Chapter 13 The Foreign Exchange Market. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-2 Chapter Preview In this chapter, we develop

Chapter 13

The ForeignExchangeMarket

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-2

Chapter Preview

• In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include:

– Foreign Exchange Market

– Exchange Rates in the Long Run

– Exchange Rates in the Short Run

– Explaining Changes in Exchange Rates


What are Foreign Exchange Rates?

Two kinds of exchange rate transactions make up the foreign exchange market:

– Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate.

– Forward transactions involve exchanges at some future date, completed at the forward rate.


Why Are Exchange Rates Important?

• When the currency of your country appreciates relative to another country, your country's goods prices abroad and foreign goods prices in your country.

1. Makes domestic exporters less competitive

2. Makes domestic importers more competitive

3. Benefits domestic consumers (you)


How is Foreign Exchange Traded?

• FX traded in over-the-counter market1. Most trades involve buying and selling bank

deposits denominated in different currencies.

2. Trades in the foreign exchange market involve transactions in excess of $1 million.

3. Typical consumers buy foreign currencies from retail dealers, such as American Express.

• FX volume exceeds $3 trillion per day.


Exchange Rates in the Long Run

• Exchange rates are determined in markets by the interaction of supply and demand.

• An important concept that drives the forces of supply and demand is the Law of One Price.


Exchange Rates in the Long Run: Law of One Price

• The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.

• Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.


If E = 50 yen/$ then price are:

American Steel Japanese Steel

In U.S. $100 $200

In Japan 5000 yen 10,000 yen

Exchange Rates in the Long Run: Law of One Price

• Law of one price E = 100 yen/$

If E = 100 yen/$ then price are:

American Steel Japanese Steel

In U.S. $100 $100

In Japan 10,000 yen 10,000 yen


Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)

• The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels.

• PPP Domestic price level 10%, domestic currency 10%

– Application of law of one price to price levels

– Works in long run, not short run


Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)

• Problems with PPP

1. All goods are not identical in both countries (i.e., Toyota versus Chevy)

2. Many goods and services are not traded (e.g., haircuts, land, etc.)

3. Transportation costs and tarrifs


Exchange Rates in the Long Run: PPP


Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run

• Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate

• The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity.



• Relative price levels: a rise in relative price levels cause a country’s currency to depreciate.

• Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate.



• Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate.

• Productivity: if a country is more productive relative to another, its currency appreciates.



• The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.




Exchange Rates in the Short Run

• In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits.

• Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand.


Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets

• We will illustrate this with a simple example

• François the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.



• Al the American has a similar problem. He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.


Re for François Re for Al

$ Deposits iD Et1

e Et Et

iD

F Deposits iF iD Et1

e Et Et

Relative Re iD iF Et1

e Et Et

iD iF Et1

e Et Et

Exchange Rates in the Short Run: Expected Returns and Interest Parity



• What this shows is simple. As the relative expected return on dollar assets increases (decreases), both François and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets.

• This leads us to our formal title for what is going on here: Interest Parity


iD iF Et1

e Et

EtExample: if iD = 6% (US interest rate) and iF = 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency?


• Interest Parity Condition– $ and F deposits perfect substitutes

(2)

%3%)3%6(1

t

tet

E

EE


Several things to recognize about the interest rate parity condition:•Expected returns are the same in both dollars and foreign assets•Equilibrium condition for the foreign exchange market

Next, we will develop supply/demand curves to explain how the exchange rate is determined.




• To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF.

• Next, we must determine the expected return in terms of dollars on dollar deposits, RD.


Deriving the Demand Curve

• The demand curve connects these points and is downward sloping because when Et is higher, expected appreciation of the dollar is higher.

Assume iF = 5%, Eet+1 = 1 euro/$

Point

A: Et = 1.05 (1.00 – 1.05)/1.05 = -4.8%

B: Et = 1.00 (1.00 – 1.00)/1.00 = 0.0%

C: Et+1 = 0.95 (1.00 – 0.95)/0.95 = 5.2%

• The demand curve is related to:

t

tetFD

E

EEii

1


Deriving the Supply Curve

• Deriving the Supply Curve

– There isn’t really anything to derive. We will take the quantity of bank deposits, bonds, and equities as fixed with respect to exchange rates.


