Chapter 10 Exchange Rates and Exchange Rate Systems

Chapter 10 Exchange Rates and Exchange Rate Systems Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Introduction: Fixed, Flexible, or In-Between? • Disagreements related to exchange rates and exchange rate systems • Countries have numerous choices • Exchange rate systems require different policies and respond differently to the pressures of the world economy Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -2

Exchange Rates and Currency Trading • Exchange rate: The price of domestic currency stated in terms of another currency • For US it is dollars per pound, or dollars per yen Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -3

Exchange Rates and Currency Trading • Frequently traded currencies are: - European Union’s euro - Japanese yen - British pound • All three are flexible exchange rates • It doesn’t matter how many of one currency is required to buy another • Can’t use “strong” and “weak” Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -4

Figure 10. 1 Dollar Exchange Rates for Commonly Traded Currencies, 1999– 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -5

Exchange Rates and Currency Trading • Appreciation: Less domestic currency is required to buy 1 unit of foreign currency • Depreciation: More domestic currency is required to buy 1 unit of foreign currency Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -6

Reasons for Holding Foreign Currencies 1. Trade and investment 2. Interest rate arbitrage • Borrow money where interest rates are low and sell it where interest rates are high • Capital inflow in high interest countries decreases interest rates • Outflow of capital from low interest rate countries increases interest rates • Powerful force in global economy Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -7

Reasons for Holding Foreign Currencies 3. Speculation • speculators sell overvalued currencies and buy undervalued currencies • Help restore equilibrium after currency has become under- or overvalued • Some argue it can be destabilizing by leading to under- or overvalued currency Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -8

Institutions • Four main groups involved in foreign currency markets: – Retail customers: firms and individuals that hold foreign currency – Commercial banks: hold inventories of foreign currencies as part the services to customer; most important of four participants – Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency – Central banks: a country’s bank of banks Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -9

Exchange Rate Risk • Exchange rate risks: currencies are constantly changing in value – Actual payment in a foreign currency will likely be a different domestic currency amount from when the contract was signed – Created mechanisms to deal with problem. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -10

Exchange Rate Risk • Forward exchange rate: The price of currency that will be delivered in the future • Forward market: A market in which the buying and selling of currencies for future delivery takes place – Eliminates risk from future payments – Contract is signed the day they agree to ship/receive goods that guarantees price for 30, 90, or 180 days • Spot market: Buying and selling of foreign currencies in the present Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -11

Exchange Rate Risk • Hedging: Use forward market to protect themselves against foreign exchange risk while holding foreign assets – Done by buying forward contract to sell foreign currency at the same time the interest earning asset matures – Covered interest arbitrage: Use of forward market by an interest rate arbitrageur against exchange rate risk Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -12

The Supply and Demand for Foreign Exchange • Currency’s value is determined by its supply and demand – Under a flexible exchange rate system currency appreciates/depreciates based on changes in supply/demand – Under a fixed exchange rate system, the central bank counteracts changes in the market to hold currency’s value constant • Biggest disadvantage: trade-off between supporting the exchange rate and maintaining economic growth. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -13

TABLE 10. 1 A Hypothetical Example of the Exchange Rate in the Long Run • Purchasing power parity (PPP): the equilibrium value of an exchange rate is at the level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -14

Exchange Rates in the Long Run • PPP is underlying tendency of exchange rates in long run, not short or medium run • If currency is over- or undervalued, automatic changes in buying/selling currency and flow of goods will restore PPP • PPP is based on goods arbitrage which fails to acknowledge other costs Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -15

Exchange Rates in the Medium Run and Short Run • Medium run forces: – The country’s economic growth: increases incomes, increases demand for imports and an outward shift in the demand foreign currency, domestic currency depreciates – Growth abroad: results in an increase of exports from the home country and an increase in the supply of foreign currency, domestic currency appreciates Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -16

Exchange Rates in the Medium Run and Short Run • Short run (a year or less) effects on the exchange rate stem from financial capital flows • These flows are determined by (1) interest rates and (2) expectations of future exchange rates Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -17

Exchange Rates in the Medium Run and Short Run • Interest parity: the difference between any two countries’ interest rates is equal to the expected change in the exchange rate • Investment choice is also determined by exchange rate movements during the period Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -18

Exchange Rates in the Medium Run and Short Run • Difference between the forward exchange rate (F) and the spot rate (R) is expected appreciation or depreciation – F > R: home currency expected to depreciate and is selling at a discount – F <R: home currency expected to appreciate and is selling at a premium – However, say, i < i* and F = R: no changes are expected in the exchange rate, and investors should invest in foreign Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -19

Exchange Rates in the Medium Run and Short Run • Capital flight can be self-fulfilling – If investors expect depreciation, they convert their assets to another currency – Demand foreign exchange increases – Supply is depressed and currency depreciates • Sudden shift in expectations occurs when government policies are inconsistent and unsustainable Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -20

TABLE 10. 4 Major Determinants of an Appreciation or Depreciation Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -21

Table 10. 2 Composition of Currency Trades, April 2007 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -22

Table 10. 3 Currency Trading Centers Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -23

The Real Exchange Rate • Foreign prices ultimately determine the purchasing power of the domestic currency in terms of the foreign currency – Real exchange rate: the market exchange rate (nominal exchange rate) adjusted for price differences between countries Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -24

Alternatives to Flexible Exchange Rates • Fixed exchange rate system: The value of a nation’s money is defined in terms of a fixed amount of a commodity (e. g. , gold) or of another currency (e. g. , U. S. dollar); the Gold standard exchange rate system • Flexible (floating) exchange rate system: The value of the currency is allowed to float up and down with market forces • Purely fixed or floating systems today are rare Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10 -25