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Ch. 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach

Ch. 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach. Exchange Rates. Exchange rate is the price of one currency in terms of another. On October 18, 2002 at 15:48:14 GMT, 1USD was worth €1.0301 or 1€ was worth $0.9709.

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Ch. 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach

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  1. Ch. 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach

  2. Exchange Rates • Exchange rate is the price of one currency in terms of another. • On October 18, 2002 at 15:48:14 GMT, 1USD was worth €1.0301 or 1€ was worth $0.9709. • On Jan. 1, 1999, 1€=$1.1497; on March 5, 2001, 1€=$0.9358. • You can check the exchange rates at http://www.economist.com/markets/currency/

  3. Exchange Rates • Changes in the exchange rates affect the prices of imports, exports, foreign assets purchased by locals and local assets purchased by foreigners. • When the domestic currency becomes more valuable (appreciates, becomes stronger), foreign commodities and assets become cheaper.

  4. Exchange Rates • If €1=$1.1497 on 01/01/99 and €1=$0.9358 on 03/05/01, then euro depreciated and USD appreciated in this period. • European goods and assets would be cheaper at the recent date. • American goods and assets would be more expensive at the recent date. • In this example exchange rates are given per euro.

  5. Price Comparisons • Suppose on 1/01/99 and 3/5/01 the price of a Ferrari remained €100,000. • Likewise, the price of a server at those dates was $50,000. • A Ferrari would have cost Americans $114,970 on 1/01/99 and $93,580 on 3/5/01. • A server would have cost Europeans [($50,000)(€1/$1.1497)]=€43,489.61 on 1/01/99 and on 3/5/01 [($50,000)(€1/$0.9358)]=€53,430.22.

  6. Price Comparisons • If the currency appreciates (as in the previous example for USD) imports become cheaper and exports more expensive. • US can get more European goods for the same amount of exports: terms of trade improvement. • If the currency depreciates (€ in the example), Europe has to give up more exports for the same amount of imports: terms of trade deterioration.

  7. The Foreign Exchange Market • Forex market is where international currencies are traded. • Major participants are commercial banks, corporations, nonbank financial institutions and central banks. • The DAILY global trading in the FX market is about $4 trillion.http://online.wsj.com/article/SB10001424052748703380104576015824083855578.html?mod=igoogle_wsj_gadgv1&

  8. http://www.economist.com/printedition/displayStory.cfm?Story_ID=4112159http://www.economist.com/printedition/displayStory.cfm?Story_ID=4112159

  9. Commercial Banks • For every import and export transaction banks have to be involved for payments. • An importer has to instruct her bank to pay the exporter in exporter’s currency. • The bank has to exchange the domestic currency for foreign currency and transfer the funds to the exporter’s bank. • Because they are involved with FX market, banks also buy and sell for their own accounts to reduce risk.

  10. Corporations • Both for importing purposes and for expenses in another country, corporations might need to have foreign currency holdings.

  11. Nonbank Financial Institutions • More and more nonbank financial institutions have been undertaking banking functions. • More and more mutual funds, insurance companies have been involved in foreign businesses.

  12. Central Banks • Central banks keep international reserves to intervene in the FX market to keep the exchange rate at a target level.

  13. The Location of FX Market • FX is traded 24/7 around the world. • Sunday is a work day in Israel. • Buying and selling is done with computers, phone lines. • In short, FX market is truly global single market. • There should not be any price differentials from one place to another.

  14. Arbitrage • Suppose $1=¥100 in New York but $1=¥101 in London. • You work at the FX desk of Citibank. • How would you make money for Citibank?

  15. Arbitrage • You buy USD in New York (sell ¥) and sell USD in London (buy ¥). • You borrow yen in New York, buy USD, exchange USD to yen in London and pay your yen debt. • ¥100 million in New York will become ¥101 million in London. http://www.marketwatch.com/tools/stockresearch/globalmarkets/default.asp?siteid=mktw&dist=10moverview&

  16. Equilibrium FX • Buying USD in New York will raise the price of $: $1 will be worth more than ¥100 or ¥100 will be worth less than $1. • Selling USD in London will lower the price of $: $1 will be less than ¥101 or ¥101 will be more than $1. • Prices in New York and London will be $1=¥100.5.

  17. Vehicle Currency • If there are hardly any trade and asset purchases between two countries, they might not have inventories of each other’s currencies. • Typically, USD is the international reserve currency that is used to exchange from one currency to another. • USD acting as a vehicle currency allows to calculate cross rates.

