Transcript Ch. 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach.

Ch. 13: Exchange Rates and
the Foreign Exchange
Market: An Asset Approach
1
Exchange Rates
Exchange rate is the price of one currency
in terms of another.
 On October 18, 2002 at 15:48:14 GMT,
1USD was worth €1.0301 or 1€ was worth
$0.9709.
 On Jan. 1, 1999, 1€=$1.1497; on March 5,
2001, 1€=$0.9358.
 You can check the exchange rates at

http://www.economist.com/markets/currency/
2
Exchange Rates
Changes in the exchange rates affect
the prices of imports, exports, foreign
assets purchased by locals and local
assets purchased by foreigners.
 When the domestic currency becomes
more valuable (appreciates, becomes
stronger), foreign commodities and
assets become cheaper.

3
Exchange Rates
If €1=$1.1497 on 01/01/99 and
€1=$0.9358 on 03/05/01, then euro
depreciated and USD appreciated in
this period.
 European goods and assets would be
cheaper at the recent date.
 American goods and assets would be
more expensive at the recent date.
 In this example exchange rates are
given per euro.

4
Price Comparisons
Suppose on 1/01/99 and 3/5/01 the price of
a Ferrari remained €100,000.
 Likewise, the price of a server at those
dates was $50,000.
 A Ferrari would have cost Americans
$114,970 on 1/01/99 and $93,580 on
3/5/01.
 A server would have cost Europeans
[($50,000)(€1/$1.1497)]=€43,489.61 on
1/01/99 and on 3/5/01
[($50,000)(€1/$0.9358)]=€53,430.22.

5
Price Comparisons



If the currency appreciates (as in the previous
example for USD) imports become cheaper
and exports more expensive.
US can get more European goods for the
same amount of exports: terms of trade
improvement.
If the currency depreciates (€ in the example),
Europe has to give up more exports for the
same amount of imports: terms of trade
deterioration.
6
The Foreign Exchange Market
Forex market is where international
currencies are traded.
 Major participants are commercial
banks, corporations, nonbank financial
institutions and central banks.
 The DAILY global trading in the FX
market is about $4 trillion.

http://online.wsj.com/article/SB10001424052748703380104576015824083855578.html?mod=igoogle_wsj_gadgv1&
7
http://www.economist.com/printedition/displayStory.cfm?Story_ID=4112159
8
Commercial Banks
For every import and export transaction
banks have to be involved for payments.
 An importer has to instruct her bank to pay
the exporter in exporter’s currency.
 The bank has to exchange the domestic
currency for foreign currency and transfer
the funds to the exporter’s bank.
 Because they are involved with FX market,
banks also buy and sell for their own
accounts to reduce risk.

9
Corporations

Both for importing purposes and for
expenses in another country,
corporations might need to have foreign
currency holdings.
10
Nonbank Financial Institutions
More and more nonbank financial
institutions have been undertaking
banking functions.
 More and more mutual funds, insurance
companies have been involved in
foreign businesses.

11
Central Banks

Central banks keep international
reserves to intervene in the FX market
to keep the exchange rate at a target
level.
12
The Location of FX Market
FX is traded 24/7 around the world.
 Sunday is a work day in Israel.
 Buying and selling is done with
computers, phone lines.
 In short, FX market is truly global single
market.
 There should not be any price
differentials from one place to another.

13
Arbitrage
Suppose $1=¥100 in New York but
$1=¥101 in London.
 You work at the FX desk of Citibank.
 How would you make money for Citibank?

14
Arbitrage
You buy USD in New York (sell ¥) and
sell USD in London (buy ¥).
 You borrow yen in New York, buy USD,
exchange USD to yen in London and
pay your yen debt.
 ¥100 million in New York will become
¥101 million in London.

http://www.marketwatch.com/tools/stockresearch/globalmarkets/default
.asp?siteid=mktw&dist=10moverview&
15
Equilibrium FX
Buying USD in New York will raise the
price of $: $1 will be worth more than
¥100 or ¥100 will be worth less than $1.
 Selling USD in London will lower the
price of $: $1 will be less than ¥101 or
¥101 will be more than $1.
 Prices in New York and London will be
$1=¥100.5.

