Types of Foreign Exchange Rates and Interest rate.docx

7/27/2019 Types of Foreign Exchange Rates and Interest rate.docx

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Types of Foreign Exchange Rates and Interest rate.

International Transactions and Currency Values

The Balance of Payments

Measures transactions in the current and capital accounts.

The Current Account

1. Merchandise trade - value of exports and imports2. Service balance - value of exports and imports of services.3. Unilateral Transfers - gifts and foreign aid to foreign interests.

The Capital Account

1. Short-term capital flows - purchase of financial assets in the money market with amaturity of less than one year. E.g. T-bills

2. Direct investments - refers to the purchase of property or the aquisition of ownershipshares in order to control a foreign business.

3. Portfolio investments - purchases of securities to hold in order to receive interest,dividends or capital gains.

Direct investments and portfolio investments represent purchases of stocks, bonds and other

financial assets with a maturity of over 1 year. - Capital market.

The BOP = 0

Since the U.S. runs a large current account deficit - over $200 billion in 1997 and expected to

reach nearly $300 billion in 1998, there is an offsetting capital account surplus (with a bit of a

fudge)

This makes the U.S. the world's largest debtor nation when looking at the difference between the

value of U.S. fiancial assets held by foreign investors and the value of foreign assets held by U.S.

investors.


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Foreign investors are attracted to U.S. financial markets because:

Develop production facilities in the U.S. to serve U.S. markets (reduce transporationcosts) and to avoid import tariffs and quotas (the average U.S. tariff on imports is about

3.5%). However, the U.S. is more restrictive on auto imports.

The U.S. is very stable politically and economically - this is a major attraction for foreigninvestors who can purchase U.S. Treasury debt with zero default risk.

If conditions change in the U.S. there could be the same capital flight that has plauged some of

the developing countries. In this case we could expect:

higher U.S. interest rates as the supply of loanable funds decreases A sharp devaluation of the dollar A reduction in the current account deficit as U.S. consumers purchase fewer foreign

goods since the dollar has devalued. And U.S. goods become cheaper abroad.

Exchange Rate Determination

Foreign exchange markets are amoung the largest markets in the world with an annual trading

volume in excess of $160 trillion

It is an over-the-counter market, with no central trading location and no set hours of trading.

Prices and other terms of trade are determined by computerized negotiation.

There are three markets for foreign exchange:

Spot market - deals with currency for immediate delivery (within one or two businessdays)

Forward market - involves the future (one, three or six months from today) delivery offoreign currency

Currency futures and options market - deals in contract to hedge against futurechanges in foreign exchange rates.


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Simple model of spot market exchange rates using supply and demand

Current Account Factors

Changes in relative inflation rates, Changes in tastes, Factors that determine comparative advantage.

Capital Account Factors

Changes in interest rates

Exchange rates can be

floating pegged floating peg

Floating exchange rates


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Exchange rates are also affected by specualation over future currency values. A currency that is

considered undervalued brings forth buy orders.

The Forward Market for Currencies

Investors, businesses and other involved in foreign currency markets may want to guarentee the

exchange rate that they will receive at some time in the future.

Take out a forward contract in the forward exchange market.

If the customer does not know if they will actually need the foreign currency, they can take out

an option forward contract.

Methods of measureing and quoting forward exchange rates:

Outright rate - defines an exchange rate (e.g. 100 = $1)

Express the forward rate as a premium or discount from the spot rate, know as the swap rate.

Express the forward rate as an annualized percentage rate above or below the current spot rate

Functions of the Forward Exchange Market

Commercial Covering

For transaction of goods and services that are to be delivered in the future.

e.g. U.S. importer of Japanese radios agrees to pay 1 million for the shipment upon receipt in 30

days.

if current spot rate is 100 = $1, and stays constant, then will cost importer $10,000

Importer faces the risk that the dollar will depreciate.

Takes out a 30-day forward contract for the delivery of 1 million at the forward market rate of

$.01/ (or 100 = $1).


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When the 1 million payment is due by the importer, the importer also takes delivery of the 1

million yen as given by the forward contract in exchange for $10,000. The

1 million is then used to pay for the radio shipment.

Hedging of an Investment Position

Suppose there is a U.S.-based mutual fund (e.g. The Japan Fund) that purchases Japanese stocks

and bonds for (primarily) U.S. investors.

