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The foreign Exchange market and exchange rates. Lecture 18. Introduction. In September 1997, global financial system trembled Currency crisis rocked Asian financial markets capital flight to US fell and so did US Exports
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Introduction • In September 1997, global financial system trembled • Currency crisis rocked Asian financial markets capital flight to US fell and so did US Exports • How investors, and individuals, make transactions when people and organizations are in different countries • Determination of exchange rates and what causes them to change overtime
Exchange Rates and Trade • 1990’s markets for goods and services and financial assets were global because of imports and exports • When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!
How is buying a domestic good different from buying a foreign good? • Buy Pakistani good, pay in Re • Buy a US good, buy $ and then pay in $ • Buy too many US goods, buying too many $ that raises $ value against Re • An increase in currency’s value as compared to that of another is Appreciation • A fall in value is depreciation • Change in currency’s value can affect domestic manufacturers and workers… How?
Example • 1DM = $0.5 • 1DM = $0.6 • Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!
Nominal Vs. Real Exchange Rate • Nominal ER doesn’t measure real purchasing power of the currency • Nominal: Re 1 = $1/84 = $0.0012 • RER = NER x P/Pf
REAL ER • Big Mac Example • Domestic Price: Rs 300 • Foreign Price: $2.56 • NER = $0.0012/Re • EXr = 0.0012 x 300/2.56 = 0.14 US BM/Pak BM
REAL ER • EXr is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another • CPI or Inflation Rates as the ratio of P/Pf
Real ER • If EXr increases,more units of foreign goods could be traded per unit of domestic goods • Relationship between EX and EXr depends on the Rates of Inflation • %Δ ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf • ΔEX/EX = ΔEXr/EXr + (πf – π)
Foreign Exchange Market • Market forces determine exchange rates that prevail for consumers and investors • International currencies traded in forEx markets • ForEx markets are over-the-counter markets • Currencies transactions in ForEx Markets: Spot Market and Forward Market
Determine LR Exchange rates • Forces of Demand and Supply • 1$ = Rs 60 1$ = Rs 50 • Rs appreciated and $ depreciate; Qd of $ increases and Qs of Rs increased! • Price level differences P > Pf • Productivity differences Prod > Prodf • Preferences (For foreign goods) • Trade Barriers
Example DM/$ PUS > PGER Long Run ER
Purchasing Power Parity Theory • Law of one price: PPP • Comparison of international price of identical good, PPP holds • When extend the concept to a group of goods, it becomes PPP theory of ER determination • Assume: EXr are constant • EX = EXr x Pf / P
Does the Theory match Reality? • Actual ER movements are just not a reflection of changing price levels • The assumption that EXr are constant is not realistic • All goods can’t be traded because of different barriers • However, PPP is a good measure for LR determination of exchange rates
Model for SR Exchange Rate Determination • Pakistan: Domestic, US: Foreign • Rs 10000 @ 5% • Year End 10000(1+0.05) = Rs 10500 • Suppose Re 1 = $0.0125 Rs10000 = $125 • $125 @ 5%, Year End 125(1+0.05) = $ 131.25 • Convert them to Rs: $0.0125*1.05 = $0.013125 / Re • $131.25/0.013125 = Rs 10000
Cont’d • Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i) • Rs (1+0.05) = Rs 1.05 • Re 1 invested abroad, Rs [EX (1+if)] / EXe • 0.0125(1.05)/0.013125 = Re 1 • Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets • 1+i = EX(1+if)/EXe • Assume: • Identical risks, liquidity and info characteristics • 1+i = 1+ if – ΔEXe / EX
Model: Comparing Exp Returns on domestic and foreign assets Yen/$ R = i • If EX = 97 Yen/$ • R > Rf • Investors should buy local assets • If EX = 105 Yen/$ • R < Rf • Investors should buy foreign assets Rf = if – ΔEXe / EX 100 5% Exp Return in DC
ER Fluctuations Yen/$ R0 R1 • Increase in domestic ‘i’ • EX appreciates • As return falls, EX depreciates Rf 100 5% Exp Return in DC
ER Fluctuations Yen/$ R0 R1 • Increase in Pe • i = ier + Pe • EXe appreciation falls • Rf increases and EX depreciates Rf Rf1 100 5% Exp Return in DC
ER Fluctuations Yen/$ R0 • Rf increased • EX depreciates • Rf falls, EX appreciates Rf Rf1 100 5% Exp Return in DC
ER Fluctuations Yen/$ R0 • EXe increases Rf falls • EX appreciates Rf1 Rf 100 5% Exp Return in DC
Currency Premiums in ForEx Markets • It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency • i = if – ΔEXe / EX – hf,d