Exchange Rates and the Foreign Exchange Market

Exchange Rates and the Foreign Exchange Market Exchange rates are important because they enable us to translate different counties’ prices into comparable terms. Exchange rates are determined in the same way as other asset prices. The general goal of this lecture is to show: How exchange rates are determined The role of exchange rates in international trade Exchange Rates and International Transactions Two types of changes in exchange rates: • Depreciation of home country’s currency – A rise in the home currency prices of a foreign currency – It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents. • Appreciation of home country’s currency – A fall in the home price of a foreign currency – It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents. The Foreign Exchange Market The major participants in the foreign exchange market are: • Commercial banks – Transactions involve the buying and selling of bank deposits in different currencies • International corporations – Foreign currency transactions to buy and sell goods assets and services • Nonbank financial institutions (Pension funds, Insurance funds) – Buy or sell foreign assets • Central banks – Conduct international reserve transactions Spot Rates and Forward Rates Spot exchange rates • Apply to exchange currencies “on the spot” Forward exchange rates • Apply to exchange currencies on some future date at a prenegotiated exchange rate Forward and spot exchange rates, while not necessarily equal, do move closely together. Spot Rates and Forward Rates Other Methods of Currency Exchange Foreign Exchange Swaps Spot sales of a currency combined with a forward repurchase of the currency. They make up a significant proportion of all foreign exchange trading. Futures and Options Futures contract • The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future. Foreign exchange 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. What influences the demand for foreign and domestic currency assets? Rate of return: the percentage change in value that an asset offers during a time period. The annual return for $100 savings account with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/$100 = 2% Real rate of return: inflation-adjusted rate of return. stated in terms of real purchasing power: the amount of real goods & services that can be purchased with the asset. the real rate of return for the above savings account when inflation is 1.5%: 2% – 1.5% = 0.5%. The asset can purchase 0.5% more goods and services after 1 year. What influences the demand for foreign and domestic currency assets? Risk of holding assets also influences decisions about whether to buy them. Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets. But we assume that risk and liquidity of bank deposits in the foreign exchange market are the same, regardless of their currency denomination. risk and liquidity are only of secondary importance when deciding to buy or sell currency. importers and exporters may be concerned about risk and liquidity, but they make up a small fraction of the market. What influences the demand for foreign and domestic currency assets? We assume that investors are primarily concerned about the rates of return on bank deposits. Rates of return are determined by interest rates that the assets earn expectations about appreciation or depreciation Demand for Foreign Currency Assets Example: R$ = 4.23 R € = 3.89 E$/ € = 1.21 Ee$/ € = 1.23 Imagine you have $1,000 that you want to invest for one year. Should you hold them in $ or Euro? Demand for Foreign Currency Assets A Simple Rule The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. • The rate of depreciation of the dollar against the euro is the percentage increase in the dollar/euro exchange rate over a year. Demand for Foreign Currency Assets The expected rate of return difference between dollar and euro deposits is: R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ where: R$ = interest rate on one-year dollar deposits R€ = today’s interest rate on one-year euro dep. E$/€ = today’s dollar/euro exchange rate Ee$/€ = dollar/euro exchange rate expected to prevail a year from today Demand for Foreign Currency Assets When the difference in the previous equation is positive, dollar deposits yield the higher expected rate of return. When it is negative, euro deposits yield the higher expected rate of return. Demand for Foreign Currency Assets Held in $ your investment will yield $1042.3 a year from now. Held in euro your investment will yield 1056.08 euro a year from now. R$ - [R € + (Ee$/ € - E$/ € )/E$/ € ]=0.0423 [0.0389+0.0165]=0.0423-0.0554=-0.0131 Difference is negative, so the euro deposit yields a higher rate of return The Market for Foreign Exchange We use the demand for (rate of return on) dollar denominated deposits and the demand for (rate of return on) foreign currency denominated deposits to construct a model of the foreign exchange market. The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity. interest parity implies that deposits in all currencies are deemed equally desirable assets Equilibrium in the Foreign Exchange Market Interest Parity: The Basic Equilibrium Condition The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Interest parity condition • The expected returns on deposits of any two currencies are equal when measured in the same currency. • It implies that potential holders of foreign currency deposits view them all as equally desirable assets. • The expected rates of return are equal when: R$ = R€ + (Ee$/€ - E$/€)/E$/€