Exchange Rates and the Foreign Exchange Market: An Asset Approach
Exchange Rate=price of a currency in term of the other January 21st, 2005
USD 1 0.533618 1.2211 0.766342 1.29668 GBP 1.87399 1 2.28834 1.43612 2.42997 CAD 0.818933 0.436997 1 0.627583 1.06189 EUR 1.3049 0.696318 1.59341 1 1.69203 AUD 0.7712 0.411526 0.941712 0.591003 1
Friday, January 21, 2005
January 23, 2006
USD 1 0.560475 1.1511 0.814598 1.32926 GBP 1.7842 1 2.05379 1.4534 2.37166 CAD 0.868734 0.486903 1 0.707669 1.15477 EUR 1.22759 0.688038 1.41308 1 1.63179 AUD 0.752298 0.421644 0.86597 0.61282 1
Jan 13, 2009
USD 1 0.668658 1.19612 0.746603 1.45423
Monday, January 12, 2009
GBP 1.49553 1 1.78885 1.11656 2.17484
CAD 0.836029 0.559017 1 0.624182 1.21577
EUR 1.33939 0.8956 1.60209 1 1.94779
AUD 0.687649 0.459802 0.822517 0.5134 1
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Exchange Rates and International Transactions E=price of foreign currency in terms of the dollar (American, direct, 1GBP=1.5$) E=price of dollar in terms of foreign currency (European, indirect, 1$=0.67GBP) How many $ cost to buy a British sweater that costs 50GBP? 1.5*50= What if you bought it on Jan 21, 2005?
What if you bought it on Jan 23, 2006?
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An appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to a decrease in the exchange rate. A depreciation of the domestic currency is a decrease in the price of the domestic currency in terms of the foreign currency, or an increase in the exchange rate. A depreciation of a country’s currency makes its good (exports) cheaper for the foreigners and imports from abroad more expensive for the residents. An appreciation: Foreigners pay more for the country’s products and domestic consumers pay less for the foreign products. Relative prices: price of sweaters in terms of designer jeans.
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Price of jeans=45$. E=1.5$/GBP US: GB:
E=1.78$/GBP; 1.2
US GB All else equals, an appreciation of a country’s currency raises the relative price of its exports and lowers the relative price of its imports.
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Exchange rates are determined in the foreign exchange market= the market in which international currency trades take place The major participants in the foreign exchange market are: 1. Commercial banks: - buy currencies for their clients (retail) - inter-bank trading (wholesale) Ex.
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2. International corporations 3. Non-bank financial institutions (pension, mutual funds) 4. Central banks Characteristics of the Market The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years ($600billion per day in 1989 and $ 3.2 trillion in 2007) New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore). The integration of financial centers implies that there can be no significant arbitrage (the process of buying a currency cheap and selling it dear) Ex. 2 currencies arbitrage: 1 euro=$1.1 in London 1euro=$1.2 In NY Start with $1,000. What is your profit?
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Triangular arbitrage London 1Danish krone=$0.1545 1Maltese Lira=$2.6961 NY: 1Maltese lira=17.30 Danish krone Start with $1,000. What is your profit?
Vehicle currency = A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Ex. In 2007, around 86% of transactions between banks involved exchanges of foreign currencies for U.S. dollars. Around 37% of foreign exchange trades were against the euro. (GBP lost importance).
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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 pre-negotiated exchange rate (30, 90, 180 days or several years) European Co. wants to import iPod nano from US and has to pay $ to the US supplier in 30 days. The importer can sell 1 iPod nano for 175 euros and has to pay 200$ for it. At the current spot exchange E=1.22$/euro, what is the profit of the importer in euros? If in 30days the $ appreciates such that E=1.1 what is the profit of the importer in euros? If the importer can buy $ at the forward rate of E=1.2 should she do it? What would be her profit in this case?
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Forward and spot exchange rates, while not necessarily equal, do move closely together.
Foreign Exchange Swaps Spot sales of a currency combined with a forward repurchase of the currency. Ex. Received 1 million $ that you have to pay to a California wine supplier. Invest in a toy factory in France for 3 months. Spot $/Swiss franc=0.7305 6 months forward $/Swiss franc=0.7338 Have 10,000Swiss francs that you need in 6 months. What is the cost of transaction?
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Futures and Options Futures contract The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future. You can trade your futures contract (Chicago Mercantile exchange)
Foreign exchange option The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date. You are under no obligation to exercise your right. Put option: gives you the right to sell the foreign currency at a known exchange rate. Call option: gives you the right to buy.
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Assets and Asset Returns
Asset Returns = The percentage increase in value an asset offers over some time period. Ex. Stock (price increased from 100 to 110$) The Real Rate of Return = the rate of return computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase. Ex. Stock (price increased from 100 to 110$) Inflation =8% Sculpture (price increased from 1,000 to 1,010$) Risk and Liquidity Savers care about two main characteristics of an asset other than its return: Risk = the variability it contributes to savers’ wealth Liquidity = the ease with which it can be sold or exchanged for goods
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Interest Rates Market participants need two pieces of information in order to compare returns on different deposits: How the money values of the deposits will change (interest rate) How exchange rates will change A currency’s interest rate is the amount of that currency an individual can earn by lending a unit of the currency for a year.
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Exchange Rates and Asset Returns • The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. • In order to decide whether to buy a GBP or a dollar deposit, one must calculate the dollar return on a GBP deposit.
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A Simple Rule The dollar rate of return on GBP deposits is approximately the GBP interest rate plus the rate of depreciation of the dollar against the euro. The rate of depreciation of the dollar against the GBP is the percentage increase in the dollar/GBP exchange rate over a year. The expected rate of return difference between dollar and GBP deposits is:
R -R - (Ee - E )/E GBP $ where: R$ = interest rate on one-year dollar deposits RGBP = today’s interest rate on oneyear GBP deposits E = today’s dollar/GBP exchange rate (number of dollars per euro) Ee = dollar/GBP exchange rate (number of dollars per GBP) expected to prevail a year from today
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Return, Risk, and Liquidity in the Foreign Exchange Market The demand for foreign currency assets depends not only on returns but on risk and liquidity. There is no consensus among economists about the importance of risk in the foreign exchange market. Most of the market participants that are influenced by liquidity factors are involved in international trade.
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Payments connected with international trade make up a very small fraction of total foreign exchange transactions. Therefore, we ignore the risk and liquidity motives for holding foreign currencies. 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
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Depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits. Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits. Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee = $1.05 per Euro
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The Relation between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits
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Equilibrium Exchange rate
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The Effect of Changing Interest rates on Exchange rates
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