Foreign Exchange

Foreign Exchange Chapter 17 Chapter 17: Foreign Exchange

Background • About 170 different foreign currencies in the world • Traded in a global currency market • Most trading occurs in only a few currencies • Euro, U.S. dollar • Currencies market is the largest financial market in the world • Decentralized—most transactions occur via telephone • Over $1 trillion U.S. dollars of transaction occur daily • Most of the trading occurs between larger international banks in London, New York City, Tokyo and Singapore Chapter 17: Foreign Exchange

Common Markets and Economic Unions • For many years countries tried to maintain a gold exchange standard • The exchange rate between currencies determined by the ratio of the weights of gold defining the currencies • However, since 1970 most national governments have abandoned the gold standard • Makes it easier for government to create money • If a country’s money supply expands too rapidly, inflation generally results Chapter 17: Foreign Exchange

Foreign Exchange Rate Fluctuations • Exchange rate movements occur when • Economic relations between countries change • Market participants’ expectations change • Governments often intervene in foreign exchange markets • Attempt to affect their currency values • Dirty float—while exchange rates are determined by the financial markets, governments are free to intervene • Happens in U.S., U.K., Japan, Germany, France, Canada Chapter 17: Foreign Exchange

Foreign Exchange Rate Fluctuations • In long run, currencies interaction is shaped by political and economic conditions • Germany and U.S. have had stable political systems for the last several decades • Thus, these currencies are viewed as ‘safe’ • Some countries (Brazil, Israel, Mexico) have experienced hyperinflation • Thus, their currencies lost purchasing power Chapter 17: Foreign Exchange

Economic Unions • Economic unions occur when countries band together and adopt a common currency • Attempt to foster cross-border trade • Expected benefits of forming an economic union • Will reduce the number of foreign exchange transactions • Increase competition by making price comparisons easier • Form a bond between the countries in the union Chapter 17: Foreign Exchange

European Monetary Union (EMU) • European Monetary Union composed of • Austria • Belgium • Finland • France • Germany • Ireland • Italy • Luxembourg • Netherlands • Portugal • Spain Adopted the euro on 1/1/1999. Euro and original countries’ currencies are still acceptable. However, after 7/1/2002 only the euro will be used. Chapter 17: Foreign Exchange

European Monetary Union (EMU) • Will the EMU work? • It is easy to argue that a common currency will facilitate cross border trade • Economic unions prior to EMU did not fare well • Latin Monetary Union, Scandinavian Monetary Union and East African Community all fell apart • Cultural differences between nations will remain • Administrative costs may exceed benefits of a common currency Chapter 17: Foreign Exchange

European Monetary Union (EMU) • Member nations created the European Central Bank (www.ecb.int) to replace member countries’ separate central banks • Reason for failure of other unions was different monetary policies pursued by separate member countries’ banks • ECB has power over inflation, deficit spending and currency stability Chapter 17: Foreign Exchange

Spot and Forward Markets • Some nations’ currency trades at a fixed rate relative to a popular currency • Other currencies have freely fluctuating exchange rates • The spot market is the current exchange rate for immediate delivery Chapter 17: Foreign Exchange

Spot and Forward Markets • A transaction of foreign currency with a future delivery date occurs in the forward market • Only a few currencies are traded in the forward market • Unprofitable to make a forward market in a currency that does not have an active market Chapter 17: Foreign Exchange

Spot and Forward Markets • An example of spot prices for different currencies are listed below Chapter 17: Foreign Exchange

Expected Foreign Exchange Rate • The expected spot rate during the next time period is equal to the value of today’s forward rate for delivery during that time period, or: • Currencies can sell at a premium or a discount in the forward market If value < (>) 0, currency is selling at a forward discount (premium). Chapter 17: Foreign Exchange

