Chapter 14 Exchange Rates and the Foreign Exchange

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach Copyright © 2012 Pearson Education. All rights reserved.

Preview • The basics of exchange rates • Exchange rates and the prices of goods • The foreign exchange markets • The demand of currency and other assets • A model of foreign exchange markets – role of interest rates on currency deposits – role of expectations of exchange rates Copyright © 2012 Pearson Education. All rights reserved. 14 -2

Definitions of Exchange Rates • Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. Suppose you are U. S. citizen: – How much $ can be exchanged for one yen? E$/¥=$0. 011185/¥ (direct or “American” term) – How much yen can be exchanged for one dollar? E¥/$=¥ 89. 40/$ (indirect or “European” term) • Exchange rates allow us to denominate the cost or price of a good or service in a common currency. – How much does a Nissan cost? ¥ 2, 500, 000 – Or, ¥ 2, 500, 000 x E$/¥ (0. 011185) = $27, 962. 50 Copyright © 2012 Pearson Education. All rights reserved. 14 -3

Examples(con’t) – The price of one iphone 6(16 G) in HK is $720. The exchange rate is ￥ 6. 21/$ , then： $720× ￥ 6. 21/$ = ￥ 4470 – In mainland China, the price is￥ 5288！ What’s the dollar price of iphone in mainland China？ Copyright © 2012 Pearson Education. All rights reserved. 14 -4

Table 14 -1: Exchange Rate Quotations Copyright © 2012 Pearson Education. All rights reserved. 14 -5

Data from Bank of China: EYuan/(100 Other Currency) 货币名称(Currency) 现钞买入价(Sell) 现钞卖出价(Buy) 发布日期(Date) 发布时间(Time) 澳大利亚元 536. 69 557. 67 2014 -03 -09 10: 30: 00 加拿大元 533. 25 554. 66 2014 -03 -09 10: 30: 00 瑞士法郎 673. 29 700. 32 2014 -03 -09 10: 30: 00 丹麦克朗 109. 94 114. 36 2014 -03 -09 10: 30: 00 欧元(Euro) 820. 49 853. 43 2014 -03 -09 10: 30: 00 英镑(Pound) 988. 51 1028. 2 2014 -03 -09 10: 30: 00 港币 (HK$) 78. 13 79. 06 2014 -03 -09 10: 30: 00 印尼卢比 0. 0519 0. 0557 2014 -03 -09 10: 30: 00 日元(Yen) 5. 7274 5. 9513 2014 -03 -09 10: 30: 00 韩国元 0. 5549 0. 6017 2014 -03 -09 10: 30: 00 澳门元 73. 96 79. 28 2014 -03 -09 10: 30: 00 林吉特 挪威克朗 98. 77 102. 74 2014 -03 -09 10: 30: 00 新西兰元 500. 76 523. 98 2014 -03 -09 10: 30: 00 菲律宾比索 13. 29 14. 25 2014 -03 -09 10: 30: 00 卢布 16. 29 17. 45 2014 -03 -09 10: 30: 00 瑞典克朗 92. 63 96. 34 2014 -03 -09 10: 30: 00 新加坡元 466 484. 71 2014 -03 -09 10: 30: 00 泰国铢 18. 33 19. 65 2014 -03 -09 10: 30: 00 新台币 19. 56 20. 96 2014 -03 -09 10: 30: 00 美元(US$) 606. 38 613. 73 2014 -03 -09 10: 30: 00 Copyright © 2012 Pearson Education. All rights reserved. 14 -6

Depreciation and Appreciation • Depreciation is a decrease in the value of a currency relative to another currency. – A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. – $1/€ → $1. 20/€ means that the dollar has depreciated relative to the euro (or E €/ $ decreases). It now takes $1. 20 to buy one euro, so that the dollar is less valuable. – The euro has appreciated relative to the dollar: it is now more valuable. Copyright © 2012 Pearson Education. All rights reserved. 14 -7

