Transcript Foreign Exchange

Exchange Rates
Exchange Rates
• An exchange rate is the price of one currency
in terms of another.
– It indicates how many units of one currency can
be bought with a single unit of another currency.
• Exchange rates are important because exports,
imports and all international financial
transactions are affected by the prices at which
currencies exchange for one another.
Exchange Rates and Trade
• Currency Appreciation
– Increase in the value of the currency
• When a country’s currency appreciates, its exports
become more expensive and its imports become less
expensive.
• Currency Depreciation
– Decrease in the value of the currency
• When a country’s currency depreciates, its exports
become less expensive and its imports become more
expensive.
Exchange Rates and Capital
Mobility
• Currency appreciation
– Increase in the value of the currency
• When the dollar appreciates, U.S. assets become
more attractive relative to foreign assets.
• Currency depreciation
– Decrease in the value of the currency
• When the dollar depreciates, U.S. assets become
less attractive relative to foreign assets.
Exchange Rates: Long Run
• Factors that affect exchange rates in the
long run include:
– Relative Price Levels
– Trade Barriers
– Preferences for Domestic Versus Foreign
Goods
– Productivity
Relative Price Levels and
Exchange Rates
• Purchasing power parity (PPP) says that
when the prices charged for essentially the
same goods in different countries diverge,
exchange rates will move in the opposite
direction and equalize the effective prices
between the two countries.
Determination of Exchange
Rates: PPP
• Purchasing power parity says that in the
long run exchange rates adjust to reflect
changes in the price levels of two countries.
– If one country’s price level rises relative to
another, its currency tends to depreciate.
– If one country’s price level falls relative to
another, its currency tends to appreciate.
PPP: Simple Example
• Assume that the USA and Canada produce
identical bushels of wheat and that the
exchange rate is $1 Canadian for $1 U.S.
• Let the price of wheat in Canada rise to
$3/bushel while the price of wheat in the
U.S. remains $2.50/bushel.
• What will happen?
Purchasing Power Parity:
Example
• Canadians will buy U.S. wheat. In order to
do this, they must first buy U.S. dollars.
– The supply of Canadian dollars in the global
marketplace increases.
– The demand for U.S. dollars in the global
marketplace increases
• The Canadian dollar depreciates and the U.S dollar
appreciates.
Purchasing Power Parity:
Example
• The price of U.S. wheat increases for
Canadians for two reasons.
– The dollar has appreciated.
– The increase in demand for U.S. wheat pushes
its price towards $3.00.
• The decrease in demand for Canadian wheat
pushes down its price down from $3.00
towards $2.50.
PPP: Simple Example
• Over time these effects combine to bring
about a single price for U.S. and Canadian
wheat.
• Conclusion:
– A rise in the price level puts downward
pressure on a currency.
– A fall in the price level puts upward pressure
on a currency.
Why PPP Works Poorly in the
Short Run
• Assumptions:
– All goods are identical in both countries.
– All goods and services are traded across
borders.
– Both countries have similar levels of
productivity.
– Consumers do not prefer one country’s goods
over another’s.
– No tariffs or quotas.
Trade Barriers and Exchange
Rates
• Barriers to free trade, increase the demand
for domestic goods, causing the domestic
currency to tend to appreciate.
• If the rising value of the currency does not
decrease foreign demand, the domestic
currency appreciates because the supply of
that currency decreases in world markets.
Preferences and Exchange Rates
• Increased demand for a country’s exports
causes its currency to appreciate.
• If the rising value of the currency does not
decrease foreign demand, the demand for
the domestic currency in world markets
increases and its value rises.
Preferences and Exchange Rates
• Decreased demand for a country’s exports
causes its currency to depreciate.
• If the falling value of the currency does not
increase foreign demand, the demand for
the domestic currency in world markets
decreases and its value falls.
Productivity and Exchange Rates
• As a country becomes more productive than
other countries, costs fall, permitting that
country to sell at lower prices.
• The decrease in price increases demand for
the country’s goods and services, causing
the value of the country’s currency to rise.
Productivity and Exchange Rates
• As a country becomes less productive than
other countries, costs rise, forcing that
country to sell at higher prices.
• The increase in price decreases demand for
the country’s goods and services, causing
the value of the country’s currency to fall.
Exchange Rates: Short Run
• The modern asset market approach to
explain exchange rate determination
emphasizes financial flows.