Analysis of Foreign Exchange Risk • Two people simultaneously invest in an Indian security • Domestic investor in India—domestic currency to purchase domestic security • Foreign investor in U.S.—uses U.S. dollars to buy an equivalent amount (500 rupees) of the same Indian security • Must purchase the rupee with U.S. dollars to make the investment • If the exchange rate fluctuates, the two investors can earn different rates of return • Even though they owned the same security over the same holding period Chapter 17: Foreign Exchange

The Domestic Investor • If the Indian investment returned 550 rupees after a one-year period (with no cash income during the period), the domestic investor has earned 10%: Chapter 17: Foreign Exchange

The Foreign Investor • The return to the foreign investor hinges on the exchange rate fluctuation • Suppose at the beginning of the investment period, the spot rate was 40 rupees for $1 or • SPt-1 = $1/Rs40 = $0.025 • Thus, the American paid $12.50 for the Indian investment • $0.025 x 500 rupees = $12.50 • If the exchange rate remains at $0.025, the American earns the same return as the Indian investor Chapter 17: Foreign Exchange

The Foreign Investor • However, most governments allow exchange rates to fluctuate • American investor has actually made two risky investments • In the risky Indian security • In the risky rupee • If the exchange rate has fluctuated to $0.0275 (a 10% gain) per rupee by the end of the investment period, the American investor’s return is: Chapter 17: Foreign Exchange

Components of Investor’s Total Return • The return to the foreign investor can be simplified as: rforeign = rdomestic + rforeign exchange gain + rforeign exchange gainrdomestic • This can be approximated by: rforeign rdomestic + rforeign exchange gain • Any investor undertaking a foreign investment faces three risk factors • Total risk = foreign currency risk + foreign security risk + covariance risk • Covariance risk can be negative or positive Chapter 17: Foreign Exchange

Risks Undertaken by International Investors • Estimates of the risks undertaken by U.S. and domestic investors, 1993-1999 inclusive: When correlation > 0 the American investor’s risk is greater than the domestic investor’s risk—causing the last column to exceed 1.0. Chapter 17: Foreign Exchange

Worldwide Currency Trading • A large international bank may make a market in 50 currencies • Responsibility for the bank’s electronic trading book may pass daily from New York to London to Tokyo and back to New York • Allows the currency market to operate around the clock Chapter 17: Foreign Exchange

Three Foreign Exchange Parity Relationships • In long run exchange rates are determined by fundamental economic relationships • Relative purchasing power parity • Inflation-based theories • Interest rate parity Chapter 17: Foreign Exchange

Relative Purchasing Power Parity (PPP) • Law of one price—identical goods should sell for the same price • Tends to equalize prices around the world • More applicable to financial goods because there are essentially no transportation costs • Relative PPP generalizes law of one price • A basket of identical goods should sell at the same price around the world • If goods are priced in a common currency and no barriers to trade exist • Adjusts for different countries’ inflation rates Chapter 17: Foreign Exchange

Relative Purchasing Power Parity (PPP) • Implies that if countries have different inflation rates, the exchange rate should fluctuate to compensate • Example: If inflationUS = 4% and inflationU.K.=8%, the U.S dollar should appreciate by 1.08/1.04 – 1 = 3.8% relative to the British pound • If this doesn’t happen, U.K. exports to the U.S. will become overpriced and U.S. exports to U.K. will become underpriced • Demand for pounds would decrease • Demand for U.S. dollar would increase • Until new equilibrium is reached Chapter 17: Foreign Exchange

Relative Purchasing Power Parity (PPP) • Thus, the relationship between inflation and exchange rates is: • In a world without restrictions, foreign exchange rates would reflect inflation differentials between countries Chapter 17: Foreign Exchange

Critique of PPP • PPP lacks the ability to explain day-to-day (or even month-to-month) changes in foreign exchange rates • One of the main problems is our inability to measure inflation • Consumers’ baskets of goods change continuously • Difficult to alter the basket of goods used in calculating a CPI • Different baskets of goods apply for different countries • Most inflation measures are based on historical data, not on expected future price changes Chapter 17: Foreign Exchange

