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Chapter13:ExchangeRatesandtheForeignExchangeMarket

Topics:

ExchangeRates
Foreignexchangemarket
Assetapproachtoexchangerates
InterestRateParityConditions

1. Definitions

a) Definitionofexchangerate:priceofonecurrencyintermsofanother.The
conventionalwayofreportingthisineconomicsishomecurrencyperforeign.Inthe
U.S.thisis$perforeigncurrency.Forexample,itmaytake$0.90tobuyone
Europeaneuro($/euro).Thisistheconventionineconomicsandwillbeusedinthis
class.

Sometimesyouwillhearquotedtheotherwayaround,oftencalledEuropeanterms.
i.e.:1.11euro/$.

b) Exchangeratesareimportantfortradebecausetheyallowyoutocomparethecostof
importstothatofdomesticgoodsincommonterms.Example:Considerthe
Mercedes:supposethegoingpriceis100thouDMinGermanyand100milItalian
Lira.WouldGermansflocktoItalytobuyMercedescars?Itdependsonthe
exchangeratecomparingDMandLiraiscomparingapplesandoranges.DM/Lira
exchangerateyesterdaywasjustabout.001.

100milL*(.001DM/L)=100thouDM.
So100milLiraisaboutthesameas100thouDM,andsotheautopriceisaboutthe
same.Wecouldalsodothisinreverse.

HowdidIfindtheDM/L?Theerateisoftenonlygivenintermsof$/poundor
$/DM.Youcandivideonebyothertofindtheerateyouwant.Inthiscase:$/Lis
.00065and$/DMis.64,soDM/L=($/L)/($/DM)=.001,wherethe$scancelout.

c) Thewayweconventionallydefinetheeratecanalsomakeitconfusingtotalkabout
changesintherate,whichwecallappreciationordepreciation.Acurrencyis
consideredtohaveappreciatedrelativetoanothercurrencyifithasgrownstronger
relativetotheothercurrency.Acurrencyisconsideredtohavedepreciatedrelative
toanothercurrencyifithasgrownweakerrelativetotheothercurrency.

SupposetheDM/Lratechangedfrom.001to.0009;wewouldsaythattheLirahad
depreciatedrelativetotheDM.OrwecouldsaytheDMappreciatedrelativetothe
L.Notethatthiscanbeconfusing.GivenhowwedefinetheGermanexchangerate
asDM/L,ifthisgetslower,wecallthisanappreciationintheDM.
IttakesfewerDMtobuyanygivenamountoflira,sotheDMhasgrownstronger.

Supposetheeratechangedasdescribed,butthedomesticcurrencypricesofa
Mercedesdidntchangerightaway.ThenwhiletheGermanpriceoftheMercedesis
100,000DM,theItalianpricewouldbeonly90,000DM.Germanswouldgoand
buyMercedesinItalytoreselltheminGermany.

Adepreciation(appreciation)ofacountryscurrencymakesitsgoodscheaper
(moreexpensive)forforeigners,andmakesforeigngoodsmoreexpensive
(cheaper)fordomesticresidents.

2. Featuresoftheforeignexchangemarket.

a)Actors
1)commercialbanks:handlemostoftheexchangemarkettransactionsinvolvea
companyhavingitscommercialbankdebititsaccount,changeitintoforeign
currencyandpaythebusinesspartnerbydepositingthiscurrencyinitsforeign
bank.Typically,electronictransactionsforbankdeposits,notadirectexchange
ofcurrencyandcoins.

Interbanktrading:abankgathersrequestsofitscustomersandenterstheforeign
exchangemarkettoexecutethetradeasaunit.Thesearelargetransactions,must
beover$1million.Enteringthemarketisamatterofcheckingthepostingsona
computernetworktoseetheratesatwhichotherbanksarewillingtotrade
currency,thencallingonthephoneandfinalizingaprice.

2)corporations:sometimescorporationsenteremarketdirectly.Increasingly
common,sincecorporationshaveplantsabroad,orbuycomponentsfromabroad.

