Exchange Rate Determination (1) International Investment/Arbitrage J.D. Han King’s University College 13-1

2 (Key Question) 1.What causes exchange rates to fluctuate? 2. How do you predict exchange rates (and their changes) in SR and LR respectively? 3. What is the ‘correct or equilibrium exchange rate’? 4.What are the benefits of having flexible exchange rates as opposed to not having ones (using the big country’s currency)?

3 International Trade and Price Level ->Purchasing Power Parity Exchange rates depend on relative price ratio or inflation differentials International Investment and Interest Rate -> Interest Parity Theorem * Overview Revisited: Three Theories There are three theories which link the economic fundamental to FOREX rate Real Factor Real Analysis Real FOREX rate changes due to real factors such as Demand and Supply of Goods Monetary Approach -> “Money Supply affects interest rates and inflation rates; Thus this encompasses the above two.

There are Four theories which link the economic fundamental to a specific equilibrium exchange rate 1) International Investment Theory (SR) - Differences in Rates of Returns 2) Purchasing Parity Theory(LR) - Relative Prices 3) Monetary Approach -Money affects i and P; thus Money affects FOREX rates 4) Real Factor Analysis - S (Technical Innovation)/ D(changes in demand)

13-5 Preview The basics of exchange rates Exchange rates and the prices of goods The foreign exchange markets The demand for currency and other assets A model of foreign exchange markets  role of interest rates on currency deposits  role of expectations about the exchange rates

Definitions of Exchange Rates: Direct Quotation Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency(S). For Canadians, S = S units of Canadian dollars to get one unit of U.S. dollar = S Canadian$/U.S.$ This quotation make the best economics sense:  How much does a Honda cost? $3,000  How much does a unit of U.S. dollar cost = Canadian $1.02

13-7 * Depreciation and Appreciation Depreciation is a decrease in the value of a currency relative to another currency. Appreciation is an increase in value. Suppose that our quotation of S per FOREX goes up:  Canadian $1/U.S.$1 --  Canadian $1.20/U.S.$1  FOREX becomes more expensive;  Appreciation of FOREX (U.S. dollar)  Depreciation of domestic currency (Canadian dollar)

13-8 Depreciation and Appreciation (cont.) Appreciation is an increase in the value of a currency relative to another currency.  An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.  $1/€1 -> $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable

Spot Rates and Forward Rates Spot FOREX rate or S is exchange rate for currency exchanges “on the spot”, or when trading is executed in the present. current spot FOREX rate = S t Spot FOREX rate of the future = S t+1 expected future FOREX rate for the next period = t S t+1 e Forward rates or F is today’s exchange rate for currency exchanges that will occur at a future (“forward”) date: Rates are negotiated between individual institutions in the present, but the exchange occurs in the future.  Contract is done today; the rate is set and known today  Delivery will be done in the future; forward dates are typically 30, 90, 180 or 360 days in the future.

The Foreign Exchange Market (cont.) Characteristics of the market: Trading occurs mostly in major financial cities: London, New York, Tokyo, Frankfurt, Singapore. The volume of foreign exchange has grown:  in 1989 the daily volume of trading was $600 billion, in 2001 the daily volume of trading was $1.2 trillion. About 90% of transactions in 2001 involved US dollars.

International Investor and Interest (Rate) Arbitrage International Investors are doing arbitrage between markets. Arbitrage means the following two activities: 1) Solely based on spot FOREX: If dollars are cheaper in New York than in London, people will buy them in New York and stop buying them in London. If triangular FOREX rate is in such a way that Canadian dollar is undervalued with respect to U.S. dollar, but not to Euro, What would the arbitrageur do? You borrow U.S. dollar, buy Canadian dollars (with the U.S. dollars), and exchange them into Euro, covert the Euro revenue into U.S. dollar, and pay back the U.S. loans. You will have some profits. 2) Based on spot FOREX rate, future expectations, Forward Rate and international interest rate differentials: moving capital across countries for a higher return:

International Investment Theory of FOREX rates 13-12

Bottom Line International Capital Flows determine FOREX rates in such a way that Capital Inflows increase the receiving country’s external value; -> Capital Inflows lowers S for the receiving country 13-13

13-14 Arbitrage for Rates of Returns on Domestic versus Foreign Investments What influences the demand for (willingness to buy) domestic or foreign currency for investors? If we assume that risk is the same between the two countries The return on domestic investment versus the return on investment in foreign country

13-15 Two Interest Rates: Domestic and Foreign Investment Options Return on Domestic Asset = interest on Canadian dollar asset = i $ Return on Foreign Investment = interest on foreign (country) interest rate + capital gains or loss due to expected changes in FOREX rates = i € + (S e $/€ - S $/€ )/S $/€