Exchange Rates in the Short Run: Equilibrium

• Equilibrium– Supply = Demand at E*

– If Et > E*, Demand < Supply, buy $, Et

– If Et < E*, Demand > Supply, sell $, Et

• The following figure illustrates this.


Exchange Rates in the Short Run: Equilibrium


Explaining Changes in Exchange Rates

• To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits.

• We will examine these separately, as well as changes in the money supply and exchange rate overshooting.


Explaining Changes in Exchange Rates: Increase in iD

1. Demand curve shifts right when– iD : because

people want to hold more dollars

2. This causes domestic currency to appreciate.


Explaining Changes in Exchange Rates: Increase in iF

1. Demand curve shifts left when– iF : because

people want to hold fewer dollars

2. This causes domestic currency to depreciate.


etE 1

Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates

1. Demand curve shifts left when– : because

people want to hold more dollars

2. This causes domestic currency to appreciate.


Explaining Changes in Exchanges Rates

• Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing

– Expected fall in relative U.S. price levels

– Expected increase in relative U.S. trade barriers

– Expected lower U.S. import demand

– Expected higher foreign demand for U.S. exports

– Expected higher relative U.S. productivity

• These are summarized in the following slides.

etE 1

Explaining Changes in Exchanges Rates

Explaining Changes in Exchanges Rates (cont.)


Applications

Our analysis allows us to take a look at the response of exchange rates to a variety of macro-economic factors. For example, we can use this framework to examine (1) the impact of changes in interest rates, and (2) the impact of money growth.


Application: Interest Rate Changes

• Changes in domestic interest rates are often cited in the press as affecting exchange rates.

• We must carefully examine the source of the change to make such a statement. Interest rates change because either (a) the real rate or (b) the expected inflation is changing. The effect of each differs.



• When the domestic real interest rate increases, the domestic currency appreciates. We have already seen this situation in Figure 4 (slide 37).

• When the domestic expected inflation increases, the domestic currency reacts in the opposite direction – it depreciates. This is shown on the next slide.


Explaining Changes in Exchange Rates: Response to i Because πe



• Changes in domestic money supply are a bit more complicated. We summarize the results on the next slide. However, you may want to read the text on this section to fully digest the effects.

Explaining Changes in Exchange Rates: Changes in the Money Supply

1. Ms , P , Eet+1 ,

shifting demand curve from D1 to D2.

2. In long run, iD returns to old level, and demand shifts from D2 to D3 (exchange rate overshooting)


Exchange rate volatility

• Exchange rate overshooting is important because it helps explain why foreign exchange rates are so volatile.

• Another explanation deals with changes in the expected appreciation of exchange rates. As anything changes our expectations (price levels, productivity, inflation, etc.), exchange rates will change immediately.


Applications

Our analysis also allows us to take a look at the weak dollar in the 1980s, and (partially) explain why it became stronger in the 1990s and 2000s. We present a summary in Figure 9, on the next slide.

Daily foreign exchange ratehttp://quotes.ino.com/exchanges/?e=FOREX

The Dollar and Interest Rates

1. Value of $ and real rates rise and fall together, as theory predicts

2. No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises

http://quotes.ino.com/exchanges/?e=FOREX

http://quotes.ino.com/exchanges/?e=FOREX


Case: The Euro’s First Nine Years

• The euro debuted in 1999 at $1.18 / euro. It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of 2007.

• Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro.


The Practicing Manger: Profiting from FX Forecasts

• Forecasters look at factors discussed here

• FX forecasts affect financial institutions managers' decisions

• If forecast euro appreciate, yen depreciate, – Sell yen assets, buy euro assets

– Make more euros loans, less yen loans

– FX traders sell yen, buy euros

Documents

Chapter 13 The Foreign Exchange Market. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-2 Chapter Preview In this chapter, we develop