Chapter Twelve Currency Markets and Exchange Rates

2 Chapter Twelve Outline 1.Introduction 2.Exchange Rates and Prices 3.Foreign Exchange Markets 4.Interest Parity 5.Demand and Supply in the Foreign Exchange Market 6.How Are Exchange Rates determined under a Fixed Regime?

3 Chapter Twelve Outline 7.The Effective Interest Rate 8.Offshore Currency Markets

4 Introduction One characteristic distinguishes international economic activity from domestic: –International transactions typically involve more than one currency. We now examine the mechanics of currency markets and their role in global trade.

5 Exchange Rates and Prices What do prices tell us? –Relative prices convey information about the opportunity costs of various goods. Relative price is sometimes referred to as a good’s real price – means the price is measured in “real” units (other goods), rather than monetary units. –We use money prices: they tell how many units of money (dollars, yen, etc.) we must pay to buy goods. Money prices must reflect relative prices or opportunity costs.

6 Exchange Rates and Prices How can we compare prices in different currencies? –Exchange rate: number of units of domestic currency required to purchase 1 unit of the foreign currency. A change in the exchange rate, other things being equal, changes all foreign prices relative to all domestic prices.

7 Foreign Exchange Markets Foreign exchange market is generic term for the worldwide institutions that exist to exchange or trade different countries’ currencies. –The daily exchange rate quotations from the Wall Street Journal: First two columns report the number of U.S. dollars required to buy one unit of foreign currency (e). Last two columns report the number of units of foreign currency required to purchase a U.S. dollar (e‘ = 1/e).

8 Foreign Exchange Markets What type of transactions happen in foreign exchange markets? –Each bank, form, or individual must choose how to allocate its available wealth among various assets. Asset: something of value. Asset portfolio: set of assets owned by a firm or individual. –Portfolio choice: allocating one’s wealth among various types of assets. –Primary determinant of any particular asset’s desirability is its expected rate of return.

9 Foreign Exchange Markets Spot exchange market: the market in which participants trade currencies for current delivery, which actually means within two business days. Clearing function of foreign exchange market: –Example: a U.S. firm decides to buy a British bond. The U.S. firm typically enters the spot foreign exchange market to buy the pounds in which the British firm wants to be paid. This happens when the U.S. firm instructs its bank to debit its dollar account and credit the pound bank account of the British firm.

10 Foreign Exchange Markets Arbitrage: refers to process by which banks, firms, or individuals seek to earn a profit by taking advantage of discrepancies among prices that prevail simultaneously in different markets. –Ensures not only that currencies exchange at same rate in different cities, but that exchange rates will be consistent across currencies. Inconsistent cross rates: quoted exchange rates in different locations that offer arbitrage opportunities – consistency restored by arbitrage actions. Triangular arbitrage: use of 3 currencies in arbitrage.

11 Foreign Exchange Markets Hedging: a way to transfer part of the foreign exchange risk inherent in all non-instantaneous transactions that involve two currencies. –Entering the foreign exchange market to hedge insulates wealth from effects of adverse changes in the exchange rate. –Short position: being short of a particular currency you will need in the near future. –Balanced, or closed, position: owning as many units of a particular currency as you need to cover your upcoming payment in that currency.

12 Foreign Exchange Markets Speculation: just the opposite of hedging – it means deliberately making your wealth depend on changes in the exchange rate by… 1.Buying a deposit denominated in a foreign currency (taking a long position) in the expectation that the currency's price will rise, allowing you to sell it later at a profit; or 2.Promising to sell a foreign currency deposit in the near future (taking a short position) in the expectation that its price will fall, allowing you to buy the currency cheaply and sell it at a profit.

13 Foreign Exchange Markets Buying currency now for delivery later. –Major markets for foreign exchange other than spot markets are forward markets. Participants sign contracts for foreign-exchange deliveries to be made at some specified future date. 30-day forward rate for pounds: the dollar price at which you can buy a contract today for a pound deposit to be delivered in 30 days. –% difference between the 30-day forward rate (e f ) on a currency and the spot rate is called the forward premium if positive and forward discount if negative.

14 Interest Parity –Uncovered interest parity applies to transactions in which participants do not use forward markets to transfer foreign exchange risk. –Covered interest parity applies to transactions in which they do. Uncovered interest parity –Individuals and firms must form an expectation about the future spot rate of a particular currency and base their asset decision on that. This expectation is called the expected future spot rate (e e ) – what people expect today about the spot rate that will prevail in the future.

15 Interest Parity Uncovered interest parity (cont.) –When all participants in an economy choose between purchasing dollar- and pound-denominated deposits in a way to maximize expected rate of return, the result is a relationship among interest rates, the current spot rate, and the participants’ expectations of the future value of the spot rate. Expected dollar rate of return on a dollar-denominated deposit is just the interest rate (i $ ). Expected dollar rate of return on a pound-denominated deposit has 2 components: the interest rate on the deposit (i £ ), and the expected rate of change in value of pounds relative to the dollar ([e e –e]/e).

