International Monetary Systems Topic: Exchange, PPP and International Monetary Systems

Contact Information and website Dr. Dave McEvoy Associate Professor of Economics Appalachian State University, NC 28608 Email: mcevoydm@appstate.edu Course Website: davemcevoy.weebly.com/imsangers2018.html

Example: Hedging You are a US Firm and you expect to receive a payment of 1 million euros from France in 90 days for exported goods. The current spot rate is $1.20 per euro. Your firm will incur losses on the deal if the exchange rate drops below $1.10 per euro. How can the US Firm use an OPTION to avoid some potential losses? US firm could buy 1 million euros in call options, say at $1.15 per euro (let’s say that is the highest available). In 90 days when the euros are paid by France, if the spot rate is < $1.15, the US Firm can sell the euros at $1.15 for certain. If the spot rate is > $1.15 then don’t call.

Example: Speculation The current spot exchange rate is $1.30 per euro. You think the euro is going to strengthen in the next 12 months. You project the exchange rate to be $1.45 per euro in 12 months. How can you exploit the exchange rates to try to make a profit in $? 1. You could buy euros today at $1.30 each and then sell the euros for dollars at $1.45 each in one year (if your projection is right. You buy 100 euros that cost you $130. You wait a year and sell the 100 euros for $145. You profit $15. 2. Forward contract for buying 100 euros at $1.30 in one year. In one year you spend $130 dollars and get 100 euros in return. You immediately sell those euros for $145 on the spot market. You profit $15.

Transactions costs 1. Cost of exchanging currencies Called “the spread” = in aggregate about 0.01% of major currency trades 2. Price of derivatives. For example, the market price of a call option is called a “premium”. The seller of the option earns the premium and in exchange the buyer has the right, but no obligation, to exercise the call.

Arbitrage (with spot rates) Consider a situation in which exchange rates offered by banks differed between two countries. In London the pound-euro spot rate = 0.55 and in Paris the pound-euro rate = 0.50. You are a banker in France. Given these rates hold in the short term, can you make a profit buying and selling currencies? Say I spend 1,000,000 euros to buy pounds in London. I get 550,000 pounds. Then I buy euros in Paris with the 550,000 pounds. I get 1,100,000 euros.

Arbitrage (the role of transactions costs) Consider a situation in which exchange rates offered by banks differed between two countries. In London the pound-euro spot rate = 0.55 and in Paris the pound-euro rate = 0.50. There is a 0.06 charge (i.e., euro amount x 0.06) for making a transaction. You are a banker in France. Given these rates hold in the short term, can you make a profit buying and selling currencies? NO

Group Work: Arbitrage (with three countries) E£/€ = 0.70 and E€/$ = 0.80 (1) What is the “indirect” exchange rate of pounds to dollars? E£/€ * E€/$ = E£/$ = 0.56

Group Work: Arbitrage (with three countries) E£/€ = 0.70 and E€/$ = 0.80 (1) What is the “indirect” exchange rate of pounds to dollars? E£/€ * E€/$ = E£/$ = 0.56 Now compare pound-dollar spot rates with this calculated “indirect” exchange rate to see if arbitrage possibilities exist. Suppose, for example, the spot rate is E£/$ = 0.50. (2) You have $1,000 to start. How can you make a profit? Take $1000 and buy 560 pounds indirectly by first buying euros (800) and then converting to pounds. Then sell 560 pounds at the spot rate of 2 dollars for 1 pound. $1120. Profit of $1.12 on the dollar.

Forward exchange rate: the role of interest Value of european investment in dollars one year from now $(1+i$) = $ E€/$ (1+i€) F$/€ Value of dollar investment in US bank in one year Exchange rate in the future -- converting euros back to dollars Euros in exchange for dollars today (spot rate) Value of investment in euros one year from now

Forward exchange rate: the role of interest $(1+i$) = $ E€/$ (1+i€) F$/€ $(1+i$) / $ E€/$ (1+i€) = F$/€ F$/€ = E$/€ (1+i$) /(1+i€) Theory of where the Forward exchange rate come from

Group work: Forward exchange rate: the role of interest F$/€ = E$/€ (1+i$) /(1+i€) Suppose the spot rate is E$/€ = 1.10: If the interest rate for both the U.S. and European investments are equal then what is the Forward exchange rate? If the interest rate for the U.S. investment is 0.05 and the European interest rate is 0.035, what is the Forward exchange rate?

Law of one price (a theory) LO1P: Identical goods sold in two different locations must sell for the same price when expressed in common currency. P($) P($) $20 $18 Q Q FRANCE U.S.

Purchasing Power (a basket of goods) The relative prices of baskets of goods compared in the same currency P€ E$/€ /P$ = real exchange rate It is the price of European basket relative to the US basket. if P€ E$/€ /P$ is increasing then prices are higher in Europe and the US currency is depreciating – the dollar can buy fewer baskets in euros

Purchasing power parity (PPP) Identical baskets of goods sold in two different locations must sell for the same price when expressed in common currency. $ $ $20 $18 £ £ FRANCE U.S. P€E$/€ =P$

Spot exchange rate implied by PPP Rearranging the real exchange rate formula given that PPP holds: E$/€ =P$/P€ Implication: The spot exchange rate should follow the relative prices of a representative basket of goods

US vs. United Kingdom Red line – P£/P$ Blue line – E£/$

US vs. France

Big Mac Index (January 2017) Big Mac prices in local currency and Big Mac prices converted to US dollars using spot exchange rate in January 2017.

Big Mac Index (January 2017) Calculate the January 2017 spot exchange rates in American terms for: France = Switzerland = South Africa = Hungary =

Group Work: Big Mac Index (January 2017) Use the prices of the Big Mac to estimate the real exchange rates for the United States with: Recall reach exchange is computed as foreign price (in $) / US price ($) France Real = Nominal = E$/Foreign = 1.046 Switzerland Nominal = E$/Foreign = 0.9769 South Africa Nominal = E$/Foreign = 0.0718 Hungary Nominal = E$/Foreign = 0.0034

Group Work: Big Mac Index (January 2017) Use the prices of the Big Mac to estimate the real exchange rates for the United States with: Recall reach exchange is computed as foreign price (in $) / US price ($) France Real = 4.29 / 5.06 = 0.848 Nominal = E$/Foreign = 1.046 Switzerland Real = 6.35/5.06 = 1.25 Nominal = E$/Foreign = 0.9769 South Africa Real = 1.89/5.06 = 0.374 Nominal = E$/Foreign = 0.0718 Hungary Real = 3.05 / 5.06 = 0.603 Nominal = E$/Foreign = 0.0034

Example (France) Real exchange rate (American Terms) = 0 Example (France) Real exchange rate (American Terms) = 0.85 I have to spend $0.85 in France to buy the equivalent of $1.00 worth of stuff in the United States. In real terms, the dollar is stronger against the euro (compared to the spot rate (nominal rate)).