tions are related to the financing of exports and imports. This suggests that most foreign-exchange

transactions are attributable to assets being traded in global markets. We take this attribute of

the foreign exchange market into account, and will set up a short-run exchange rate model that

focuses on investors’ decisions to purchase assets internationally. The model is appropriately called

an asset-market approach to the exchange rate

13.1 Asset-Market Approach to the Exchange Rate

Investors make their financial decisions by comparing the rates of return of foreign investment with

those of domestic investment. If rates of return from foreign investment are larger, they will desire

to shift their funds abroad. Interest arbitrage refers to the process of moving funds into foreign

currencies to take advantage of higher investment yields abroad. But investors assume a risk when

they have foreign investments: when the investment’s proceeds are converted back into the home

currency, their value may fall because of a change in the exchange rate.

Example. Suppose you have $100,000 and want to decide if you want to invest in a dollar-

denominated asset or a euro-denominated asset for a year. To see which asset you want to buy,you need to calculate the rate of return for both assets. You will then choose the currency with

the highest rate of return.

Let’s first calculate the rate of return to the dollar-denominated asset. Suppose that the interest

rate for the dollar-denominated assets is 10%. This implies that if you invest your money into

the dollar-denominated assets, your dollar-denominated asset will be worth $100,000*(1+0.1) =

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$110,000 in a year. In other words, the rate of return to the dollar-denominated asset will equal

the U.S. interest rate.

Next, we want to calculate the rate of return to the euro-denominated asset. The rate of return

on the euro-denominated asset will not only depend on the interest rate on the euro-denominated

asset (8%), but also on the expected change in the currency’s exchange rate. To demonstrate this,

we need to take a number of steps:

1. Convert $100,000 into euros at the current exchange rate of E euro$

= 0.8. This will give you

$100,000 * 0.8 euro/$ = 80,000 euro.

2. With an interest rate of 8%, the euro-denominated asset will be worth euro 80,000*(1+0.08)

= euro 86,400 after a year.

3. The final worth of the euro-denominated asset needs to be reconverted into dollars. Suppose

that the dollar is expected to depreciate from 1.3 to 1.354 in a year (depreciation of 4%). Inthat case, the euro-denominated asset will be worth euro 86,400 * $/euro 1.354 = $116,985.6.

Investing in euro assets is clearly more profitable than investing in dollar assets, since you receive

$116, 985.6− $10, 000 = $6, 985.6 more from doing so.

In conclusion, despite the fact that the interest rate on U.S. deposits is higher than that of European

deposits, the rate of return of holding your money in Euro deposits for a year is higher than that

of holding it in dollar deposits. The reason is that the depreciation of the dollar has increased the

rate of return of holding money in euros.

13.1.1 Simple Rule

The dollar rate of return on dollar deposits is the US interest rate:

(13.1) Rate of return on dollar-denominated assets = RUS

The dollar rate of return on euro deposits is approximately the euro interest rate plus the expected

rate of depreciation of the dollar against the Euro:

(13.2) Rate of return on dollar-denominated assets = REU +(E e$/euro− E $/euro)

E $/euro

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13.2 Equilibrium in the Foreign Exchange Market: Interest Parity

If RUS > REU +(E e

$/euro−E $/euro)

E $/euro, dollar deposits yield the higher expected rate of return and

investors buy dollar deposits.

If RUS < REU +(E e

$/euro

−E $/euro)

E $/euro , euro deposits yield the higher expected rate of return and investorsbuy euro deposits.

We have already mentioned above that the foreign exchange market is efficient. Foreign exchange

traders arbitrage away all differences in the rate of return of different currencies. As a result, the

foreign exchange market is in equilibrium when deposits of all currencies offer the same expected

rate of return. Only in that case is there no excess supply of some type of deposit and no excess

demand of another. This is the interest parity condition .

(13.3) RUS = REU + (E

e

$/euro−

E $/euro)E $/euro

The interest parity condition states that the foreign exchange market is in equilibrium when deposits

of all currencies offer the same expected rate of return.

13.3 Exchange Rate as the Equilibrating Force

So how does the interest parity condition find its equilibrium? As you might expect, the exchange

rate will be the equilibrating factor.

Suppose the interest parity condition does not hold. If RUS < REU +(E e

$/euro

−E $/euro)

E $/euro , then nobodywill want to continue to hold dollar deposits and everybody will want to hold Euro deposits. As a

result, investors will start selling dollars for euros in the foreign exchange market, thus inducing a

depreciation of the dollar until the interest parity condition holds again.

Exercise: What happens to the exchange rate if RUS > REU +(E e

$/euro−E $/euro)

E $/euro?

Exercise: What happens to the current exchange rate if investors suddenly expect a future depre-

ciation?

13.4 Graphical Representation of the Interest Parity Condition

In this section, we want to represent graphically the interest parity condition in such a way that we

can use it to discuss changes in the exchange rate. For this purpose, we will set up a graph in which

the exchange rate E $/euro is depicted on the Y-axis and the rate of return to assets is depicted on

the X-axis.

