- 1. Chapter 13 The Foreign Exchange Market
2. Chapter Preview
- In the mid-1980s, American businesses became less competitive
relative to their foreign counterparts.By the 2000s, though,
competitiveness increased.Why?
- Part of the answer can be found in exchange rates.In the 1980s,
the dollar was strong, and US goods were expensive to foreign
buyers.
3. Chapter Preview
- By the 1990s and 2000s, the dollar weakened, so American goods
became cheaper and American businesses became more
competitive.
4. Chapter Preview
- In this chapter, we develop a modern view of exchange rate
determination that explains recent behavior in the foreign exchange
market.Topics include:
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- Exchange Rates in the Long Run
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- Exchange Rates in the Short Run
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- Explaining Changes in Exchange Rates
5. Foreign Exchange Market
- Most countries of the world have their own currencies: the U.S
dollar., the euro in Europe, the Brazilian real, and the Chinese
yuan, just to name a few.
- The trading of currencies and banks deposits is what makes up
the foreign exchange market.
6. What are Foreign Exchange Rates?
- Two kinds of exchange rate transactions make up the foreign
exchange market:
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- Spot transactionsinvolve the near-immediate exchange of bank
deposits, completed at thespot rate .
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- Forward transactionsinvolve exchanges at some future date,
completed at theforward rate .
7. Foreign Exchange Market
- The next slide shows exchange rates for four currencies from
1990-2006.
- Note the difference in rate fluctuations during the
period.Which appears most volatile?The least?
8. 9. Why Are Exchange Rates Important?
- When the currency of your country appreciates relative to
another country, your country's goods pricesabroad and foreign
goods pricesin your country.
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- Makes domestic businesses less competitive
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- Benefits domestic consumers (you)
10. Why Are Exchange Rates Important?
- For example, in 1999, the euro was valued at $1.18.On April 26,
2006, it was valued at $1.36.
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- Euro appreciated 15% (1.36-1.18) / 1.18
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- Dollar depreciated 13% (0.75-0.85) / 0.85
-
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- Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18
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- We can see exchange rates in the WSJ.
11. Foreign Exchange Market:Exchange Rates Current foreign
exchange rates http://www.federalreserve.gov/releases/H10/hist 12.
How is Foreign Exchange Traded?
- FX traded in over-the-counter market
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- Most trades involve buying and selling bank deposits
denominated in different currencies.
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- Trades in the foreign exchange market involve transactions in
excess of $1 million.
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- Typical consumers buy foreign currencies from retail dealers,
such as American Express.
- FX volume exceeds $3 trillion per day.
13. Exchange Rates in the Long Run
- Exchange rates are determined in markets by the interaction of
supply and demand.
- An important concept that drives theforces of supply and demand
is the Lawof One Price.
14. Exchange Rates in the Long Run: Law of One Price
- The Law of One Price states that the price of an identical good
will be the same throughout the world, regardless of which country
produces it.
- Example: American steel costs $100 per ton, while Japanese
steel costs 10,000 yen per ton.
15. Exchange Rates in the Long Run: Law of One Price
- Law of one price E= 100 yen/$
16. Exchange Rates in the Long Run: Theory of Purchasing Power
Parity (PPP)
- The theory of PPP states that exchange rates between two
currencies will adjust to reflect changes in price levels.
- PPPDomestic price level10%, domestic currency10%
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- Application of law of one price to price levels
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- Works in long run, not short run
17. Exchange Rates in the Long Run: Theory of Purchasing Power
Parity (PPP)
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- All goods are not identical in both countries(i.e., Toyota
versus Chevy)
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- Many goods and services are not traded (e.g., haircuts, land,
etc.)
18. Exchange Rates in the Long Run: PPP 19. Exchange Rates in
the Long Run: Factors Affecting Exchange Rates in Long Run
- Basic Principle: If a factor increases demand for domestic
goods relative to foreign goods, the exchange rate
- The four major factors are relative price levels, tariffs and
quotas, preferences for domestic v. foreign goods, and
productivity.
20. Exchange Rates in the Long Run: Factors Affecting Exchange
Rates in Long Run
- Relative price levels: a rise in relativeprice levels cause a
countrys currencyto depreciate.
