1. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Eight Foreign Exchange Markets

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-2 McGraw-Hill/Irwin Foreign Exchange Markets Overview Foreign exchange (FX) markets Foreign exchange rate Foreign exchange risk Currency depreciation/appreciation Foreign exchange (FX) markets Foreign exchange rate Foreign exchange risk Currency depreciation/appreciation

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-3 McGraw-Hill/Irwin Overview There are two relevant prices involved in international trade. The first is the price of the good or service purchased and the second is the price of the currency. In many transactions the first price is fixed but the latter will normally fluctuate with changes in the foreign exchange rate. Fluctuating exchange rates, like fluctuating prices, cause risk in international business transactions. The foreign exchange rate is in a sense the ‘entry fee’ to purchase a country’s financial and real goods and services. Depreciating foreign currencies hurt the home currency value of foreign assets, but also reduce the home currency value of foreign liabilities. The converse is true for appreciating currencies. There are two relevant prices involved in international trade. The first is the price of the good or service purchased and the second is the price of the currency. In many transactions the first price is fixed but the latter will normally fluctuate with changes in the foreign exchange rate. Fluctuating exchange rates, like fluctuating prices, cause risk in international business transactions. The foreign exchange rate is in a sense the ‘entry fee’ to purchase a country’s financial and real goods and services. Depreciating foreign currencies hurt the home currency value of foreign assets, but also reduce the home currency value of foreign liabilities. The converse is true for appreciating currencies.

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-4 McGraw-Hill/Irwin Fixed Vs. Float In fixed or tightly managed floating systems currencies are said to be either revalued (upward) or devalued (downward). In free floating systems, the terms are appreciation and depreciation respectively.

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-5 McGraw-Hill/Irwin Background and History of Foreign Exchange Markets Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) Smithsonian Agreement II (1973) Bretton Woods Agreement (1944-1977) Smithsonian Agreement (1971) Smithsonian Agreement II (1973)

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-6 McGraw-Hill/Irwin The story of Bretton Wood The fixed exchange rate system failed because U.S. inflation was greater than the rest of the developed world. The system was based on the willingness of foreign countries to hold dollars and backed by the willingness of the U.S. to exchange dollars for gold. At that time, the dollar’s value was fixed at $35 per ounce of gold. As more and more market participants doubted that the value of the dollar could be maintained, fewer participants were willing to hold dollars, preferring gold or other currencies instead. The Fed and other central banks were unable to continue to maintain the value of the dollar as depletion of gold reserves ensued. The fixed exchange rate system failed because U.S. inflation was greater than the rest of the developed world. The system was based on the willingness of foreign countries to hold dollars and backed by the willingness of the U.S. to exchange dollars for gold. At that time, the dollar’s value was fixed at $35 per ounce of gold. As more and more market participants doubted that the value of the dollar could be maintained, fewer participants were willing to hold dollars, preferring gold or other currencies instead. The Fed and other central banks were unable to continue to maintain the value of the dollar as depletion of gold reserves ensued.

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-7 McGraw-Hill/Irwin USA Gold Reserves

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-8 McGraw-Hill/Irwin Gold Prices

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-9 McGraw-Hill/Irwin Gold and Inflation

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-10 McGraw-Hill/Irwin FX Market Prior to 1972 all forward foreign exchange trading was over–the–counter trading involving banks. The International Monetary Market (IMM) began trading foreign currency futures contracts in 1972 although the OTC forward market still dominates trading activity

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-11 McGraw-Hill/Irwin Advantages of trading currency futures on an exchange Anonymity of parties No credit risk concerns because the exchange’s clearinghouse guarantees performance of both parties Standardized known terms of contracts Liquidity: Most futures contracts do not result in making or taking delivery because participants who are long (short) in a futures contract can easily go short (long) in the same contract, netting their position to zero. There is a much lower likelihood of finding a counterparty to offset a given OTC forward contract. Anonymity of parties No credit risk concerns because the exchange’s clearinghouse guarantees performance of both parties Standardized known terms of contracts Liquidity: Most futures contracts do not result in making or taking delivery because participants who are long (short) in a futures contract can easily go short (long) in the same contract, netting their position to zero. There is a much lower likelihood of finding a counterparty to offset a given OTC forward contract.