Depreciation and Appreciation (cont. ) • Appreciation is an increase in the value of a currency relative to another currency. – An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. – $1/€ → $0. 90/€ means that the dollar has appreciated relative to the euro (or E $/€ increases). It now takes only $0. 90 to buy one euro, so that the dollar is more valuable. – The euro has depreciated relative to the dollar: it is now less valuable. Copyright © 2012 Pearson Education. All rights reserved. 14 -8

Depreciation and Appreciation (cont. ) • A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency. – A Nissan costs ¥ 2, 500, 000 = $25, 000 at E$/¥=0. 01 – becomes more expensive $27, 962. 50 at E$/¥= 0. 011185 • A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive. • A depreciated currency lowers the price of exports relative to the price of imports. (China? ) Copyright © 2012 Pearson Education. All rights reserved. 14 -9

Depreciation and Appreciation (cont. ) • An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency. – A Nissan costs ¥ 2, 500, 000 = $27, 962. 50 at E$/¥= 0. 011185 – becomes less expensive $25, 000 at E$/¥= 0. 010 • An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive. • An appreciated currency raises the price of exports relative to the price of imports. Copyright © 2012 Pearson Education. All rights reserved. 14 -10

Table 14 -2: $/£ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters Relative price (in the same currency) =Price of Sweater/Price of Jeans =(£ 50*E$/£)/$45 =£ 50/($45*E£/$) Copyright © 2012 Pearson Education. All rights reserved. 14 -11

Foreign Exchange Markets • The set of markets where foreign currencies and other assets are exchanged for domestic ones – Institutions buy and sell deposits of currencies or other assets for investment purposes. • The daily volume of foreign exchange transactions was $4. 0 trillion in April 2010 – up from $500 billion in 1989. • Most transactions (85% in April 2010) exchange foreign currencies for U. S. dollars. Copyright © 2012 Pearson Education. All rights reserved. 14 -12

Foreign Exchange Markets The participants: 1. Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. 2. Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. 3. Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. 4. Central banks: conduct official international reserves transactions. Copyright © 2012 Pearson Education. All rights reserved. 14 -13

Foreign Exchange Markets (cont. ) • Buying and selling in the foreign exchange market are dominated by commercial and investment banks. – Inter-bank transactions of deposits in foreign currencies occur in amounts $1 million or more per transaction. – Central banks sometimes intervene, the impact of their transactions may be large even though the volume of transactions is small. Copyright © 2012 Pearson Education. All rights reserved. 14 -14

Foreign Exchange Markets (cont. ) • Computer and telecommunications technology transmit information rapidly and have integrated markets. • The integration of financial markets implies that there can be no significant differences in exchange rates across locations. – Arbitrage: buy at low price and sell at higher price for a profit. – If the euro were to sell for $1. 1 in New York and $1. 2 in London, could buy euros in New York (where cheaper) and sell them in London at a profit. – No arbitrage: the market is efficient! • U. S. dollar is used as vehicle currency, which improves the efficiency of transactions. Copyright © 2012 Pearson Education. All rights reserved. 14 -15

Spot Rates and Forward Rates • Spot rates are exchange rates for currency exchanges “on the spot, ” or when trading is executed in the present. • Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date. – Forward dates are typically 30, 90, 180, or 360 days in the future. – Rates are negotiated between two parties in the present, but the exchange occurs in the future. – Reduces the risk of exchange rate. Copyright © 2012 Pearson Education. All rights reserved. 14 -16

Fig. 14 -1: Dollar/Pound Spot and Forward Exchange Rates, 1983– 2011 Source: Datastream. Rates shown are 90 -day forward exchange rates and spot exchange rates, at end of month. Copyright © 2012 Pearson Education. All rights reserved. 14 -17

Other Methods of Currency Exchange • Foreign exchange swaps: a combination of a spot sale with a forward repurchase. – Swaps allow parties to meet each other’s needs for a temporary amount of time and often cost less in fees than separate transactions. – For example, suppose Toyota receives $1 million from American sales, plans to use it to pay its California suppliers in three months, but wants to invest the money in euro bonds in the meantime. Copyright © 2012 Pearson Education. All rights reserved. 14 -18