16 Interest Parity Uncovered interest parity (cont.) –Using the pound example in the text, the general case algebraically is: If i $ < i £ + (e e -e)/e, purchase the pound-denominated deposits. –Numerically: 1.5% < 1% + [($2.02/£1 - $2.00/£1)/$2.00/£1)] = 2%, therefore, purchase pound-denominated deposits.

17 Interest Parity Uncovered interest parity (cont.) –Using the dollar example in the text, the general case algebraically is: If i $ > i £ + (e e -e)/e, purchase the dollar-denominated deposits. –Numerically: 3% > 1% + [($2.02/£1 - $2.00/£1)/$2.00/£1)] = 2%, therefore, purchase dollar-denominated deposits.

18 Interest Parity Uncovered interest parity (cont.) –From the previous two equations, we see that there will be no incentive to shift from one currency to the other when the expected dollar rates of return on the two types of deposits are equal. This equilibrium condition is known as uncovered interest parity. It holds when… General Case i $ = i £ + (e e -e)/e Numerical Example 2% = 1% + [($2.02/£1 - $2.00/£1)/$2.00/£1)] = 2%

19 Interest Parity Uncovered interest parity (cont.) –An alternative way of writing the uncovered parity condition puts the interest differential (i $ - i £ ) on the left-hand side. The term on the right-hand side is the expected increase (if positive) or decrease (if negative) in the value of pounds against dollars, expressed in percentage terms.

20 Interest Parity Uncovered interest parity (cont.) –Chicago Mercantile Exchange (through its International Monetary Market) offers speculators a forum for the sale and purchase of foreign exchange futures contracts.

21 Interest Parity Covered interest parity: –Using the pound example in the text and letting e f represent the forward rate, the general case is: If i $ < i £ + (e f -e)/e, purchase the pound-denominated deposits. Numerically: 1.5% < 1% + [($2.02/£1 - $2.00/£1)/$2.00/£1)] = 2%, therefore, purchase pound-denominated deposits.

22 Interest Parity Covered interest parity (cont.): –Using the dollar example in text, the general case is: If i $ > i £ + (e f -e)/e, purchase the dollar-denominated deposits. Numerically: 1% > 2% + [($1.50/£1 - $2.00/£1)/$2.00/£1)] = -23%, therefore, purchase dollar-denominated deposits.

23 Interest Parity Uncovered interest parity (cont.) –Both the interest differential and the forward premium or discount on foreign exchange must be taken into account in choosing deposits denominated in different currencies based on their rates of return, When participants make their decisions based on the previous two equations, the resulting equilibrium condition is known as covered interest parity. It holds when… General Case i $ = i £ + (e f -e)/e Numerical Example 2% = 1% + [($2.02/£1 - $2.00/£1)/($2.00/£1)] = 2%,

24 Interest Parity Does interest parity hold? –Empirical support for the relationship is quite strong, but the results are sensitive to the testing technique. The parity relationship holds more closely when all deposits used in the test are issued in a single country. –A 2 nd country could impose restrictions on the movement of funds across their borders.

25 Interest Parity Does interest parity hold? –Offshore currency markets provide perfect opportunity for testing interest parity. Offshore deposits (or Eurocurrencies) are currencies held in deposit outside their country of issue – a dollar deposit held anywhere outside the U.S. is a Eurocurrency (or Eurodollar) deposit, regardless of who owns the deposit.

26 Demand/Supply in Foreign Exchange Markets Equilibrium in the foreign exchange market and interest parity are equivalent conditions. Demand curve for a foreign currency: shows how many units of the currency individuals would want to hold at various exchange rates. –Similarly, the supply curve for a foreign currency shows how many units of foreign-currency deposits are available for individuals to hold at various exchange rates.

27 Demand/Supply in Foreign Exchange Markets Demand for foreign exchange –Relationship between the quantity demanded of foreign exchange and the spot exchange rate (expressed as the domestic currency price of a unit of foreign currency) is a negative one. As the exchange rate rises, the quantity of foreign exchange demanded falls. The negatively sloped line in Figure 12.5 illustrates the negative relationship between the quantity demanded of foreign exchange and the exchange rate.

28 Figure 12.5: The Exchange Rate and the Quantity Demanded of Foreign Exchange e = $/£ D e 1 e 2 0Quantity Demanded of £-Denominated Deposits i $,i +,e e + f + )( _

29 Demand/Supply in Foreign Exchange Markets The supply of foreign exchange –Because the stock of foreign-currency- denominated deposits available at any time is fixed, one can represent the supply of foreign exchange by a vertical line, S £, in Figure The supply curve is vertical because the supply of deposits in existence at any time does not depend on the exchange rate.