– Financial transactions in the U.S. are over 25
times greater than the amount of exports and
imports.
• In the short run, decisions to hold domestic
or foreign assets play a more important role
than trade.
Expected Return
• Demand for dollar deposits vis a vis foreign
deposits depends on the relative expected
return on the deposits.
– A higher expected return on dollar deposits
relative to foreign deposits results in a higher
demand for dollar deposits.
– A higher expected return on foreign deposits
relative to dollar deposits results in a higher
demand for foreign deposits.
Expected Return: Foreign
Perspective
• The return on dollar deposits received by a
foreigner depends on the interest rate and
the exchange rate between dollars and the
foreign currency because….
– Interest earned on U.S. deposits is denominated
in dollars and must be converted into the
foreign currency.
Expected Return: Stable
Currencies
• Assume you are French and you have
bought a U.S. asset that pays 10% interest.
– If the exchange rate between the U.S. and
France does not change, you receive the full
10%.
Expected Return: Changing
Currency Values
• Assume you are French and you have
bought a U.S. asset that pays 10% interest.
• Also assume that the exchange rate between
France and the U.S. changes.
• You will not receive 10%.
– You may receive more than 10% or less than
10%.
Expected Return: Dollar
Appreciation
• Assume you are French and you own a U.S.
asset that pays 10%.
• Assume also that the dollar has appreciated
relative to the euro.
– This means that the dollar buys
euros.
– This means that you earn
than 10%.
Expected Return: Dollar
Depreciation
• Assume you are French and you own a U.S.
asset that pays 10%.
• Assume also that the dollar has depreciated
relative to the euro.
– This means that the dollar buys
euros.
– This means that you earn
than 10%.
Expected Return: The Math
• The formula for the expected return on
dollar deposits (RET$) in terms of euros is:
• RET$ = i$ + (E$t+1 – E$t)/E$t
• The expected return equals the interest return
denominated in dollars (i$ ) plus the expected
dollar appreciation.
– E$t+1 is the expected value of the dollar in the next period.
– E$t is the expected value of the dollar today.
Expected Return: French Assets
• If you are French, the expected return on
French deposits is the French interest rate.
• There is no exchange rate exposure.
Relative Expected Return
• If you are French, the relative expected
return on dollar deposits is the difference
between the expected return on dollar
deposits and the expected return on euro
deposits.
• To invest profitably, we must compare the
two.
Relative Expected Return: The
Math
• The relative expected return on dollar
deposits equals:
• Relative RET$ = i$ – if + (E$t+1 – E$t)/E$t
• The relative expected return equals the interest
return denominated in dollars minus the interest
on French deposits plus the dollar appreciation.
Expected Return: American
Perspective
• The return on euro deposits received by an
American depends on the French interest
rate and the exchange rate between dollars
and the euro because….
– Interest earned on French deposits is
denominated in euros and must be converted
into dollars.
Expected Return: The Math
• The formula for the expected return on
French deposits (RETF) in terms of dollars
is:
• RETF = if – (E$t+1 – E$t)/E$t
• The expected return equals the interest return
denominated in euros (if ) plus the appreciation in
the euro.
• Euro appreciation is the negative of dollar
appreciation so we subtract dollar appreciation
from our return.
Expected Return: U.S. Assets
• The expected return on U.S. deposits for
Americans is the U.S. interest rate because
there is no exchange rate exposure.
Relative Expected Return
• If you are American, the relative expected
return on dollar deposits is the difference
between the expected return on dollar
deposits and the expected return on euro
deposits.
• To invest profitably, we must compare the
two.
Relative Expected Return: The
Math
• The relative expected return on dollar
deposits equals:
• Relative RET$ = i$ – (if – (E$t+1 – E$t)/E$t)
•
= i$ – if + (E$t+1 – E$t)/E$t
• The relative expected return equals the interest
return denominated in dollars minus the interest on
French deposits plus the dollar appreciation.
Conclusion
• The relative expected return on dollar
deposits is the same whether it is calculated
form the foreign point of view or the
domestic point of view.
– When the dollar is expected to appreciate,
Americans and foreigners prefer to hold
dollar denominated deposits.
Interest Rate Parity
Understanding Exchange Rates in the
Short Run
Explaining Interest Rates with
Interest Rate Parity
• Interest rate parity says that the higher
domestic real rates of interest are relative to
foreign real interest rates, the higher will be
the value of the domestic currency, other
things remaining the same.