  18. Cross Rates • Suppose $1=¥100 and $1=SF0.75. • What is the cross rate between Yen and Swiss Franc? • ¥1=$0.01 • ¥1=$0.01(SF0.75/$) =SF0.0075 • SF1=$1.33 • SF1=$1.33(¥100/$)=¥133

  19. Spot and Forward Rates • FX transaction that takes effect immediately (even if the funds cannot be cleared before two days) is a spot transaction. • FX transaction that will take effect in the future (say one month or three months) is a forward transaction. • The difference between the spot and forward rates shows the interest rate differential between two currencies.

  20. Spot and Forward Rates

  21. http://www.ny.frb.org/

  22. Spot and Forward • You import VCRs from Japan. You have to pay ¥100 million in six months. Japanese funds pay 1% interest annually. • You need ¥99,502,487.56 today to have the funds in six months: (1.005x=100,000,000). • You could exchange $795,002.29 today: [(¥99,502,487.56)/¥125.16/$]. • You could keep your $795,002.29 and earn 2.8% interest so that you could exchange $806,132.32 at ¥124.05 to pay ¥100 million.

  23. Spot and Forward • If it doesn’t make any difference, i.e., it costs you the same amount today, why bother? • Because in six months ¥/$ rate may be different. • If ¥/$ rate in six months turns out to be ¥120, you could only get ¥96,735,878.40. ($806,132.32)(¥120). • By entering a forward contract with your bank you know exactly how much you are paying and can price your VCRs accordingly.

  24. Other Instruments To Reduce Risk • FX Swaps: You buy a foreign currency with the understanding that you will sell it in a specified time. • Futures: You buy a futures contract that will deliver a certain amount of foreign currency at a specified price at a specified date. You can sell this contract within the period; you can’t sell forward contract. • Options: You buy a put option to have the right to sell; you buy a call option to have the right to buy.

  25. Example of Futures Lifetime Open Open High Low Settle Chg High Low Interest Japanese Yen (CME) - ¥12,500,000; $ per 100¥ Dec .8444 .8463 .8418 .8448 - .9600 .8412 255,775 Mr07 .8548 .8564 .8524 .8552 - .9526 .8518 16,492 Euro (CME) - €125,000; $ per € Dec 1.2586 1.2615 1.2562 1.2602 .0013 1.3135 1.1913 156,956 Mr07 1.2625 1.2665 1.2616 1.2655 .0013 1.3207 1.2020 2,150 WSJ, October 25, 2006, p. C10.

  26. FX: Commodity or Asset • Not long ago, the demand and supply of foreign currency were determined through import and export demands. • Thirty years ago current account determined the demand and supply of foreign currency.

  27. FX: Commodity or Asset • In 1980 US (not global) foreign currency trading was around $18 billion per day. In Oct. 2008 this amount was $762 billion per day. http://www.newyorkfed.org/fxc/volumesurvey/2008/octoberfxsurvey2008.pdf • It is not imports/exports but the function of FX as an asset that matters.

  28. The Demand for an Asset • Foreign currency bank deposits are assets. • As with any asset, the future value is paramount in determining price. • Assets (wealth) allow to postpone purchasing power into the future.

  29. The Demand for an Asset • The demand for an asset depends on the generated income (interest rate), capital gain (expected price), riskiness, liquidity.

  30. Rate of Return • A $1000 bond that pays $50 provides an interest rate of 5%. • If you sell the bond for $1100, your rate of return is 15%. • If you sell the bond for $900, your rate of return is -5%. • If inflation were 5%, your real rate of return would have been 10% and -10%, respectively.

  31. Risk • Risk is a measure of uncertainty of future returns. The higher the variations in returns, the higher is the risk. • The higher the risk, the less desirable is the asset.

  32. Liquidity • Liquidity is a measure of cost and speed to convert an asset into cash. The cheaper and speedier an asset can be converted to cash, the more liquid it is. • The more liquid an asset, the more desirable it is.

  33. http://www.economist.com/printedition/displayStory.cfm?Story_ID=3786551http://www.economist.com/printedition/displayStory.cfm?Story_ID=3786551

  34. Comparison of Returns • Suppose the $/€ exchange rate is $0.93 per €. • What is the €/$ rate? It is the reciprocal, or 1/0.93 = €1.075

  35. Comparison of Returns • Suppose $ deposits pay 5% interest rate. • Suppose € deposits pay 8% interest rate. • Which asset ($ or €) would you rather hold? € of course.

