Exchange Rate Determination

1. June 11, 2012 Shapiro Two - Exchange Rate Determination 1 Exchange Rate Determination Chapter Two Shapiro

2. June 11, 2012 Shapiro Two - Exchange Rate Determination 2 Foreign exchange risk liquidity in terms of a different currency for international transactions lags involved (credit transactions) exposure from a position in a currency an importer holding a payable denominated in a different currency an exporter holding a receivable denominated in a different currency http://www.oanda.com/convert/fxhistory

3. June 11, 2012 Shapiro Two - Exchange Rate Determination 3 Market Participants market makers banks, foreign exchange dealers, foreign exchange brokers firms exporters, importers individuals (investors) speculators and arbitragers central banks & treasuries

4. June 11, 2012 Shapiro Two - Exchange Rate Determination 4 Market Makers Chartered banks – the main market Hold positions in foreign exchange Buy and sell spot and forward Sell over-the-counter options Hedge open positions buy buying and selling Exchange traded options and futures Make money on the bid-ask spread Exchange dealers Hold positions specialize in specific currencies Make money on the bid-ask spread Exchange brokers Broker deals paid commissions

5. June 11, 2012 Shapiro Two - Exchange Rate Determination 5 Demanders and suppliers of foreign exchange Firms (primary demanders) Exporters paid in foreign currency want home currency When you buy foreign, sellers usually demand payment in their own currency Some exceptions (all oil transactions denominated in us dollars) Buying home currency both spot and forward Individuals (travelers) Buying foreign currency spot or forward (traveler’s checks) Individuals (investors) Buying foreign currency spot

6. June 11, 2012 Shapiro Two - Exchange Rate Determination 6 Wild Cards in the Market Speculators - create volatility? Trying to profit from a perceived miss-valuation of a currency If currency is perceived overvalued More of it will be needed in the future to buy another currency It will be shorted (puts for example) Arbitrageurs - create stability? Profiting from a riskless arbitrage Triangular arbitrage Direct price different than price through another currency

7. June 11, 2012 Shapiro Two - Exchange Rate Determination 7 Wild Cards in the Market Central banks May try to influence the trend of the value of a currency Buying foreign exchange to prevent depreciation Selling foreign exchange to prevent appreciation Trying to prevent appreciation or depreciation of the currency May try to reduce volatility in the markets The direction of the trend line is not important But the volatility around the trend line is important Reduce the costs of hedging to exporters and importers

8. June 11, 2012 Shapiro Two - Exchange Rate Determination 8 Thickness of the market 1.19 trillion per day (2004) spot, forward, and swap transactions major centers London 700 billion/day New York 450 billion/day Japan 200 billion/day major currencies usd 45% Euro 20% yen 10%

9. June 11, 2012 Shapiro Two - Exchange Rate Determination 9 The Spot Exchange rate Price of one currency in terms of another For delivery today (four business days) Price fluctuates constantly to reflect market conditions

10. June 11, 2012 Shapiro Two - Exchange Rate Determination 10 Spot rate e0 , cd, terms = cd/usd = 1.1522 cd cost of the usd Canadian terms, European terms, direct interbank quotes usually in European terms e0 , usd terms = usd/cd = 0.8679 usd cost of the cd American terms, indirect

11. June 11, 2012 Shapiro Two - Exchange Rate Determination 11 Bid/ask (Offer) quotations bid - what the dealer will buy for ask (offer) - what the dealer will sell for spread a function of increased volatility (risk) Individual firm risk Increased market risk Forward exchange rates far into the future dealers and banks generate revenues from the spread

12. June 11, 2012 Shapiro Two - Exchange Rate Determination 12 Example - spot rates

13. June 11, 2012 Shapiro Two - Exchange Rate Determination 13 Equilibrium Spot Rate determinants Demand for CD by holders of foreign currency foreigners want to buy something Canadian goods, services, securities, etc. Supply from Canadians holding CD demanding foreign exchange Canadians want to buy something foreign goods, services, securities, etc

14. June 11, 2012 Shapiro Two - Exchange Rate Determination 14 Equilibrium Spot Rate

15. June 11, 2012 Shapiro Two - Exchange Rate Determination 15 Factors affecting money & exchange rates 1. economic growth economic growth increases demand for base 2. inflation CB controls the supply of base money 3. interest rates CB controls the bank rate directly CB influences term structure of interest rates indirectly 4. political risk

16. June 11, 2012 Shapiro Two - Exchange Rate Determination 16 1. Economic Growth

17. June 11, 2012 Shapiro Two - Exchange Rate Determination 17 1. Economic Growth Growth increases the demand for money demand for money curve shifts up Assume CB keeps money supply constant no change in the vertical supply curve the value of money increases prices and value of money inversely related domestically - deflation internationally - exchange rate appreciation

18. June 11, 2012 Shapiro Two - Exchange Rate Determination 18 2. Money Supply

19. June 11, 2012 Shapiro Two - Exchange Rate Determination 19 2. Money Supply Central Bank increases supply of money supply curve shifts out Assuming no change in demand for money the demand for money curve remains stationary the value of money decreases prices and value of money inversely related domestically - inflation internationally - exchange rate depreciation

