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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 2
Exchange rates in the short run
• The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates.
• In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 3
Comparing expected returns across nations
• We consider Euroland the “home country”, and the domestic currency €.
• The USA are the “foreign country” with the foreign currency $.
Euro deposits bearan interest rate i€.
Dollar deposits bearan interest rate i$.
How does Hans, the European, compare the return on dollar deposits abroad
with the return on domesticinvestments in € ?
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 4
Comparing expected returns across nations
• If Hans invests in the USA, he must realize that his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €.
• If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 5
Comparing expected returns across nations
• More formally
€
RET$(€) = i$ −w e t+1 −wtwt
€
Differential RET (€) = i€ − (i$ −w e t+1 −wtwt
)
= i€ − i$ +w e t+1 −wtwt
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 6
Comparing expected returns across nations
• If Bill invests in Euroland, he must realize that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $.
• If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€ ), then the expected return is 3% + 10% = 13%.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 7
Comparing expected returns across nations
• More formally
€
RET€($) = i€ +w e t+1 −wtwt
€
Differential RET ($) = i$ − (i€ +w e t+1 −wtwt
)
= i$ − i€ −w e t+1 −wtwt
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 8
The key point:
RET$ and RET€ are symmetrical (with opposite sign)
As the relative expected return on €-deposits increases, both domestic and foreign residentsrespond in the same way: they want to holdmore €-deposits and fewer deposits in $.€
- Differential RET ($){ } = − i$ − i€ −
w e t+1 −wtwt
⎧ ⎨ ⎩
⎫ ⎬ ⎭
= i€ − i$ +w e t+1 −wtwt
€
Differential RET (€) = i€ − i$ +w e t+1 −wtwt
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 9
Interest parity condition
• At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk.
• When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:
€
i€ = i$ −w e t+1 −wtwt
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 10
Why? Arbitrage and liquidity trading
• Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 11
Market adjustment: Examples
We assume: i$ = 10%, and wet+1 = 1 $/€.
• When wt = 1.0 $/€, the expected appreciation/ depreciation of the € = 0% and the expected return in € is then equal to i$ = 10% (Point B).
• When wt = 0.95 $/€, wet = 0.052 =5.2%, and the
expected return in € = 4.8% (Point A).
• When wt = 1.05 $/€, wet = -0.048 =-4.8%, and the
expected return in € = 14.8% (Point C).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 12
Equilibrium in forex markets
wt ($/€)
1.00
1.05
0.95
Expected return (€)
RET€ RET$
A
10%5.2% 14.8%
B
C
D
E
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 13
What happens in disequilibrium
• When w ≠ 1.0, there is a market reaction:
– w > 1: People will try to sell € and buy $.=> “Selling €” and “buying $”
– But no one holding $ will sell at that price, there is “excess supply” of euros;i.e. the price of €-deposits relative to $-deposits must fall.
– The amount of dollars per euro falls, the euro depreciates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 14
What happens in disequilibrium
• When :
– w < 1: People will try to sell $ and buy €.=> “Selling $” and “buying €”
– But no one holding € will sell at that price, there is “excess supply” of dollars;i.e. the price of $-deposits relative to €-deposits must fall.
– The amount of dollars per euro increases, the euro appreciates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 15
Change in the foreign interest rate
• If the foreign interest rate increases, the expected return RET$ also increases.
• This leads to a depreciation of the euro.
• The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 16
Equilibrium in forex markets
wt ($/€)
wB
Expected return (€)
RET€ RET$
iD
B
C
RET$
wC
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 17
Change in the domestic interest rate
• An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET€ schedule to the right.
• It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 18
Equilibrium in forex markets
wt ($/€)
wB
Expected return (€)
RET€ RET$
i€B
B
CwC
RET€
i€C
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 19
What about inflation ?
• If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific
• Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate.
• On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 20
Factors that affect the exchange rate
Domestic interest rate
Foreign interest rate
Price expectations (D/F)
Expected import demand
Expected export demand
Expected productivity (D/F)
Change invariable
Exchange rate change
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 21
The analysis of forex markets
Paul Bernd SpahnPaul Bernd SpahnPaul Bernd Spahn
EuroEuroEuro
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 22
Volume of forex transactions, in bill.$
Share of financial innovations
Daily, month of April
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 23
Forex turnover by currency pairs (in per cent)
¥
$ € Other
€ 30
20 3
£ 11 2
SFr 5 1
Other 25 2 2
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 24
Forex transactions by market place (April 2001)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 25
Actors in forex markets
Volume of trading by groups of actorsB
ill.
US
dollars
per
day
With traders
With non-financial institutions
With other financial institutions
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 26
The forex market is highly concentrated
Citygroup 9,74
Deutsche Bank 9,08
Goldman Sachs 7,09
JP Morgan 5,22
Chase Manhattan Bank 4,69
Credit Suisse First Boston 4,10
UBS Warburg 3,55
State Street Bank & Trust 2,99
Bank of America 2,99
Morgan Stanley Dean Witter 2,87
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 27
And will be concentrated even more …
• Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology.
• On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 28
Short and long run: the $/DEM-market
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