3)Nonbankfinancialinstitutions:Therehasbeenmuchderegulationoffinancial
markets,sofinancialinstitutionsotherthanbankscancompetewithbanksin
providingservicesinemarket.Couldbepensionfunds,orpurespeculationby
fundmanager.
.
4)Centralbanks:Welearnedinthepreviouschapterthatcentralbankssometimes
interveneintheemarkettoincreaseordecreasethesupplyoftheircurrencyor
purposefullyaffecttheerate.Thesizeofofficialforeigneinterventionsis
relativelysmall,becausethereissomuchprivatemoneybeingthrownaround.
Itsquestionablewhetheranycentralbankisabigenoughplayertoaffectthings.

b)Characteristics
Thevolumeisenormous:overatrilliondollarsaday.RecallthatU.S.GDPwas
only6.7trillioninthewholeyearof1994.Banksdealingintheemarkettendto
beconcentratedincertainkeyfinancialcities,suchasLondon(largest),NY,
Tokyo,FrankfurtandSingapore.

Highlyintegratedglobally:whenonemajormarketisclosedusuallyanotheris
open,sopeoplecantradearoundtheclock,movingfromonecentertoanother.
Integrationmeansequotesindifferentcentersmustbethesame.Thisis
guaranteedbyarbitrage(=makingacertainrisklessprofitonafinancialtrade):If
NYoffersmoreDMfora$(lowerpriceofDM,higherpriceof$,E$/DMislow)
thanFrankfurtdoes,peoplecouldtaketheir$,selltheminNYforDM,andthen
selltheseinFrankfurtfor$,therebymakingaprofit.

Obviously,thiscantlast.TheincreaseddemandforDMinNYwoulddriveup
thepriceofDMintermsof$.Therearecomputersmonitoringsuchopenings
andreadytotakeadvantageofthem.Soanygapscloseupveryquickly.

The$haslongbeenthevehiclecurrency.Mostetransactionsbetweenbanks
havetakenplacein$,evenifwanttochangeLiraforFrenchFranc,notdollars.
DMandYenwerealsousedasvehicles,butlessso.Thismaychangewiththe
euro.

c)Spotandforwardrates
Theexchangetransactionsdiscussedsofartakeplaceonthespotmarket.The
spotrateistherateforcurrencytransactionsthattakeplacebasicallyimmediately
(twodaysforthecheckstoclear).Forwardexchangeratesrelateto
arrangementsacurrencytradeatsomedateinfuture.Thisisawayofhedging
againsttheriskoferatechanges.

SupposeBestBuyelectronicsisexpectingashipmentofSonyTVsinamonth,
forwhichitneedstopayYen.ItcouldwaituntiltheshipmenttobuytheYento
paySony,butthereisuncertaintywithrespecttothefuturevalueofthatYen.If
theYenappreciates,the$pricethestorehastopaytogettheTVscouldchange.
Toavoidthisrisk,itcouldarrangeforacurrencytradetobeexecutedlateratan
agreedupon(forward)erate.

Swaps:anotherpossibilityistocombineaspotwithaforwardarrangement:i,e.,
haveaspotsale,withanarrangementtorepurchaseinthefutureatasetrate.
Whydothis?SupposethatourelectronicsstoresoldsomecomputersinJapan
andreceivedYen,knewitwouldneedthemagaininamonthtobuySonyTVs,
butdidntwanttohangonthemoneyinYenforthemonth,insteadwantingto
holditindollarsfordomesticexpenses.Mostlikelytherewouldbelower
brokersfeesifbothtransactionsarearrangetogether.Thisistheequivalentofa
timespreadinstockoptions.

Futures:likeaforwardarrangement,exceptyoucansellthecontracttosomeone
else.Thecurrencyexchangeoccurswhenthecontractcomesdue,andis
deliveredtowhoeverisholdingthecontractintheend.
Options:givetherighttobuy(call)orsell(put)anamountofcurrencyata
specifiederateanytimebeforeaspecifieddate.

Bothfuturesandoptionscanbeboughtandsold,withoutmessingaroundwiththe
underlyingsecurity(currency).Thisisusefulifyouropinionsabouttheerate
change,andoptionsallowgreaterleverage.However,thisalsolendsitselfto
speculativetrading.i.e.,ifitsuddenlylookslike$willappreciate,acontract
specifyingdollarsbedeliveredforagivenamountofYenlooksmoreattractive,
andsothepriceofthecontractgoesup.