20. June 11, 2012 Shapiro Two - Exchange Rate Determination 20 3. Term Structure of  Interest Rates

21. June 11, 2012 Shapiro Two - Exchange Rate Determination 21 3. Shift in Term Structure of  Interest Rates Central bank changes the bank rate only rate directly controlled by CB least risky rate in the economy no default risk little interest rate risk - overnight funds rate other rates will ratchet up relative to risk default - ability to pay interest rate risk - relative to term to maturity

22. June 11, 2012 Shapiro Two - Exchange Rate Determination 22 4. Political Risk party in power makes the rules distribution of income and wealth tax law transfers regulatory environment increase or decrease frims’ costs of doing business change of party in power change in the rules for example PQ in power in Québec

23. June 11, 2012 Shapiro Two - Exchange Rate Determination 23 4. Jump Shift in Term Structure

24. June 11, 2012 Shapiro Two - Exchange Rate Determination 24 4. Jump Shift in Term Structure Small change in power structure new rules some increase in uncertainty about future small discrete change in market risk premium Large change in power structure systemic change in the economy large increase in uncertainty about future large discrete change in market risk premium

25. June 11, 2012 Shapiro Two - Exchange Rate Determination 25 Fluctuations in the spot rate Demand for the cd increases - appreciation cd buys more foreign currency it cost more in foreign currency to buy the cd Supply of the cd increases - depreciation cd buys more foreign currency it costs less in foreign currency to buy the cd

26. June 11, 2012 Shapiro Two - Exchange Rate Determination 26 Asian flu (1997) Countries involved Thai baht, Indonesian rupiah, Malaysian Ringgit, Philippine peso, S. Korean wan Over cooked economy Government guaranteed risky loans BOT surplus, exchange rate appreciation Chinese yuan depreciated 25% Chinese goods more competitive Trade went to China Asian rim countries lost market Financial crisis as multiple bankruptcies

27. June 11, 2012 Shapiro Two - Exchange Rate Determination 27 New Equilibrium Spot Rate

28. June 11, 2012 Shapiro Two - Exchange Rate Determination 28 Percent change

29. June 11, 2012 Shapiro Two - Exchange Rate Determination 29 Year end exchange rates

30. June 11, 2012 Shapiro Two - Exchange Rate Determination 30 An Example - direct terms assume

31. June 11, 2012 Shapiro Two - Exchange Rate Determination 31 An Example - indirect terms assume

32. June 11, 2012 Shapiro Two - Exchange Rate Determination 32 cd appreciation it costs less cd to buy the usd 1.1522 cd/usd versus 1.2036 cd/usd consequently cd prices of US goods decrease this means that the cd appreciates or increases in value relative to the usd

33. June 11, 2012 Shapiro Two - Exchange Rate Determination 33 Second example - direct terms

34. June 11, 2012 Shapiro Two - Exchange Rate Determination 34 Second example - indirect terms

35. June 11, 2012 Shapiro Two - Exchange Rate Determination 35 cd appreciation it costs less cd to buy the usd 1.1522 cd/usd versus 1.5968 cd/usd consequently cd prices of US goods decrease this means that the cd appreciates or increases in value relative to the usd

36. June 11, 2012 Shapiro Two - Exchange Rate Determination 36 The Spot Exchange rate Price for current delivery Price of one currency in terms of another Delivery no later than four business days Price market determined fluctuates to reflect new information

37. June 11, 2012 Shapiro Two - Exchange Rate Determination 37 Equilibrium Spot Rate Current demand for CD by holders of foreign currency foreigners want to buy something Canadian Current supply from Canadians holding CD demanding foreign exchange Canadians want to buy something foreign

38. June 11, 2012 Shapiro Two - Exchange Rate Determination 38 Spot rate e0 , Can terms = CD/USD = 1.1522 e0 , us terms = USD/CD = 0.8679

39. June 11, 2012 Shapiro Two - Exchange Rate Determination 39 Changes in the spot rate Positive change Costs more CD tp buy the USD Costs more CD to buy US goods CD depreciates Negative change Costs less CD to buy USD Costs less CD to buy US goods CD appreciates

40. June 11, 2012 Shapiro Two - Exchange Rate Determination 40 The Forward Exchange rate Price for future delivery Price of one currency in terms of another Delivery date to be determined if contracted Price market determined fluctuates to reflect new information

41. June 11, 2012 Shapiro Two - Exchange Rate Determination 41 Equilibrium Forward Rate Future demand for CD by holders of foreign currency expressed in today’s markets foreigners contracting to buy something Canadian today But will pay for it at a future date Current supply from Canadians holding CD demanding foreign exchange expressed in today’s markets Canadians contracting to buy something foreign today But expect to pay for it in the future

42. June 11, 2012 Shapiro Two - Exchange Rate Determination 42 Forward exchange rates

43. June 11, 2012 Shapiro Two - Exchange Rate Determination 43 Forward rate f180 , can terms = CD/USD = 1.1619 f180 , us terms = USD/CD = 0.8607

44. June 11, 2012 Shapiro Two - Exchange Rate Determination 44 Forward premium/discount

45. June 11, 2012 Shapiro Two - Exchange Rate Determination 45 Central Banks Monetary policy Bank rate (interest rate adjustments) Money supply (2% inflation) Regulation of the banking system Exchange rate policy Bank rate (attract foreign capital?) Reduce volatility Monetize the debt???

