Transcript Chapter 8

Chapter 8
The Foreign- Exchange Market and
Exchange Rates
•
•
However, individual country currencies
are exchanged in financial markets.
Two types of foreign exchange markets
1. Cash Market – Spot Market in which agents
set a price to exchange cash in less than two
days.
2. Derivative Market - Forward market in
which agents set a price to exchange currency
at some future date.
•
Both markets are Over-the-Counter
markets.
HK Dollar Exchange Rates
22
.22
20
.20
18
.18
16
.16
14
12
.14
10
.12
80
82
84
86
88
90
US
92
94
YEN
96
98
00
• Exchange Rate: EX - # of foreign currency
units purchased for 1 domestic currency
unit.
• An increase in EX is an appreciation and a
decrease in EX is a depreciation.
• Define the expected growth rate of the
exchange rate as
e
e
EX

EX

EX
1
e 

EX
EX
Exchange Rates and International Trade
• A toaster in Hong Kong which sells at price PHK
denominated in HK$ or order a toaster from Japan
selling at price PJPN. (Both toasters have
equivalent characteristics)
• The price of the Japanese toaster can be converted
to HK dollars by dividing by the $HK: $Yen
exchange rate.
P JPN
HK
• Buy HK toaster if P 
buy Japanese
HK :JPN
EX
toaster otherwise.
Real Exchange Rate
• Broaden our perspective, PHK is a broad
based index of domestic prices and PJPN is a
broad based index of Japanese prices.
• The relative price of domestic goods is the
real exchange rate
EX r 
P
PF
EX

EX  P
PF
LOOP, PPP, and RER
• The Law of One Price states that a good selling in
different markets should have the same price in
both markets.
– If not arbitrageurs will buy in cheap markets and sell in
expensive until prices are equalized.
• Applied to all goods LOOP implies Purchasing
Power Parity. The price of goods in the domestic
market should be equal to the price of goods in
foreign markets divided by the exchange rate.
• PPP implies a constant real exchange rate.
Inflation and Exchange Rates
• If PPP holds, then real
exchange rate is constant. This
would imply that exchange rate
appreciations occur when
foreign inflation is higher than
domestic inflation.
• When foreign goods cost more
(in terms of foreign currency),
people are willing to pay higher
prices for domestic currency to
buy the more competitive
domestic products.
EX r 
P
PF
EX
EX  P

PF
EX
EX r

  f 
EX
EX
HK-US Real Exchange Rates
100
90
80
70
60
50
40
60
65
70
75
80
85
90
HK-US Real Exchange Rate
95
Real Exchange Rate Appreciation
•
Long-run real exchange rate appreciations
are caused by
1. Increases in preferences for domestic goods
relative to foreign goods.
2. Trade barriers which allow domestic prices to
remain relatively high.
3. Productivity Growth which increases demand
and prices for non-traded goods including
land which is in relatively fixed supply.
Theory and Reality
• PPP does not hold in the short-run. Pricing
mechanism may not work that quickly to insure
law of one price.
• Among developed countries, over long time
periods, exchange rate appreciations are closely
related to exchange rate differentials. Real
exchange rates are roughly stationary.
• High growth developing countries experience
long-term real exchange rate appreciations.
International Trade and Finance
• Level of the nominal exchange rate, affects
international trade
• By contrast, the expected growth rate of
exchange rates affects international finance.
Interest Rates
• Consider the decision to buy a HK bond with a yield of 1+i
denominated in HK dollars or a Japanese bond
denominated in Yen with a yield of 1+if. (Assume both
bonds have equivalent risk, liquidity, and information
characteristics).
• With HK$1 you could buy a bond and receive HK$1+i
after 1 period. With HK$1 dollar you could buy ¥EX, and
buy a bond that would pay-off ¥(1+if)·EX. This could then
be exchanged for
EX  (1  i f )
(1  i f )
HK $
 HK $ EX 1
EX 1
EX
• Define the expected domestic Dollar return on a foreign bond as
1  R f  HK$
(1  i f )
EX 1
EX
e

