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					        Lecture 5




UNDERSTANDING
EXCHANGE RATES (1)




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   1
         What is an “exchange rate”?

• The price of one currency in terms
  of another (say dollars per euro)
  is called the exchange rate.
• Foreign exchange (forex) transactions
  are effected on specific markets for:
   – spot transactions;
   – forward transactions;
   – futures transactions;
   – options

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   2
         Appreciation and depreciation

• If you pay more € for forex, your
  currency € is said to “depreciate”; if you
  pay less, your currency “appreciates”

   w=€/$                                         w=€/$
         Depreciation                                  Appreciation




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                  3
         Why are exchange rates important?

• They affect the relative price of domestic
  and foreign goods.
• When a country’s currency appreciates,
  the country’s goods become more
  expensive abroad, and foreign goods
  become cheaper.
• Will the exchange rate equate foreign
  and domestic prices?

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   4
         The law of one price

• Under market conditions, arbitrage will
  indeed equate prices in the different
  regions of the domestic economy.
• If there are no barriers to trade,
  this also applies to international trade.
• If the price level in country A is higher
  than in country B, the exchange rate
  should correct for this difference.

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   5
         The law of one price

• Identical goods should sell for the same price
  in two separate markets when there are no
  transportation costs and no differential taxes
  applied in the two markets.
• Consider the following information about
  movie video tapes sold in the US
  and Mexican markets:
   – Price of videos in US market (Pv) = $20
   – Price of videos in Mexican market (Pv) = p150
   – Spot exchange rate (p/$) = 10 p/$


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   6
         The law of one price

• The dollar price of videos sold in Mexico can
  be calculated by dividing the video price in
  pesos by the spot exchange rate.
• If the law of one price held, then the dollar
  price would have to be p150/10p/$ = $15
  in Mexico to match the price in the US.
• Since the dollar price of the video is less than
  the dollar price in the US, the law of one price
  does not hold in this circumstance.
• If the law holds, we speak of “purchasing-
  power parity” (PPP).
 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   7
        The Big-Mac index (PPP ?)




           Zur Anzeige wird der QuickTime™ Dekompressor „TIFF (LZW)“ benötigt.




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                              8
Effective exchange rate and PPP (against the $)




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   9
         PPP and short-term exchange rate

PPP, et
            Short-term exchange rate (e)



                                                       PPP




                                                             Time t

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                  10
         The purchasing power parity (PPP) theory

• The PPP theory makes sense only
  in the long run.
• In the short run there are significant
  deviations from PPP due to short-term
  movements of capital.

    Zur Anze ige wird der Qu ickTime™ Dekomp resso r „TIFF (L ZW)“ benötigt.




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                           11
         Factors that affect exchange rates: long run

• Factors that affect the exchange rates
  are (w = depreciation, w = appreciation):
   – Relative price levels: if P/P*, then w
   – Tariffs and quota: if import duty , then w
   – A shift in preferences for domestic
     versus foreign goods:
        • if export demand , then w
        • if import demand , then w
   – Productivity: If productivity , then w

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   12
         The DEM in the longer run

                     Long-term development of DEM/US $

   4,5

    4

   3,5

    3

   2,5

    2

   1,5

    1

   0,5

    0
     48

     51

     54

     57

     60

     63

     66

     69

     72

     75

     78

     81

     84

     87

     90

     93

     96

     99

     02
   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   19

   20
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main      13
        The organization of the forex spot market




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   14
        A typical trading desk for spot forex




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   15
        A typical trading desk for spot forex




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   16
        The exchange rate of the Dollar (in €)




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   17
        Volatility GBP/EUR, hourly




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   18
        Volatility of JPY/USD, 10 mins



                   • Mastertextformat bearbeiten
                        – Zweite Ebene
                             • Dritte Ebene
                                   – Vierte Ebene

                                        • Fünfte Ebene




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main      19
        Volatility USD/EUR, tick chart




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   20
        Pound sterling during the 1992 crisis


                   • Mastertextformat bearbeiten
                        – Zweite Ebene
                             • Dritte Ebene
                                   – Vierte Ebene

                                        • Fünfte Ebene




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main      21
        The Asian crisis 1997-98




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   22
        The crisis of the Argentinian peso




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   23

				
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