1. Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Topic 7 Exchange Rates and the Foreign Exchange Market: An Asset Approach

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-2 Preview The basics of exchange rates Exchange rates and the prices of goods The foreign exchange market The demand for foreign currency deposits Equilibrium in the foreign exchange market  role of interest rates  role of expectations of future exchange rates

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-3 Introduction The price of one currency in terms of another is called an exchange rate. Because of their strong influence on the current account and other macroeconomic variables, exchange rates are among the most important prices in an open economy. An exchange rate is also an asset price, so the principles governing the behavior of other asset prices also govern the behavior of exchange rates.

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-4 Definitions of Exchange Rates Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.  How much can be exchanged for one dollar? ¥102/$1  How much can be exchanged for one yen? $0.0098/¥1 Exchange rates allow us to denominate the cost or price of a good or service in a common currency.  How much does a Honda cost? ¥3,000,000  Or, ¥3,000,000 x $0.0098/¥1 = $29,400

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-5 Table 1: Exchange Rate Quotations Exchange rates are reported daily in newspapers’ financial sections. This shows the dollar exchange rates for currencies traded in NY at 4:00 p.m. on July 23, 2007. Rates listed here are interbank rates: the rates banks charge to each other. No amount less than $1 million is traded at these “wholesale” rates.

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-6 Depreciation and Appreciation Depreciation is a decrease in the value of a currency relative to another currency.  A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.  $1/€1 → $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.  The euro has appreciated relative to the dollar: it is now more valuable.

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-7 Depreciation and Appreciation (cont.) Appreciation is an increase in the value of a currency relative to another currency.  An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.  $1/€1 → $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.  The euro has depreciated relative to the dollar: it is now less valuable.

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-8 Depreciation and Appreciation (cont.) A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.  How much does a Honda cost? ¥3,000,000  ¥3,000,000 x $0.0098/¥1 = $29,400  ¥3,000,000 x $0.0106/¥1 = $31,800 A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive. A depreciated currency lowers the price of exports relative to the price of imports.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-9 Depreciation and Appreciation (cont.) An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.  How much does a Honda cost? ¥3,000,000  ¥3,000,000 x $0.0098/¥1 = $29,400  ¥3,000,000 x $0.0090/¥1 = $27,000 An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive. An appreciated currency raises the price of exports relative to the price of imports.

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-10 Foreign Exchange Markets Exchange rates are determined by the interaction of individuals, firms, and financial institutions that buy and sell foreign currencies to make international payments. The market in which international currency trades take place is called the foreign exchange market.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-11 Foreign Exchange Markets (cont.) Major participants: 1.Commercial banks and other depository institutions Vast majority of foreign exchange transactions involve the exchange of bank deposits denominated in different currencies. Banks routinely enter the foreign exchange market to meet the needs of their customers –primarily corporations.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-12 Foreign Exchange Markets (cont.) 2.Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) Buy and sell foreign currencies for investment. 3.Corporations Conduct foreign currency transactions to buy/sell goods, services, and assets.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-13 Foreign Exchange Markets (cont.) 4.Central banks Conduct official international reserves transactions. Volume of these transactions are not typically large but may have strong impacts on exchange rates. Market participants watch central bank actions for clues about future macroeconomic policies that may impact exchange rates.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-14 Foreign Exchange Markets (cont.) Foreign exchange trading takes place in many financial centers, with the largest volume of trade occurring in:  London, New York, Tokyo, Frankfurt, and Singapore The daily volume of foreign exchange transactions was $3.2 trillion in April 2007.  About 86% of transactions involved US dollars.  About 37% of transactions involved euros.

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-15 Foreign Exchange Markets (cont.) Computer and telecommunications technology transmit information rapidly so the foreign exchange market is highly integrated. The integration of financial centers implies that there is no significant arbitrage between markets.  Arbitrage: buying at a low price and selling at a high price for a profit. What will happen if dollars are cheaper in New York than in Hong Kong? People will buy dollars in New York and sell them in Hong Kong, so that their price rises in New York and falls in Hong Kong, until the price of dollars is equal in both markets.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-16 Foreign Exchange Markets (cont.) Most transactions between banks (86% in 2007) are exchanges of foreign currencies for U.S. dollars. U.S. dollar is sometimes called a vehicle currency because of its pivotal role in so many foreign exchange deals.  A vehicle currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Why is the U.S. dollar so prominent?  U.S. is the largest economy in the world with 30% of total output.  Easy to find buyers and sellers for U.S. dollars.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-17 Spot Rates and Forward Rates Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is executed in the present. Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.  Forward dates are typically 30, 90, 180, or 360 days in the future.  Rates are negotiated between two parties in the present, but the exchange occurs in the future.