16
Vehicle Currency
If there are hardly any trade and asset
purchases between two countries, they
might not have inventories of each
other’s currencies.
 Typically, USD is the international
reserve currency that is used to
exchange from one currency to another.
 USD acting as a vehicle currency allows
to calculate cross rates.

17
Cross Rates
Suppose $1=¥100 and $1=SF0.75.
 What is the cross rate between Yen and
Swiss Franc?
 ¥1=$0.01
 ¥1=$0.01(SF0.75/$) =SF0.0075
 SF1=$1.33
 SF1=$1.33(¥100/$)=¥133

18
Spot and Forward Rates
FX transaction that takes effect immediately
(even if the funds cannot be cleared before
two days) is a spot transaction.
 FX transaction that will take effect in the
future (say one month or three months) is a
forward transaction.
 The difference between the spot and
forward rates shows the interest rate
differential between two currencies.

19
Spot and Forward Rates
20
http://www.ny.frb.org/
21
22
Spot and Forward
You import VCRs from Japan. You have
to pay ¥100 million in six months.
Japanese funds pay 1% interest annually.
 You need ¥99,502,487.56 today to have
the funds in six months:
(1.005x=100,000,000).
 You could exchange $795,002.29 today:
[(¥99,502,487.56)/¥125.16/$].
 You could keep your $795,002.29 and earn
2.8% interest so that you could exchange
$806,132.32 at ¥124.05 to pay ¥100
million.

23
Spot and Forward




If it doesn’t make any difference, i.e., it costs
you the same amount today, why bother?
Because in six months ¥/$ rate may be
different.
If ¥/$ rate in six months turns out to be ¥120,
you could only get ¥96,735,878.40.
($806,132.32)(¥120).
By entering a forward contract with your bank
you know exactly how much you are paying
and can price your VCRs accordingly.
24
Other Instruments To Reduce Risk
FX Swaps: You buy a foreign currency with
the understanding that you will sell it in a
specified time.
 Futures: You buy a futures contract that will
deliver a certain amount of foreign currency
at a specified price at a specified date. You
can sell this contract within the period; you
can’t sell forward contract.
 Options: You buy a put option to have the
right to sell; you buy a call option to have the
right to buy.

25
Example of Futures
Open
High
Low
Settle Chg
Japanese Yen (CME) - ¥12,500,000; $ per 100¥
Dec
.8444
.8463
.8418
.8448
Mr07
.8548
.8564
.8524
.8552
Euro (CME) - €125,000; $ per €
Dec
1.2586 1.2615 1.2562 1.2602 .0013
Mr07
1.2625 1.2665 1.2616 1.2655 .0013
Lifetime
High
Low
Open
Interest
.9600
.9526
255,775
16,492
.8412
.8518
1.3135 1.1913 156,956
1.3207 1.2020
2,150
WSJ, October 25, 2006, p. C10.
26
FX: Commodity or Asset
Not long ago, the demand and
supply of foreign currency were
determined through import and
export demands.
 Thirty years ago current account
determined the demand and
supply of foreign currency.

27
FX: Commodity or Asset

In 1980 US (not global) foreign currency
trading was around $18 billion per day.
In Oct. 2008 this amount was $762
billion per day.
http://www.newyorkfed.org/fxc/volumesurvey/2008/octoberfxsur
vey2008.pdf

It is not imports/exports but the function
of FX as an asset that matters.
28
The Demand for an Asset
Foreign currency bank deposits are
assets.
 As with any asset, the future value is
paramount in determining price.
 Assets (wealth) allow to postpone
purchasing power into the future.

