1. 1 The foreign Exchange market and exchange rates Lecture 18

2. 2 Introduction In September 1997, global financial system trembled Currency crisis rocked Asian financial markets  capital flight to US fell and so did US Exports How investors, and individuals, make transactions when people and organizations are in different countries Determination of exchange rates and what causes them to change overtime

3. 3 Exchange Rates and Trade 1990’s markets for goods and services and financial assets were global because of imports and exports When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!

4. 4 How is buying a domestic good different from buying a foreign good? Buy Pakistani good, pay in Re Buy a US good, buy $ and then pay in $ Buy too many US goods, buying too many $ that raises $ value against Re 1. An increase in currency’s value as compared to that of another is Appreciation 2. A fall in value is depreciation 3. Change in currency’s value can affect domestic manufacturers and workers… How?

5. 5 Example 1DM = $0.5 1DM = $0.6 Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!

6. 6 Nominal Vs. Real Exchange Rate Nominal ER doesn’t measure real purchasing power of the currency Nominal: Re 1 = $1/84 = $0.0012 RER = NER x P/P f

7. 7 REAL ER Big Mac Example Domestic Price: Rs 300 Foreign Price: $2.56 NER = $0.0012/Re EX r = 0.0012 x 300/2.56 = 0.14 US BM/Pak BM

8. 8 EX r is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another CPI or Inflation Rates as the ratio of P/P f REAL ER

9. 9 Real ER If EX r increases, more units of foreign goods could be traded per unit of domestic goods Relationship between EX and EX r depends on the Rates of Inflation %Δ  ΔEX r /EX r = ΔEX/EX + ΔP/P – ΔP f /P f ΔEX/EX = ΔEX r /EX r + (π f – π)

10. 10 Foreign Exchange Market Market forces determine exchange rates that prevail for consumers and investors International currencies traded in forEx markets ForEx markets are over-the-counter markets Currencies transactions in ForEx Markets: Spot Market and Forward Market

11. 11 Determine LR Exchange rates Forces of Demand and Supply 1$ = Rs 60  1$ = Rs 50 Rs appreciated and $ depreciate; Q d of $ increases and Q s of Rs increased! Price level differences  P > P f Productivity differences  Prod > Prod f Preferences (For foreign goods) Trade Barriers

12. 12 Example DM/$ P US > P GER Long Run ER

13. 13 Purchasing Power Parity Theory Law of one price: PPP Comparison of international price of identical good, PPP holds When extend the concept to a group of goods, it becomes PPP theory of ER determination Assume: EX r are constant EX = EX r x P f / P

14. 14 Does the Theory match Reality? Actual ER movements are just not a reflection of changing price levels The assumption that EX r are constant is not realistic All goods can’t be traded because of different barriers However, PPP is a good measure for LR determination of exchange rates

15. 15 Model for SR Exchange Rate Determination Pakistan: Domestic, US: Foreign Rs 10000 @ 5% Year End  10000(1+0.05) = Rs 10500 Suppose Re 1 = $0.0125  Rs10000 = $125 $125 @ 5%, Year End  125(1+0.05) = $ 131.25 Convert them to Rs: $0.0125*1.05 = $0.013125 / Re $131.25/0.013125 = Rs 10000

16. 16 Cont’d Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i) Rs (1+0.05) = Rs 1.05 Re 1 invested abroad, Rs [EX (1+i f )] / EX e 0.0125(1.05)/0.013125 = Re 1 Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets 1+i = EX(1+i f )/EX e Assume: Identical risks, liquidity and info characteristics 1+i = 1+ i f – ΔEX e / EX

17. 17 Model: Comparing Exp Returns on domestic and foreign assets If EX = 97 Yen/$ R > R f Investors should buy local assets If EX = 105 Yen/$ R < R f Investors should buy foreign assets Exp Return in DC Yen/$ R = i 5% 100 R f = i f – ΔEX e / EX

18. 18 ER Fluctuations Increase in domestic ‘i’ EX appreciates As return falls, EX depreciates Exp Return in DC Yen/$R0R0 5% 100 RfRf R1R1

19. 19 ER Fluctuations Increase in P e i = i e r + P e EX e appreciation falls R f increases and EX depreciates Exp Return in DC Yen/$R0R0 5% 100 RfRf R1R1 Rf 1Rf 1

20. 20 ER Fluctuations R f increased EX depreciates R f falls, EX appreciates Exp Return in DC Yen/$R0R0 5% 100 RfRf Rf 1Rf 1

21. 21 ER Fluctuations EX e increases  R f falls EX appreciates Exp Return in DC Yen/$R0R0 5% 100 RfRf Rf 1Rf 1

22. 22 Currency Premiums in ForEx Markets It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency i = i f – ΔEX e / EX – h f,d