18. Fig. 1: Dollar/Pound Spot and Forward Exchange Rates, 1981–2007 Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month. Spot and forward exchange rates tend to move in a highly correlated fashion.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-19 Spot Rates and Forward Rates (cont.) Forward rates are used to eliminate short-run exchange rate risk. E.g., Radio Shack must pay ¥9,000 for each Japanese radio in 30 days. Each radio can sell for $100, so profits depend on the dollar cost of the radios.  Current spot rate: $0.0105/¥ → cost per radio = $0.0105/¥ x ¥9,000 = $94.50 → profit = $100 - $94.50 = $5.50.  If $ depreciates: $0.0115/¥ → cost per radio = $0.0115/¥ x ¥9,000 = $103.50 → loss = $100 - $103.50 = -$3.50.

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-20 Spot Rates and Forward Rates (cont.) To avoid this risk, Radio Shack can make a 30-day forward exchange deal with B of A.  B of A sells yen to Radio Shack in 30 days at a rate of $0.0107/¥. Thus, Radio Shack is guaranteed the cost per radio = $0.0107/¥ x ¥9,000 = $96.30 and profit = $3.70.

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-21 Other Methods of Currency Exchange Foreign exchange swaps: a combination of a spot sale with a forward repurchase.  Swaps often result in lower fees or transactions costs because they combine two transactions. E.g., Toyota has just received $1 million from U.S. sales and knows it must pay those dollars to a MI supplier in 3 months. Toyota would also like to invest the $1 million in euro bonds. A 3 month swap of dollars into euros avoids the fees from two separate transactions: (1) selling dollars for spot euros and (2) selling the euros for dollars on the forward market.

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-22 Other Methods of Currency Exchange (cont.) Futures contracts: a contract that a specified amount of foreign currency will be delivered on a specified date in the future.  Contracts can be bought and sold in organized futures market, and only the current owner is obliged to fulfill the contract.

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-23 Other Methods of Currency Exchange (cont.) Options contracts: gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.  Option’s seller is required to sell or buy the foreign currency at the discretion of the option’s owner, who is under no obligation to exercise his right.  Such contracts are helpful if you are uncertain about the timing of foreign currency payments.

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-24 Other Methods of Currency Exchange (cont.) Forwards, swaps, futures, and options are all examples of financial derivatives –which are recorded in a country’s financial account.  Financial derivatives are a class of assets that are more complicated than stocks and bonds, but with values that can depend on stock or bond values.  In 2006, the net cross-border derivative flow into the U.S. was $28.8 billion.

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-25 The Demand for Currency Deposits What influences the demand for (willingness to buy) deposits denominated in domestic or foreign currency? Demand for bank deposits is influenced by the same factors that influence the demand for any other asset.  Namely, what is the expected real rate of return?

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-26 The Demand for Currency Deposits (cont.) Rate of return: the percentage change in value that an asset offers over some time period.  The annual return for $100 savings deposit with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/$100 = 2%.

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-27 The Demand for Currency Deposits (cont.) Real rate of return: inflation-adjusted rate of return,  represents the additional amount of goods and services that can be purchased with earnings from the asset.  The real rate of return for the above savings deposit when inflation is 1.5% is: 2% – 1.5% = 0.5%. After accounting for the rise in the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year. If the inflation rate is 0% then (nominal) rates of return = real rates of return.

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-28 The Demand for Currency Deposits (cont.) Risk of holding assets also influences decisions about whether to buy them. Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets. For now, we assume that all bank deposits have the same level of risk and liquidity, regardless of their currency denomination.

