Chapter Twelve
The Foreign Exchange Market
Copyright © 2004 Pearson Education Canada Inc. Slide 12–3
Exchange Rates, 1974–2002
Copyright © 2004 Pearson Education Canada Inc. Slide 12–4
The Foreign Exchange Market
• Definitions
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
Copyright © 2004 Pearson Education Canada Inc. Slide 12–5
The Foreign Exchange Market
• Currency appreciates, country's goods prices abroad and foreign goods prices in that country
1. Makes domestic businesses less competitive
2. Benefits domestic consumers
• FX traded in over-the-counter market1. Trade is in bank deposits denominated in different
currencies
Copyright © 2004 Pearson Education Canada Inc. Slide 12–6
Law of One Price
• Example: Canadian steel $100 per ton, Japanese steel, 10 000 yen per ton
Copyright © 2004 Pearson Education Canada Inc. Slide 12–7
If E = 50 yen/$ then price are:
Canadian Steel Japanese Steel
In Canada $100 $200
In Japan 5000 yen 10,000 yen
Law of One Price
• Law of one price E = 100 yen/$
If E = 100 yen/$ then price are:
Canadian Steel Japanese Steel
In Canada $100 $100
In Japan 10 000 yen 10 000 yen
Copyright © 2004 Pearson Education Canada Inc. Slide 12–8
Purchasing Power Parity (PPP)
• PPP Domestic price level 10%, domestic currency 10%
1. Application of law of one price to price levels
2. Works in long run not short run
• Problems with PPP1. All goods not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded (e.g., haircuts)
Copyright © 2004 Pearson Education Canada Inc. Slide 12–9
Copyright © 2004 Pearson Education Canada Inc. Slide 12–10
PPP: Canada and U.S.
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Factors Affecting E in Long Run
• Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E
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Expected Returns and Interest Parity
Re for Francois Re for Al
$ Deposits iD Et1
e Et Et
iD
F Deposits iF iD Et1
e Et Et
Relative Re iD iF Et 1
e Et Et
iD iF Et 1
e Et Et
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iD iF Et1
e Et
Et
Et1e Et
Et
5% i F 15%
– Example: if iD = 10% and expected appreciation of $,
Expected Returns and Interest Parity
• Interest Parity Condition– $ and F deposits perfect substitutes
(2)
Copyright © 2004 Pearson Education Canada Inc. Slide 12–14
Deriving RF Curve
• RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF
A s s u m e i F = 1 0 % , E et + 1 = 1 e u r o / $
P o i n t
A : E t = 0 . 9 5 0 . 1 0 1 . 0 0 . 9 5 . 9 5 0 . 0 4 8 4 . 8 %FR
B : E t = 1 . 0 0 . 1 0 1 . 0 1 . 0 1 . 0 0 . 1 0 0 1 0 . 0 %FR
C : E t + 1 = 1 . 0 5 0 . 1 0 1 . 0 1 . 5 1 . 0 5 0 . 5 8 5 . 8 %FR
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Deriving RD Curve
• Deriving RD Curve– Points B, D, E, RD = 10%, so curve is vertical
• Equilibrium– RD = RF at E*
– If Et > E*, RF > RD, sell $, Et
– If Et < E*, RF < RD, buy $, Et
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Equilibrium in the Foreign Exchange Market
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Shifts in RF
1. RF curve shifts right when– iF : because RF at
each Et
– Eet+1 : because expected
appreciation of F at each Et and RF
2. Occurs: 1. Domestic P ; 2. Restrictions on trade ; 3. Imports ; 4. Exports ; 5. Productivity
Figure 4: Shifts in the Schedule for the Expected Return on Foreign Deposits RF
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Shifts in RD
1. RD shifts right when
– iD , because RD at each Et
– Assumes that domestic πe unchanged, so domestic real rate
Factors that Shift RF and RD
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Copyright © 2004 Pearson Education Canada Inc. Slide 12–20
Response to i Because πe
1. πe , Eet+1 , expected
appreciation of F , RF shifts out to right
2. iD , RD shifts to right
3. However because πe > iD , real rate , Ee
t+1 more than iD RF shifts out > RD shifts out and Et
Copyright © 2004 Pearson Education Canada Inc. Slide 12–21
Response to Ms
1. Ms , P , Eet+1 ,
expected appreciation of F , RF shifts right
2. Ms , i D , RD shifts leftGo to point 2 and Et
3. In long run, i D returns to old level, RD shifts back, go to point 3 and get exchange rate overshooting
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Why Exchange Rate Volatility?
• Expectations of Eet+1 fluctuate
• Exchange rate overshooting
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Profiting from FX Forecasts
• Forecasters look at factors discussed here
• FX forecasts affect financial institutions managers' decisions
• If forecast yen appreciate, yen depreciate, – Sell franc assets, buy euro assets
– Make more euros loans, less yen loans
– FX traders sell yen, buy euros