Other Methods of Currency Exchange (cont. ) • Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date. – Contracts can be bought and sold in markets, and only the current owner is obliged to fulfill the contract. Copyright © 2012 Pearson Education. All rights reserved. 14 -19

Other Methods of Currency Exchange (cont. ) • Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. – Contracts can be bought and sold in markets. – A contract gives the owner the option, but not obligation, of buying or selling currency if the need arises. Copyright © 2012 Pearson Education. All rights reserved. 14 -20

The Demand of Asset • What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency? • As currencies are assets, we first look at what factors can influence the demand of asset: a. Rate of return b. Risk c. Liquidity Copyright © 2012 Pearson Education. All rights reserved. 14 -21

The Demand of Asset (cont. ) • Rate of return: the percentage change in value that an asset offers during a time period. – Definition: – Last year, you bought an apartment at price of 1 million RMB, if annual rent is 50, 000 RMB, and this year the market value of your apartment is 1. 2 million, then the rate of return =(1. 2+0. 05 -1)/1=25%. – The annual return for $100 savings deposit with an interest rate of 2% is $100 x 1. 02 = $102, so that the rate of return = ($102 – $100)/$100 = 2%. l l As the value of asset is measured in currency, the rate of return defined above is nominal. Expected rate of return: Copyright © 2012 Pearson Education. All rights reserved. 14 -22

The Demand of Asset (cont. ) • Real rate of return: inflation-adjusted rate of return, – Definition: – The value of assets is measured by the amount of goods & services. – The real rate of return for the above savings deposit when inflation is 1. 5% is approximately 2% – 1. 5% = 0. 5%. l Expected real rate of return Copyright © 2012 Pearson Education. All rights reserved. 14 -23

The Demand of Asset (cont. ) • Although people care about real rates of return when they purchase asset, nominal rates of return are still useful to compare real returns on different assets. • The difference of real rates of return of two assets is given by Copyright © 2012 Pearson Education. All rights reserved. 14 -24

The Demand of Asset (cont. ) • Risk of holding assets also influences decisions about whether to buy them. • Individuals on average do not like risk (risk averse). Example: Two lotteries A: with prob. ½ get 0, with prob. ½ get 100, B: get 50 for sure, Which lottery do you prefer? • Mathematically, utility function is concave: • Risk is measured by the second order moments (e. g. std) Copyright © 2012 Pearson Education. All rights reserved. 14 -25

The Demand of Asset (cont. ) • Suppose you have $1 million, want to make investment. There are two projects with the same expected rates of return A: Deposit in bank and earn 10% interest rate, B: Buy stock, with prob. ½ loss 10%, and with prob. ½ earn 30%. • For A, the final return is $1. 1 m for sure. • For B, the final return is random: 1/2 $0. 9 m $1. 3 m • If you do not like risk, A is better than B. Copyright © 2012 Pearson Education. All rights reserved. 14 -26

The Demand of Asset (cont. ) • Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets. • Cash has high liquidity, house has low liquidity. • Why liquidity influences the asset demand? • Consider two assets Asset A: easy to sell at price p 1 Asset B: in order to sell at price p 2, you have to pay a cost c • For A, the return is p 1 • For B, the return is p 2 -c • Definitely, if p 1=p 2, A is better than B Copyright © 2012 Pearson Education. All rights reserved. 14 -27

The Demand of Currency Deposits • The demand of currency deposits is similar to that of general asset • But when we exclusively look at the foreign exchange market, we assume that risk and liquidity of different currency deposits are essentially the same, regardless of their currency denomination. – Risk and liquidity are only of secondary importance when deciding to buy or sell currency deposits. l Therefore, we assume: – – The interest rates of different currency deposits share the same risk (more extremely, they are riskless). It is with equally ease to buy or sell different currencies. Copyright © 2012 Pearson Education. All rights reserved. 14 -28

The Demand of Currency Deposits (cont. ) • We therefore say that investors are primarily concerned about the expected rates of return on currency deposits. • Expected rates of return that investors expect to earn are determined by two factors – interest rates that the assets denominated in different currencies will earn – expected change of exchange rate: expectations about appreciation or depreciation Copyright © 2012 Pearson Education. All rights reserved. 14 -29