Fisher’s Inflation-Based Theories • During 1930s Irving Fisher states that nominal interest rates could be divided into: • Constant real rate • Fluctuating expected rate of inflation • (1 + nominal rate) = (1 + real rate) x ( 1 + expected inflation) • Can be approximated by • Nominal rate  real rate + expected inflation • Critics argue Fisher’s model is too simple • Assumes the real rate remains constant Chapter 17: Foreign Exchange

Fisher’s Inflation-Based Theories • Fisher extended his model to an open economy • Allows trading between countries and multiple currencies • Differences between countries’ nominal interest rates can be explained by • Differences in real rates • Differences in inflation rates • Known as the Fisher open model Chapter 17: Foreign Exchange

Fisher Open Model • If two countries have the same real rate, the differences in their nominal rates can be explained by differences in their expected inflation rates • More useful for analyzing long-run than short-run relationships • Also, differences in countries’ real rates causes problems Chapter 17: Foreign Exchange

Interest Rate Parity • Occurs when market returns in two countries are equal when they are denominated in the same currency • Applies law of one price to nominal interest rates • Adjusts to remove exchange rate effects • Uncovered interest rate parity involves no offsetting ‘cover’ to hedge the position Chapter 17: Foreign Exchange

Uncovered Interest Rate Parity • Not useful for predicting because • Comparison must be made across countries on assets of equal risk • Can be troublesome if different levels of sovereign risk exist • The expected spot price1 is difficult to measure • Foreign exchange adjustments needed to derive the model make the model cumbersome • The covered interest rate parity model is easier to use Chapter 17: Foreign Exchange

Covered Interest Rate Parity • Forward contracts can be used to earn arbitrage profits if the relationships do not hold Chapter 17: Foreign Exchange

Example: Covered Arbitrage • Given information: • FP1 = C$/US$ = 1.17 • SP0= C$/US$ = 1.16 • Nominal rateU.S. (domestic) = 10% • Nominal rateCanada (foreign) = 13% • Substituting these values into the covered interest rate parity equation yields the following inequality: Chapter 17: Foreign Exchange

Example: Covered Arbitrage • Arbitrage profits could be earned by • Borrowing U.S. dollars for 10% • Converting the U.S.$ to Canadian$ at the current spot price of 1.16 • Investing the Canadian$ in an investment returning 13% • Buying a foreign exchange forward contract guaranteeing the exchange rate in 1 year of C$1.17 per U.S.$ Chapter 17: Foreign Exchange

Example: Covered Arbitrage • If this were done with $100,000 U.S., the result would be: • If this inequality existed arbitrage would lead to • Increase in demand for Canadian dollars • Lead to a reduction in the C$/US$ exchange rate • Increase in supply of Canadian dollars in the forward market • Lead to an increase in the C$/US$ foreign exchange rate Chapter 17: Foreign Exchange

Simplified Summary of Equilibrium Conditions • Profit seekers can use the covered interest rate parity equation to determine if profitable currency trading opportunities exist • However, profitable trading opportunities will not exist for long • Arbitrageurs must be prepared to transact quickly • In less liquid markets, covered interest rate parity is more likely to be violated Chapter 17: Foreign Exchange

The Bottom Line • When buying a foreign currency-denominated asset an investor faces foreign exchange risk and foreign investment risk • Several European nations are trying to reduce international trade barriers by executing transactions in a single currency (the euro) • While similar unions have been unsuccessful, supporters hope it will lead to trade stimulation Chapter 17: Foreign Exchange

The Bottom Line • Parity relationship exist to explain foreign exchange rates • Purchasing power parity • Identical goods should sell for the same price, regardless of the currency • Interest rate parity—applies law of one price to nominal interest rates • Covered interest rate parity Chapter 17: Foreign Exchange

Foreign Exchange