EX
 Rf if 
EX
• The expected domestic Dollar return on a domestic bond R = i.
• Given that domestic and foreign bonds have equivalent risk,
liquidity and information characteristics, open international
capital markets imply that they should have the same return
when measured in the same currency.
1  R  HK$
f
(1  i f )
EX 1
EX
EX e
R i 
EX
f
f
– If domestic interest rates (measured in domestic currency) are
lower than foreign interest rates (measured in foreign currency),
the market expects the domestic currency to appreciate over the
life of the bonds.
– If domestic interest rates are higher than foreign interest rates, the
market expects the domestic currency to depreciate in value.
Long Term Interest Rate
Differentials
•
We observe long-term differences in
interest rates across countries. One
explanation is that there is long-term
depreciation of the currency of the high
interest rate country versus the low
interest rate country.
Short-term Determinants of
Exchange Rates
• Large fluctuations in exchange rates around trend
between most countries currencies.
• The HK$-US$ exchange rate is set by the
HKMA’s monetary policy. However, this is an
exceptional case.
• Most countries monetary authorities allow an
independent interest rate. The exchange rate then
fluctuates to equalize returns.
• Many small countries set monetary policy to
stabilize exchange rates.
Short-Term Foreign Bond Returns
• Holding the foreign interest rate and expected future exchange rate
constant, the return is a positive function of the current exchange rate.
• The higher is the exchange rate, the more foreign dollars you can get
for each domestic dollar that you pay today and thus the more foreign
currency bonds you can buy for 1 unit of domestic currency.
• Ex. The current yield on a 1 year Japanese T-bill is .03% . The HK$-¥
exchange rate hovers between 15 and 16. Assume that the expectation
of the exchange rate 1 year from now is EX+1 =15. We can map this
into returns as a function of the exchange rate
EX
if
14
14.5
15
15.5
16
EX_+1
0.0003
0.0003
0.0003
0.0003
0.0003
15
15
15
15
15
R
-0.07113
-0.03418
0.0003
0.032558
0.0628
Rise in Domestic Interest Rates
• An increase in domestic interest rates means that
the exchange rate must be greater today than in the
future.
• An increase in the interest rate implies a rise in the
exchange rate.
• Intuition – A rise in domestic interest rates makes
domestic bonds more attractive relative to foreign
bonds. Portfolio holders purchase the domestic
currency bidding up the exchange rate.
Rise in Foreign Rates
• An increase in domestic interest rates means that
the exchange rate must be lower today than in the
future.
• An increase in the foreign interest rate implies a
fall in the exchange rate (holding the future
exchange rate level constant).
• Intuition – A rise in foreign interest rates makes
foreign bonds more attractive relative to domestic
bonds. Portfolio holders purchase the foreign
currency, putting downward pressure on the
exchange rate.
Rise in Expected Future
Exchange Rate
• A rise in the expected future exchange rate means
that the current exchange rate must increase to
equalize returns.
• An increase in the expected future exchange rate
increases the current exchange rate.
• Intuition: A rise in the future exchange rate
increases the foreign currency pay-off of investing
in domestic currency bonds. As foreign portfolio
holders buy domestic currency to take advantage,
the domestic currency price is bid up.
Rise in Expected Inflation
• For a given real interest rate, a rise in the expected
inflation rate will lead to a rise in the domestic
interest rate.
• A rise in future prices will lead to less future
demand for domestic currency and a depreciation
of the future expected exchange rate and a rise in
domestic currency returns of foreign currency
bonds.
• Effect on current exchange rates are ambiguous
but thought to be more likely to lead to a
depreciation.
Rise in
Spot Exchange Rate: E
Domestic Currency
Returns of Foreign
Currency Bonds
Domestic Interest Rate:
i↑
↑
↑
Foreign Interest Rate iF↑ ↓
Unchanged
Expected Exchange
Rate E+1 ↑
↑
Unchanged
Expected Domestic
Inflation π ↑
Ambiguous
↑
Premium
•
Define hf,d as the premium paid by issuers of
domestic bonds over foreign bonds.
i i
•
f
EX e

 h f ,d
EX
hf,d can be either positive or negative.
1. If domestic bonds have more attractive risk or
liquidity properties, hf,d > 0.
2. If domestic bonds have less attractive risk or liquidity
properties, hf,d < 0.
Currency Risk Premium and Exchange Rates
• Equal returns across countries presumes that the
representative bonds across markets have equal
characteristics (in terms of risk, liquidity, and information).
This is unlikely to hold true in practice.
• Example: After many years of recession and political
instability, bonds issued by corporations and governments
in Indonesia are likely to be more risky than bonds issued
by corporations and governments in Hong Kong.
• Example: Hong Kong banks are able to use Exchange
Fund bonds as collateral for short-term loans that can be
used to replenish their overnight aggregate balances. EF
bonds have unique liquidity properties.
East Asian Crisis
• During late 1990’s, risk premiums on bonds issued
in many East Asian countries rose dramatically.
• In Indonesia, Korea, Malaysia, Philippines, and
Thailand exchange rates depreciated dramatically.
(Taiwan and Singapore, to a lesser extent).
• In Hong Kong, exchange rates stayed the same,
but interest rates rose atypically above US levels.
A Rise in the Domestic Risk Premium
i
EX
RF
RF-h’
h’↓
R
Corrected Version of Slide 9 from
Chapter 6
• Q: Why does the Demand Curve for Loanable
Funds Slope Down?
A: If bond issuers must offer a high interest
payment to borrow, the attractiveness of
borrowing or financing borrowing in the bond
market will drop.
• Q: Why does the Supply Curve for Bonds Slope
Up.
A: If bond issuers receive a high price for a
given future face value, the attractiveness of
borrowing or financing in the bond market rises.