Fig. 14 -2: Interest Rates on Dollar and Yen Deposits, 1978– 2011 Source: Datastream. Three-month interest rates are shown. Copyright © 2012 Pearson Education. All rights reserved. 14 -30

A Concrete Example • Suppose the interest rate on a dollar deposit is 2%. • Suppose the interest rate on a euro deposit is 4%. • Does a euro deposit yield a higher expected rate of return? – Suppose today the exchange rate E$/€ is 1, and the expected rate one year in the future Ee$/€ is 0. 97. – These € 100 will yield € 104 after one year. – These € 104 are expected to be worth: € 104 x. Ee$/€ (0. 97) = $100. 88. Copyright © 2012 Pearson Education. All rights reserved. 14 -31

The Demand of Currency Deposits (cont. ) • The rate of return in terms of dollars from investing in euro deposits is ($100. 88 – $100)/$100 = 0. 88%. • Let’s compare this rate of return with the rate of return from a dollar deposit. – The rate of return is simply the interest rate. – After 1 year the $100 is expected to yield $102: ($102 – $100)/$100 = 2% • The euro deposit has a lower expected rate of return: thus, all investors should be willing to hold dollar deposits and none should be willing to hold euro deposits. Copyright © 2012 Pearson Education. All rights reserved. 14 -32

The Demand of Currency Deposits (cont. ) • Note that the expected rate of appreciation of the euro was ($0. 97 – $1)/$1 = – 0. 03 = – 3%. • We simplify the analysis by saying that the dollar rate of return on euro deposits approximately equals – the interest rate on euro deposits – plus the expected rate of appreciation of euro deposits – 4% + – 3% = 1% ≈ 0. 88% – R€ + (Ee$/€ – E$/€)/E$/€ Copyright © 2012 Pearson Education. All rights reserved. 14 -33

A mathematical Illustration • Suppose the interest rate of dollar deposit is. • Suppose the interest rate of euro deposit is. • The current exchange rate is , the exchange rate in next year is. • The rate of return of dollar deposit is just. • The rate of return of euro deposit is: depreciation of dollar or appreciation of euro Copyright © 2012 Pearson Education. All rights reserved. 14 -34

The Demand of Currency Deposits (cont. ) • The difference in the rate of return on dollar deposits and euro deposits is –R€ –(Ee$/€ – E$/€)/E$/€ R$ expected rate of return = interest rate on dollar deposits interest rate on euro deposits current expected exchange rate expected rate of appreciation of the euro expected rate of return on euro deposits Copyright © 2012 Pearson Education. All rights reserved. 14 -35

Table 14 -3: Comparing Dollar Rates of Return on Dollar and Euro Deposits Copyright © 2012 Pearson Education. All rights reserved. 14 -36

Model of Foreign Exchange Markets • We use the – demand of (rate of return on) dollar denominated deposits – and the demand of (rate of return on) foreign currency denominated deposits to construct a model of foreign exchange markets. • This model 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 equally desirable assets. – Interest parity implies that arbitrage in the foreign exchange market is not possible (no arbitrage condition). Copyright © 2012 Pearson Education. All rights reserved. 14 -37

Model of Foreign Exchange Markets (cont. ) • Interest parity says: R$ = R€ + (Ee$/€ – E$/€)/E$/€ • Why should this condition hold? Suppose it didn’t. – Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€ – Then no investor would want to hold euro deposits, driving down the demand price of euros. – Then all investors would want to hold dollar deposits, driving up the demand price of dollars. – The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved: R$ > R€ + (Ee$/€ – E$/€)/E$/€ Copyright © 2012 Pearson Education. All rights reserved. 14 -38

Model of Foreign Exchange Markets (cont. ) • How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits? Copyright © 2012 Pearson Education. All rights reserved. 14 -39

Table 14 -4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/€ = $1. 05 per Euro Copyright © 2012 Pearson Education. All rights reserved. 14 -40

Model of Foreign Exchange Markets (cont. ) • Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why? – When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits. Copyright © 2012 Pearson Education. All rights reserved. 14 -41