The fund manager faces two types of risk:

market risk- the value of his or her assets will decline,

exchange rate risk- since the assets are denominated in yen, but the value of theseassets are reported in dollars, a depreciation of the yen will reduce the NAV of the

portfolio even if the yen value of the portfolio remains constant.

To reduce exchange rate risk, the fund manager can hedge with currency forwards.

Fund manager sells forward contracts of yen.

e.g. fear is that the yen will depreciate from 100 = $1

Managersells forward contracts worth 1 billion ($10m) at exchange rate of 100 = $1.

When this forward contract matures, if the spot price of the yen has depreciated to 120 = $1, the

fund can buy yen on the spot market and deliver them at the contract price of 100 = $1.

Will cost the fund manager $8.3 million to purchase 1 billion and then can sell yen for $10

million.

For a profit of $1.7 million on the foreign exchange transaction.

If the fund manager sells contracts in an amount that covers both principal and interest or

dividends, then the manager has "locked in" their investment return regardless of which way

exchange rates go.


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If instead the yen were to appreciate, the currency trading losses are offset by the increased

dollar value of the portfolio due to the yen's appreciation.

Speculation on Future Currency Prices

Speculators will buy currency for future delivery if they believe the spot rate will be higher on

the delivery date than at the current forward rate (appreciate).

Speculators will sell currency forward contracts if they believe the spot rate will be lower on the

delivery date than at the current forward rate (depreciate).

Covered Interest Arbitrage

Arises when an investor invests in foreign securities because the interest rate is higher than on

comparable domestic securities.

Covered Interest Arbitrage - reduce currency risk by using a forward contract.

Currency Futures

While forward contracts usually result in the actual delivery of the currency, futures contracts in

foreign currency are increasingly used. These contracts are typically zeroed out and the currency

is not delivered.

e.g. you buy one ton of pork belly futures, rather than taking delivery, you zero out the contract

by selling an opposite contract before the first contract matures.

Note that as currencies appreciate in the spot market, the market value of currency futures also

rise along with the market value of the underlying currency.

The Principle of Interest Rate Parity


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the net rate of return to the investor from any foreign investment is equal to the interest earned

plus or minus the forward premium or discount on the price of the foreign currency involved in

the transaction.

Under normal circumstances, the forward discount or premium on one currency relative to

another is directly related to the difference in interest rates between the two countries involved.

The currency of a nation with the higher market interest rates normally sells at a forward

discount in relation to the currency of the nation with lower interest rates.

The currency of a nation with the lower market interest rates normally sells at a forward

premium in relation to the currency of the nation with lower interest rates.

Interest rate parity exists when the interest rate differential between two nations exactly equals

the forward discount or premium of the two currencies.

When parity exists, the currency markets are in equilibrium and there is no net flow of capital

funds between the two countries seeking a higher return.

In this case, the higher return from interest rates abroad is fully offfset by the cost of covering

currency risk in the forward exchange market.

e.g. Interest rates in the U.S. are 3% higher than in Japan.

As a result, the dollar, when in equilibrium, sells at a 3% discount in the forward exchange

market. While the yen sells at a 3% premium.

In this case, once currency risk is covered, there is no yield benefit for Japanese investors to

purchase U.S. securities.

Unless, they also expected the prices of these U.S. securities to rise.

When interest rate parity does not exist, then there are international net capital flows.

**** e.g. Interest rates in the U.S. are 3% higher than in Japan.


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And the dollar sells at only a 1% discount in the forward exchange market.

Money flows from Japan to the U.S. as Japanese investors have a net return of 2% after covering

for exchange rate risk.

Also the $ appreciates relative to the yen due to the increased demand for dollars.

But if the dollar is considered overvalued, then expect it to depreciate back to normal value.

Fearing the dollars depreciation, Japanese investors are selling forward contracts on dollar,

increasing the discount on these contract and also increasing the premium on contracts to buy

yen.

Comparing Expected returns on domestic and foreign assets

Assume that the spot exchange rate is 100 = $1 and the expected exchange rate in one year

(EXe) is 105 = $1, a 5% increase in the value of the dollar.

Assume that the present yield on a one-year 100,000 Japanese government bond equals 5%.

If you buy this bond, the cost in dollars is $1,000 that is then converted to yen.

After one year, the value of the investment equals 105,000.

The expected dollar value of the investment is:

105,000/105 = $1,000

A general formula to compare total returns from investing $1 in a domestic or foreign asset.