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A first thing we want to know if the relation between the exchange rate E $/euro and the rate of

return to U.S. assets. Since an exchange rate change has no impact on the the U.S. interest rate,

RUS , the rate of return to U.S. assets remains unchanged. We can therefore represent the rate of

return to U.S. assets curve as a vertical line at RUS .

Suppose that, all else equal, the dollar depreciates. What happens to the rate of return of euroassets? Since the expected exchange rate has not changed, the present depreciation actually leads

to an increase in the expected rate of appreciation. As a result, the rate of return of euro assets

goes down. There is therefore a negative relationship between the exchange rate E $/euro and the

rate of return of euro assets REU +(E e

$/euro−E $/euro)

E $/euro.

13.4.1 Graphical Representation

13.5 Comparative Statics

13.5.1 The Effect of Changing the US Interest Rates on the Current Exchange

Rate

An increase in the U.S. interest rate increases the rate of return of holding US deposits relative

to holding Euro deposits. This leads to an excess demand for US dollars and an excess supply of

Euros. As a result, the dollar appreciates.

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13.5.2 The Effect of Changing the European Interest Rates on the Current

Exchange Rate

Euro weaker after rate cut

BBC - May 11, 2001

The euro fell to three-week lows against the US dollar on Friday after the European Central Bank

(ECB) surprised the markets and cut interest rates by a quarter point to 4.5% the day before.

Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut

July 15, 2003

Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut. The Canadian Dollar

has fallen almost a cent today against the U.S. Dollar after the quarter of a percent interest rate

cut.

A decrease in the EU interest rate reduces the rate of return of holding euro deposits relative to

holding dollar deposits. This leads to an excess demand for dollars and an excess supply of euros.As a result, the dollar appreciates.

General result: All else equal, an increase in the interest rate paid on deposits of a currency causes

that currency to appreciate against foreign currencies.

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13.5.3 The Effect of Changing Expectations on the Current Exchange Rate

Dollar Holds Near Strongest in Almost Seven Weeks Against Euro

December 23, 2004 (Reuters) — The dollar dropped to record lows against the euro on Thursday in

partly technically driven trading after a mixed batch of U.S. economic reports provided no motivationto buy the currency.

Dollar Holds Near Strongest in Almost Seven Weeks Against Euro

January 10, 2005 (Bloomberg) — The dollar traded near its strongest in almost seven weeks against

the euro in Asia on speculation the Bush administration will act to reduce the record U.S. deficits

amid signs of faster economic growth.

The U.S. currency drew support from comments on Jan. 7 by Treasury Secretary John Snow that

policy makers “want to do things to sustain the strength” of the dollar, in part by reducing the U.S.budget deficit. The dollar is also benefiting from expectations the Federal Reserve will raise interest

rates, widening the yield advantage over Europe.

Dollar Drops Against Euro, Yen After Trade Gap Widens to Record

January 12, 2005 (Bloomberg) — The dollar fell by the most in more than five weeks against the euro

and declined against the yen after the U.S. trade deficit unexpectedly grew to a record in November.

The dollar dropped 7.1 percent against the euro and 4.3 percent versus the yen last year on concern

the U.S. will fail to attract enough international investment to compensate for the shortfall in the

current account.

Dollar Heading for Biggest Weekly Gain in 11 Against Euro, Yen

March 25, 2005 (Bloomberg) – The dollar headed for its biggest winning week in 11 against both the

euro and the yen on speculation accelerating U.S. inflation will force the Federal Reserve to quicken

the pace of raising interest rates.

Dollar rises to 5-1/2-month high versus yen

April 4, 2005 (Reuters) – The dollar hit a fresh five-and-a-half month high against the yen on Monday

as the market shrugged off a poor U.S. jobs report and focused on the Federal Reserve’s plan to

keep lifting interest rates.

The dollar was initially dumped on Friday after a report showed the U.S. economy generated just

110,000 non-farm jobs last month, half of what economists had forecast.

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But the U.S. currency soon recovered as the market zeroed in on U.S. data that showed a slight rise

in hourly wages, as well as another report showing prices paid by manufacturers spiked in the same

month.

It found further support after Fed officials signalled they would keep lifting rates to fight off simmering

inflation pressures, with St. Louis Fed President William Poole suggesting on the weekend there wasa risk of higher inflation.

“As long as expectations for further U.S. rate hikes remain, it’s going to be a bit hard to dump the

dollar,” said Toshiaki Kimura, forex manager at Mitsubishi Trust and Banking Corp.

An expected appreciation of the dollar decreases the rate of return of holding euro deposits relative

to holding dollar deposits. This leads to an excess demand for dollars and an excess supply of

euros. As a result, the dollar appreciates.

We conclude that, all else equal, a rise in the expected future exchange rate causes a rise in the

current exchange rate. Similarly, a fall in the expected future exchange rate causes a fall in the

current exchange rate.

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Asset Market Approach : PAKISTAN