Model of Foreign Exchange Markets (cont. ) • Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. Why? – When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby rising the expected rate of return of foreign currency deposits. Copyright © 2012 Pearson Education. All rights reserved. 14 -42

Fig. 14 -3: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits Copyright © 2012 Pearson Education. All rights reserved. 14 -43

The Current Exchange Rate and the Expected Rate of Return on Dollar Deposits Current exchange rate, E$/€ 1. 07 1. 05 1. 03 1. 02 1. 00 0. 031 0. 050 R$ Copyright © 2012 Pearson Education. All rights reserved. 0. 069 0. 079 0. 100 Expected dollar return on dollar deposits, R$

Fig. 14 -4: Determination of the Equilibrium Dollar/Euro Exchange Rate R$ = R€ + (Ee$/€ – E$/€)/E$/€ Point 1: equilibrium Point 2: return of dollar deposit is relatively high Point 3: return of euro deposit is relatively low Copyright © 2012 Pearson Education. All rights reserved. 14 -45

Fig. 14 -5: Effect of a Rise in the Dollar Interest Rate Copyright © 2012 Pearson Education. All rights reserved. 14 -46

Fig. 14 -6: Effect of a Rise in the Euro Interest Rate Copyright © 2012 Pearson Education. All rights reserved. 14 -47

Model of Foreign Exchange Markets • The effects of changing interest rates: – an increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. – This leads to an appreciation of the currency. – Higher interest rates on dollar-denominated assets cause the dollar to appreciate (dollar is more attractive). – Higher interest rates on euro-denominated assets cause the dollar to depreciate. Copyright © 2012 Pearson Education. All rights reserved. 14 -48

The Effect of an Expected Appreciation of the Euro Individuals and institutions now expect the euro to appreciate Copyright © 2012 Pearson Education. All rights reserved.

The Effect of an Expected Appreciation of the Euro • If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollardenominated goods. – The expected rate of return on euros therefore increases. – An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy). Copyright © 2012 Pearson Education. All rights reserved. 14 -50

Fig. 14 -7: Cumulative Total Investment Return in Australian Dollar Compared to Japanese Yen, 2003 -2010 Source: Exchange rates and three-month treasury yields from Global Financial Data. Copyright © 2012 Pearson Education. All rights reserved. 14 -51

Covered Interest Parity • The interest parity we have talked is uncovered interest parity: R$ = R€ + (Ee$/€ – E$/€)/E$/€ • Covered interest parity relates interest rates across countries and the rate of change between forward exchange rates and the spot exchange rate: where F$/€ R$ = R€ + (F$/€ – E$/€)/E$/€ is the forward exchange rate. • It says that rates of return on dollar deposits and “covered” foreign currency deposits are the same. – Covered positions using the forward rate involve little risk. Copyright © 2012 Pearson Education. All rights reserved. 14 -52

Summary 1. An exchange rate is the price of one country’s currency in terms of another country’s currency. • It enables us to translate different countries’ prices into comparable terms. Copyright © 2012 Pearson Education. All rights reserved. 14 -53

Summary (cont. ) 2. Depreciation of a currency means that it becomes less valuable and goods denominated in it are less expensive: exports are cheaper and imports more expensive. 3. Appreciation of a currency means that it becomes more valuable and goods denominated in it are more expensive: exports are more expensive and imports cheaper. Copyright © 2012 Pearson Education. All rights reserved. 14 -54

Summary (cont. ) 4. Commercial and investment banks that invest in deposits of different currencies dominate the foreign exchange market. – Expected rates of return are most important in determining the willingness to hold these deposits. 5. Rates of return on currency deposits in the foreign exchange market are influenced by interest rates and expected exchange rates. Copyright © 2012 Pearson Education. All rights reserved. 14 -55

Summary (cont. ) 6. Equilibrium in the foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity. 7. An increase in the interest rate on a currency’s deposit leads to an increase in its expected rate of return and to an appreciation of the currency. Copyright © 2012 Pearson Education. All rights reserved. 14 -56

Summary (cont. ) 8. An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and leads to an actual appreciation. Copyright © 2012 Pearson Education. All rights reserved. 14 -57