13-16 Two Rates of Returns The difference in the rate of return on dollar deposits and euro deposits is i $ versus i € + (S e $/€ - S $/€ )/S $/€ expected rate of return = interest rate on dollar deposits interest rate on euro deposits expected rate of return on euro deposits expected exchange rate current exchange rate expected rate of appreciation of the euro

13-17 “Uncovered Interest (Rate) Parity” The foreign exchange market for international investors or arbitrageurs is in equilibrium when deposits of all currencies offer the same expected rate of return: uncovered interest (rate) parity. No big unilateral/averanchal flow of capital

Changes in FOREX rate and Capital Flows at disequilibrium At Disequilibrium of Uncovered Interest parity  Suppose i $ > i € + (S e $/ € - S $/ € )/S $/ €. - No investor would want to hold euro deposits, driving down the demand and price of euros. - all investors would want to hold Canadian dollar deposits, driving up the demand and price of dollars. - Capital Inflows to Canada - The Canadian dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved. - FOREX rate or S falls for Canada.  Suppose i $ < i € + (S e $/ € - S $/ € )/S $/ € - Capital Outflows from Canada - S rises for Canadia

6. Dynamics Suppose that initially FOREX market is in equilibrium and UCIP holds. What will happen to S if there is a change in the following variables? 1) If i rises, E falls. 1)If i f rises, S rises. 2)If S e rises, S rises. 3)If M increases, S rises. 4)If M f increase, S falls

13-20 *The effects of changing interest rates on S:  an increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits.  This leads to an increase in demand for that curreny  The price of the currency goes up: an appreciation of the currency.  A rise in dollar interest rates causes the dollar to appreciate.  A rise in euro interest rates causes the dollar to depreciate.

13-21 *The Effect of an Expected Appreciation of the Euro or S e on S: If people expect the euro to appreciate in the future, then the expected return on euros therefore increases. Investment will pay off in a valuable (“strong”) euro. So people start buying Euro now, and the demand for Euro rises. The Price of Euro in terms of Dollars rises.  An expected appreciation of a currency leads to an actual appreciation -> “self-fulfilling prophecy”

* The effect of changing domestic money supply on S Domestic Money supply rises -> Domestic Interest Rate falls -> Rate of Returns on domestic investment falls -> Capital Outflows -> (Excess) Demand for FOREX rises and demand for domestic currency falls -> FOREX or S rises

*The Effect of changing foreign money supply on S In the short-run, i f falls. -> ROR for foreign investment falls -> Demand for FOREX falls -> Price of FOREX or S falls

7. Efficient FOREX Market: Unbiased-Forward-Rate Theory t S e t+1 = F t+1 “The expected future spot rate is equal to the forward rate”

Forward Premium tells the expected change in S: Δ% S e = (S e – S)/S If FOREX market is efficient, then S e = F Δ% S e = (F- S)/ S Forward premium or discount is equal to the market’s expected change in the spot rate.

13-26 *Test of FOREX Market Efficiency t S e t+1 = S t+1 + e Note that F has replaced S e Thus, F t+1 = S t+1 + e Forward Rate is the best predictor for the future spot rate.

‘Covered’ Interest Parity Covered interest parity : i $ = i € + (F $/€ - S $/€ )/S $/€ at eq. where F $/€ is the Forward Exchange Rate. Alternatively, i $ - i € = (F $/€ - S $/€ )/S $/€ at eq. where (F $/€ - S $/€ )/S $/€ is Forward Premium (+) or Forward Discount (-)

At Disequilibrium, When i $ - i € > (F $/€ - S $/€ )/S $/€, Capital inflows occur, and S falls if and only if the domestic and foreign investment are perfect substitutes

Dynamics If the FOREX market revises expectations of FOREX upwards, then what will happen to the spot rate S $/€ ? i I f M M f 13-29

At equilibrium, the rates of return on domestic (dollar) deposits, and the return on the non-risk or “covered” foreign investment are the same.  How could you make easy, risk-free money in the foreign exchange markets if covered interest parity did not hold?  Covered positions using the forward rate involve little risk

8. Limitations of CIP and UCIP: Even when i $ < i € +(F $/€ - S $/€ )/S $/€, Capital may not flow out and S may not rise if i € rises due to an increased risk premium The Assumption of Domestic an Foreign Investments being Perfect Substitutes may not hold at all times. Quite often CIP and UCIP may not hold if domestic and foreign investments are imperfect substitutes