Transcript Document

Chapter 19
The Foreign Exchange
Market
Exchange Rate
• An exchange rate can be quoted in two ways:
• Direct (price quotation system): The price of the foreign
currency in terms of domestic currency.
– Quotes in American terms (goes up, domestic currency
depreciation)
• Indirect (quantity quotation system): The price of domestic
currency in terms of the foreign currency.
– Quotes in European terms (goes up, domestic currency
appreciation)
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1. International Financial Market
• The Bank for International Settlements estimated the
trading value reached more than $2 trillion per day.
• Vehicle currency: determined primarily by transactions
costs.
• Whenever the indirect exchange costs through the vehicle
are less than direct exchange costs between two nonvehicle currencies. Example: Peso-USD and USD-Won
vs. Peso-Won.
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Types of Transaction:
– Spot: Apply to exchange currencies “on the spot”
– Forward: Apply to exchange currencies on some future date at a
prenegotiated exchange rate
– Future: The buyer buys a promise that a specified amount of
foreign currency will be delivered on a specified date in the future.
– Option: The owner has the right to buy or sell a specified amount
of foreign currency at a specified price at any time up to a
specified expiration date.
– Swap: Spot sales of a currency combined with a forward
repurchase of the currency. Swap makes up a significant proportion
of all foreign exchange trading.
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2. Average Exchange Rates
(Effective Exchange Rate Index)
•
Nominal: A nominal effective exchange rate is
the exchange rate of the domestic currency visà-vis other currencies weighted by their share in
either the country international trade or
payments.
•
S ei 
n

j 1, j  i
j
S ji
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n

j 1, j  i
j
1
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Average Exchange Rates
• Real: Real effective exchange rates take account
of price level differences between trading partners.
Movements in real effective exchange rates
provide an indication of the evolution of a
country’s aggregate external price
competitiveness.
s ei 
n

j 1, j  i
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j
s ji
,
Pi
s ji 
S ij Pj
19-6
3. Real Exchange Rates
SPF / PH
–
H: home; F: foreign
SPT / PNT
–
;
SPWPI / PCPI
T: tradable goods; NT: nontradable goods
Terms of Trade:
Px / SPm
–
X: exports; M: imports
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4. Purchasing Power Parity
•
•
•
•
•
LOP: law of one price
Absolute PPP (E = PH/PF)
Relative PPP (ΔS/S =ΔPH/PH - ΔPF/PF )
OECD: Purchasing Power Parities (PPPs) are currency conversion
rates that both convert to a common currency and equalize the
purchasing power of different currencies. In other words, they eliminate
the differences in price levels between countries in the process of conversion.
How many products are included in the basket of goods and services used
for the PPP calculation?
– The final products list for the 1999 comparison covered around 2,500 consumer
goods and services, 34 occupations in government, education and health services,
186 types of equipment goods and 20 construction projects.
•
Big Mac Parity
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Problems with PPP
•
Trade Barriers and Nontradables
– Transport costs and governmental trade restrictions make trade expensive and in
some cases create nontradable goods.
• The greater the transport costs, the greater the range over which the exchange rate
can move.
•
Departures from Free Competition
– When trade barriers and imperfectly competitive market structures occur together,
linkages between national price levels are weakened further. (pricing to the market)
•
International Differences in Price Level Measurement
– Government measures of the price level differ from country to country because
people living in different counties spend their income in different ways.
•
PPP in the Short Run and in the Long Run
– Departures from PPP may be even greater in the short- run than in the long run.
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5. PPP and Non-Traded Goods
• Balassa-Samuelson Effect
– Balassa (1964) and Samuelson (1964)
• The observation that consumer price levels in wealthier
countries are systematically higher than in poorer ones.
• An economic model predicting the above, based on the
assumption that productivity or productivity growth-rates
vary more by country in the traded goods' sectors than in
other sectors.
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6. Interest Parity
•
Covered Interest Parity
•
Ft
1  it  (1  i )
Example:
St

t
1 + 0.0678 > (1 + 0.0422)
There is arbitrage profit
•
= 1.0178
0.9961
1.0200
Logarithmic approximation,
it  it 
f t  st
Forward premium
(discount)
Ft  St on domestic (foreign) currency against

foreigni(domestic)
t  it  currency
St
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Interest Parity
• Uncovered Interest Parity
e
S
1  it  (1  it ) t 1
St
• Using interest parity to think about:
– What is the relationship between spot exchange rate
and interest rate?
– What to do with a currency crisis?
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Equilibrium in the
Foreign Exchange Market
Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Exchange rate, S$/€
S2$/€
Return on
dollar deposits
2
1
S1$/€
S3
3
$/€
Expected return
on euro deposits
i$
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Rates of return
(in dollar terms)
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The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure 14-4: Effect of an Increase in the Money Supply on the Interest
Rate
Interest
rate, i
Real money
supply
Real money
supply increase
1
i1
2
i2
L(i,Y1)
M1
P
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M2
P
Real money
holdings
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The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure 14-6: Simultaneous Equilibrium in the U.S. Money Market
and the Foreign-Exchange Market
Dollar/euro
exchange Rate, S$/€
Return on
dollar deposits
Foreign
exchange
market
0
Money
market
1'
S1$/€
MSUS
PUS
(increasing)
i1 $
1
Expected
return on
euro deposits
L(i$, YUS)
Rates of
return
(in dollar
terms)
U.S. real
money
supply
U.S. real money holdings
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The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure 14-8: Effect on the Dollar/Euro Exchange Rate and Dollar
Interest Rate of an Increase in the U.S. Money Supply
Dollar/euro
exchange Rate, S$/€
Return on
dollar deposits
S2$/€
S1$/€
0
M1US
PUS
M2US
PUS
2'
1'
i2 $ i1 $
1
Expected
return on
euro deposits
L(i$, YUS)
Rates of
return
(in dollar
terms)
Increase in U.S.
real money supply
2
U.S. real money holdings
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Beyond Purchasing Power Parity: A General Model of Long-Run
Exchange Rates
•
Monetary approach to the exchange rate
•
•
In the United States:
PUS = MsUS/L (R$, YUS)
In Europe:
PE = MsE/L (R€, YE)
S $/€ = PUS/ PE
•
A General Model of Long-Run Exchange Rates
S $/€ = q$/€ x (PUS/ PE)
•
The most important determinants of long-run swings in nominal exchange rates (assuming that all
variables start out at their long-run levels):
–
–
–
–
A shift in relative money supply levels
A shift in relative money supply growth rates
A change in relative output demand
A change in relative output supply
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Beyond Purchasing Power Parity: A General Model of Long-Run Exchange
Rates
Table 15-1: Effects of Money Market and Output Market Changes on the
Long-Run Nominal Dollar/Euro Exchange Rate, S$/€
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