- Tariffs and quotas: increasing trade barriers causes a countrys
currency to appreciate.
21. Exchange Rates in the Long Run: Factors Affecting Exchange
Rates in Long Run
- Preferences for domestic v. foreign goods: increased demand for
a countrys good causes its currency to appreciate; increased demand
for imports causes the domestic currency to depreciate.
- Productivity: if a country is more productive relative to
another, its currency appreciates.
22. Exchange Rates in the Long Run: Factors Affecting Exchange
Rates in Long Run
- The following table summarizes these relationships.By
convention, we are quoting, for example, the exchange rate, E, as
units of foreign currency / 1 US dollar.
23. Exchange Rates in the Long Run: Factors Affecting Exchange
Rates in Long Run 24. Exchange Rates in the Short Run
- In the short run, it is key to recognize that an exchange rate
is nothing more than the price of domestic bank deposits in terms
of foreign bank deposits.
- Because of this, we will rely on the tools developed in Chapter
4 for the determinants of asset demand.
25. Exchange Rates in the Short Run: Expected Returns on
Domestic and Foreign Assets
- We will illustrate this with a simple example
- Fran ois the Foreigner can deposit excess euros locally, or he
can convert them to U.S. dollars and deposit them in a U.S.
bank.The difference in expected returns depends on two things:
local interest rates and expected future exchange rates.
26. Exchange Rates in the Short Run: Expected Returns on
Domestic and Foreign Assets
- Al the American has a similar problem.He can deposit excess
dollars locally, or he can convert them to euros and deposit them
in a foreign bank.The difference in expected returns depends on two
things: local interest rates and expected future exchange
rates.
27. Exchange Rates in the Short Run: Expected Returns and
Interest Parity 28. Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
- What this shows is simple.As the relative expected return on
dollar assets increases (decreases), both Fran ois and Al respond
by holding more (fewer) dollar assets and fewer (more) foreign
assets.
- This leads us to our formal title for what is going on here:
Interest Parity
29. Exchange Rates in the Short Run: Expected Returns and
Interest Parity
- Interest Parity Condition
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- $ and F deposits perfect substitutes
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- Example: ifi D= 6% (US interest rate) andi F= 3% (foreign
currency interest rate), what is the expected appreciation of the
foreign currency?
(2) 30. Exchange Rates in the Short Run: Expected Returns and
Interest Parity
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- Several things to recognize about the interest rate parity
condition:
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- Expected returns are the same in both dollars and foreign
assets
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- Equilibrium condition for the foreign exchange market
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- Next, we will develop supply/demand curves to explain how the
exchange rate is determined.
31. Exchange Rates in the Short Run: Expected Returns and
Interest Parity
- To determine the equilibrium condition, we must first determine
the expected return in terms of dollars on foreign deposits,
RF.
- Next, we must determine the expected return in terms of dollars
on dollardeposits, RD.
32. Deriving the Demand Curve
- The demand curve connects these points and is downward sloping
because whenE tis higher, expected appreciation of the dollar is
higher.
33. Deriving the Supply Curve
- Deriving the Supply Curve
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- There isnt really anything to derive.We will take the quantity
of bank deposits, bonds, and equities as fixedwith respect to
exchange rates .
34. Exchange Rates in the Short Run: Equilibrium
- The following figure illustrates this.
35. Exchange Rates in the Short Run: Equilibrium 36. Explaining
Changesin Exchange Rates
- To understand how exchange rates shift in time, we need to
understand the factors that shift expected returns for domestic and
foreign deposits.
- We will examine these separately, as well as changes in the
money supply and exchange rate overshooting.
37. Explaining Changes in Exchange Rates: Increase ini D
- Demandcurve shifts right when
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- i D : because people want to hold more dollars
- This causes domestic currency to appreciate.
38. Explaining Changes in Exchange Rates: Increase ini F
- Demandcurve shifts left when
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- i F : because people want to hold fewer dollars
- This causes domestic currency to depreciate.
39. Explaining Changes in Exchange Rates: Increase in Expected
Future FX Rates
- Demandcurve shifts left when
-
- : because people want to hold more dollars
- This causes domestic currency to appreciate.
