1. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 6 UNDERSTANDING EXCHANGE RATES (2)

2. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main2 Exchange rates in the short run The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates. In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $).

3. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main3 Comparing expected returns across nations We consider Euroland the “home country”, and the domestic currency €. The USA are the “foreign country” with the foreign currency $. Euro deposits bear an interest rate i €. Dollar deposits bear an interest rate i $. How does Hans, the European, compare the return on dollar deposits abroad with the return on domestic investments in € ?

4. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main4 Comparing expected returns across nations If Hans invests in the USA, he must realize that his return in terms of € is not i $. He must adjust the return for any expected appreciation/depreciation of the $ against the €. If $-deposits bring an interest rate of i $ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€  ), the expected return in € is 5% - 10% = -5%.

5. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main5 Comparing expected returns across nations More formally

6. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main6 Comparing expected returns across nations If Bill invests in Euroland, he must realize that his return in terms of $ is not i €. He must adjust the return for any expected appreciation/depreciation of the € against the $. If €-deposits bring an interest rate of i € =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€  ), then the expected return is 3% + 10% = 13%.

7. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main7 Comparing expected returns across nations More formally

8. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main8 The key point: RET $ and RET € are symmetrical (with opposite sign) As the relative expected return on €-deposits increases, both domestic and foreign residents respond in the same way: they want to hold more €-deposits and fewer deposits in $.

9. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main9 Interest parity condition At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk. When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:

10. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main10 Why? Arbitrage and liquidity trading Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition

11. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main11 Market adjustment: Examples We assume: i $ = 10%, and w e t+1 = 1 $/€. When w t = 1.0 $/€, the expected appreciation/ depreciation of the € = 0% and the expected return in € is then equal to i $ = 10% (Point B). When w t = 0.95 $/€,  w e t = 0.052 =5.2%, and the expected return in € = 4.8% (Point A). When w t = 1.05 $/€,  w e t = -0.048 =-4.8%, and the expected return in € = 14.8% (Point C).

12. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main12 Equilibrium in forex markets w t ($/€) 1.00 1.05 0.95 Expected return (€) RET € RET $ A 10%5.2% 14.8% B C D E

13. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main13 What happens in disequilibrium When w ≠ 1.0, there is a market reaction: –w > 1: People will try to sell € and buy $. => “Selling €” and “buying $” –But no one holding $ will sell at that price, there is “excess supply” of euros; i.e. the price of €-deposits relative to $-deposits must fall. –The amount of dollars per euro falls, the euro depreciates.

14. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main14 What happens in disequilibrium When : –w “Selling $” and “buying €” –But no one holding € will sell at that price, there is “excess supply” of dollars; i.e. the price of $-deposits relative to €-deposits must fall. –The amount of dollars per euro increases, the euro appreciates.

15. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main15 Change in the foreign interest rate If the foreign interest rate increases, the expected return RET $ also increases. This leads to a depreciation of the euro. The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate).

16. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main16 Equilibrium in forex markets w t ($/€) wBwB Expected return (€) RET € RET $ iDiD B C wCwC

17. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main17 Change in the domestic interest rate An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET € schedule to the right. It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €.

18. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main18 Equilibrium in forex markets w t ($/€) wBwB Expected return (€) RET € RET $ i€Bi€B B C wCwC RET € i€Ci€C

19. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main19 What about inflation ? If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate. On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate.

20. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main20 Factors that affect the exchange rate Domestic interest rate Foreign interest rate Price expectations (D/F) Expected import demand Expected export demand Expected productivity (D/F) Change in variable Exchange rate change

21. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main21 The analysis of forex markets

22. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main22 Volume of forex transactions, in bill.$ Share of financial innovations Daily, month of April

23. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main23 Forex turnover by currency pairs (in per cent) ¥ $ € Other € 30 203 £ 112 SFr 51 Other 2522

24. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main24 Forex transactions by market place (April 2001)

25. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main25 Actors in forex markets Volume of trading by groups of actors Bill. US dollars per day With traders With non-financial institutions With other financial institutions

26. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main26 The forex market is highly concentrated Citygroup9,74 Deutsche Bank9,08 Goldman Sachs7,09 JP Morgan5,22 Chase Manhattan Bank4,69 Credit Suisse First Boston4,10 UBS Warburg3,55 State Street Bank & Trust2,99 Bank of America2,99 Morgan Stanley Dean Witter2,87

27. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main27 And will be concentrated even more … Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology. On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction.

28. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main28 Short and long run: the $/DEM-market

29. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main29 Short and long run: the $/£-market