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Lecture 5
UNDERSTANDING
EXCHANGE RATES (1)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What is an “exchange rate”?
• The price of one currency in terms
of another (say dollars per euro)
is called the exchange rate.
• Foreign exchange (forex) transactions
are effected on specific markets for:
– spot transactions;
– forward transactions;
– futures transactions;
– options
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Appreciation and depreciation
• If you pay more € for forex, your
currency € is said to “depreciate”; if you
pay less, your currency “appreciates”
w=€/$
Depreciation
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
w=€/$
Appreciation
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Why are exchange rates important?
• They affect the relative price of domestic
and foreign goods.
• When a country’s currency appreciates,
the country’s goods become more
expensive abroad, and foreign goods
become cheaper.
• Will the exchange rate equate foreign
and domestic prices?
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The law of one price
• Under market conditions, arbitrage will
indeed equate prices in the different
regions of the domestic economy.
• If there are no barriers to trade,
this also applies to international trade.
• If the price level in country A is higher
than in country B, the exchange rate
should correct for this difference.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The law of one price
• Identical goods should sell for the same price
in two separate markets when there are no
transportation costs and no differential taxes
applied in the two markets.
• Consider the following information about
movie video tapes sold in the US
and Mexican markets:
– Price of videos in US market (Pv) = $20
– Price of videos in Mexican market (Pv) = p150
– Spot exchange rate (p/$) = 10 p/$
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The law of one price
• The dollar price of videos sold in Mexico can
be calculated by dividing the video price in
pesos by the spot exchange rate.
• If the law of one price held, then the dollar
price would have to be p150/10p/$ = $15
in Mexico to match the price in the US.
• Since the dollar price of the video is less than
the dollar price in the US, the law of one price
does not hold in this circumstance.
• If the law holds, we speak of “purchasingpower parity” (PPP).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Big-Mac index (PPP ?)
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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Effective exchange rate and PPP (against the $)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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PPP and short-term exchange rate
PPP, et
Short-term exchange rate (e)
PPP
Time t
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The purchasing power parity (PPP) theory
• The PPP theory makes sense only
in the long run.
• In the short run there are significant
deviations from PPP due to short-term
movements of capital.
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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Factors that affect exchange rates: long run
• Factors that affect the exchange rates
are (w = depreciation, w = appreciation):
– Relative price levels: if P/P*, then w
– Tariffs and quota: if import duty , then w
– A shift in preferences for domestic
versus foreign goods:
• if export demand , then w
• if import demand , then w
– Productivity: If productivity , then w
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The DEM in the longer run
Long-term development of DEM/US $
4,5
4
3,5
3
2,5
2
1,5
1
0,5
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02
0
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The organization of the forex spot market
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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A typical trading desk for spot forex
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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A typical trading desk for spot forex
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The exchange rate of the Dollar (in €)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Volatility GBP/EUR, hourly
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Volatility of JPY/USD, 10 mins
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– Zweite Ebene
• Dritte Ebene
– Vierte Ebene
• Fünfte Ebene
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Volatility USD/EUR, tick chart
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Pound sterling during the 1992 crisis
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– Zweite Ebene
• Dritte Ebene
– Vierte Ebene
• Fünfte Ebene
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The Asian crisis 1997-98
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The crisis of the Argentinian peso
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