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-29 The Demand for Currency Deposits (cont.) We therefore say that investors are primarily concerned about the rates of return on currency deposits. Rates of return that investors expect to earn are determined by:  interest rates that the deposits earn  expectations about the currency’s appreciation or depreciation against other currencies

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-30 The Demand for Currency Deposits (cont.) A currency deposit’s interest rate is the amount of that currency an individual can earn by lending a unit of the currency for one year. The rate of return for a deposit in domestic currency is the interest rate that the deposit earns. To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider  the interest rate for the foreign currency deposit  the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-31 The Demand for Currency Deposits (cont.) Suppose the interest rate on a dollar deposit is 10% and the interest rate on a euro deposit is 5%. Suppose today’s exchange rate is $1.10/€, and the expected rate in one year is $1.165/€. Does a dollar deposit yield a higher expected rate of return?  $100 can be exchanged today for €90.91.  These €90.91 will yield €95.45 after one year.  These €95.45 are expected to be worth $1.165/€ x €95.45 = $111.20 in one year.

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-32 The Demand for Currency Deposits (cont.) The rate of return in terms of dollars from investing in euro deposits is ($111.20-$100)/$100 = 11.2%. Let’s compare this rate of return with the rate of return from a dollar deposit.  The rate of return is simply the interest rate.  After 1 year the $100 is expected to yield $110: ($110-$100)/$100 = 10% The dollar deposit has a lower expected rate of return.

33. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-33 The Demand for Currency Deposits (cont.) Note that the expected rate of appreciation of the euro was = ($1.165-$1.10)/$1.10 = 5.9% Simplify this analysis by saying that the dollar rate of return on euro deposits roughly equals  the interest rate on euro deposits  plus the expected rate of appreciation of the euro against the dollar  5% + 5.9% = 10.9% ≈ 11%  R € + (E e $/€ - E $/€ )/E $/€

34. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-34 The Demand for Currency Deposits (cont.) The difference in the rate of return on dollar deposits and euro deposits is R $ - (R € + (E e $/€ - E $/€ )/E $/€ ) = R $ - R € - (E e $/€ - E $/€ )/E $/€ expected rate of return = interest rate on dollar deposits interest rate on euro deposits expected rate of return on euro deposits expected exchange rate current exchange rate expected rate of appreciation of the euro

35. Table 2: Comparing Dollar Rates of Return on Dollar and Euro Deposits Case 1: interest difference in favor of dollar deposits is 4% and no change in the exchange rate is expected; so dollar deposits provide 4% higher returns. Case 2: interest difference in favor of dollar deposits is 4%, but the euro is expected to appreciate by 4%; so dollar and euro deposits provide equal returns. Case 3: interest difference in favor of dollar deposits is 4%, but the euro is expected to appreciate by 8%; so euro deposits provide 4% higher returns. Case 4: interest difference in favor of euro deposits is 2%, but the euro is expected to depreciate by 4%, so dollar deposits provide 2% higher returns.

36. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-36 Model of Foreign Exchange Markets We use the  demand for (rate of return on) dollar deposits  and the demand for (rate of return on) foreign currency deposits to construct a model of foreign exchange markets. This model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.  Interest parity implies that deposits in all currencies are equally desirable assets.

37. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-37 Model of Foreign Exchange Markets (cont.) Interest parity says: R $ = R € + (E e $/ € - E $/ € )/E $/ € Why should this condition hold? Suppose it didn’t.  Suppose R $ > R € + (E e $/ € - E $/ € )/E $/ €  Then no investor would want to hold euro deposits, driving down the demand and price of euros.  Then all investors would want to hold dollar deposits, driving up the demand and price of dollars.  The dollar would appreciate and the euro would depreciate, increasing the right-hand side until equality was achieved: R $ > R € + (E e $/ € - E $/ € )/E $/ €

38. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-38 Model of Foreign Exchange Markets (cont.) (Assuming interest rates and future exchange rates are unchanged) how do changes in the current exchange rate affect the expected rate of return on foreign currency deposits? Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why?  When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return on foreign currency deposits.

39. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-39 Model of Foreign Exchange Markets (cont.) Appreciation of the domestic currency today raises the expected return on foreign currency deposits. Why?  When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby raising the expected rate of return on foreign currency deposits.

40. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-40 Model of Foreign Exchange Markets (cont.) Table 3 shows the dollar return on euro deposits for various levels of today’s $/€ exchange rate, always assuming that the expected future exchange rate remains fixed at $1.05/€ and the euro interest rate is fixed at 5%.  A rise in today’s exchange rate (a depreciation of the dollar) always lowers the expected dollar return on euro deposits.  A fall in today’s exchange rate (an appreciation of the dollar) always raises this return.

