Chapter 12 The Foreign Exchange Market

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Preview We develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include: – Foreign Exchange Market – Exchange Rates in the Long Run – Exchange Rates in the Short Run – Explaining Changes in Exchange Rates

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market Most countries of the world have their own currencies: the U.S., France, Brazil, and India, just to name a few. The trading of currencies and banks deposits is what makes up the foreign exchange market.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market The next slide shows exchange rates for four currencies from Note the difference in rate fluctuations during the period. Which appears most volatile? The least?

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market: Historical Exchange Rates Current foreign exchange rates Figure 13.1: Exchange Rates, 1990–2004

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Foreign Exchange Market Definitions 1.Spot exchange rate 2.Forward exchange rate 3.Appreciation 4.Depreciation

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market: Why Are Exchange Rates Important? When the currency of your country appreciates relative to another country, your country's goods prices  abroad and foreign goods prices  in your country. 1.Makes domestic businesses less competitive 2.Benefits domestic consumers (you)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market: How is Foreign Exchange Traded? FX traded in over-the-counter market 1.Most trades involve buying and selling bank deposits denominated in different currencies. 2.Trades in the foreign exchange market involve transactions in excess of $1 million. 3.Typical consumers buy foreign currencies from retail dealers, such as American Express.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run Exchange rates are determined in markets by the interaction of supply and demand. An important concept that drives the forces of supply and demand is the Law of One Price.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Law of One Price The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it. Example: American steel $100 per ton, Japanese steel 10,000 yen per ton

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Law of One Price Law of one price  E = 100 yen/$

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels. PPP  Domestic price level  10%, domestic currency  10% – Application of law of one price to price levels – Works in long run, not short run

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) Problems with PPP 1.All goods are not identical in both countries (i.e., Toyota versus Chevy) 2.Many goods and services are not traded (e.g., haircuts, land, etc.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: PPP Figure 13.2 Purchasing Power Parity, United States/United Kingdom, 1973–2004 (Index: March 1973 = 100)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate  The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Relative price levels: a rise in relative price levels cause a country’s currency to depreciate. Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate. Productivity: if a country is more productive relative to another, its currency appreciates.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits. Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Deposits We will illustrate this with a simple example Francois the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Expected Returns and Interest Parity

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Example: if i D = 10% and expected appreciation of $, Exchange Rates in the Short Run: Expected Returns and Interest Parity Interest Parity Condition – $ and F deposits perfect substitutes (2)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Expected Returns and Interest Parity To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF. Next, we must determine the expected return in terms of dollars on dollar deposits, RD.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Deriving R F Curve R F curve connects these points and is upward sloping because when E t is higher, expected appreciation of F higher, R F 

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Deriving R D Curve Deriving R D Curve – Points B, D, E, R D = 10%, so curve is vertical

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Short Run: Equilibrium Equilibrium – R D = R F at E* – If E t > E*, R F > R D, sell $, E t  – If E t < E*, R F < R D, buy $, E t  The following figure illustrates this.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.3 Equilibrium in the Foreign Exchange Market Exchange Rates in the Short Run: Equilibrium

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Explaining Changes in Exchange Rates To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits. We will examine these separately, as well as changes in the money supply and exchange rate overshooting.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.4 Shifts in the Schedule for the Expected Return on Foreign Deposits RF Explaining Changes in Exchange Rates: Shifts in R F 1.R F curve shifts right when – i F  : because R F  at each E t – E e t+1  : because expected appreciation of F  at each E t and R F  2.Occurs: 1. Domestic P  ; 2. Restrictions on trade  ; 3. Imports  ; 4. Exports  ; 5. Productivity 

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.5 Shifts in the Schedule for the Expected Return on Domestic Deposits RD Explaining Changes in Exchange Rates: Shifts in R D 1.R D shifts right when – i D , because R D  at each E t – Assumes that domestic π e unchanged, so domestic real rate 

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Explaining Changes in Exchange Rates: Factors that Shift R F and R D

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Explaining Changes in Exchange Rates: Factors that Shift R F and R D (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.6 Effect of a Rise in the Domestic Nominal Interest Rate as a Result of an Increase in Expected Inflation Explaining Changes in Exchange Rates: Response to i  Because π e  1.π e , E e t+1 , expected appreciation of F , R F shifts out to right 2.i D , R D shifts to right 3.However because π e  > i D , real rate , E e t+1  more than i D   R F shifts out > R D shifts out and E t 

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.7 Effect of a Rise in the Money Supply Explaining Changes in Exchange Rates: Changes in the Money Supply 1.M s , P , E e t+1 , expected appreciation of F , R F shifts right 2.M s , i D , R D shifts left—go to point 2 and E t  3.In long run, i D returns to old level, R D shifts back, go to point 3 and get exchange rate overshooting

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Case: Why are Exchange Rates So Volatile Expectations of Eet+1 fluctuate Exchange rate overshooting

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 13.8 Value of the Dollar and Interest Rates, 1973–2004 Daily foreign exchange rate The Dollar and Interest Rates 1.Value of $ and real rates rise and fall together, as theory predicts 2.No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Practicing Manger: 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

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Summary Foreign Exchange Market: the market for deposits in one currency versus deposits in another. Exchange Rates in the Long Run: driven primarily by the law of one price as it affects the four factors discussed.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Summary (cont.) Exchange Rates in the Short Run: short- run rates are determined by the demand for assets denominated in both domestic and foreign currencies. Explaining Changes in Exchange Rates: factors leading to shifts in the RF and RD schedules were explored.