29
The Demand for an Asset

The demand for an asset depends on
the generated income (interest rate),
capital gain (expected price),
riskiness, liquidity.
30
Rate of Return
A $1000 bond that pays $50 provides an
interest rate of 5%.
 If you sell the bond for $1100, your rate of
return is 15%.
 If you sell the bond for $900, your rate of
return is -5%.
 If inflation were 5%, your real rate of
return would have been 10% and -10%,
respectively.

31
Risk
Risk is a measure of uncertainty of
future returns. The higher the
variations in returns, the higher is the
risk.
 The higher the risk, the less desirable
is the asset.

32
Liquidity
Liquidity is a measure of cost and speed
to convert an asset into cash. The
cheaper and speedier an asset can be
converted to cash, the more liquid it is.
 The more liquid an asset, the more
desirable it is.

33
http://www.economist.com/printediti
on/displayStory.cfm?Story_ID=3786
551
34
Comparison of Returns
Suppose the $/€ exchange rate is $0.93
per €.
 What is the €/$ rate?

It is the reciprocal, or 1/0.93 = €1.075
35
Comparison of Returns
Suppose $ deposits pay 5% interest
rate.
 Suppose € deposits pay 8% interest
rate.
 Which asset ($ or €) would you rather
hold?

€ of course.
36
Comparison of Returns
Suppose you will need your $ a year
from now. Today the exchange rate is
$0.93/€.
 You expect the $/€ rate to be $0.91.
 Do you expect the $ to appreciate or
depreciate?
 Do you expect the € to appreciate or
depreciate?

Your expectation is for $ to appreciate and for €
to depreciate.
37
Comparison of Returns
The rate of appreciation of $ will increase
the percentage return on USD.
 The rate of depreciation of € will decrease
the percentage return on €.
 If € is expected to move from $0.93 to
$0.91, its rate of depreciation is ($0.91$0.93)/$0.93 = -0.0215 or -2.15%.
 The rate of appreciation for $ is (€1.099€1.075)/ €1.075= 0.022 or 2.2%.

38
Comparison of Returns



Since the appreciation/depreciation
calculations are approximately equal, we
will treat them to be equal for simplicity.
If we compare interest rate on $ (5%) with
the returns on € (8% - 2.15%), we are still
better off keeping our wealth in €.
If we compare interest rate on € (8%) with
the returns on $ (5% + 2.2%), again we are
still better off keeping our wealth in €.
39
Comparison of Returns
R$ compared to R€ + [($/€)e - ($/€)]/($/€)
will show dollar returns in US versus dollar
returns in Europe.
 R€ compared to R$ + [(€/$)e - (€/$)]/(€/$)
will show euro returns in Europe versus
euro returns in the US.
 If the exchange rate is always kept as
($/€), the euro returns comparison will be
R$ - [($/€)e - ($/€)]/($/€) or appreciation of
euro subtracted from R$.

40
Comparison of Returns
The difference between appreciation and
depreciation is the result of simplifying the
calculation.
 The correct calculation proceeds from
exchanging a $ into €, earning interest on €,
exchanging € back to $ and subtracting the
principal ($1).
 $1(€/$) [1+R€] ($/€)e - $1 = [1+
R€][($/€)e/($/€)] - [($/€)/($/€)] + R€
[($/€)/($/€)] - R€ [($/€)/($/€)]

41
Comparison of Returns
Replace $/€ by E.
 =[1+ R][Ee/E] - [E/E] + R [E/E] - R [E/E]
 = [REe/E - RE/E] + R + [Ee/E - E/E]
 = R[(Ee-E)/E] + R + [(Ee-E)/E]
 When interest rate and
appreciation/depreciation rate are small, the
first term may be ignored.