Value of $1 investment after one year = EX ( 1 + if) / EXe

where:

i = interest rate on the domestic security


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if= interest rate on the foreign security EX = current exchange rate EXe = expected future exchange rate

in this example:

(100 = $1)(1.05) / (105 / $1) = $1.00

can rewrite the formula so it divides the return into two parts, interest and expected exchange

rate change:

Value of $1 investment after one year = 1 + if - (change)EXe / EX

in our example the expected change in the exchange rate was 5% as the yen depreciated from

100 = $1 to 105 = $1

Foreign-exchange Market Equilibrium

Would a situation in which investors could earn a higher expected rate of return from buying

Japanese rather than U.S. assets persist for a long time? The opportunity for traders in the foreign

exchange market to make a profit eliminates these opportunities.

If a U.S. asset has a higher expected return than a comparable Japanese asset, traders would sell

Japanese assets and buy the U.S. assets, increasing the demand for dollars. As a result, the dollar

will appreciate relative to the yen to the point at which investors are indifferent between holding

U.S. or Japanese assets.


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The concept is illustrated in the above graph.

The y-axis measures the current exchange rate (EX) The x-axis is the expected rate of return, in dollar terms from investing in a U.S. or

Japanese asset.

o for U.S. assets, the expected rate of return, R, equals the U.S. interest rate io the expected rate of return on foreign assets in dollar terms, Rf , equals if - (change)EX

e

/ EX.

For Japanese assets, the expected rate of return, Rf equals the Japanese interest rate ifless the

expected appreciation of the dollar.

R is a vertical line because the return on U.S. assets is the same regardless of the exchange rate.

Assume a U.S. interest rate of 5%

To graph Rfagainst the exchange rate, we must first specify the expected future yen/dollar

exchange rate.

This is done by calculating the dollar's expected rate of appreciation, a component of Rf .


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If the current yen/dollar spot rate exceeds that expected future exchange rate, investors believe

that the dollar is unually strong and it will eventually depreciate.

For a given expected exchange rate, a graph of Rfagainst the current exchange rate slopes

upward; as the yen/dollar exchange rate rises, the dollar's expected rate of appreciation falls,

pushing up Rf.

the more the yen depreciates, the less we expect it to depreciate in the future.

e.g assume that the future yen/dollar exchange rate is expected to be 100 and that Japanese

interest rates are 5%.

a.

If the current exchange rate is also 100/$1, no dollar appreciation is expected and Rfequals the 5% Japanese interest rate.

b. If the current exchange rate is 105/$1, the dollar is expected to depreciate back to100/$1 (for a decrease of 4.8%) and Rfequals the 5% Japanese interest rate plus the

appreciation of the yen of 4.8% for a total of 9.8%.

c. If the current exchange rate is 97/$1, the dollar is expected to appreciate back to100/$1 (for an increase of 3.1%) and Rfequals the 5% Japanese interest rate minus the

depreciation of the yen of 3.1% for a total of 1.9%.

connecting these three points yields the Rfline.

The equilibrium exchange rate is the one that equates R and Rf . In this case it is 100/$1

Suppose the exchange rate is 97/$1.

The dollar is expected to appreciate by 3.1%

Since the rate of return on Japanese assets is 1.9%, investors switch to U.S. assets.

The increased demand for dollars leads to a dollar appreciation. The appreciation of the dollar

continues as long as the relative yield on U.S. assets is higher. Finally the yields are in

equilibrium at 100/$1.


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Interest Rate Parity

The exchange rate market condition described here is known as the interest rate parity condition.

Given identical characteristics regarding risk, liquidity, time to maturity, etc, domestic andforeign assets should have identical nominal returns.

Any difference in the nominal rate of return between identical assets in two countries reflects

expected currency appreciation or depreciation.

When the domestic interest rate is higher than the foreign interest rate, the domestic currency is

expected to depreciate.

Equilibrium condition is: Expected return on domestic asset - Expected return on foreign asset

i = if - (change)EXe / EX

This does not imply that nominal interest rates are the same throughout the world. Rather that

expected nominal returns on comparable domestic and foreign assets are the same.

In real terms, the real interest rate parity condition is:

i + r = (1 + rf)(EXr/ EXer)

Expected real return on domestic investment = expected real return on foreign investment.

Exchange Rate Fluctutations

Changes in domestic real interest rates


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The expected return on domestic bonds depends on the interest rate i.

That interest rate is the sum of the expected real rate of interest and the expected rate of inflation

Holding expected inflation constant, an increase in the domestic interest rate increases the

expected rate of return on domestic assets, shifting the R curve to the right.