Interest Rate Parity: Assumptions
• Foreign and U.S. deposits have similar risk
and liquidity characteristics.
• There are few impediments to capital
mobility.
– Foreigners can easily purchase American assets
and Americans can easily purchase foreign
assets.
• Therefore, foreign and American deposits
are perfect substitutes.
Interest Rate Parity: Investor
Behavior
• When capital is mobile and bank deposits
are perfect substitutes….
– If the expected return on dollar deposits is
above foreign deposits, everyone will want to
hold dollar deposits.
– If the expected return on foreign deposits is
above American deposits, everyone will want
to hold foreign deposits.
Interest Rate Parity Condition
• For existing supplies of both dollar and
foreign deposits to be held, it must be true
that there is no difference in their expected
returns.
– The relative expected return must equal zero.
• Relative RET$ = i$ – if + (Et+1 – Et)/ Et = 0 or
i$ = if – (Et+1 – Et)/ Et
Interest Rate Parity Condition:
Implications
• If the domestic rate is above the foreign
interest rate, positive expected appreciation of
the foreign currency is expected.
– The expected appreciation compensates for the
lower foreign interest rate.
° i$ = if – (Et+1 – Et)/ Et
° 10% = 8% – x
Interest Rate Parity Condition:
Implications
• If the domestic rate is below the foreign
interest rate, positive expected appreciation of
the domestic currency is expected.
– The expected appreciation compensates for the
lower domestic interest rate.
° i$ = if – (Et+1 – Et)/ Et
° 8% = 10% – x
Foreign Exchange Market Model
RETD
Et
RETF
10.5
RETD is the return on dollar deposits in
the U.S.
10.0
RETF is the expected return on euro
deposits in terms of dollars.
9.5
0
Et is the exchange rate = euros/dollars.
RET$ is the expected return on
deposits in terms of dollars.
5%
10%
15%
RET$
Foreign Exchange Market Model:
Derivation
RETD
Et
RETF
Let if = 10%, Et = 9.5 and Et+1=10.
10.5
RETF = 0.10 – (10 – 9.5)/9.5
= 0.10 – 0.052 = 0.48
10.0
9.5
0
We plot the combination 9.5 and 4.8 at
point 1.
1
5%
10%
15%
RET$
Foreign Exchange Market Model:
Derivation
RETD
Et
RETF
10.5
Let if = 10%, Et = 10 and Et+1 =10.
10.0
RETF = 0.10 – (10 – 10)/10
= 0.10 – 0 = 0.10
9.5
0
2
We plot the combination 10 and 10 at
point 2.
1
5%
10%
15%
RET$
Foreign Exchange Market Model:
Derivation
RETD
Et
3
10.5
0
We plot the combination 10.5 and 14.8
at point 3.
1
5%
Let if = 10%, Et = 10.5 and Et+1 = 10.
RETF = 0.10 – (10 – 10.5)/10.5
= 0.10 – (– 0.048) = 0.148
2
10.0
9.5
RETF
10%
15%
RET$
Foreign Exchange Market Model
RETF
RETD
Et
10.5
Equilibrium occurs where the return
on foreign assets equals the return
on domestic assets.
10.0
9. 5
0
5%
10%
15%
RET$
Stability of Equilibrium
• At equilibrium there are either no forces
causing change or there are equal off-setting
forces.
• If the equilibrium is stable, disequilibrium
positions cannot exist indefinitely.
– Forces in the model will tend to eliminate either
the excess supply or excess demand.
Foreign Exchange Market Model
RETF
RETD
Et
Equilibrium occurs where the return
on foreign assets equals the return
on domestic assets.
10.5
10.0
If the return on foreign assets exceeds
the return on domestic assets, the
currency will depreciate.
0
5%
10%
15%
RET$
Equilibrium
• Let the exchange rate be 10.5
– The expected return on euro deposits is now
greater than the return on dollar deposits.
– Holders of dollar deposits now will try to sell
them and buy euro deposits, but no one will
want them at the exchange rate of 10.5.
– The excess supply of dollars will cause the
dollar to fall.
– The dollar falls until equilibrium is reached at
the exchange rate of 10.
Foreign Exchange Market Model
RETF
RETD
Et
Equilibrium occurs where the return
on foreign assets equals the return
on domestic assets.
10.0
If the return on foreign assets is less than
the return on domestic assets, the
currency will appreciate.