30 Figure 12.6: The Supply of Foreign Exchange e = $/£ 0Quantity Supplied of £-Denominated Deposits S £

31 Demand/Supply in Foreign Exchange Markets The supply of foreign exchange (cont.) –Exchange rate regime: in each country, the government decides the type of policy to follow regarding the exchange rate. Four types of regime: 1.Flexible or floating exchange rates; 2.Fixed or pegged exchange rates; 3.Managed floating (a mixture of flexible and fixed); and 4.Exchange controls.

32 Exchange Rate Determination under a Flexible Rate Regime Since the 1970s, most countries have moved towards the use of flexible, or floating, exchange rates. –Demand for and supply of each currency in FX market determine the exchange rate. –Figure 12.7 shows the equilibrium exchange rate (e 3 ) between the dollar and the pound. The exchange rate moves to equate the quantity demanded and the quantity supplied of pounds. See Figure 12.7

33 Figure 12.7: Equilibrium in the Foreign Exchange Market under a Flexible Rate Regime e = $/£ e 1 e 3 e 2 0Quantity of £-Denominated Deposits Surplus of £ Shortage of £ S£S£ D£D£

34 Exchange Rate Determination under a Flexible Rate Regime –We call a rise in the market-determined rate a depreciation of the currency whose price has fallen, and an appreciation of the currency whose price has risen. Any change in economic conditions that increases the demand for a particular currency causes that currency to appreciate. –Figure 12.8 illustrates an example.

35 Figure 12.8: Shifts in the Demand for Foreign Exchange Change the Exchange Rate e = $/£ e 1 e 0 e 2 0Quantity of £-Denominated Deposits S£S£ i e e i £ e f $       i e e i £ e f $ D£D£ 0 D£D£ 1 D£D£ 2

36 Exchange Rate Determination under a Fixed Rate Regime Exchange rates have not been flexible through most of modern economic history. –Central banks used fixed or pegged exchange rates for their respective currencies. Figure 12.9 shows a pegged exchange rate above the equilibrium rate. –To maintain the exchange rate at a certain point, a central bank must stand ready to absorb the excess quantity supplied of a foreign currency.

37 Figure 12.9: A Pegged Exchange Rate above the Equilibrium Rate e = $/£ e 1 0Quantity of £-Denominated Deposits Intervention S£S£ D£D£ p

38 Exchange Rate Determination under a Fixed Rate Regime Intervention: when a central bank steps into the market to buy or sell a particular currency. –If a country’s central bank chooses to adjust the pegged exchange rate downward, the policy is called a revaluation of that currency. Analogous to an appreciation under a flexible regime. Figure shows a pegged exchange rate below the equilibrium rate.

39 Figure 12.10: A Pegged Exchange Rate below the Equilibrium Rate e = $/£ e 2 0Quantity of £-Denominated Deposits Intervention S£S£ D£D£ p

40 Exchange Rate Determination under a Fixed Rate Regime For intervention purposes, governments hold stocks of deposits denominated in various foreign currencies, called foreign exchange reserves. Under a fixed regime, if the central bank chooses to reset the exchange rate at a level higher than equilibrium, the policy is called a devaluation. –This is analogous to a depreciation under a flexible regime.

41 Effective Exchange Rate Because an exchange rate is merely the relative price of two currencies, a currency may appreciate against some currencies at the same time it depreciates against others. –It is impossible, using bilateral exchange rates, to determine whether a currency is generally appreciating or depreciating in foreign exchange markets. –Useful to have effective exchange rates…an indicator of the trend of a currency's overall movement relative to other currencies “on average.”

42 Offshore Currency Markets Why do they exist? 1.Banks can partially escape costly national regulations and lower their operating costs. –Yields higher profits and/or ability to pay higher rates to depositors. –Examples: Cayman Islands, Hong Kong, Singapore, Panama. 2.Firms increasingly need more financial services than typically provided in one country. –Ability to hold bank deposits in different currencies and locales helps minimize costs of doing business.

43 Offshore Currency Markets 3.Political reason: to avoid the possibility of having your assets frozen by a country not friendly to your interests, your country may choose to hold deposits in an offshore bank. –Soviet Union deposited their dollars in a Paris bank.

44 Key Terms in Chapter 12 Clearing Arbitrage Inconsistent cross rates Triangular arbitrage Hedging Foreign exchange risk Short position Balanced (closed) position

45 Key Terms in Chapter 12 Speculation 30-day forward rate Forward premium Forward discount Expected future spot rate Uncovered interest parity Interest differential Covered interest parity

46 Key Terms in Chapter 12 Offshore deposits (Eurocurrencies) Demand curve for a foreign currency Supply curve for a foreign currency Exchange rate regime Flexible (floating) exchange rate Depreciation Appreciation Fixed (pegged) exchange rate

47 Key Terms in Chapter 12 Intervention Revaluation Foreign exchange reserves Devaluation Bilateral exchange rate Effective exchange rate