Transcript Document

The foreign Exchange market
and exchange rates
Lecture 18
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Introduction
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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
Exchange Rates and Trade
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1990’s markets for goods and services
and financial assets were global because
of imports and exports
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When an individual, business, or G in one
country trades, lends or borrows in
another, they must use a nominal
exchange rate!
How is buying a domestic good
different from buying a foreign good?
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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
An increase in currency’s value as compared
to that of another is Appreciation
A fall in value is depreciation
Change in currency’s value can affect
domestic manufacturers and workers… How?
Example
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1DM = $0.5
1DM = $0.6
Since DM value in terms of $ has
increased, DM has appreciated or became
more expensive while $ depreciated!
Nominal Vs. Real Exchange Rate
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Nominal ER doesn’t measure real
purchasing power of the currency
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Nominal: Re 1 = $1/84 = $0.0012
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RER = NER x P/Pf
REAL ER
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Big Mac Example
Domestic Price: Rs 300
Foreign Price: $2.56
NER = $0.0012/Re
EXr = 0.0012 x 300/2.56 =
0.14 US BM/Pak BM
REAL ER
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EXr is computed from price indices which
compares the price of a group of goods in
one country with the price of similar group
of goods in another
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CPI or Inflation Rates as the ratio of P/Pf
Real ER
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If EXr increases, more units of foreign goods
could be traded per unit of domestic goods
Relationship between EX and EXr depends
on the Rates of Inflation
%Δ  ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf
ΔEX/EX = ΔEXr/EXr + (πf – π)
Foreign Exchange Market
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Market forces determine exchange rates that
prevail for consumers and investors
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International currencies traded in forEx markets
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ForEx markets are over-the-counter markets
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Currencies transactions in ForEx Markets: Spot
Market and Forward Market
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Determine LR Exchange rates
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Forces of Demand and Supply
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1$ = Rs 60  1$ = Rs 50
Rs appreciated and $ depreciate; Qd of $
increases and Qs of Rs increased!
Price level differences  P > Pf
Productivity differences  Prod > Prodf
Preferences (For foreign goods)
Trade Barriers
Example
DM/$
PUS > PGER
Long Run ER
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Purchasing Power Parity Theory
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Law of one price: PPP
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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: EXr are constant
EX = EXr x Pf / P
Does the Theory match Reality?
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Actual ER movements are just not a
reflection of changing price levels
The assumption that EXr 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
Model for SR Exchange Rate
Determination
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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
$131.25/0.013125 = Rs 10000
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Cont’d
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Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i)
Rs (1+0.05) = Rs 1.05
Re 1 invested abroad, Rs [EX (1+if)] / EXe
0.0125(1.05)/0.013125 = Re 1
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Under Interest Rate Parity: expected return on domestic
assets should equate expected return on foreign assets
1+i = EX(1+if)/EXe
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Assume:
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Identical risks, liquidity and info characteristics
1+i = 1+ if – ΔEXe / EX
Model: Comparing Exp Returns on
domestic and foreign assets
Yen/$
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R=i
Rf = if – ΔEXe / EX
If EX = 97 Yen/$
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R > Rf
Investors should
buy local assets
100
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If EX = 105 Yen/$
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5%
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Exp Return in DC
R < Rf
Investors should
buy foreign assets
ER Fluctuations
Yen/$
R0
R1
Rf
100
5%
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Exp Return in DC
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Increase in
domestic ‘i’
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EX appreciates
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As return falls,
EX depreciates
ER Fluctuations
Yen/$
R0
R1
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Increase in Pe
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i = ier + Pe
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EXe appreciation
falls
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Rf increases and
EX depreciates
Rf
Rf 1
100
5%
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Exp Return in DC
ER Fluctuations
Yen/$
R0
Rf
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Rf increased
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EX
depreciates
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Rf falls, EX
appreciates
Rf 1
100
5%
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Exp Return in DC
ER Fluctuations
Yen/$
R0
Rf
1
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EXe
increases 
Rf falls
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EX
appreciates
Rf
100
5%
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Exp Return in DC
Currency Premiums in ForEx
Markets
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It’s a number that indicates investors
collective preference for financial
instruments denominated in one currency
relative to those denominated in the other
currency
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i = if – ΔEXe / EX – hf,d
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