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-12 McGraw-Hill/Irwin Disadvantages of using currency futures rather than forwards the difficulty in obtaining the exact contract specifications desired since currency futures are actively traded on only the major currencies and long– term contracts may not be available or may be relatively illiquid. In addition, futures are cash settled daily, gains and losses on forwards are not recognized until contract maturity, which makes forwards more suitable for hedging in many cases. Currency options are traded on the Philadelphia Stock Exchange and provide yet another way to speculate on foreign currency movements or hedge currency transactions. the difficulty in obtaining the exact contract specifications desired since currency futures are actively traded on only the major currencies and long– term contracts may not be available or may be relatively illiquid. In addition, futures are cash settled daily, gains and losses on forwards are not recognized until contract maturity, which makes forwards more suitable for hedging in many cases. Currency options are traded on the Philadelphia Stock Exchange and provide yet another way to speculate on foreign currency movements or hedge currency transactions.

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-13 McGraw-Hill/Irwin Foreign Exchange Transactions Spot or immediate transactions are normally settled within two to three business days currencies may be bought or sold forward for one or more months (transaction dates beyond 1 year are less common). As a country’s exchange rate increases, its exports may become more expensive and imports may be relatively cheaper. A strong currency can contribute to a current account deficit. Conversely, a weaker currency may improve the current account deficit Spot or immediate transactions are normally settled within two to three business days currencies may be bought or sold forward for one or more months (transaction dates beyond 1 year are less common). As a country’s exchange rate increases, its exports may become more expensive and imports may be relatively cheaper. A strong currency can contribute to a current account deficit. Conversely, a weaker currency may improve the current account deficit

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-14 McGraw-Hill/Irwin Foreign Exchange Transactions Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-15 McGraw-Hill/Irwin Foreign Exchange Market Trading (in billions of U.S. dollars)

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-16 McGraw-Hill/Irwin percentage changes in the value of a currency Rates can be quoted two ways: 1. Dollar value of one unit of foreign currency: £1 = $1.60 2. Foreign currency value of the dollar: $1 = £0.625 These two quotes are inverses. if in the above quote we say the pound appreciated 10%, how is the new value of the pound calculated? £1 = $1.60 initially so the new value of the pound is $1.60  1.1 = $1.76. The value of the dollar did not drop 10% however. The inverse of $1.76 is 0.5682 so the $1 = £0.5682, a 9.09% drop. Rates can be quoted two ways: 1. Dollar value of one unit of foreign currency: £1 = $1.60 2. Foreign currency value of the dollar: $1 = £0.625 These two quotes are inverses. if in the above quote we say the pound appreciated 10%, how is the new value of the pound calculated? £1 = $1.60 initially so the new value of the pound is $1.60  1.1 = $1.76. The value of the dollar did not drop 10% however. The inverse of $1.76 is 0.5682 so the $1 = £0.5682, a 9.09% drop.

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-17 McGraw-Hill/Irwin The trade off If the dollar appreciates, the foreign currency value of the dollar rises but the dollar value of the foreign currency falls.

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-18 McGraw-Hill/Irwin What was behind the dollar drop? 1. An increased focus on the U.S. current account deficit which was reaching record levels in absolute terms and as a percent of GDP. Greenspan commented that the size and continued growth of the deficit may not be ultimately sustainable because it required foreigners to be willing to hold large quantities of dollars (dollar assets).

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-19 McGraw-Hill/Irwin 2. Europe had higher interest rates than the U.S. This puts pressure on the dollar to fall against the euro through carry trades. (In carry trades the investor borrows in the low interest rate currency, sells the currency and invests in the high interest rate currency. This puts pressure on the dollar to fall if USA rates are lower than in Europe) Notably though in the same time period Japan had lower interest rates than the U.S. and the dollar fell against the yen also even with heavy intervention from the Bank of Japan. 2. Europe had higher interest rates than the U.S. This puts pressure on the dollar to fall against the euro through carry trades. (In carry trades the investor borrows in the low interest rate currency, sells the currency and invests in the high interest rate currency. This puts pressure on the dollar to fall if USA rates are lower than in Europe) Notably though in the same time period Japan had lower interest rates than the U.S. and the dollar fell against the yen also even with heavy intervention from the Bank of Japan.

