# Foreign Exchange Markets The ForeignExchange Market and Exchange

• Slides: 26

Foreign Exchange Markets The Foreign-Exchange Market and Exchange Rates

Appreciation and Depreciation • Appreciation: when your currency becomes more expensive in terms of other currencies. (For example If 1 USD cost 1 Euro and then went up to 1. 2 Euros you have an appreciation • Depreciation: when your currency becomes less expensive in terms of other currencies. (For example if the USD cost 1 Euro and then went down to. 8 Euros you have a depreciation) Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 3

Exchange Rates • The nominal exchange rate is the price of one country’s exchange rate in terms of another’s. • Example: In India, if you want to buy a dollar, it costs 50 Rupees on the market- so, the nominal exchange for dollars is 1/50=. 02 dollars per rupee in India. In the U. S, the nominal exchange rate for a rupee is 50 rupees to the dollar. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4

Real Exchange Rate • The real exchange rate is the purchasing power of a currency relative to the purchasing power of other currencies. • Things cost different amounts in each country. For example, to take the Indian case with 50 rupees to the dollar. A shirt in India may cost 250 rupees, while in the U. S it costs 10 dollars. Are you better off buying in India or in the U. S? To check, we have to calculate the real exchange rate Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 5

Real E. R • Formula: EXr=[EX X P]/Pf • Real E. R= (Nominal ER X Domestic Price)/Foreign Price • = (Rs. 50/\$1 )*(\$10)/Rs. 250=2 Indian Shirts/1 U. S Shirt • So shirts are in real terms, twice as expensive in the U. S as they are in India Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 6

Price indices • In reality, we compare not prices of any particular good, but general prices (price indices) (basket of goods containing lots of common items) • So we compare general price levels Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8

Relationship between Nominal and Real Exchange Rates over time • Formula: EXr=[EX * P]/Pf So, in percentages DEXr/EXr= DEX/EX+DP/P-DPf/Pf %change in RE=% change in nominal+ percentage change in price level domestically- percentage change in price level in the foreign country Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 9

Example DEXr/EXr= DEX/EX+DP/P-DPf/Pf Let us take our previous example and say that shirts cost more in the US- (now they are \$15). The RER is now • (Rs. 50/\$1 )*(\$15)/Rs. 250=3 Indian Shirts/1 U. S Shirt • The change in EX=0, in P=50% in Pf=0 • Change in EXr=50% Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 10

Foreign-Exchange Markets • Spot market transactions involve immediate exchanges of currency or bank deposits. Example: I exchange one dollar for 45 rupees today • Forward transactions involve future exchanges of currencies or bank deposits. Example: I buy a contract today to exchange \$1 for 45 rupees 3 months from now? Why? • Zero sum game. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11

Causes of Higher Long-run Exchange Rates • A decrease in a country’s relative price level (If U. S goods are cheaper than in India, more people will buy U. S goods, and bid up the price of the dollar) • An increase in a country’s relative productivity • (If U. S goods are made more productively, they will be cheaper than in India, more people will buy U. S goods, and bid up the price of the dollar) • A decrease in a country’s demand foreign goods or a rise in foreign demand for a country’s exports (If people think that Indian goods are not of the same quality, they will buy more U. S goods…etc) • An increase in a country’s tariffs (foreign goods become costlier) Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 12

Rearranging our Equation DEX/EX = DEXr/EXr + pf-p p refers to inflation Nominal E. R change = Real E. R change+ difference in foreign and domestic inflation rates Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13

Another Determinant of Exchange Rates • The flow of goods and services (called trade) is not the only thing that moves between countries • Capital flows too (financial flows between countries). • Just like with trade, borrowers need finance in their local currency and sellers need repayment in their own currency, so they need foreign exchange markets. • How does this explain the fact that while the U. S has a constant and huge trade deficit, its currency isn’t depreciating fast? Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15

Determining Short-run Exchange Rates • Investors compare the return on a domestic asset with the return on a foreign asset evaluated in terms of domestic currency. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 17

Example in the Book • Two assets with equal risk- Japanese Bonds and U. S Bonds each offering 5% return. • Basic point- overall return (R) depends on both interest rate and exchange rate • The return on a domestic asset (1 + i) should be compared with the return on a foreign asset evaluated in terms of domestic currency (1+ if – ∆EXe/EX). Note Exe= expected change • If Japanese yen depreciates by 5% over the year the return to the U. S bond is 1+. 05=1. 05=5% return, while to the Japanese bond=1+. 05 -. 05=1= 0% return Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 18

The graph shows the expected rate of return on a Japanese bond. Let the expected exchange rate one year from now be 100. If current ER is 105, then actual R=. 05+5/105=. 098=9. 8% If current ER is 97, then actual R=. 05+ (-3/97)=1. 9% 19

Rules • Nominal interest rate parity: ceteris paribus, the nominal returns of domestic and foreign assets must be equal. • International capital mobility results in an exchange rate market equilibrium reflecting the nominal interest rate parity condition: When domestic and foreign assets have identical risk, liquidity, and information characteristics, their nominal returns (measured in the same currency) also must be identical (i = if – ∆EXe/EX). • Real interest rate parity: expected real rates of interest are equal. (1 + r) = (1 + rf)(EXrr/EXre ). Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 20

Play ball! • You are a currency speculator. Choose (as soon as you can) what currency, Yen or the Dollar, you would under the following bits of news… Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 25

Choices • “Japanese productivity continues to increase” • “U. S announces unilateral tariffs on all Japanese products” • “U. S products seen to be of better quality” • “Japanese raise interest rates” • “Higher expected inflation in the U. S” • “Moody’s downgrades Japanese bonds” • “U. S trade deficit continues to rise” Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 26