42
The Demand for Currency Deposits


The difference in the rate of return on dollar
deposits and euro deposits is
R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) =
R$
- R€
- (Ee$/€ - E$/€)/E$/€
expected rate
of return =
interest rate
on dollar
deposits
interest rate
on euro
deposits
expected
exchange rate
current
exchange rate
expected rate of appreciation
of the euro
expected rate of return on euro deposits
43
The Demand for Currency Assets
44
Applications



$ interest rate is 10%; € interest rate is 8%.
Spot ($/€) rate is $0.93 per euro.
If ($/€)e were (a) $0.95; (b) $0.91; (c) $0.97
where would you park your deposits?
(a) € appreciates by (.95-.93)/.93 = 2.15%
10% < 8% + 2.15%.
(b) € depreciates by (.91-.93)/.93 = - 2.15%
10% > 8% - 2.15%.
(c) € appreciates by (.97-.93)/.93 = 4.3%
10% < 8% + 4.3%.
45
Equilibrium
When returns from $ are the same as
returns from euro, there will be no
adjustments: the foreign exchange market
between USD and euro is in equilibrium.
 The returns are equal when the USD
interest rate is exactly equal to euro interest
rate plus the rate of appreciation of euro.
 Alternatively, the returns are equal when
the euro interest rate is equal to $ interest
rate minus the depreciation of euro.

46
Equilibrium
Equilibrium in the foreign exchange market
will take place when the interest parity
condition holds.
 R$ = R€ + [($/€)e - ($/€)]/($/€)
 If R$ > R€ + [($/€)e - ($/€)]/($/€), there will
be an excess demand for USD (excess
supply of €) in the foreign exchange market.
 If R$ < R€ + [($/€)e - ($/€)]/($/€), there will
be an excess demand for euro and an
excess supply of USD.

47
Current FX and Returns
If the current FX goes up, e.g., euro
appreciates today but the expected FX
remains the same, the dollar return on euro
deposits will decrease.
 R€ + [($/€)e - ($/€)]/($/€) will be lower if ($/€)
rises.
 R$ - [($/€)e - ($/€)]/($/€) will be higher if
($/€) rises.
 In other words, if USD depreciates today,
the dollar return on euro deposits will fall.

48
Expected Returns on Euro Deposits
when Ee$/€ = $1.05 Per Euro
Expected rate of
Current
Interest rate on
dollar
exchange rate euro deposits
depreciation
E$/€
R€
(1.05 - E$/€)/E$/€
Expected dollar return
on euro deposits
R€ + (1.05 - E$/€)/E$/€
1.07
0.05
-0.019
0.031
1.05
0.05
0.000
0.050
1.03
0.05
0.019
0.069
1.02
0.05
0.029
0.079
1.00
0.05
0.050
0.100
49
50
Practice This




$/£ today is $1.5 per £.
$/£ a year from now is expected to be $1.4.
US interest rate is 6%.
What is the expected £ return on USD
deposits? (You cannot find the expected
return on £ deposits without R£).
R$ + [(£/$)e - (£/$)]/(£/$) = 0.06 +
[(1/1.4)-(1/1.5)]/(1/1.5) or .06 + .0714
= 13.14%.
51
Practice This




$/£ today is $1.6 per £.
$/£ a year from now is expected to be $1.4.
US interest rate is 6%.
What is the expected £ return on USD
deposits? (You cannot find the expected
return on £ deposits without R£).
R$ + [(£/$)e - (£/$)]/(£/$) = 0.06 + [(1/1.4)
- (1/1.6)]/(1/1.6) or 0.06 + 0.143 = 20.3%.
52
Practice This
$/£ today is $1.5 per £.
 $/£ a year from now is expected to be
$1.4.
 UK interest rate is 15%.
 What is the expected dollar return on £
deposits?

R£ + [($/£)e - ($/£)]/($/£) = 0.15 + (-0.1/1.5)
or 0.15 - 0.067 = 8.3%.
53
Practice This
$/£ today is $1.6 per £.
 $/£ a year from now is expected to be
$1.4.
 UK interest rate is 15%.
 What is the expected dollar return on £
deposits?

