1. 1 Exchange Rates CHAPTER 13

2. 2 Exchange Rates What are they? What are they? How does one describe their movements? How does one describe their movements?

3. 3 Exchange Rates The nominal exchange rate is the price of one currency in terms of another. The nominal exchange rate is the price of one currency in terms of another. The spot rate applies to trades “on the spot”. The spot rate applies to trades “on the spot”.

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5. 5 Exchange Rate Quotes Currency Trading Currency Trading WSJ Section C, January 11, 2004 WSJ Section C, January 11, 2004 US $ equivalent Currency per US $ US $ equivalent Currency per US $ (E $/¥ ) (E ¥/$ ) (E $/¥ ) (E ¥/$ ) Japan.00940$ 106.37 ¥ E = E HC/FC is the home currency value of the foreign currency E = E HC/FC is the home currency value of the foreign currency

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8. 8 Between Jan 2003 and Jan 2004 Which currency appreciated? Which currency appreciated? Did E rise? Did E rise?

9. 9 Who Participates in this Market? Banks and near banks Banks and near banks Corporations Corporations Central Banks Central Banks

10. 10 Other Characteristics Volume Volume Vehicle Currencies Vehicle Currencies Spot and Forward Markets Spot and Forward Markets

11. 11 What Are the Effects of Changes in E? Gains and losses for international asset holders Gains and losses for international asset holders Changes in price competitiveness in international goods markets Changes in price competitiveness in international goods markets

12. 12 Exchange Rates & Imports US import (Japanese car) sells for 2 mill. ¥ US import (Japanese car) sells for 2 mill. ¥ As the ¥ appreciates & the $ depreciates, the price of US imports  As the ¥ appreciates & the $ depreciates, the price of US imports  E $/¥ E ¥/$ Price of US Import ($) E $/¥ E ¥/$ Price of US Import ($).008 125.008(2000000) = $16000.008 125.008(2000000) = $16000.010 100.01(2000000) = $20000.010 100.01(2000000) = $20000.012 83.012(2000000) = $24000.012 83.012(2000000) = $24000

13. 13 Exchange Rates & Exports US export (car) sells for $20000 US export (car) sells for $20000 As the ¥ appreciates & the $ depreciates, the price of US exports  As the ¥ appreciates & the $ depreciates, the price of US exports  E $/¥ E ¥/$ Price of US Export (¥) E $/¥ E ¥/$ Price of US Export (¥).008 125 125(20000) = ¥2500000.008 125 125(20000) = ¥2500000.010 100 100(20000) = ¥2000000.010 100 100(20000) = ¥2000000.012 83.3 83.3(20000) = ¥1666667.012 83.3 83.3(20000) = ¥1666667

14. 14 Forward Rates Spot 30 day 90 day 180 day Spot 30 day 90 day 180 day forward forward forward forward forward forward $ per £ 1.8486 1.8443 1.8355 1.8219 A forward contract is a contract to trade in the future A forward contract is a contract to trade in the future Forward rates indicate market expectations for the future. Forward rates indicate market expectations for the future.

15. 15 Expectations of Mr. Typical E Mar 2004 Probability E Mar 2004 Probability 1.78 5% 1.78 5% 1.79 10% 1.79 10% 1.80 20% 1.80 20% 1.81 30% E e = 1.81 1.81 30% E e = 1.81 1.82 20% 1.82 20% 1.83 10% 1.83 10% 1.84 5% 1.84 5%

16. 16 Expectations and Forward Rates Current (six month) forward rate on the £: Current (six month) forward rate on the £: F $/£ =1.82 F $/£ =1.82 Mr Typical decides to speculate Mr Typical decides to speculate Goes “short” in the forward market for pounds Goes “short” in the forward market for pounds

17. 17 Expectations and Forward Rates Mr. Typical’s plan: Agree to sell $100000 worth of pounds Agree to sell $100000 worth of pounds (£ 54945= 100000/1.82) in 6 months (£ 54945= 100000/1.82) in 6 months Next March buy £ 54945 on the spot market for $99450 (=54945x1.81) and sell it for $100000 as agreed. Next March buy £ 54945 on the spot market for $99450 (=54945x1.81) and sell it for $100000 as agreed.

