Lecture 4

1. Lecture 4 Exchange rate markets

2. 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

3. Definitions of Exchange Rates • Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. • How much can be exchanged for one dollar? ¥102/$1 • How much can be exchanged for one yen? $0.0098/¥1 • Exchange rates allow us to denominate the cost or price of a good or service in a common currency. • How much does a Honda cost? ¥3,000,000 • Or, ¥3,000,000 x $0.0098/¥1 = $29,400

4. Examples of Exchange Rate Quotations

5. How Exchange Rates Behave • Over time, exchange rates may be stable (fixed) or may fluctuate (floating). • Here, which exchange rate is fixed? Which is floating? • What happened to the yuan/dollar rate in 2005–06? • What happened to the dollar/euro rate in 2002–04?

6. Independence and Monetary Policy:The Choice of Exchange Rate Regime • Most countries have their own currency as sovereign nations. But what is their exchange rate regime choice? • Fixed or floating? Both are important:

7. 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 → $1.20/€1 means that the dollar has depreciated relative to the euro. 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.

8. 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/€1 → $0.90/€1 means that the dollar has appreciated relative to the euro. 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.

9. 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. • How much does a Honda cost? ¥3,000,000 • ¥3,000,000 x $0.0098/¥1 = $29,400 • ¥3,000,000 x $0.0100/¥1 = $30,000 • 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.

10. 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. • How much does a Honda cost? ¥3,000,000 • ¥3,000,000 x $0.0098/¥1 = $29,400 • ¥3,000,000 x $0.0090/¥1 = $27,000 • 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.

11. $/£ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters

12. Multilateral Exchange Rates • The bilateral exchange rate, as seen above, shows the price at which one currency is exchanged for another. • In practice, it is possible for one currency to appreciate relative to one currency, while depreciating relative to another. • In order to understand the “average” change in the value of a currency, we need to use a multilateral exchange rate.

13. Multilateral Exchange Rates • The nominal effective exchange rate (NEER) is calculated as the sum of the trade shares multiplied by the exchange rate changes for each country. • The dollar weight of each currency in the basket (in a base year) is given by the share of that country in U.S. trade. • Changes in the dollar price of this basket tell us how the value of the dollar has changed “on average” against the entire basket of currencies. • The NEER shows these changes against all foreign currencies “on average”.

14. Multilateral Exchange Rates • Computing the NEER • If the home country trades with countries 1,…,N then the fractional (%) change in NEER relative to the base year is given by finding the trade-weighted average change in each bilateral exchange rate:

15. How Much Has the Dollar Fallen? The U.S. dollar depreciated against some key currencies between 2002-2004. This depreciation was not as pronounced when measured against major U.S. trading partners. The major trading partners were mostly floating countries, like U.K., Japan, Canada. The others included countries with more fixed exchange rates, like China, India.

16. How Much Has the Dollar Fallen?

17. Exchange Rate Regimes: Fixed versus Floating • Fixed exchange rate (pegged exchange rate) • Where a country’s exchange rate does not fluctuate at all (or only narrowly) against some base currency over a sustained period, usually a year or longer. • Government intervention in the market for foreign exchange is needed to maintain the fixed exchange rate. • Floating exchange rate (flexible exchange rate) • A country’s exchange rate typically fluctuates over time. • The government makes no attempt to peg the exchange rate against a base currency. • Appreciations and depreciations may occur from year to year, each month, even by the day or every minute. • The amplitude or volatility of these fluctuations may vary greatly from one floating regime to another

18. Recent Exchange Rate ExperiencesDeveloped Countries

19. Recent Exchange Rate Experiences • Developed Countries • There is a great deal of short-run exchange rate volatility. • U.S. dollar is floating relative to the Japanese yen, British pound, and Canadian dollar (also known as the “loonie”) • Patterns for the euro are similar. • Danish krone maintains a ±2% exchange rate band to the euro through intervention by the Danish central bank.

20. Recent Exchange Rate Experiences Developing Countries

21. Recent Exchange Rate Experiences • Developing Countries • Exchange rates in developing countries tend to be more volatile. • Some countries adopted fixed exchange rate regimes, but were forced to abandon the peg after an exchange rate crisis. • Many have adopted variants of fixed exchange rate regimes • Managed float, designed to prevent dramatic changes in the exchange rate without committing to a strict peg. • Crawl, where the exchange rate follows a trend, rather than a strict peg.

22. Recent Exchange Rate Experiences • There are official and unofficial exchange rate regimes. • The difference occurs because some countries that adopt one regime follow another in practice. • E.g., they say they float but they really peg. • Instead of fixed and floating there is a continuum • Free floating versus managed floating • Crawls and bands allow some movement • No such movement in a hard peg; sometimes this takes the form of a currency board, a very hard peg with special rules (as we shall see later). • Some countries have no currency of their own.

23. Independence and Monetary Policy:The Choice of Exchange Rate Regime • Another option? • Some groups of countries that eliminates their individual currencies in favor of a common currency. • In January 2008 the Eurozone expanded again, from 13 to 15 countries (2 of the above coins went out of use). • Several other countries are in line to join soon. • The policies governing the value of the common currency are jointly decided by governments in the participating countries.

24. Independence and Monetary Policy:The Choice of Exchange Rate Regime • Yet another option? • Other countries may decide against an individual currency and use the currency of another country, without the ability to have a say in policy. (This note is no longer in use) • This is known as dollarization. • Examples: Ecuador (US$), El Salvador (US$), Panama (US$),Liechtenstein (SFr), Montenegro (€), Pitcairn Island (NZ$)

25. Recent Exchange Rate Experiences

26. 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 is close to 4 trillion in 2004. • About 90% of transactions involved US dollars.

27. Foreign Exchange Markets The participants: • Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. • Non-bank financial institutions (mutual funds, hedge funds,securities firms,insurancecompanies, pension funds) may buy/sell foreign assets for investment. • Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. • Central banks: conduct official international reserves transactions.

28. 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, but the direct effects of their transactions are small and transitory in many countries.

29. Recent Exchange Rate Experiences Computer and telecommunications technology transmit information rapidly and have integrated markets The integration of markets implies that there is no significant arbitrage between markets

30. Recent Exchange Rate Experiences Arbitrage: buying at a low price and selling at a high price for a profit. If dollars are cheaper in New York than in Hong Kong, what do you predict will happen? When other factors are the same, people will buy assets in New York and stop buying them in Hong Kong, so that their price in New York rises and their price in Hong Kong falls, until they are equal in the two markets.

31. 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.

32. Fig. 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981–2007 Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.

33. Other Methods of Currency Exchange • Foreign exchange swaps: a combination of a spot sale with a forward repurchase. • Swaps often result in lower fees or transactions costs because they combine two transactions, and they allow parties to meet each others needs for a temporary amount of time. • 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.

34. Other Methods of Currency Exchange • 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.

35. Arbitrage and Spot Exchange Rates Arbitrage with Three Currencies

36. Arbitrage and Spot Exchange Rates • Cross Rates and Vehicle Currencies • The vast majority of currency pairs are exchanged through a third currency. • This is because some foreign exchange transactions are relatively rare, making it more difficult to exchange currency directly. • When a third currency is used in these types of transactions, it is known as a vehicle currency. • As of April 2007, the most common vehicle currency was the U.S. dollar – used in 86% of all foreign exchange transactions. • The euro, Japanese yen, and British pound are also used as vehicle currencies.