46. June 11, 2012 Shapiro Two - Exchange Rate Determination 46 Fixed exchange rates Advantages reduces short-run exchange rate volatility reduce costs of international trade Disadvantages Externally mandated discipline (loss of sovereignty Monetary policy Fiscal policy Impede relative price adjustments

47. June 11, 2012 Shapiro Two - Exchange Rate Determination 47 Means to manage exchange rates Currency Boards Central Bank Intervention devalutaion/revaluation Joint Intervention

48. June 11, 2012 Shapiro Two - Exchange Rate Determination 48 China Currency Board gold, silver dollar assets (T-bills) 80% $400 billion some foreign exchange Yuan cash & currency Commercial Bank reserves The Balance of Trade Surplus with the world is huge. Accumulating very large dollar reserves. Since the Chinese economy is growing, the demand for Yuan keeps increasing which mitigates inflationary pressure. However, the dollar assets are so large, that the government is also seeking to counter the BOT surplus with a Capital account deficit by investing overseas (particularly in South and Central America, Africa, the Middle East). There have also been Chinese attempts to invest in Canada by buying up Canadian companies. China has deep enough pockets to discourage speculators.The Balance of Trade Surplus with the world is huge. Accumulating very large dollar reserves. Since the Chinese economy is growing, the demand for Yuan keeps increasing which mitigates inflationary pressure. However, the dollar assets are so large, that the government is also seeking to counter the BOT surplus with a Capital account deficit by investing overseas (particularly in South and Central America, Africa, the Middle East). There have also been Chinese attempts to invest in Canada by buying up Canadian companies. China has deep enough pockets to discourage speculators.

49. June 11, 2012 Shapiro Two - Exchange Rate Determination 49 Dollarization Countries adopt a currency not their own Informally Black and grey markets exist in which the medium of exchange is the dollar Formally Panama, Ecuador Lose all sovereignty with regard to monetary and exchange rate policy

50. June 11, 2012 Shapiro Two - Exchange Rate Determination 50 Euro-Zone (Currency Unification) Independent European Central Bank convergence criteria nominal inflation < 1.5% above avg of 3 with lowest in previous year long-term interest < 2.0 % above avg of 3 with lowest in previous year fiscal deficit no more than 3 % of GDP debt no more than 60% of GDP

51. June 11, 2012 Shapiro Two - Exchange Rate Determination 51 Countries in the Euro Belgium (franc) Germany (deutschemark) Spain (peseta) France (franc) Ireland (punt) Luxembourg (franc) Italy (lira) Netherlands (guilder) Austrian (shilling) Portugal (escudo) Finland (markka) Vatican City (lira) Greece (drachma) Slovenia (tolar)

52. June 11, 2012 Shapiro Two - Exchange Rate Determination 52 EU Countries not in Euro zone Bulgaria (Lev) Cyprus (Pound) Czech Republic (Koruna) Denmark (krone) Estonia (Kroon) Hungary (Forint) Latvia (Lats) Lithuania (Litas) Malta (Lire) Poland (Zloty) Romania (Leu) Slovakia (Koruna) Sweden (krona) United Kingdom (pound)

53. June 11, 2012 Shapiro Two - Exchange Rate Determination 53 Candidate countries for the EU Croatia Macedonia Turkey

54. June 11, 2012 Shapiro Two - Exchange Rate Determination 54 Free Float

55. June 11, 2012 Shapiro Two - Exchange Rate Determination 55 Intervention

56. June 11, 2012 Shapiro Two - Exchange Rate Determination 56 gold silver cd denominated t-bills foreign currency denominated t-bills cash currency chartered bank reserves held at the Bank of Canada Unsterilized Intervention

57. June 11, 2012 Shapiro Two - Exchange Rate Determination 57 Domestic Affects of an Unsterilzed Intervention Base money increases by amount of purchase pressure exerted on prices to increase inflation in the economy Canadian goods cost more in cd

58. June 11, 2012 Shapiro Two - Exchange Rate Determination 58 Foreign Affects of anUnsterlized Intervention short run exchange rate is not allowed to adjust long run higher Canadian inflation US goods cost relatively less to Canadians Canadian goods cost relatively more to US consumers exchange rate remains relatively constant

59. June 11, 2012 Shapiro Two - Exchange Rate Determination 59 gold silver cd denominated t-bills foreign currency denominated t-bills cash currency chartered bank reserves held at the Bank of Canada Sterlized Intervention

60. June 11, 2012 Shapiro Two - Exchange Rate Determination 60 Domestic Affects of an Sterilzed Intervention Base money remains constant prices remain constant

61. June 11, 2012 Shapiro Two - Exchange Rate Determination 61 Foreign Affects of anSterlized Intervention short run exchange rate is not allowed to adjust long run pressure remains on exchange rate to depreciate BOT deficit remains eventually the cd price of the usd will increase