18. 18 Expectations and Forward Rates If “the market” agrees with Mr. Typical’s expectation (guess) and acts on it: If “the market” agrees with Mr. Typical’s expectation (guess) and acts on it: Lots of sellers of pounds (buyers of dollars) in the forward market and few buyers. Lots of sellers of pounds (buyers of dollars) in the forward market and few buyers. F $/£ falls until it equals 1.81 ( =E e ) F $/£ falls until it equals 1.81 ( =E e )

19. 19 Is this result based on the notion that everyone thinks E will fall to 1.81 ? No No

20. 20 Expectations of Mr. Bull E next year Probability E next year Probability 1.79 5% 1.79 5% 1.80 10% 1.80 10% 1.81 20% 1.81 20% 1.82 30% E e = 1.82 1.82 30% E e = 1.82 1.83 20% 1.83 20% 1.84 10% 1.84 10% 1.85 5% 1.85 5%

21. 21 Expectations of Ms. Bear E next year Probability E next year Probability 1.77 5% 1.77 5% 1.78 10% 1.78 10% 1.79 20% 1.79 20% 1.80 30% E e = 1.80 1.80 30% E e = 1.80 1.81 20% 1.81 20% 1.82 10% 1.82 10% 1.83 5% 1.83 5%

22. 22 Expectations and the Forward Rate Suppose F $/£ falls until 1.81 = E e Suppose F $/£ falls until 1.81 = E e Mr. Bull goes “long” in the pound Mr. Bull goes “long” in the pound (committed to buy at 1.81; hopes to sell at 1.82) (committed to buy at 1.81; hopes to sell at 1.82) Ms. Bear sells the pound “short” Ms. Bear sells the pound “short” (committed to sell at 1.81; hopes to buy at 1.80) (committed to sell at 1.81; hopes to buy at 1.80) Mr. Typical stays out of the market Mr. Typical stays out of the market

23. 23 Expectations and the Forward Rate E e =1.81 means as much money thinks the spot rate will be above 1.81 as thinks that it will be below 1.81 in July E e =1.81 means as much money thinks the spot rate will be above 1.81 as thinks that it will be below 1.81 in July If F $/£ > 1.81 speculators will flood “short” side of the market until F $/£ = 1.81 If F $/£ > 1.81 speculators will flood “short” side of the market until F $/£ = 1.81 If F $/£ < 1.81 speculators will flood “long” side of the market until F $/£ = 1.81 If F $/£ < 1.81 speculators will flood “long” side of the market until F $/£ = 1.81

24. 24 Who Participates in Forward Markets? Speculators Speculators Hedgers Hedgers

25. 25 Hedging Forward contracts can be used to protect against (hedge) exchange risk Forward contracts can be used to protect against (hedge) exchange risk Value of 1 Million Pounds Value of 1 Million Pounds in 30 days in 30 days Value of £ Value of $ $ Receipts $ 1.60 £ 0.63 $ 1600000 $ 1.60 £ 0.63 $ 1600000 $ 1.80 £ 0.56 $ 1800000 $ 1.80 £ 0.56 $ 1800000 $ 2.00 £ 0.50 $ 2000000 $ 2.00 £ 0.50 $ 2000000

26. 26 Other Contracts An option gives you the right, but not the obligation, to trade currencies in the future An option gives you the right, but not the obligation, to trade currencies in the future A futures contract requires the payment of $ now, in order to receive a specified amount of £’s in the future. A futures contract requires the payment of $ now, in order to receive a specified amount of £’s in the future.

27. 27 What Makes (spot) Exchange Rates Fluctuate?

28. 28 Exchange Rate Determination What makes E rise and fall? What makes E rise and fall? Supply and Demand (of course) Supply and Demand (of course) What makes Supply and Demand fluctuate? What makes Supply and Demand fluctuate? Most exchanges of currency are used to finance the purchase of foreign assets not foreign goods Most exchanges of currency are used to finance the purchase of foreign assets not foreign goods

29. 29 Interest Parity Why Should Interest Rates be Different in Different Countries?