41. Table 3: Today’s Exchange Rate and the Expected Dollar Return on Euro Deposits When E e $/€ = $1.05 per Euro If today’s exchange rate is $1.00/€, then the expected appreciation of the euro is 5%. The return on euro deposits is 10% = 5% (expected euro appreciation) + 5% (interest on euro deposits). If the dollar depreciates so today’s exchange rate is $1.03/€, then the expected appreciation of the euro is 1.9%. The return on euro deposits is now 6.9% = 1.9% (expected euro appreciation) + 5% (interest on euro deposits). Thus, a depreciation of today’s dollar lowers the dollar returns to euro deposits.

42. Fig. 2: Relation Between the Current Exchange Rate and the Expected Dollar Return on Euro Deposits This is a graph of columns 1 and 4 from Table 3. It shows how expected dollar returns on euro deposits vary with the current $/€ exchange rate.

43. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-43 The Equilibrium Exchange Rate Exchange rates always adjust to maintain interest parity. Assuming R $, R €, and E e $/€ are all given, Figure 3 shows how the equilibrium exchange rate is determined. The equilibrium exchange rate occurs at point 1 where returns on dollar and euro deposits are equal. Why will exchange rates settle at point 1? Consider how exchange rates would adjust if they are initially at point 2 or point 3 instead.

44. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-44 The Equilibrium Exchange Rate (cont.) At point 2, the return on dollar deposits is greater than the return on euro deposits. There is an excess demand for dollar deposits (and an excess supply of euro deposits) which causes the dollar to appreciate against the euro. The dollar will appreciate (and the euro will depreciate) until interest parity is achieved. Recall that an appreciation of the dollar lowers the euro deposit’s current dollar cost, making euro deposits more attractive.

45. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-45 The Equilibrium Exchange Rate (cont.) At point 3, the return on euro deposits is greater than the return on dollar deposits. There is an excess demand for euro deposits (and an excess supply of dollar deposits) which causes the dollar to depreciate against the euro. The dollar will depreciate (and the euro will appreciate) until interest parity is achieved. Recall that a depreciation of the dollar raises the euro deposit’s current dollar cost, making euro deposits less attractive.

46. Fig. 3: Determination of the Equilibrium $/€ Exchange Rate R€2R€2 R€3R€3 $↑$↑ Equilibrium occurs at point 1 where returns are equal. At point 2, there is an excess demand for dollar deposits which causes the dollar to appreciate. At point 3, there is an excess supply of dollar deposits which causes the dollar to depreciate. $↓$↓

47. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-47 The Effect of Changing Interest Rates on Equilibrium Exchange Rates An increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. This leads to an appreciation of the currency.  Higher interest rates on dollar deposits causes the dollar to appreciate.  Higher interest rates on euro deposits causes the dollar to depreciate.

48. Fig. 4: Effect of a Rise in the Dollar Interest Rate A rise in U.S. interest rates shifts the dollar return line outward. The return on dollar deposits is now higher than the return on euro deposits (point 1 to point 1’). There is an excess demand for dollar deposits (and an excess supply of euro deposits) so the dollar must appreciate for interest parity to hold (point 1’ to point 2). Point 2 is the new equilibrium. $↑$↑ ↑i

49. Fig. 5: Effect of a Rise in the Euro Interest Rate $↓$↓ 1’ R€R€ A rise in euro interest rates shifts the expected euro return curve outward. The return on euro deposits is now higher than the return on dollar deposits (point 1 to point 1’). There is an excess demand for euro deposits so the dollar must depreciate (point 1’ to point 2). Point 2 is the new equilibrium.

50. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-50 The Effect of an Expected Appreciation of the Euro If people expect the euro to appreciate in the future, then euro deposits will pay in valuable euros, so that these future euros will be able to buy more dollars and more dollar- denominated goods.  The expected rate of return on euro deposits therefore increases.  An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy).  An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy).

51. Fig. 6: Effect of an Expected Rise of the Euro $↓$↓ Euro is expected to rise $↓$↓ R€R€ A rise in the expected future value of the euro shifts the expected euro return curve outward. The return on euro deposits is now higher than the return on dollar deposits (point 1 to point 1’). There is an excess demand for euro deposits so the dollar must depreciate (point 1’ to point 2). Point 2 is the new equilibrium. 1’