The increased demand for dollars leads to an appreciation of the dollar.

Changes in domestic expected inflation


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Hold foreign real rate of return Rfconstant

If domestic inflatonary expectations increase, then domestic currency loses purchasing power,

causing it to depreciate.

Two things happen:

1. The higher domestic nominal interest rate shifts the expected rate of return to the right(foreign investors will not be affected by the domestic inflation increase but have the

benefits of higher return on assets). As a result, the current exchange rate rises.

2. An increase in expected inflation reduces expected appreciation of the domestic currency,so the expected foreign rate of return shifts to the right, increasing the attractiveness of

foreign assets to consumers.

Although the two effects work in opposite directions, we can usually expect the domestic

currency to depreciate with higher inflation.

Changes in foreign interest rates


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An increase in the foreign real interest rate shifts the foreign expected rate of return from Rf0 to

Rf1 because at any exchange rate, the foreign rate of return increases.

Currency depreciates as money moves abroad.

Changes in the Expected Future Exchange Rate


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If the expected future exchange rate increases, expected appreciation of the domestic currency

rises.

Since an appreciation of the domestic currency is good for the value of domestic assets, investors

increase their demand for the domestic currency.

And the expected rate of return on the foreign assets falls due to the relative depreciation of that

currency shift inward the return on foreign assets.

Resulting in an increase in the actual exchange rate.

Currency Premiums in Foreign-Exchange Markets

The interest rate parity condition is based on the assumption that domestic and foreign assets

with similar attributes are perfect substitutes.

But if we allow for imperfect substitutability, we can modify the equation to allow for a currency

premium where investors have a preference for the financial assets denominated in one currency

over the other.

i = if - (change)EXe / EX - hf,d

For example, assume that the one year T-bill rate in the U.S. is 8% and the one-year government

bond rate in Germany is 5%.

Also assume that investors expect the dollar to depreciate against the mark by 4% over the

coming year.

The one-year mark/dollar currency premium is

8% = 5% - ( -4%) - hf,d , or hf,d= 1%

This implies that investors require a 1% higher expected rate of return on the German bond

relative to the U.S. T-bill to make the two financial assets equally attractive.


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If hf,dis positive, it implies that investors prefer the domestic currency asset.

In this case, investors will not buy a foreign bond if the expected rate of return just equals that of

a domestic bond.

Investors require an additional incentive to buy the foreign asset, the currency premium in the

form of a higher yield on foreign assets.

The size of the currency premium depends on:

investors aversion to currency risks, differences in liquidity in markets

information about foreign investment opportunities investors' belief that one currency is more stable or safer than another.

Traditional view of exchange rates results in adjustments to international trade in goods. Other

approaches include the capital account as a determinent of exchange rates.

Explore the role of financial assets.

Monetary Approach to the Balance of Payments

The basic premise of the MABP is that any balance-of-payments disequilibrium is based on

monetary disequilibrium.

The exchange rate between any two currencies is determined by relative money demand andmoney supply between the two countries.

Monetary disequilibrium implies a difference exists between the amount of money people wish

to hold and the amount supplied by the monetary authorities.


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If people demand more money than is supplied domestically by the central bank, then the excess

demand for money would be satisfied by inflows of money from abroad.

In contrast, an oversupply of money domestically, leaves the economy for other countries.

The Fed controls the money supply by altering base money (equal to banking reserves plus

currency in circulation). Increases in the monetary base leads to increases in the money supply.

The monetary base can be divided into domestic and international components:

domestic component is comprised of domestic credit. the remainder is comprised of international reserves. (money items that can be used to

settle international debts, primarily foreign exchange)

Example: A U.S. exporter receives payment in foreign currency

payment is presented to a commercial bank to be converted into dollars and deposited inthe firm's account.

If the commercial bank has no use for the foreign currency, the bank will exchange theforeign currency for dollars with the Fed.

The Fed creates new money to buy the foreign currency by increasing the commericalbank's reserve deposit with the Fed (part of required reserves).

Thus the Fed is accumulating international reserves, and this process expands themonetary base.

Note: the Fed make undertake currency sterilization by using monetary policy tools to absorb

the increase in reserves from the banking system.

The Model:

Assume a small open economy that has no effect on the international price of goods or the

interest rate it faces in foreign markets.

