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Foreign trade and/or investments abroad require currency conversion.

Exchange Rates and Trade. Foreign trade and/or investments abroad require currency conversion. Nominal exchange rate = price of one currency in terms of another currency. Direct quotations = units of domestic currency per unit of foreign currency = E $/¥ = 1/E ¥/$ .

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Foreign trade and/or investments abroad require currency conversion.

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  1. Exchange Rates and Trade Foreign trade and/or investments abroad require currency conversion. Nominal exchange rate = price of one currency in terms of another currency. Direct quotations = units of domestic currency per unit of foreign currency = E$/¥ = 1/E¥/$. Indirect quotations = units of foreign currency per unit of domestic currency = E¥/$. Appreciation = increase in value of denominator currency relative to numeratorNominal for $ = E¥/$0 / E¥/$-1 - 1 (indirect) or for ¥ = E¥/$-1 / E¥/$0 - 1 (direct) Exchange rate changes affect how much customers pay for foreign imports. Sony’s long run profit = f(innovation, efficiency and marketing) Sony’s short run profit = f(price it charges relative to its competitors’ prices) Sony sells mostly abroad. ¥ appreciation affects its foreign currency prices: appreciation from ¥105 to ¥100 per € reduces Sony’s profit by about €30B. Real exchange rate = for exchanging goods & services among countries = e£/$. e£/$ in terms of Big Macs = ($ price in US) / (£ price in UK * E$/£) = $ in Us / $ in UK. e£/$ in general = CPI$ / (CPI£ * E$/£) = CPI$ / (CPI£ / E£/$) = E£/$ * (CPI$ / CPI£)

  2. Foreign-Exchange Cross Rates The second entry in the US row shows that the exchange rate on this day was $1.3034 per €. The last entry in the € row shows that the exchange rate can be expressed as €0.7672 per $. Cross rates (simultaneous sell currency A for the common one and use it to buy currency B) might be more accurate and less expensive if A and B currencies trade infrequently. For n currencies Intermediary needs n-1 desks versus n(n-1)/2 possible pairs. If common is denominator currency, cross gives division E¥/C$c = E¥/$ / EC$/$ = 78.685/0.9785 = 80.414 If common is numerator currency, reverse cross division E€/£c = E$/£ / E$/ € = 1.6133/1.3034 = 1.2378 Figure 8.1

  3. Foreign-Exchange Market An OTC spot (immediate delivery at current spot price) and forward (future delivery at today agreed forward price) market where currencies are traded. Large commercial banks (willing to buy/sell major currencies at any time) are market makers while investment portfolio managers and central banks are customers. Primary for-ex trading in London, NY & Tokyo, secondary in HK, Singapore & Zurich. Exchange-rate risk = probability of losses due to exchange rates fluctuations. Derivatives allow hedger to reduce risk & speculator to bet on future currency value. forward premium for $ = F¥/$ / E¥/$ - 1 (indirect) or for ¥ = E¥/$ / F¥/$ - 1 (direct) To hedge against ↓ / ↑ in currency value sell / buy that currency in the forward market. Futures contracts (traded through exchanges e.g. CBOT) reduce counterparty risk but volume is at least 10 times smaller than for the forward contracts. Call and put currency options are also available but more expensive than futures.

  4. Exchange Rates in the Long Run Law of one price (identical products price is = everywhere) is basis for Purchasing Power Parity = exchange rates move to equalize the purchasing power of currencies. In the long run arbitrage activity causes PPP to hold: exchange rates ensure that a unit of currency buys the same amount of goods and services in every country. If Coke costs $2 in US & £1 in UK, E$/£eql = 2. If π£& π$ increase 0 & 50%, Coke costs $3 in US & still £1 in UK. With E$/£ = 2, UK products cheaper in US and vice versa. Convert $2 to £1, buy Coke in UK, sell it for $3 in US. $ will depreciate 50% to E$/£ = 3 to eliminate trade deficit. PPP prediction: Nominal $ appreciation = %Δ E£/$ = π£- π$. (Recall: e£/$ = E£/$ * (CPI$ / CPI£). If PPP holds %Δe£/$ = %ΔE£/$ + %ΔCPI$ - %ΔCPI£.) Combining Fisher’s Effect (R = (1+r)(1+π) - 1 ≈ r + π) & r$ = r£, with PPP gives International Fisher’s Effect%ΔE£/$= π£- π$ = (I£+ r£) - (I$ + r$) = I£- I$ Interest Rate Parity: return on $ assets = exchange rate adjusted return on £ assets, is enforced through CIA [$1*(1 + I$) = $1* E£/$(1 + I$) / F£/$]

  5. Should Big Macs Have the Same Price Everywhere as Predicted by PPP? The Economist tracks Big Mac pricesaround the world. • Is the table consistent with the PPP?Except in UK and Japan, PPP in general does not hold. • Is there arbitrage profit?Impossible to earn arbitrage profitby simultaneously buying Big Mac lowin one & selling it high in another country because Big Mac is not tradable. Real-world reasons why PPP cannot be a complete explanation of exchange rates: 1. Not all products can be traded internationally 2. Products are differentiated 3. Governments impose barriers to trade, e.g., tariffs (a tax a government imposes on imports) and quotas (a limit a government imposes on the quantity of imports)

  6. The International Fisher’s Effect Investors account for > 95% of for-ex demand => international capital mobility. Exchange-rate risk for buying ¥ bonds: ¥ depreciating against $ lowers $ return. To eliminate arbitrage profits, ¥-$ interest rates differential = nominal $ appreciation. Would you follow this investment advice: To earning an above-average return, borrow in US at 3% and invest it in Japan in a comparable investment at 6%. If the International Fisher’s Effect holds, a 3% ¥-$ interest rates differential means that investors expect $ to appreciate 3% against ¥. Interest rates differential do not always reflect expected appreciation for: 1. Differences in default risk and liquidity. 2. Transactions costs. 3. Exchange-rate risk. Inclusion of currency premium in International Fisher’s Effect accounts for added risk of investing abroad: I$ = IFC - Expected $ appreciation – Currency premium In addition to chasing higher returns (e.g. emerging markets - developing countries with rapid economic growth, like BRIC) foreign investing can reduce systematic risk if domestic & foreign country’s movement along business cycle is asynchronous.

  7. A Demand and Supply Model of Exchange Rates Determines both the equilibrium E¥/$ and e¥/$, holding prices constant. Demand for $ = demand by foreign households & firms for US real & fin assets. Demand for $ in exchange for ¥ slopes downward because as exchange rate (price of $ in terms of ¥) decreases demanded for $ increases. Supply of $ = willingness of households & firms that own $ to exchange them for ¥. Supply for $ in exchange for ¥ slopes upward because as exchange rate (price of $ in terms of ¥) increases supply of $ increases.

  8. The “Flight to Quality” during the Financial Crisis Movements in the Trade-Weighted Exchange Rate of the U.S. Dollar During the financial crisis of 2007–2009, many foreign investors sought a safe haven in US Treasuries. As a result, the demand for dollars and thus the dollar exchange rate increased. The increase in demand was not primarily due to higher US interest rates but to problems in the international fin system. Currency crises in several East Asian countries (South Korea, Thailand, Malaysia and Indonesia) combined with Argentinian and Russian fin problems sharply lowered the values of these currencies. In a “flight to quality” many foreign investors purchased $ denominated assets, particularly US Treasuries, perceived as safe.

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