Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and Exchange Rate Systems

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Introduction: Fixed, Flexible, or In-Between? Disagreements related to exchange rates and exchange rate systems Countries have numerous choices Exchange rate systems require different policies and respond differently to the pressures of the world economy

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates and Currency Trading Exchange rate: The price of domestic currency stated in terms of another currency For US it is dollars per pound, or dollars per yen

Exchange Rates and Currency Trading Frequently traded currencies are: - European Union’s euro - Japanese yen - British pound All three are flexible exchange rates It doesn’t matter how many of one currency is required to buy another Can’t use “strong” and “weak” Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-4

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Figure 10.1 Dollar Exchange Rates for Commonly Traded Currencies, 1999–2008

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates and Currency Trading Appreciation: Less domestic currency is required to buy 1 unit of foreign currency Depreciation: More domestic currency is required to buy 1 unit of foreign currency

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Reasons for Holding Foreign Currencies 1.Trade and investment 2.Interest rate arbitrage Borrow money where interest rates are low and sell it where interest rates are high Capital inflow in high interest countries decreases interest rates Outflow of capital from low interest rate countries increases interest rates Powerful force in global economy

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Reasons for Holding Foreign Currencies 3.Speculation speculators sell overvalued currencies and buy undervalued currencies Help restore equilibrium after currency has become under- or overvalued Some argue it can be destabilizing by leading to under- or overvalued currency

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Institutions Four main groups involved in foreign currency markets: –Retail customers: firms and individuals that hold foreign currency –Commercial banks: hold inventories of foreign currencies as part the services to customer; most important of four participants –Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency –Central banks: a country’s bank of banks

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rate Risk Exchange rate risks: currencies are constantly changing in value –Actual payment in a foreign currency will likely be a different domestic currency amount from when the contract was signed –Created mechanisms to deal with problem.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rate Risk Forward exchange rate: The price of currency that will be delivered in the future Forward market: A market in which the buying and selling of currencies for future delivery takes place –Eliminates risk from future payments –Contract is signed the day they agree to ship/receive goods that guarantees price for 30, 90, or 180 days Spot market: Buying and selling of foreign currencies in the present

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rate Risk Hedging: Use forward market to protect themselves against foreign exchange risk while holding foreign assets –Done by buying forward contract to sell foreign currency at the same time the interest earning asset matures –Covered interest arbitrage: Use of forward market by an interest rate arbitrageur against exchange rate risk

Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Supply and Demand for Foreign Exchange Currency’s value is determined by its supply and demand –Under a flexible exchange rate system currency appreciates/depreciates based on changes in supply/demand –Under a fixed exchange rate system, the central bank counteracts changes in the market to hold currency’s value constant Biggest disadvantage: trade-off between supporting the exchange rate and maintaining economic growth.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 10.1 A Hypothetical Example of the Exchange Rate in the Long Run Purchasing power parity (PPP): the equilibrium value of an exchange rate is at the level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Long Run PPP is underlying tendency of exchange rates in long run, not short or medium run If currency is over- or undervalued, automatic changes in buying/selling currency and flow of goods will restore PPP Usually equalization is through exchange rates, not prices PPP is based on goods arbitrage which fails to acknowledge other costs

Exchange Rates in the Medium Run and Short Run Medium run forces: –The country’s economic growth: increases incomes, increases demand for imports and an outward shift in the demand for foreign currency, domestic currency depreciates –Growth abroad: results in an increase of exports from the home country and an increase in the supply of foreign currency, domestic currency appreciates Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Medium Run and Short Run Short run (a year or less) effects on the exchange rate stem from financial capital flows These flows are determined by (1) interest rates and (2) expectations of future exchange rates

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Medium Run and Short Run Interest parity: the difference between any two countries’ interest rates is equal to the expected change in the exchange rate –If i = i*, investors are indifferent –If i > i*, investors prefer home to foreign investment Best choice is also determined by exchange rate movements during the period

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Medium Run and Short Run Difference between the forward exchange rate (F) and the spot rate (R) is expected appreciation or depreciation –F > R: home currency expected to depreciate and is selling at a discount –F<R: home currency expected to appreciate and is selling at a premium –However, say, i < i* and F = R: no changes are expected in the exchange rate, and investors should invest in foreign

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Medium Run and Short Run Processes in economy continue until interest parity condition is reached –i – i* = (F-R)/R –Interest rate differentials are approximately equal to expected changes in the exchange rate

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Exchange Rates in the Medium Run and Short Run Capital flight can be self-fulfilling –If investors expect depreciation, they converts their assets to another currency –Demand for foreign exchange increases –Supply is depressed and currency depreciates Sudden shift in expectations occurs when government policies are inconsistent and unsustainable

Table 10.2 Composition of Currency Trades, April 2007 Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Table 10.3 Currency Trading Centers Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 10.4 Major Determinants of an Appreciation or Depreciation

Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Real Exchange Rate Foreign prices ultimately determine the purchasing power of the domestic currency in terms of the foreign currency –Real exchange rate: the market exchange rate (nominal exchange rate) adjusted for price differences between countries

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Alternatives to Flexible Exchange Rates Fixed exchange rate system: The value of a nation’s money is defined in terms of a fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar); the Gold standard exchange rate system Flexible (floating) exchange rate system: The value of the currency is allowed to float up and down with market forces Purely fixed or floating systems today are rare