Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 5 UNDERSTANDING EXCHANGE RATES (1)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main2 What is an “exchange rate”? The price of one currency in terms of another (say dollars per euro) is called the exchange rate. Foreign exchange (forex) transactions are effected on specific markets for: –spot transactions; –forward transactions; –futures transactions; –options

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main3 Appreciation and depreciation If you pay more € for forex, your currency € is said to “depreciate”; if you pay less, your currency “appreciates” w=€/$ Depreciation w=€/$ Appreciation

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main4 Why are exchange rates important? They affect the relative price of domestic and foreign goods. When a country’s currency appreciates, the country’s goods become more expensive abroad, and foreign goods become cheaper. Will the exchange rate equate foreign and domestic prices?

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main5 The law of one price Under market conditions, arbitrage will indeed equate prices in the different regions of the domestic economy. If there are no barriers to trade, this also applies to international trade. If the price level in country A is higher than in country B, the exchange rate should correct for this difference.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main6 The law of one price Identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Consider the following information about movie video tapes sold in the US and Mexican markets: –Price of videos in US market (P v ) = $20 –Price of videos in Mexican market (P v ) = p150 –Spot exchange rate (p/$) = 10 p/$

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main7 The law of one price The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by the spot exchange rate. If the law of one price held, then the dollar price would have to be p150/10p/$ = $15 in Mexico to match the price in the US. Since the dollar price of the video is less than the dollar price in the US, the law of one price does not hold in this circumstance. If the law holds, we speak of “purchasing- power parity” (PPP).

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main8 The Big-Mac index (PPP ?)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main9 Effective exchange rate and PPP (against the $)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main10 PPP and short-term exchange rate PPP, e t Time t Short-term exchange rate (e) PPP

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main11 The purchasing power parity (PPP) theory The PPP theory makes sense only in the long run. In the short run there are significant deviations from PPP due to short-term movements of capital.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main12 Factors that affect exchange rates: long run Factors that affect the exchange rates are (w  = depreciation, w  = appreciation) : –Relative price levels: if P/P* , then w  –Tariffs and quota: if import duty , then w  –A shift in preferences for domestic versus foreign goods: if export demand , then w  if import demand , then w  –Productivity: If productivity , then w 

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main13 The DEM in the longer run

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main14 The organization of the forex spot market

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main15 A typical trading desk for spot forex

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main16 A typical trading desk for spot forex

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main17 The exchange rate of the Dollar (in €)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main18 Volatility GBP/EUR, hourly

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main19 Mastertextformat bearbeiten –Zweite Ebene Dritte Ebene –Vierte Ebene Fünfte Ebene Volatility of JPY/USD, 10 mins

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main20 Volatility USD/EUR, tick chart

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main21 Mastertextformat bearbeiten –Zweite Ebene Dritte Ebene –Vierte Ebene Fünfte Ebene Pound sterling during the 1992 crisis

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main22 The Asian crisis

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main23 The crisis of the Argentinian peso