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-20 McGraw-Hill/Irwin 3. Asian central banks continued to acquire dollars to keep their currencies from rising. Europe did not follow suit and the result was a stronger euro. 4. The USA administration did not seem to mind having the dollar drop. A falling dollar can help the export sector of the U.S. economy. 3. Asian central banks continued to acquire dollars to keep their currencies from rising. Europe did not follow suit and the result was a stronger euro. 4. The USA administration did not seem to mind having the dollar drop. A falling dollar can help the export sector of the U.S. economy.

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-21 McGraw-Hill/Irwin The Decline of the U.S. Dollar Market traders focused on the widening of the U.S. current account deficit Interest rate differentials across major economies, interest rates higher in Europe High volume of central bank intervention relative to past practice, especially in Asian countries Cheap dollar makes exports from other countries more expensive relative to U.S. products Market traders focused on the widening of the U.S. current account deficit Interest rate differentials across major economies, interest rates higher in Europe High volume of central bank intervention relative to past practice, especially in Asian countries Cheap dollar makes exports from other countries more expensive relative to U.S. products

22. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-22 McGraw-Hill/Irwin Exchange buying and selling Any event that will lead to the receipt of foreign currency may be hedged by selling the currency forward. Any event that requires payment of foreign currency in the future may be hedged by buying the currency forward. Hedgers may have difficulty hedging beyond one year with forwards; this is one reason for the creation of longer term swaps. Any event that will lead to the receipt of foreign currency may be hedged by selling the currency forward. Any event that requires payment of foreign currency in the future may be hedged by buying the currency forward. Hedgers may have difficulty hedging beyond one year with forwards; this is one reason for the creation of longer term swaps.

23. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-23 McGraw-Hill/Irwin Hedging with Forwards Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L 71.875 M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L 71.875 M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M

24. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-24 McGraw-Hill/Irwin Role of FIs in Foreign Exchange Transactions Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating Net exposure Net long (short) in a currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating

25. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-25 McGraw-Hill/Irwin Liabilities to and Claims on Foreigners Reported by Banks in U.S., Payable in Foreign Currencies ($M)

26. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-26 McGraw-Hill/Irwin Net exposure The dollar value of foreign currency assets is at risk from falling exchange rates. The dollar value of foreign currency liabilities is at risk from rising foreign currency values. Net exposure is the value of exposed assets minus the value of exposed liabilities. If this calculation is positive the firm has a net exposure to falling exchange rates if negative the firm’s dollar value will be reduced by rising foreign currency values. The dollar value of foreign currency assets is at risk from falling exchange rates. The dollar value of foreign currency liabilities is at risk from rising foreign currency values. Net exposure is the value of exposed assets minus the value of exposed liabilities. If this calculation is positive the firm has a net exposure to falling exchange rates if negative the firm’s dollar value will be reduced by rising foreign currency values.

27. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-27 McGraw-Hill/Irwin FI’s overall net foreign exchange (FX) exposure Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) = Net foreign assets + Net FX bought = Net position

28. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-28 McGraw-Hill/Irwin Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2004

29. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-29 McGraw-Hill/Irwin The Role of Financial Institutions in Foreign Exchange Transactions The foreign exchange market is largely an interbank OTC market that operates 24 hours a day. Banks are some of the world’s largest and most active currency traders. The majority of interbank exchange trading is now done electronically with Reuters and electronic brokerage systems (EBS) dominating activity. The electronic trading platforms have been integrated with corporate customers, allowing the corporate customer to process exchange orders with a bank in a highly automated format. The foreign exchange market is largely an interbank OTC market that operates 24 hours a day. Banks are some of the world’s largest and most active currency traders. The majority of interbank exchange trading is now done electronically with Reuters and electronic brokerage systems (EBS) dominating activity. The electronic trading platforms have been integrated with corporate customers, allowing the corporate customer to process exchange orders with a bank in a highly automated format.

30. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-30 McGraw-Hill/Irwin Other way of hedging Larger firms centralize their exchange risk management and net their exposures across subsidiaries. Because currency values are related, additional netting across currencies can be done and not all exposures have to be individually hedged. Newer risk assessment methods such as Value at Risk (VAR) can be used to improve hedging efficiency by accounting for the correlation among currencies Larger firms centralize their exchange risk management and net their exposures across subsidiaries. Because currency values are related, additional netting across currencies can be done and not all exposures have to be individually hedged. Newer risk assessment methods such as Value at Risk (VAR) can be used to improve hedging efficiency by accounting for the correlation among currencies

31. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-31 McGraw-Hill/Irwin Numerical example of currency arbitrage A currency quote in the U.S. for the £ is £1 = $1.8302 - $1.8409. or $1=0.5464-0.5432 The first number is the dealer’s bid price, the latter is the dealer’s ask. A similar quote for the dollar in London may be $1 = £0.5252 - £0.5288. A currency trader could take advantage of these quotes by selling dollars and buying the pound at the U.S. quote at the ask price of $1.8409 / £. A currency quote in the U.S. for the £ is £1 = $1.8302 - $1.8409. or $1=0.5464-0.5432 The first number is the dealer’s bid price, the latter is the dealer’s ask. A similar quote for the dollar in London may be $1 = £0.5252 - £0.5288. A currency trader could take advantage of these quotes by selling dollars and buying the pound at the U.S. quote at the ask price of $1.8409 / £.

32. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-32 McGraw-Hill/Irwin This will yield 1/$1.8409 = £0.5432 per dollar exchanged. The trader can simultaneously buy dollars (sell pounds) at the London ask of £0.5288. This will give £0.5432 / £0.5288 = $1.0272. The trader can accomplish these trades risklessly in a matter of moments. This works because the dollar is valued more highly at the U.S. quote where the trader sold dollars and bought pounds This will yield 1/$1.8409 = £0.5432 per dollar exchanged. The trader can simultaneously buy dollars (sell pounds) at the London ask of £0.5288. This will give £0.5432 / £0.5288 = $1.0272. The trader can accomplish these trades risklessly in a matter of moments. This works because the dollar is valued more highly at the U.S. quote where the trader sold dollars and bought pounds

33. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-33 McGraw-Hill/Irwin Numerical example of covered interest arbitrage A bank has borrowed $1 million at 4% for one year (bullet borrowing). It can convert the dollars to euros at a spot exchange rate of $1.20 per euro. Annual interest rates on euro denominated deposits are 5% and the one year forward rate to sell euros against the dollar is $1.19 The transactions of the arbitrage are A bank has borrowed $1 million at 4% for one year (bullet borrowing). It can convert the dollars to euros at a spot exchange rate of $1.20 per euro. Annual interest rates on euro denominated deposits are 5% and the one year forward rate to sell euros against the dollar is $1.19 The transactions of the arbitrage are

34. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-34 McGraw-Hill/Irwin Borrow $1 million at 4% for one year. In one year the bank will owe $1 mill * 1.04 = $1,040,000 Convert the $1 million to euro today at the spot of $1.20 / euro: $1,000,000 * € / $1.20 = €833,333 Invest the euros in the deposits paying 5%. In one year the deposits will yield: €833,333 * 1.05 = €875,000 Sell the euros forward to ensure the dollar value in one year: €875,000 * $1.19 / € = $1,041,250 Repay the amount owed of $1,040,000, and clear the difference, $1,250, risklessly without using any of the bank’s money. Borrow $1 million at 4% for one year. In one year the bank will owe $1 mill * 1.04 = $1,040,000 Convert the $1 million to euro today at the spot of $1.20 / euro: $1,000,000 * € / $1.20 = €833,333 Invest the euros in the deposits paying 5%. In one year the deposits will yield: €833,333 * 1.05 = €875,000 Sell the euros forward to ensure the dollar value in one year: €875,000 * $1.19 / € = $1,041,250 Repay the amount owed of $1,040,000, and clear the difference, $1,250, risklessly without using any of the bank’s money.

35. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-35 McGraw-Hill/Irwin This works because the euro drops in value by less than the difference in interest rates (see the interest rate parity discussion. London remains the global capital of international finance and currency trading. This works because the euro drops in value by less than the difference in interest rates (see the interest rate parity discussion. London remains the global capital of international finance and currency trading.

36. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-36 McGraw-Hill/Irwin FIs participate in foreign currency market for four reasons 1. To facilitate international trade for their corporate customers 2. To allow corporations to take positions in currencies. 3. To hedge open (unhedged) positions created by the first and second activities. 4. To speculate on currency movements. 1. To facilitate international trade for their corporate customers 2. To allow corporations to take positions in currencies. 3. To hedge open (unhedged) positions created by the first and second activities. 4. To speculate on currency movements.

37. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-37 McGraw-Hill/Irwin Interaction of Interest Rates, Inflation and Exchange Rates For an excellent article on global linkages and an explanation of terms often quoted in the media see the article: “International Credit Market Connections, Steven Strongin, Federal Reserve Bank of Chicago, Economic Perspectives, July/August 1990, pp.2- 10.

38. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-38 McGraw-Hill/Irwin Purchasing Power Parity The concept underlying purchasing power parity (PPP) is the law of one price, or the idea that similar traded goods and services that provide similar benefits should have the same price in different countries. Arbitrage opportunities then ensure the ‘law’ will hold. The concept underlying purchasing power parity (PPP) is the law of one price, or the idea that similar traded goods and services that provide similar benefits should have the same price in different countries. Arbitrage opportunities then ensure the ‘law’ will hold.

39. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-39 McGraw-Hill/Irwin If relative purchasing power parity (PPP) holds then differences in inflation rates between two countries are perfectly adjusted for by changes in exchange rates to maintain constant purchasing power. In other words, the nominal exchange rate adjusts to maintain a constant real exchange rate as relative inflation rates change. If relative purchasing power parity (PPP) holds then differences in inflation rates between two countries are perfectly adjusted for by changes in exchange rates to maintain constant purchasing power. In other words, the nominal exchange rate adjusts to maintain a constant real exchange rate as relative inflation rates change.

40. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-40 McGraw-Hill/Irwin The concept underlying PPP is the idea that similar traded goods and services that provide similar benefits should have the same price in different countries. For example if the nominal $/¥ exchange rate is $0.009091/¥ and the U.S. has 3% inflation and Japan has 1%; the nominal exchange rate would adjust to ¥1 = $0.009091  1.03/1.01 = $0.009271. With the new stronger yen one could purchase exactly the same amount of U.S. goods and services as before, i.e. the real exchange rate; $0.009271  1.01/1.03 = $0.009091 is unchanged. The concept underlying PPP is the idea that similar traded goods and services that provide similar benefits should have the same price in different countries. For example if the nominal $/¥ exchange rate is $0.009091/¥ and the U.S. has 3% inflation and Japan has 1%; the nominal exchange rate would adjust to ¥1 = $0.009091  1.03/1.01 = $0.009271. With the new stronger yen one could purchase exactly the same amount of U.S. goods and services as before, i.e. the real exchange rate; $0.009271  1.01/1.03 = $0.009091 is unchanged.

41. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-41 McGraw-Hill/Irwin Thus if S0 is the original spot rate and S1 is the new spot rate then Relationship 1 S1 / S0 = (1 + IPUS) / (1+ IPF) where IP is the expected level of inflation in the home (US) and foreign (F) country respectively. Using the approximation version as Relationship 1: (S1 – S0) / S0 = IPUS – IPF. Thus if S0 is the original spot rate and S1 is the new spot rate then Relationship 1 S1 / S0 = (1 + IPUS) / (1+ IPF) where IP is the expected level of inflation in the home (US) and foreign (F) country respectively. Using the approximation version as Relationship 1: (S1 – S0) / S0 = IPUS – IPF.

42. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-42 McGraw-Hill/Irwin Tips The exchange rates must be in the form of U.S. dollars per unit of foreign currency. There are significant costs to applying the arbitrage strategy that underlies the idea of PPP because Differential tariffs and other regulations, transportation and insurance costs, fixing prices for given contract periods, etc. all imply that PPP is unlikely to hold exactly, even for traded goods and services, particularly in the short run. The empirical evidence generally indicates that PPP holds only over longer time periods such as 5-7 years, except in countries experiencing hyperinflation The exchange rates must be in the form of U.S. dollars per unit of foreign currency. There are significant costs to applying the arbitrage strategy that underlies the idea of PPP because Differential tariffs and other regulations, transportation and insurance costs, fixing prices for given contract periods, etc. all imply that PPP is unlikely to hold exactly, even for traded goods and services, particularly in the short run. The empirical evidence generally indicates that PPP holds only over longer time periods such as 5-7 years, except in countries experiencing hyperinflation

43. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-43 McGraw-Hill/Irwin Purchasing Power Parity, Fisher effect The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = nominal Interest rate in the United States i S = Interest rate in Switzerland IPUS = equal to the expected level of U.S. inflation RIRUS = the real U.S. interest rate. This relationship should hold in each country, and if the Real Interest Rate is the same in two countries then the nominal interest rates in the two countries should differ only by the differences in inflation. then: i US - i S = IP US - IP S The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i S = IP S + RIR S where: i US = nominal Interest rate in the United States i S = Interest rate in Switzerland IPUS = equal to the expected level of U.S. inflation RIRUS = the real U.S. interest rate. This relationship should hold in each country, and if the Real Interest Rate is the same in two countries then the nominal interest rates in the two countries should differ only by the differences in inflation. then: i US - i S = IP US - IP S

44. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-44 McGraw-Hill/Irwin Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t

45. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-45 McGraw-Hill/Irwin Balance of Payment Accounts Balance of payment accounts Current account Capital accounts Balance of payment accounts Current account Capital accounts

46. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-46 McGraw-Hill/Irwin U.S. Balance of Payment Accounts Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0 Current Accounts Exports of good, services, and income $1,298,392 Imports of goods, services, and income -1,665,325 Unilateral transfers, net -50,501 Total current accounts -$ 417,429 Balance on goods -426,615 Balance on services 78,805 Balance on investment income -19,118 Capital Accounts U.S. assets abroad, net -$439,563 Foreign assets in the U.S., net 896,185 Statistical discrepancy -39,193 Total capital accounts $417,429 Sum of current and capital accounts $ 0

47. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-47 McGraw-Hill/Irwin What factors determine the supply and demand of the dollar provided for foreign exchange? Relative inflation rates: The country with the higher inflation rate will tend to see its currency devalue relative to other countries with lower inflation rates. Relative real interest rates: Countries with higher real rates will attract more capital and have higher currency values. Relative economic growth rates: Countries with higher real growth rates will tend to attract more capital. Demand for a country’s goods and services and financial assets. The higher the demand, the greater a country’s currency is likely to be, ceteris paribus. For example, specialized products or brand names such as Marlboro or Levi jeans may create steady (inelastic) demand for a country’s products. Government restrictions on foreign exchange, trade and investment can depress a currency’s value. Consumer preferences for domestic versus foreign goods. Relative inflation rates: The country with the higher inflation rate will tend to see its currency devalue relative to other countries with lower inflation rates. Relative real interest rates: Countries with higher real rates will attract more capital and have higher currency values. Relative economic growth rates: Countries with higher real growth rates will tend to attract more capital. Demand for a country’s goods and services and financial assets. The higher the demand, the greater a country’s currency is likely to be, ceteris paribus. For example, specialized products or brand names such as Marlboro or Levi jeans may create steady (inelastic) demand for a country’s products. Government restrictions on foreign exchange, trade and investment can depress a currency’s value. Consumer preferences for domestic versus foreign goods.

48. ©2007, The McGraw-Hill Companies, All Rights Reserved 8-48 McGraw-Hill/Irwin Risk is also a major determinant of a currency’s value; hence, other factors that can affect a currency’s value include : The economy’s history. The shorter the history and the more volatile the economy, the lower the currency value, ceteris paribus. The reputation of the central bank. Strong, independent central banks with a history of keeping inflation low add to a currency’s value. Large foreign currency reserves help maintain a currency’s value. Argentina has managed to keep the peso on par with the U.S. dollar, in part by holding large dollar reserves. Large current account deficits can foreshadow currency problems since these imply a large amount of foreign capital is needed to finance current spending levels. Modest to low foreign currency debt to GDP ratios help maintain a currency’s value. The recent crisis in Asia was largely just another leverage crisis. Appropriate fiscal policy spending in line with the country’s ability to pay for the spending without incurring large amounts of foreign borrowing. The economy’s history. The shorter the history and the more volatile the economy, the lower the currency value, ceteris paribus. The reputation of the central bank. Strong, independent central banks with a history of keeping inflation low add to a currency’s value. Large foreign currency reserves help maintain a currency’s value. Argentina has managed to keep the peso on par with the U.S. dollar, in part by holding large dollar reserves. Large current account deficits can foreshadow currency problems since these imply a large amount of foreign capital is needed to finance current spending levels. Modest to low foreign currency debt to GDP ratios help maintain a currency’s value. The recent crisis in Asia was largely just another leverage crisis. Appropriate fiscal policy spending in line with the country’s ability to pay for the spending without incurring large amounts of foreign borrowing.