  36. Comparison of Returns • Suppose you will need your $ a year from now. Today the exchange rate is $0.93/€. • You expect the $/€ rate to be $0.91. • Do you expect the $ to appreciate or depreciate? • Do you expect the € to appreciate or depreciate? Your expectation is for $ to appreciate and for € to depreciate.

  37. Comparison of Returns • The rate of appreciation of $ will increase the percentage return on USD. • The rate of depreciation of € will decrease the percentage return on €. • If € is expected to move from $0.93 to $0.91, its rate of depreciation is ($0.91-$0.93)/$0.93 = -0.0215 or -2.15%. • The rate of appreciation for $ is (€1.099- €1.075)/ €1.075= 0.022 or 2.2%.

  38. Comparison of Returns • Since the appreciation/depreciation calculations are approximately equal, we will treat them to be equal for simplicity. • If we compare interest rate on $ (5%) with the returns on € (8% - 2.15%), we are still better off keeping our wealth in €. • If we compare interest rate on € (8%) with the returns on $ (5% + 2.2%), again we are still better off keeping our wealth in €.

  39. Comparison of Returns • R$ compared to R€ + [($/€)e - ($/€)]/($/€)will show dollar returns in US versus dollar returns in Europe. • R€ compared to R$ + [(€/$)e - (€/$)]/(€/$) will show euro returns in Europe versus euro returns in the US. • If the exchange rate is always kept as ($/€), the euro returns comparison will be R$ - [($/€)e - ($/€)]/($/€) or appreciation of euro subtracted from R$.

  40. Comparison of Returns • The difference between appreciation and depreciation is the result of simplifying the calculation. • The correct calculation proceeds from exchanging a $ into €, earning interest on €, exchanging € back to $ and subtracting the principal ($1). • $1(€/$) [1+R€] ($/€)e - $1 = [1+ R€][($/€)e/($/€)] - [($/€)/($/€)] + R€ [($/€)/($/€)] - R€ [($/€)/($/€)]

  41. Comparison of Returns • Replace $/€ by E. • =[1+ R][Ee/E] - [E/E] + R [E/E] - R [E/E] • = [REe/E - RE/E] + R + [Ee/E - E/E] • = R[(Ee-E)/E] + R + [(Ee-E)/E] • When interest rate and appreciation/depreciation rate are small, the first term may be ignored.

  42. current exchange rate expected exchange rate interest rate on euro deposits expected rate of return = interest rate on dollar deposits expected rate of appreciation of the euro expected rate of return on euro deposits The Demand for Currency Deposits • The difference in the rate of return on dollar deposits and euro deposits is • R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) = R$ - R€ - (Ee$/€ - E$/€)/E$/€

  43. The Demand for Currency Assets

  44. Applications • $ interest rate is 10%; € interest rate is 8%. • Spot ($/€)rate is $0.93 per euro. • If ($/€)e were (a) $0.95; (b) $0.91; (c) $0.97 where would you park your deposits? (a) € appreciates by (.95-.93)/.93 = 2.15% 10% < 8% + 2.15%. (b) € depreciates by (.91-.93)/.93 = - 2.15% 10% > 8% - 2.15%. (c) € appreciates by (.97-.93)/.93 = 4.3% 10% < 8% + 4.3%.

  45. Equilibrium • When returns from $ are the same as returns from euro, there will be no adjustments: the foreign exchange market between USD and euro is in equilibrium. • The returns are equal when the USD interest rate is exactly equal to euro interest rate plus the rate of appreciation of euro. • Alternatively, the returns are equal when the euro interest rate is equal to $ interest rate minus the depreciation of euro.

  46. Equilibrium • Equilibrium in the foreign exchange market will take place when the interest parity condition holds. • R$ = R€ + [($/€)e - ($/€)]/($/€) • If R$ > R€ + [($/€)e - ($/€)]/($/€), there will be an excess demand for USD (excess supply of €) in the foreign exchange market. • If R$ < R€ + [($/€)e - ($/€)]/($/€), there will be an excess demand for euro and an excess supply of USD.

  47. Current FX and Returns • If the current FX goes up, e.g., euro appreciates today but the expected FX remains the same, the dollar return on euro deposits will decrease. • R€ + [($/€)e - ($/€)]/($/€) will be lower if ($/€) rises. • R$ - [($/€)e - ($/€)]/($/€) will be higher if ($/€) rises. • In other words, if USD depreciates today, the dollar return on euro deposits will fall.

  48. Expected Returns on Euro Deposits when Ee$/€ = $1.05 Per Euro

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