9. 5
0
5%
10%
15%
RET$
Equilibrium
• Let the exchange rate be 9.5
– The expected return on dollar deposits is now
greater than the return on euro deposits.
– Holders of euro deposits now will try to sell
them and buy dollar deposits, but no one will
want them at the exchange rate of 9.5.
– The excess demand for dollars will cause the
dollar to rise.
– The dollar rises until equilibrium is reached at
the exchange rate of 10.
Changes in Exchange Rates
• To explain how exchange rates change over
time, we have to understand the factors that
shift the expected-return schedules for
domestic dollar deposits and foreign
deposits.
Shifting the Expected-Return
Schedule for Foreign Deposits
• The RETF schedule shifts when there is a
change in the foreign interest rate.
– An increase in the foreign interest rate shifts the
RETF schedule to the right and causes the
domestic currency to depreciate.
– A decrease in the foreign interest rate shifts the
RETF schedule to the left and causes the
domestic currency to appreciate.
Shifting the Expected-Return
Schedule for Foreign Deposits
Et
RETD1
RETF3
RETF1
RETF2
Other things remaining the same, a
change in i f changes the expected
return on foreign deposits.
If i f rises, at any given exchange rate,
RETF is higher so we shift the RETF
schedule to the right.
If i f falls, at any given exchange rate,
RETF is lower so we shift the RETF
schedule to the left.
0
RET$
Foreign Interest Rate Rises
Et
RETD
RETF1
RETF2
E1
E2
0
1
2
RET$
An increase in the expected return on
foreign deposits causes the domestic
currency to depreciate.
The higher rates of return on foreign
financial assets attract U.S. buyers.
In order to buy foreign financial assets,
U.S. investors must first buy foreign
currency.
The supply of dollars increases
in the global marketplace and
the dollar depreciates.
Shifting the Expected-Return
Schedule for Foreign Deposits
• The RETF schedule shifts when there is a
change in the expected future exchange
rate.
– A rise in the expected future exchange rate
shifts the RETF schedule to the left and causes
the domestic currency to appreciate.
– A fall in the expected future exchange rate
shifts the RETF schedule to the right and causes
the domestic currency to depreciate.
Shifting the Expected-Return
Schedule for Foreign Deposits
Et
RETD1
RETF2
RETF1
RETF3
Other things remaining the same, a
change in Et+1 changes the expected
appreciation of the dollar.
If Et+1 rises, the euro is expected to fall
and RETF will be lower. We shift the
RETF schedule to the left.
If Et+1 falls, the euro is expected to rise
and RETF will be higher. We shift
the RETF schedule to the right.
0
RET$
Shifting the Expected-Return
Schedule for Domestic Deposits
Et RETD1
RETD2
RETD3
RETF
A rise in the domestic interest rate
shifts RETD to the right and causes
an appreciation of the domestic
currency.
A fall in the domestic interest rate
shifts RETD to the left and causes
a depreciation of the domestic
currency.
0
RET$
Real Rate of Interest Rises
Et
RETD1 RETD2 RET
F
E2
E1
0
2
A rise in the real domestic rate of
interest causes the currency to
appreciate.
The higher rates of return on U.S.
financial assets attract foreign
buyers. In order to buy U.S.
financial assets, foreigners must
first buy dollars.
1
RET$
The demand for dollars increases
in the global marketplace and
the dollar appreciates.
Inflation and the Exchange Rate
Et
RETD RETD2 RETF1
RETF2
An increase in inflation causes the
currency to depreciate.
E1
E2
0
1
If nominal interest rates rise because of
an increase in the inflation premium,
the rise in expected domestic inflation
leads to a decline in the expected
appreciation of the dollar.
2
RET$
Money Supply and the Exchange
Rate
Et
RETD2 RETD1
RETF1 RETF
2
An increase in the money supply can cause the
domestic currency to depreciate, if it causes an
increase in the domestic price level that leads
to a lower expected future exchange rate.
1
E1
E2
E3
The decline in the expected appreciation
of the dollar raises the expected return of
foreign deposits.
2
3
In the short run, domestic interest rates fall
0
RET$
Volatility of Exchange Rates
• Exchange rates are volatile because
– Exchange rates are determined by
expectations about domestic interest rates,
foreign interest rates, inflation, and many
other variables.
– When expectations change about any of these
variables, exchange rates are affected.