Currency Exchange Rates

Who is affected by a change in the currency exchange rate? U.S. tourists going to a foreign country Foreign tourists coming to the U.S. Consumers Hospitality industry catering to foreigners Companies that export Companies that import Companies that produce at home and sell at home U.S. workers

Who benefits from a rising U.S. Dollar? U.S. tourists going to a foreign country Consumers Companies that import

Who is hurt by a rising U.S. Dollar? Foreign tourists coming to the U.S. Hospitality industry catering to foreigners Companies that export Companies that produce at home and sell at home U.S. workers

What is a strong Dollar? The dollar is considered strong versus another currency if it gives you more purchasing power in this country. Example: You can buy a beer at a beech in San Diego for an average of $ 4. If you go to Antalya, Turkey, you can buy a beer for about 6 lira. The currency exchange rate is: 1$ = 2.5 lira. Therefore, you get the beer in Antalya for $2.40. That means the U.S. dollar is stronger than the lira. If you go to a beach in Kristiansand, Norway, the average price of a beer is about 44 Krone. The currency exchange rate is: 1$ = 8 Krone. Therefore, you get the beer in Kristiansand for $ 5.5. That is, the Norwegian Krone is stronger than the U.S. Dollar and much stronger than the Turkish lira.

A strong dollar is a sign of a strong America? Ronald Reagan Two forces: Consumer psychology and its impact on the real economy Eroding competitiveness of the U.S. industry

Who Determines the Price of Currencies? 1. Free Market Exchange Rates are Determined by the Supply and Demand for the Currencies. • free float (no intervention) $, €, ₤, Swiss Frank,

2. Government Central Banks intervene in the currency markets • “dirty”or managed float (some intervention) Now more rare but was quite common for: €, ₤, ¥ • fixed exchange rate or “peg” (unlimited intervention at a fixed rate) Chinese Yuan

Factors Influencing the Supply and Demand of Currencies Trade Increasing imports are increasing the supply for the domestic currency; increasing exports are increasing the demand for the domestic currency. An export surplus will increase the value of the domestic currency (ceteris paribus)

Investment Capital exports increase the supply of the domestic currency; capital imports increase the demand for the domestic currency. The domestic currency will increase (decrease) if the country receives more (less) foreign investment than it invests in foreign countries (ceteris paribus).

International Financial Transactions

Inflation and Currencies Purchasing Power Parity Real exchange rate (Exchange rate after removing the effects of inflation) will stay the same through arbitrage in markets for goods Absolute Purchasing Power Parity The purchasing power of the dollar is the same everywhere in the world Relative Purchasing Power Parity Exchange rates move to offset differences in rates of inflation.

Purchasing Power Parity Mechanism If a product has a different price in different countries after exchanging the currency, arbitrage opportunities are being created. The ensuing trade and exchange of currencies will go on until the arbitrage opportunity disappears.

Purchasing Power Parity Mechanism Example: A basket of goods costs $ 100 in the U.S. The same basket of goods costs Euro 80 in Europe. The currency exchange rate is: 1 Euro = 1.25 $. Can you make money by trading?

Purchasing Power Parity Mechanism A year later: The basket of goods costs $ 100 in the U.S. The same basket of goods costs Euro 80 in Europe. The currency exchange rate is: 1 Euro = 1 $. (= the dollar got stronger) Can you make money by trading? Buy the basket in Europe for Euro 80 ( = $ 80) and sell in the U.S. for $ 100 U.S. imports ( = trade deficit), Europe exports ( = trade surplus) Dollar goes down Euro goes up until new exchange rate: 1 Euro = 1.25 $

Purchasing Power Parity in the Real World Big Mac Index (The Economist) Pacific Exchange Rate Service: http://fx.sauder.ubc.ca/PPP.html

The impact of exchange rate movements differs depending on: whether the item affected is real (goods, real estate…) or nominal (bond at maturity…)

Example: 100% Russian Inflation Real Asset Rb value x exchange = $ value before Rb 100,000 .04 ($/Rb) $ 4,000 after(mon.) Rb 200,000 .02 ($/Rb) $ 4,000 Nominal Asset Rb value x exchange = $ value after(mon.) Rb 100,000 .02 ($/Rb) $ 2,000

Nominal Exchange Rate: Cited Exchange Rate e = $/Rb   Real Exchange Rate: e’ = e (1 + П RUS ) / (1 + П US) e’ = real Exchange Rate П RUS = Russian Inflation (1 or 100%) П US = U.S. Inflation (0) e’ = .02 {(1 + 1)/(1+0)} = .04 $/Rb

Equal return on $ investment Interest Rates and Currencies Interest Rate Parity Return on a dollar invested must be the same everywhere through arbitrage in financial markets Equal return on $ investment (1+iUS) = 𝑓 𝑒 (1+iGer) e = $/€ Spot market f = $/€ Forward market

Interest Rates and Currencies Interest Rate Parity Risk adjusted return on a dollar invested must be the same everywhere. Interest Parity Mechanism A difference in the return on a dollar invested in a foreign currency creates arbitrage opportunities. The ensuing investment decisions will go on until the arbitrage opportunity disappears.

Example Interest Rate Parity A U.S. investor thinks about investing $100 either in one year U.S. T-Bills at 2% interest rate or in one year Swiss notes at 4% interest rate. It is assumed that the default risk is the same. The return of the investment after one year n the U.S. is: (1 + iUS ) 1.02 X 100 = $102 2. In order to invest in Switzerland the investor has to: a. Buy Swiss Frank on the Spot Market. The Spot Rate is 1$ = 1.5000 SF or 1SF = $0.6667 He gets 150 SF b. Invest in Swiss notes. The expected return after one year is: (1 + iSF ) 1.04 X 150 = 156 SF c. Hedge the currency exchange rate risk for 156 SF. He has to sell 156 SF in one year at the forward rate, using a forward contract. The forward rate is : 1$ = 1.5294 SF or 1SF = $0.6539 d. After one year he collects SF 156 from the Swiss Notes and sells SF 156 at the forward rate using his forward contract entered into a year ago. The return of the investment in Dollar after one year is: 156/1.5294 = $102