30. 30 Equilibrium Exchange Rate Asset market approach to E – E is determined by financial factors. Asset market approach to E – E is determined by financial factors. International trades of assets are far larger than international trades of goods International trades of assets are far larger than international trades of goods The value of the foreign currency (E) depends on interest rates here & abroad, R HC, & R FC, and expectations of the future The value of the foreign currency (E) depends on interest rates here & abroad, R HC, & R FC, and expectations of the future

31. 31 Demand For Foreign Currency Assets Factors influencing this decision Factors influencing this decision  Interest rates at home & abroad, R HC & R FC  Exchange rate now, E  Expected exchange rate in the future, E e. Because the (expected) return on foreign bonds is [(1 + R FC )E e /E] - 1  R FC + (E e - E)/E The (known) return on domestic bonds is R HC

32. 32 Equilibrium E Graph determines E as a function of E e, R $, & R € Graph determines E as a function of E e, R $, & R € E1E1 E $/ € R$1R$1 $R € R

33. 33 Equilibrium E R $ = 7% R € = 5% E $/€ = 1.00 R $ = 7% R € = 5% E $/€ = 1.00 Should an American investor put her funds in German assets? Should an American investor put her funds in German assets? Depends on what she expects to happen to E by the time she repatriates her funds Depends on what she expects to happen to E by the time she repatriates her funds

34. 34 Equilibrium E Suppose she expects the euro to rise to 1.08 by next year (8% appreciation) Suppose she expects the euro to rise to 1.08 by next year (8% appreciation) E e $/€ = 1.08 E e $/€ = 1.08 Expected return from investing abroad is Expected return from investing abroad is [(1 + R € )E e /E] - 1 = 13.4% [(1 + R € )E e /E] - 1 = 13.4%  R € + (E e - E)/E = 13%  R € + (E e - E)/E = 13%

35. 35 Interest Parity Foreign assets look like a good deal Foreign assets look like a good deal (13% is better than 7%) (13% is better than 7%) Of course the euro might not go up that Of course the euro might not go up that much and the domestic return is certain much and the domestic return is certain Go for it! Go for it!

36. 36 Equilibrium E If she takes the plunge, what about everyone else? If she takes the plunge, what about everyone else? They will too if they share her opinion that They will too if they share her opinion that the dollar will fall by 8% the dollar will fall by 8%

37. 37 Equilibrium E If lots of American do this they will be selling dollars (buying euros) on the spot market for foreign exchange If lots of American do this they will be selling dollars (buying euros) on the spot market for foreign exchange Lots of sellers put downward pressure on the $ (upward pressure on the euro) Lots of sellers put downward pressure on the $ (upward pressure on the euro) E will rise, but how far? E will rise, but how far?

38. 38 Equilibrium E E e E R € + (E e -E)/E R $ E e E R € + (E e -E)/E R $ 1.08 1.00 13% 7% 1.08 1.00 13% 7% 1.08 1.02 11% 7% 1.08 1.02 11% 7% 1.08 1.04 9% 7% 1.08 1.04 9% 7% 1.08 1.06 7% 7% 1.08 1.06 7% 7% 1.08 1.08 5% 7% 1.08 1.08 5% 7% 1.08 1.10 3% 7% 1.08 1.10 3% 7%

39. 39 Equilibrium E Graph determines E as a function of E e, R $, & R € Graph determines E as a function of E e, R $, & R € E1E1 E $/ € R$1R$1 $R € R

40. 40 Equilibrium E R $ is the US interest rate, vertical because the R $ is independent of E. R $ is the US interest rate, vertical because the R $ is independent of E. $R € is the $ return on German bonds, $R € is the $ return on German bonds, R € + (E e - E)/E $R € depends negatively on E. $R € depends negatively on E.  As current value of the € (E) , the future expected appreciation of € , & the $R € .

41. 41 Equilibrium E The equilibrium condition is called interest parity, and requires the equality of expected $ returns. The equilibrium condition is called interest parity, and requires the equality of expected $ returns. R $ = $R € = R € + (E e - E)/E What if R $ < $R € = R € + (E e - E)/E ? What if R $ < $R € = R € + (E e - E)/E ? What if R $ > $R € = R € + (E e - E)/E ? What if R $ > $R € = R € + (E e - E)/E ?

42. 42 Interest Parity to German Investors E e E R $ - (E e -E)/E R € E e E R $ - (E e -E)/E R € 1.08 1.00 -1% 5% 1.08 1.00 -1% 5% 1.08 1.02 1% 5% 1.08 1.02 1% 5% 1.08 1.04 3% 5% 1.08 1.04 3% 5% 1.08 1.06 5% 5% 1.08 1.06 5% 5% 1.08 1.08 7% 5% 1.08 1.08 7% 5% 1.08 1.10 9% 5% 1.08 1.10 9% 5%

43. 43 Interest Parity E e = 1.08 this the “typical” expectation E e = 1.08 this the “typical” expectation Maybe euro “bulls” expect 1.10 and euro “bears” expect 1.06 Maybe euro “bulls” expect 1.10 and euro “bears” expect 1.06 How do they invest? How do they invest?