The demand for money equals:


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L = kPY

where:

L = money demand

P = domestic price level Y = real income or wealth k= constant fraction indicating how much money demand will change given a change in

P or Y

If increase P and/or Y will increase L

The supply of money equals:

M = R + D

where:

M = money supply R = international reserves D = domestic credit

Assume equilibrium in the money market of M = L

The adjustment mechanism that ensures equilibrium of M = L will vary with the exchange rate

regime.

With fixed exchange rates, money supply adjusts to money demand through internationalflows of money via balance-of-payments imbalances.

With flexible exchange rates, money demand will be adjusted to a money supply set bythe central bank via exchange rate changes.

With a floating peg, there are both international monetary flows and exchange ratechanges.

skipping some mathematical steps, we have:


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With Flexible Exchange Rates:

- E = PF + Y - D

P

F

= foreign prices

all variables are in percentage changes (e.g. E is percentage change in the exchange rate)

(note the negative before the E)

and assume reserve flows (R) equal zero

Implications:

E is measured in domestic currency units per foreign currency unit, as increase in E means that

foreign currency is becoming more expensive or appreciating in value and the domestic currency

is depreciating.

e.g. at E0, $1 = 100

at E1, $1 = 90

In the equation, E has a positive relation to changes in D and an inverse relation to changes in PF

and Y.

an increase in the domestic credit (D) given a constant PF and Y (so that the demand for money

is constant) will result in a depreciation of the domestic currency. The increase in the money

supply leaves the country.

An increase in PF will increase the domestic demand for money as imports become more costly.

With constant domestic credit, there is an excess demand for money. Individuals try to increase

their money balances, increasing the demand for domestic currency. There is a decrease in E or

an appreciation of the domestic currency.

With Fixed Exchange Rates:


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R - E = PF + Y - D

all variables are in percentage changes (e.g. E is percentage change in the exchange rate)

R = international reserves

This is the same as before, but reserves are used to offset changes in the exchange rate. If a

currency is devaluing below desired levels, the central bank will intervene buy purchasing its

domestic currency with some of its foreign currency reserves.

for example, an increase in domestic credit, D, everything else constant, will lead to a decrease in

international reserves as the central bank buys the domestic currency to support its value.

Portfolio-balance Approach to the Balance of Payments

In the monetary approach, the exchange rate between any two currencies is determined by

relative money demand and money supply between the two countries. Relative supplies of

domestic and foreign bonds are not a factor.

The portfolio-balance approach allows for both relative money market condition and for bond

markets to determine the exchange rate.

The monetary approach assumes that domestic and foreign bonds are perfect substitutes and thus

investors are indifferent as to which ones they hold. Bond holders only care about relative rates

of return and require no risk premium to hold foreign bonds.

In the portfolio-balance approach foreign and domestic bonds are imperfect substitutes. Savers

have preferences in how they distribute their portfolio over different country's assets. As

investors increase their allocation of portfolio assets in a given country, their risk rises and they

desire a greater risk premium to compensate.

The PB approach assumes that assets are imperfect substitutes internationally because investors

percieve foreign exchange risk to be attached to foreign-currency-denominated bonds.

The spot exchange rate is modified to:


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- E = PF + Y - D - B + BF

all variables are in percentage changes

B = percentage change in the supply of domestic bonds

BF = percentage change in the supply of foreign bonds

If the supply of domestic bonds rises relative to the supply of foreign bonds (increase B holding

BF constant), there will be an increased risk premium on the domestic bonds that will cause the

domestic currency to depreciate in the spot market.

But we also need to consider adjustments to international trade in financial assets.

Since financial assets are traded almost continuously, exchange rates constantly adjust as

changes in demand and supply of financial assets in diffierent nations change.

Assume perfect capital mobility => capital will flow freely between nations because there are no

significant transactions costs or capital controls that act as barriers to investment.

In this case, spot and forward exchange rates will adjust instantly to changing financial market

conditions.


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In this case, relative bond supplies and demands as well as relative money market conditions

determine the exchange rate.

Conclusion

The exchange rate of the currency in which a portfolio holds the bulk of its investments

determines that portfolio's real return. A declining exchange rate obviously decreases the

purchasing power of income and capital gains derived from any returns. Moreover, the exchange

rate influences other income factors such as interest rates, inflation and even capital gains from

domestic securities. While exchange rates are determined by numerous complex factors that

often leave even the most experienced economists flummoxed, investors should still have some

understanding of how currency values and exchange rates play an important role in the rate of

return on their investments.
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Types of Foreign Exchange Rates and Interest rate.docx