Slide 13-1Copyright © 2003 Pearson Education, Inc. Exchange Rates and International Transactions ...

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Copyright © 2003 Pearson Education, Inc.

Exchange Rates and International Transactions

Exchange rates translate different countries’ prices into comparable terms:

$ Price of French Cognac = ($/€) x (€/Bottle) Exchange rates are determined in the same way as

other asset prices: Supply and Demand Chapter goal: Show how exchange rates are

determined

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Depreciation of home country’s currency: $/€ up– Makes domestic goods cheaper for foreigners and

foreign goods more expensive for domestic residents

Appreciation of home country’s currency: $/€ down– Makes foreign goods cheaper for domestic residents

Forward and spot exchange rates move together.– Spot exchange rates: The prices of currencies

delivered “on the spot”

– Forward exchange rates: Prenegotiated prices of currencies delivered on futures date


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Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981-2001


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The Foreign Exchange Market• Major Players in the Foreign Exchange Market

– Commercial banks– International corporations– Nonbank financial institutions

• Interbank trading accounts for most activity in the foreign exchange market

• New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

• The integration of financial centers implies that there can be no significant arbitrage opportunities (Buy Low – Sell High)

• The $ -- the world’s vehicle currency– In 2001, around 90% of transactions between banks

involved exchanges of foreign currencies for U.S. dollars.

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Foreign Exchange Swaps make up a significant proportion of all foreign exchange trading• Spot sales of a currency combined with a forward repurchase

of the currency.

Foreign Exchange Futures Contract• The owner buys a promise that a specified amount of foreign

currency will be delivered on a specified date in the future at a specified price.

Foreign Exchange Options Contract• The owner buys the right to buy or sell a specified amount of

foreign currency at a specified price (strike price) at any time up to a specified expiration date.


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Demand for a foreign currency bank deposit depends on Asset Return: the percent increase in the deposit’s value over

some time period.• Returns on deposits traded in the foreign exchange market depend

on interest rates and expected exchange rate changes.

Real Rate of Return: the rate of return measured in terms of some broad representative basket of products that savers regularly purchase adjust for price inflation

Risk: the variability the deposit contributes to savers’ wealth

Liquidity: the ease with which it can be sold or exchanged for goods

The Demand for Foreign Currency Assets

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Interest Rates on Dollar and Deutschemark Deposits, 1975-1998

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Expected rate of return difference between dollar and euro deposits:

R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= (R$ - R€)- (Ee

$/€ -E$/€ )/E$/€

= the interest rate difference – expected appreciation of the euro

where:

R$ = interest rate on one-year dollar deposits

R€= today’s interest rate on one-year euro deposits

E$/€ = today’s dollar/euro exchange rate (number of dollars per euro)

Ee$/€ = dollar/euro exchange rate (number of dollars per euro)

expected to prevail a year from today

The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro (the euro’s rate of appreciation).

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Comparing Dollar Rates of Return on Dollar and Euro Deposits

The Demand for Foreign Currency Assets

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Interest Parity: The Basic Equilibrium ConditionThe foreign exchange market is in equilibrium when all currencies offer the same expected rate of return.

R$ = R€ + (Ee$/€ - E$/€)/E$/€

• If the $ is expected to depreciate, (Ee$/€ - E$/€)/E$/€ > 0, US

interest rates must exceed foreign rates by a like amount to keep funds from fleeing abroad.

• Depreciation of the $ today (with the expected future exchange rate unchanged) lowers the expected dollar return on euro deposits.

– If the $ becomes cheaper today, US deposits become more attractive euro deposits become less attractive euro interest rates must rise relative to the US rate to maintain interest rate parity

• Appreciation of the $ today raises the dollar return expected of euro deposits euro deposits become more attractive

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Today’s Dollar/Euro Exchange Rate and the Expected DollarReturn on Euro Deposits When Ee

$/€ = $1.05 per EuroNote: As the $ appreciates, the expected return on € deposits increases

Equilibrium in the Foreign Exchange Market

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R$

Return on

dollar deposits, R$

For given R$ , R€ , and Ee$/ €

Rates of return(in dollar terms)

Exchange rate, E$/€

E2$/€ 2

1E1$/€

E3$/€

3

Expected return on euro deposits

Equilibrium in the Foreign Exchange Market

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An increase in the US interest rate $ appreciation

An increase in euro interest rates $ depreciation

A rise in the expected future $/€ exchange rate causes a rise in the current exchange rate.• If we expect the $ to depreciate in the future we rush to

euros now the $ depreciates now.

Interest Rates, Expectations, and Equilibrium

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Dollar return

R2$R1

$

Rise in the Dollar Interest Rate Dollar Appreciation



2E2$/€

1'1E1$/€

Expected euro return


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Dollar return

R$

Effect of a Rise in the Euro Interest Rate Euro Appreciation



1E1$/€

2E2$/€

Rise in euro interest rate



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Dollar return

R$

Rise in the Expected Future $/€ Exchange Rate Expected Euro Appreciation Euro Appreciation Now



1E1$/€

2E2$/€

Rise in Ee$/€



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