Exchange Rates Chapter 8

Firm in Home serve foreign markets / source from abroad? Stay domestic Export Export or local production? Import or local production? Import Multinational activity: horizontal Multinational activity: vertical no yes, serve foreign market yes, source from abroad export local production import local production Selling in foreign currency Producing and selling in foreign currency Producing in foreign currency Buying in foreign currency nature of exchange rate risk Figure 8.1 Exchange rates, trade and multinational activity

Exposure to exchange rate risks Economic exposure –Transaction risk –Translation risk Spot versus forward exchange rates

Figure 8.2 Some exchange rates; daily data, 2000 – 2011 Data source:

Figure 8.3 Australia – USA; spot and forward exchange rates of US dollar, Data source: IFS.

Arbitrage (Table 8.3) Players and markets Forward exchange rates and hedging Trading volume (Fig. 8.4)

Figure 8.4 Global foreign exchange market turnover, 1998 – 2010 Data source: BIS (2010), triennial central bank survey

Figure 8.5 Most used currencies on the foreign exchange market, 1998 – 2010 Data source: BIS (2010); * Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200 percent instead of 100 percent.

Exchange rates and prices Effective exchange rates

Figure 8.6 Exchange rates and prices, Calculations based on World Development Indicators online; 64 observations; the line has a 45  slope.

Figure 8.7 Exchange rates and intervention

Figure 8.8 De facto exchange rate arrangements, April 30, 2010 Data source: IMF (2010, Appendix II); selected countries listed for each regime, see also Table 23.1

Figure 8.9 US dollar: effective exchange rates, Data source:

Figure 8.9 US dollar: effective exchange rates, Data source:

Figure 8.10 Out-of-sample exchange rate forecasting Data source: Meese and Rogoff (1983)

Figure 8.11 Canada; interest rates and inflation rate (CPI), 1970 – 2011 Data source: IFS; bank rate (end of period) and cpi (% change), monthly data

Figure 8.12 UK; interest rates and term structure, Data source: IFS; 3 and 6 month Paris Interbank Offer rate

Arbitrage and interest parity Fisher equation: r = i - π Covered interest parity (Fig. 8.13) Equilibrium condition: [F(1+i US )/E]L = [(1+i EU )]L  F/E = (1+i EU )/(1+i US )

Figure 8.13 Two investment options

(BOX 8.4) Figure 8.14 Australia – USA: 12-month covered interest parity Data source: IFS; shown interest rates are interbank offered rates,

Interest parity, transaction costs, exchange rates, and capital mobility r home = r foreign + risk + TC A simple version of uncovered interest parity (UIP) condition: r home = r foreign + dE ; TC = 0, risk = dE Given r foreign,UIP indicates that in a world of high degree of capital mobility, the domestic interest rate can differ from the foreign interest rate only if the exchange rate is not fixed.