3. Assetapproachtoexchangerates:

a) Howdoestheforeignexchangemarketdeterminewhattheexchangeratewillbe?
Thistextusestheassetapproachwhichisbaseduponinterestrateparity.There
isalsoamoretraditionalmonetaryapproachwhichisbaseduponpurchasing
powerparity,andwemaydiscussitattimes.

Recallthatmostforeignexchangeholdingsareinformofbankdeposits,whicharea
typeofasset,andthesecanbeanalyzedinthesamemannerasanyotherasset.

b) Determinantsofassetprices:Thekeyelementistheexpectedrateofreturn:

Inthecaseofyoursavingaccountindollars,youcareabouttheinterestrate.
Inthecaseofastock,youcareaboutthedividendandthecapitalgain:Supposeyou
pay$100forashareofFord,andyougetadividendpaymentof$5andresellthe
shareinayearfor$105.Yourrateofreturnis10%.

Itisimportanttounderstandthatwearetypicallydealingwithexpectations,asthe
worldisanuncertainplace.

Inadditiontotherealrateofreturn,investorscareabouttwootherfeatures:risk
andliquidity.

Riskpertainstouncertaintyabouttheactualrateofreturn.Evenifastockhasa
higherexpectedpayoffthanasavingaccount,thefactthatthepayoffisuncertain
meansitmaybelessdesirable,becausepeopleoftendontlikerisk.

Liquidity:howeasyitistoconverttheassettocash;thethicknessofthemarket.

c) Foreigncurrencyassets:Whatistheexpectedreturnforthelargebankaccounts
usedinforeignexchangemarkettransactions?Thetypicallydopayaninterestrate.
Animportantadditionalaspecttoconsiderforanaccountinaforeigncurrencyisthat
changesintheeratewhileholdingthecurrencyalsoaffectthevalueoftheassetwhen
convertedbacktothedomesticcurrency.
Sowhenyouaredecidingwhethertoholdyourassetsin$accountsoreuroaccounts,
youneedtoconsidertheinterestratesoneachdepositoptionandtheexpectedchange
intheexchangerateinthemeantime.Seetheexampleonpp.3423.

d) Wecansimplifythiscalculationwithafairlystraightforwardderivation.Follow
bookp.344andgooverTable13.3.Notethatappreciationanddepreciationareflip
sidesofthesamecoinwithrespecttotwocomparedcurrencies.

4. EquilibriumintheForeignExchangeMarket

a) Thebasicequilibriumconditionintheforeignexchangemarketisinterestparity.
Thismeansthatdepositsofallcurrenciesreceivethesameexpectedrateofreturn
(ignoresriskandliquidityissues,amongothers).Givenacertaininterestrateon$
deposits(R$),acertaininterestrateoneurodeposits(REU),andgivencertain
expectationsaboutthefutureexchangerate(Ee$/EU),thentheinterestparitycondition
tellsusthecurrentspotexchangeratethatbalancesdemandandsupplyintheforeign
exchangemarket.

Equilibratingprocess:Forexample,supposeacasewherethetotalreturnoneuro
assetsarelessthanon$assets,giventhecurrentspotexchangerateandgivenour
expectationforthefuturespotexchangerate.Inthiscase,holdingeuroassetsisless
attractivethanholding$assets,andpeoplewilltrytoselltheireuroandbuy$.This
excesssupplyofeurowillimmediatelybiddownthecurrentvalueofeuroandbidup
thevalueof$;inotherwordsthecurrentspotexchangerateE$/EUwillfall.

Butsincewestillareexpectingthesamefuturevalueoftheexchangerateinthe
future(aratherdubiousassumption),thefactthatthecurrentspotrateislowermeans
weexpectalargerEUappreciationoverthetimeweareholdingtheEUasset.This
veryfactraisesthetotalreturnontheEUasset,andmakesitmoreattractivethan
before.Thisprocesswillcontinueuntilthecurrentspotratefallsenoughthatthe
expectedEUappreciationovertimemakesthetotalEUreturnexactlyequalsthe
returnonthe$asset.AtthispointthereisnoexcesssupplyofEUforeignexchange,
andthespotexchangeratehasreacheditsequilibriumlevel.

b) Effectofchanginginterestrates:Ifanyoftheunderlyingconditionschange,thenthis
willrequireachangeinthespotexchangerate.IfR$rises,thisshiftstheverticalline
(dollarreturns)totheright,whichmeanstheequilibriumexchangerateE$/EUislower
(theEUisworthless).