44. 44 Interest Parity If Mr. Bull is American, what does he do? If Mr. Bull is American, what does he do? Best guess is a 9% return overseas Best guess is a 9% return overseas Buy foreign assets Buy foreign assets Buy euros on the spot market (enough sellers?) Buy euros on the spot market (enough sellers?)

45. 45 Interest Parity If Ms. Bear is American, what does she do? If Ms. Bear is American, what does she do? Best guess is a 5% return overseas Best guess is a 5% return overseas Buy domestic assets Buy domestic assets Stay out of the foreign exchange market Stay out of the foreign exchange market

46. 46 Interest Parity If Mr. Typical is American, what does he do? If Mr. Typical is American, what does he do? Best guess is a 7% return overseas Best guess is a 7% return overseas Buy domestic assets (same return, no exchange risk) Buy domestic assets (same return, no exchange risk) Stay out of the foreign exchange market Stay out of the foreign exchange market

47. 47 Interest Parity If Herr Bull is German, what does he do? If Herr Bull is German, what does he do? Best guess is a 3% return overseas (in U.S.) Best guess is a 3% return overseas (in U.S.) Buy domestic (German) assets Buy domestic (German) assets Stay out of the foreign exchange market Stay out of the foreign exchange market

48. 48 Interest Parity If Herr Typical is German, what does he do? If Herr Typical is German, what does he do? Best guess is a 5% return overseas (in U.S.) Best guess is a 5% return overseas (in U.S.) Buy domestic assets (same return, no exchange risk) Buy domestic assets (same return, no exchange risk) Stay out of the foreign exchange market Stay out of the foreign exchange market

49. 49 Interest Parity If Frau Bear is German, what does she do? If Frau Bear is German, what does she do? Best guess is a 7% return overseas (in U.S.) Best guess is a 7% return overseas (in U.S.) Buy foreign (American) assets Buy foreign (American) assets Sell euros (to Mr. Bull) in spot market Sell euros (to Mr. Bull) in spot market

50. 50 Interest Parity E e = 1.08 and “typical” investors sees approximately equal returns in foreign and domestic assets E e = 1.08 and “typical” investors sees approximately equal returns in foreign and domestic assets American euro “bulls” (dollar “bears”) invest in German assets and buy €’s from German euro “bears” (dollar “bulls”) in the spot market to finance the investment American euro “bulls” (dollar “bears”) invest in German assets and buy €’s from German euro “bears” (dollar “bulls”) in the spot market to finance the investment

51. 51 Increased Interest Rates at Home (R $  ) E $/ € E1E1 1 R$1R$1 $R € R R$2R$2 2 E2E2

52. 52 Increased Interest Rates at Home (R $  ) Fed worries about inflationary pressures and pushes R $  Fed worries about inflationary pressures and pushes R $  Bond traders move out of € & into $’s Bond traders move out of € & into $’s € depreciates (E  ) € depreciates (E  ) $ appreciates $ appreciates

53. 53 Increased Interest Rates Abroad (R €  ) E $/ € E1E1 1 R$1R$1 $R € 1 R

54. 54 Increased Interest Rates Abroad (R €  ) ECB becomes worried about inflation & pushes R € . ECB becomes worried about inflation & pushes R € . Which way do bond traders move? Which way do bond traders move? What happens to the value of the €? What happens to the value of the €? What happens to the value of the $? What happens to the value of the $?

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56. 56 Increased Future Value of the Euro (E $/€ e  ) E $/ € E1E1 1 R$1R$1 $R € 1 R

57. 57 Increased Future Value of the Euro (E $/€ e  ) Future German budget deficits likely to , future R € likely to , future E $/€ e . Future German budget deficits likely to , future R € likely to , future E $/€ e . Which way do bond traders move? Which way do bond traders move? What happens to the value of the €? What happens to the value of the €? What happens to the value of the $? What happens to the value of the $?

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59. 59 Covered Interest Parity Our earlier interest parity condition was R HC = R FC + (E e - E)/ E Our earlier interest parity condition was R HC = R FC + (E e - E)/ E This is called uncovered interest parity, we are not “covered” against exchange risk This is called uncovered interest parity, we are not “covered” against exchange risk

60. 60 Covered Interest Parity Covered interest parity is Covered interest parity is R $ = R € + (F $/€ - E $/€ )/ E $/€ R $ = R € + (F $/€ - E $/€ )/ E $/€  Forward rate replaces the expected spot rate  We are covered against exchange risk.