R£ + [($/£)e - ($/£)]/($/£) = 0.15 + (-0.2/1.6)
or 0.15 - 0.125 = 2.5%.
54
Practice Result
When £ appreciated today, £ returns on
USD deposits increased.
 When $ depreciated today, $ returns on
£ deposits decreased.

55
Graphical Representation
Current FX
$/£
1.6
1.5
2.5%
8.3%
Expected USD return
on £ deposits
56
Suppose expected $/€ rate is 1.1.
1.6
Suppose € interest rate is 5%.
1.4
How will the $ returns on euro
spot exchange rates?
$ returns on € deposits Spot $/€
88.3%
0.6
62.1%
0.7
42.5%
0.8
27.2%
0.9
15.0%
1
5.0%
1.1
-3.3%
1.2
-10.4%
1.3
-16.4%
1.4
Spot $/euro
deposits will respond to different
1.2
1
0.8
0.6
0.4
0.2
-50.0%
0
0.0%
50.0%
100.0%
Expected $ return on euro deposits
57
The Current Exchange Rate and the
Expected Return on Dollar Deposits
Current exchange
rate, E$/€
1.07
1.05
1.03
1.02
1.00
0.031
0.050
R$
0.069
0.079 0.100
Expected dollar return
on dollar deposits, R$
58
Equilibrium: Interest Parity
Current FX
$/£
Return on $ deposits
1.6
Equilibrium FX
1.5
2.5%
R$
8.3%
Expected USD return
on £ deposits
59
Equilibrium: Interest Parity
Current FX
$/£
1.6
Return on $ deposits
A
Equilibrium FX
1.5
2.5%
R$
8.3%
At A, return on
$ is higher than
return on £.
People move
away from £
into $. Demand
for $ increases,
supply of £
increases. $
appreciates, £
depreciates.
Expected USD return
on £ deposits
60
Equilibrium: Interest Parity
Current FX
$/£
Return on $ deposits
1.6
Equilibrium FX
1.5
B
2.5%
R$
8.3%
At B, return on £
deposits are
higher than $
deposits. People
move away from
$ into £. USD
depreciates and
£ appreciates.
Expected USD return
on £ deposits
61
Determination of the Equilibrium
Exchange Rate
No one is willing to
hold euro deposits
No one is willing to
hold dollar deposits
62
Try These
What happens to current FX rate when
US interest rate rises?
 What happens to current FX rate when
UK interest rate rises?
 What happens to current FX rate when
expected FX rate ($/£)e falls?

Always remember the interest parity:
R$ = R£ + [($/£)e - ($/£)]/($/£)
63
US Interest Rate Hike
Current FX
$/£
Return on $ deposits
Equilibrium FX
2.5%
R$
8.3%
Expected USD return
on £ deposits
64
UK Interest Rate Hike
Current FX
$/£
Return on $ deposits
Equilibrium FX
2.5%
R$
8.3%
Expected USD return
on £ deposits
65
The Effect of an Expected
Appreciation of the Euro
People now
expect the
euro to
appreciate
66
The Effect of an Expected
Appreciation of the Euro

If people expect the euro to appreciate in the
future, then investment will pay off in a valuable
(“strong”) euro, so that these future euros will be
able to buy many dollars and many dollar
denominated goods.



the expected return on euros therefore increases.
an expected appreciation of a currency leads to an
actual appreciation (a self-fulfilling prophecy)
an expected depreciation of a currency leads to an
actual depreciation (a self-fulfilling prophecy)
67
Covered Interest Parity

Covered interest parity relates interest rates across
countries and the rate of change between forward
exchange rates and the spot exchange rate:
R$ = R€ + (F$/€ - E$/€)/E$/€
where F$/€ is the forward exchange rate.

It says that rates of return on dollar deposits and
“covered” foreign currency deposits are the same.


How could you make easy, risk-free money in the foreign
exchange markets if covered interest parity did not hold?
Covered positions using the forward rate involve little risk.
68