Theintuitiongoeslikethis:ariseinR$makes$depositsmoreattractivethanbefore,
sothereisanexcessdemandfordollarsthatdrivesupthecurrentvalueofthedollar
anddrivesdownthecurrentvalueoftheEU(E$/EUfalls).Similarly,ifREUrises,this
shiftstheEUreturnscurvetotheright.NowtheEUassetsbecomemoreattractive
andthereisexcessdemandforEU.ThisbidsupthecurrentvalueoftheEU,whichis
ariseinE$/EU.

Ingeneralweseethatiftheinterestraterisesinacountry,thenthistendstoincrease
thevalueofthatcountryscurrency.Wecanalsoconsidertheeffectsofachangein
theexpectedfutureexchangerate.IfEe$/EUrises,thisshiftstheEUreturncurvetothe
rightjustlikecaseaboveandraisesthecurrentspotexchangerate.Theideaisthatif
youexpectEUcurrencytoriseinvalueovertime,EUassetsbecomemoreattractive
forthisreason,andthereisexcessdemandforEU,whichbidsuptheircurrentvalue.

Infuturesessions,wewilldiscusssomeoftheeconomicreasonsforwhythesecases
mightarise,thatis,whyinterestratesorexpectationsmightchange.

c) Empiricaltestsoninterestparity:Itisdifficulttotesttheinterestrateparity
condition,becauseitisdifficulttogetameasureofpeoplesexpectations.Some
economistshaveusedtheactualfutureexchangerateasaproxyforexpectationsin
thepast,assumingthatpeoplecorrectlypredictthefuturerate.Someeconomistshave
usedsurveydataonexpectationstheycallpeoplewhotakepartintheforeign
exchangemarketandaskthemwhatratestheyexpect.Bothsetsofteststendtofind
theinterestparityconditiondoesnotholdwell.Butthismaysimplyreflectthefact
thattheexpectedfutureexchangeratecomponentoftheequationwasmeasuredwith
error,notthatthetheorywaswrong.

Anotherreasonwhythetestsmayrejecttheinterestparityconditionistheroleof
risk.Thereissomeriskinvolvedbecauseyoudonotknowaheadoftimewhatthe
futureexchangeratewillbe;ifyourexpectationsturnouttobewrong,thepayoff
fromyourinvestmentschememaybedifferentfromwhatyouexpected.Thismay
makepeoplerequireanadditionalexpectedreturnonEUdepositsascompensation
foruncertainty.Inthiscasetherewouldbeanextratermintheinterestparity
equation:RPrepresentingtheriskpremium:

R$=REU+(Ee$/EUE$/EU)/E$/EURP

(Note:RPcaninprinciplebeeitherpositiveornegative,dependingonhowtheriskis
perceivedbothbypeopletradingEUfor$andthosetrading$forEU,sinceboth
groupsareexposedtorisksofdifferenttypes).

d) Coveredinterestparity:Ifexchangeriskistheproblem,isntthereawaytogetridof
that?Yes,useaforwardcontracttocreateariskfreeversionoftheinterestparity
relation.

Denotetheforwardrate:F$/EU

Thissuggestsariskfreeversionofinterestrateparity,calledcoveredinterestrate
parity:

R$=REU+(F$/EUE$/EU)/E$/EU
Theoldequationthenisoftencalleduncoveredinterestrateparity.Empirical
evidencesupportscoveredinterestparity.Infact,itseemsthisishowforwardrates
aredetermined.DealersscancurrentEandF,andifseeifthereisanimmediate
arbitrage,therebyclosingthewindowofopportunity..

DoesthisimplythattheforwardrateFistheexpectedfuturevalueofthespot
exchangerate?(DoesF$/EU=Ee$/EU?)Thisistrueonlyifbothuncoveredandcovered
interestrateparityconditionshold.