61. 61 Covered Interest Parity Suppose R HC < R FC + (F - E)/ E Suppose R HC < R FC + (F - E)/ E How could you make a riskless profit with no money tied up? How could you make a riskless profit with no money tied up?

62. 62 Covered Interest Parity Suppose R $ = 4% R £ = 8% E $/£ = 1.85 F $/£ = 1.80 Suppose R $ = 4% R £ = 8% E $/£ = 1.85 F $/£ = 1.80 R £ + (F $/£ - E $/£ )/ E $/£ = 5.3% > R $ R £ + (F $/£ - E $/£ )/ E $/£ = 5.3% > R $

63. 63 Covered Interest Parity The PLAN: The PLAN: Borrow $10000000 for 1 year at 4% Borrow $10000000 for 1 year at 4% Buy £ 5410000 on the spot market at 1.85 Buy £ 5410000 on the spot market at 1.85 Buy £ 5410000 of 1 year British bonds at 8% Buy £ 5410000 of 1 year British bonds at 8% Sell £ 5840000 on the forward market at 1.80 Sell £ 5840000 on the forward market at 1.80

64. 64 Covered Interest Parity Next year: Take £ 5840000 (principal plus interest) and fulfill the forward contract receiving $10510000 Take £ 5840000 (principal plus interest) and fulfill the forward contract receiving $10510000 Repay $10400000 (principal plus interest) Repay $10400000 (principal plus interest) Buy a Porsche with the remaining $110000 Buy a Porsche with the remaining $110000

65. 65 Covered Interest Parity Since R $ < R £ + (F $/£ - E $/£ )/ E $/£ Borrow at 4% and lend at 5.3% You get income risk free with no commitment of your own funds Too good to be true? (too good to last long)

66. 66 R $ < R £ + (F $/£ - E $/£ )/E $/£ Borrowing on U.S. credit market increases » R $ tends to rise » R $ tends to rise Purchases of pounds on the spot market increase » E tends to rise » E tends to rise Sales of pounds on the forward market increase » F tends to fall » F tends to fall Lending in the British credit market increases » R £ tends to fall » R £ tends to fall

67. 67 Covered Interest Parity These pressures continue as long as there is a profit to be made. These pressures continue as long as there is a profit to be made. Markets adjust until: R $ = R £ + (F $/£ - E $/£ )/E $/£ Markets adjust until: R $ = R £ + (F $/£ - E $/£ )/E $/£ Covered interest parity is restored rapidly if deviations from parity appear Covered interest parity is restored rapidly if deviations from parity appear

68. 68 Figure 13-2 Interest Rates on Dollar and Deutschemark Deposits, 1975-2000

69. 69 Figure 15-3 The Dollar/DM Exchange Rate and Relative U.S./German Price Levels, 1964-2000

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73. 73 Interest Rates in Argentine Banks Deposits in Pesos Dollars Deposits in Pesos Dollars May 22 2000 9.0% 7.1%

74. 74 Exchange Rate Risk Why do peso deposits in Argentine banks pay higher interest than dollar deposits in the same banks? Why do peso deposits in Argentine banks pay higher interest than dollar deposits in the same banks? Exchange risk Exchange risk Depositors think there is a greater chance of peso depreciation than appreciation Depositors think there is a greater chance of peso depreciation than appreciation

75. 75 Interest Rates in Argentine Banks Deposits in Pesos Dollars Deposits in Pesos Dollars May 22 2000 9.0% 7.1% Sep 6 2001 26.7% 17.7%

76. 76 Risk Premium Why do dollar debts of the Argentine government pay high interest than U.S. debt? Why do dollar debts of the Argentine government pay high interest than U.S. debt? Default risk Default risk Bond holders think there is a greater chance the Argentine government will be unable to repay its debts Bond holders think there is a greater chance the Argentine government will be unable to repay its debts

77. 77 Risk Premium R PESO = R $ + (E PESO/$ e - E PESO/$ )/ E PESO/$ +   = risk premium  = risk premium  > 0 for Argentina (compared to U.S.)  > 0 for Argentina (compared to U.S.)  < 0 for U.S. (compared to Argentina)  < 0 for U.S. (compared to Argentina)