Transcript Document

Money and Banking
Lecture 5
The Foreign Exchange Market
Ch. 17
Selcuk Caner
Bilkent University
7/18/2015
1
Foreign Exchange I

Exchange rate—price of one currency in
terms of another
 Foreign exchange market—the financial
market where exchange rates are
determined
 Spot transaction—immediate (two-day)
exchange of bank deposits
– Spot exchange rate

Forward transaction—the exchange of
bank deposits at some specified future
date
7/18/2015
– Forward exchange rate
2
Foreign Exchange II

Appreciation—a currency rises in value
relative to another currency

Depreciation—a currency falls in value
relative to another currency

When a country’s currency appreciates, the
country’s goods abroad become more
expensive and foreign goods in that
country become less expensive and vice
versa

Over-the-counter market mainly banks
7/18/2015
3
7/18/2015
4
Exchange Rates in the Long
Run

Law of one price

Theory of Purchasing Power Parity
– Assumes all goods are identical in
both countries
– Trade barriers and transportation costs
are low
– Many goods and services are not traded
across borders
7/18/2015
5
Factors that Affect Exchange
Rates
in the Long Run

Relative price levels

Trade barriers

Preferences for domestic versus
foreign goods

Productivity
7/18/2015
6
7/18/2015
7
7/18/2015
8
Exchange Rates in the Short
Run

An exchange rate is the price of domestic
assets in terms of foreign assets

Using the theory of asset demand—the
most important factor affecting the demand
for domestic (dollar) assets and foreign
(euro) assets is the expected return on
these assets relative to each other
7/18/2015
9
Comparing Expected Returns I
Dollar assets pay an interest rate of i D and do not have any capital gain
Foreign assets have an interest rate of i F and there is no capital gain
To compare the expected returns on dollar assets and foreign assets
the returns must be converted into the currency unit used
Et  the spot exchange rate
Et+1  the exchange rate for the next period
e
Et+1
- Et
 the expected rate of appreciation for the dollar
Et
7/18/2015
10
Comparing Expected Returns
II
The expected return on dollar assets R D in terms of foreign currency
is the sum of the interest rate on dollar assets
plus the expected appreciation of the dollar
e
Et1
 Et
R in term of euros = i 
Et
D
D
The expected return on foreign assets R F is i F
e
E
 Et
Relative R D  i D  i F  t1
Et
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
7/18/2015
11
Comparing Expected Returns
III
The expected return on foreign assets R F in terms of dollars
is the interest rate on foreign assets i F plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar
e
Et1
 Et
R in terms of dollars = i 
Et
F
F
The expected return on the dollar assets R D is i D
e
e
Et1
 Et
Et1
 Et
D
F
Relative R  i  (i 
) i i 
Et
Et
D
D
F
Which is the same as previously
Relative expected return on dollar assets is the same whether it is
calculated in terms of euros or in terms of dollars
As the relative expected return on dollar assets increases, both foreigners and
domestic residents will want to hold more dollar assets
7/18/2015
12
Interest Parity Condition
E  Et
i i 
Et
D
F
e
t1

Capital mobility with similar risk and liquidity 
the assets are perfect substitutes

The domestic interest rate equals the foreign
interest rate minus the expected appreciation of
the domestic currency

Expected returns are the same on both domestic
and foreign assets

An equilibrium condition
7/18/2015
13
20
-0,1
0
-0,2
-20
7/18/2015
diff. int. rates
06/30/2006
06/30/2005
06/30/2004
06/30/2003
06/28/2002
06/29/2001
06/30/2000
06/30/1999
06/30/1998
06/30/1997
06/30/1996
06/30/1995
06/30/1994
06/30/1993
06/30/1992
06/30/1991
06/30/1990
06/30/1989
06/30/1988
06/30/1987
06/30/1986
06/30/1985
06/30/1984
06/30/1983
06/30/1982
06/30/1981
06/30/1980
140
0,6
120
0,5
100
0,4
80
0,3
0,2
60
0,1
40
0
-0,3
per. change fx ytl/$
14
Demand and Supply
for Domestic Assets

Demand
– Relative expected return
– At lower current values of the dollar
(everything else equal), the quantity
demanded of dollar assets is higher

Supply
– The amount of bank deposits, bonds,
and equities in the U.S.
– Vertical supply curve
7/18/2015
15
7/18/2015
16
7/18/2015
17
7/18/2015
18
7/18/2015
19
7/18/2015
20
7/18/2015
21
7/18/2015
22
7/18/2015
23
Exchange Rate Overshooting

Monetary Neutrality
– In the long run, a one-time percentage rise in
the money supply is matched by the same onetime percentage rise in the price level

The exchange rate falls by more in the
short run than in the long run
– Helps to explain why exchange rates exhibit so
much volatility
7/18/2015
24
7/18/2015
25
The Dollar and Interest Rates

While there is a strong
correspondence between real interest
rates and the exchange rate, the
relationship between nominal interest
rates and exchange rate movements
is not nearly as pronounced
7/18/2015
26
7/18/2015
27