40. Explaining Changes in Exchanges Rates
- Similar to determinants of exchange rates in the long-run, the
following changes increase the demand for foreign goods (shifting
the demand curve to the right), increasing
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- Expected fall in relative U.S. price levels
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- Expected increase in relative U.S. trade barriers
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- Expected lower U.S. import demand
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- Expected higher foreign demand for U.S. exports
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- Expected higher relative U.S. productivity
- These are summarized in the following slides.
41. Explaining Changes in Exchanges Rates 42. Explaining
Changesin Exchanges Rates (cont.) 43. Applications
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- Our analysis allows us to take a look at the response of
exchange rates to a variety of macro-economic factors.For example,
we can use this framework to examine (1) the impact of changes in
interest rates, and (2) the impact of money growth.
44. Application: Interest Rate Changes
- Changes in domestic interest rates are often cited in the press
as affecting exchange rates.
- We must carefully examine the source of the change to make such
a statement.Interest rates change because either (a) the real rate
or (b) the expected inflation is changing.The effect of each
differs.
45. Application: Interest Rate Changes
- When thedomestic real interest rateincreases, the domestic
currency appreciates.We have already seen this situation in Figure
4 (slide 37).
- When thedomestic expected inflationincreases, the domestic
currency reacts in the opposite direction it depreciates.This is
shown on the next slide.
46. Explaining Changes in Exchange Rates: Response toi Because e
47. Application: Interest Rate Changes
- Changes in domestic money supply are a bit more complicated.We
summarize the results on the next slide.However, you may want to
read the text on this section to fully digest the effects.
48. Explaining Changes in Exchange Rates: Changes in the Money
Supply
- M s ,P ,E e t +1 , shifting demand curve from D 1to D 2 .
- In long run,i Dreturns to old level, and demand shifts from D
2to D 3( exchange rate overshooting)
49. Exchange rate volatility
- Exchange rate overshootingis important because it helps explain
why foreign exchange rates are so volatile.
- Another explanation deals with changes in the expected
appreciation of exchange rates.Asanythingchanges our expectations
(price levels, productivity, inflation, etc.), exchange rates will
change immediately.
50. Applications
-
- Our analysis also allows us to take a look at the weak dollar
in the 1980s, and (partially) explain why it became stronger in the
1990s and 2000s.We present a summary in Figure 9, on the next
slide.
51. The Dollar and Interest Rates
- Value of $ and real rates rise and fall together, astheory
predicts
- No association between $ and nominal rates:$ falls in late1970s
as nominal rate rises
Daily foreign exchange rate
http://quotes.ino.com/exchanges/?e=FOREX 52. Case: The Euros First
Nine Years
- The euro debuted in 1999 at $1.18 / euro.It declined to $0.83
by October 2000, but has recovered, trading at $1.35 by the end of
2007.
- Initially, the European countries had relatively weaker
economies, but that has reversed in recent years, weakening the
dollar relative to the euro.
53. Reading the WSJ
- The figure on the next slide shows the Currency Trading column
from the Wall Street Journal on July 11, 2007.
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- Warnings from Home Depot and other sectors that the economy is
weakening signaling possible Fed rate cuts (did that happen?)
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- Dollar returns expected to be lower in the future dollar
expected to depreciate
54. 55. The Practicing Manger:Profiting from FX Forecasts
- Forecasters look at factors discussed here
- FX forecasts affect financial institutionsmanagers'
decisions
- If forecast yen appreciate, yen depreciate,
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- Sell franc assets, buy euro assets
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- Make more euros loans, less yen loans
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- FX traders sell yen, buy euros
56. Chapter Summary
- Foreign Exchange Market: the market for deposits in one
currency versus depositsin another.
- Exchange Rates in the Long Run: driven primarily by the law of
one price as it affects the four factors discussed.
57. Chapter Summary (cont.)
- Exchange Rates in the Short Run: short-run rates are determined
by the demand for assets denominated in both domestic and foreign
currencies.
- Explaining Changes in Exchange Rates: factors leading to shifts
in the demand and supply schedules were explored.