Exchange Rates

Antu Panini Murshid

Todays Agenda

Nominal vs. real exchange rate Asset market approach Uncovered interest rate parity

Currencies and Exchange Rates

Each country has a currency in which the prices of goods and services are quoted An exchange rate is the price of one currency in terms of another. This is sometimes called the nominal exchange rate

Exchange Rate Quoting

An exchange rate can be quoted in two ways Direct (American) terms and indirect (European) terms In this course we will always (unless otherwise stated) quote the exchange rate in direct terms

Direct Terms

Price of foreign currency in terms of national currency How many units of national currency do we need to buy a unit of foreign currency

Example $/, $/ Todays dollar-euro exchange rate is $1.07384 per euro

Indirect Terms

Price of national currency in terms of foreign currency How many units of foreign currency do we need to buy a unit of national currency

Example /$, /$ Todays euro-dollar exchange rate is 0.931015 per USD

Appreciation and Depreciation of a Currency

A depreciation of the dollar against the euro means that the price of a euro in terms of dollars has gone up An appreciation of the dollar against the euro means that the price of a euro in terms of dollars has gone down

Appreciation and Depreciation of a Currency

If the dollar depreciates against the euro this must mean that the euro has appreciated against the dollar If the dollar appreciates against the euro this must mean that the euro has depreciated against the dollar

Appreciation and Depreciation of the Exchange Rate

An exchange rate depreciation means the domestic currency has depreciated and an exchange rate appreciation means the domestic currency has appreciated If the exchange rate depreciates then e If the exchange rate appreciates then e

Example

If the $/ exchange rate moves from e=1.00 to e=.95. exchange rate has appreciated by 5% Dollar has appreciated against the euro by 5% (it now cost $0.95 as opposed to $1 to buy 1) and the euro has depreciated against the dollar by approximately 5% (it now costs 1.05 to buy $1)

Real Exchange Rate

Suppose a car in UK costs 30,000, if e=1.50, then dollar price is $45,000, i.e. the price of foreign goods in terms of domestic currency is ePf Suppose the same car in the US costs $36,000, then the price of the foreign car in terms of the price of domestic cars is ePf/P=1.25

Real Exchange Rate

The real exchange rate () gives the price of a unit of a foreign goods, in terms of the price of domestic goods That is = ePf / P, where P is the domestic price level and Pf is foreign price level

Real Exchange Rate Appreciation/Depreciation

If we say that the real exchange rate has depreciated

if either e P or Pf

If we say that the real exchange rate has appreciated

if either e P or Pf

Competitiveness

If the real exchange rate depreciates, the price of foreign goods relative to the price of domestic goods increases and exports become more competitive while imports become more expensive If the real exchange rate appreciates, the price of foreign goods relative to the price of domestic goods decreases and exports become less competitive while imports become cheaper

Foreign Exchange Market

Players in the foreign exchange market

Commercial banks, large corporations, non-bank financial institutions, central banks

Commercial banks are by far the largest players in the foreign exchange market. However large corporations like IBM and GE also engage in significant transactions. Another groups of important players are central banks

Foreign Exchange Market

Characteristics of the market

The main markets are London, New York, Tokyo Daily global value of forex trading $1.7 trillion $ vehicle currency

Determination of the Spot Exchange Rate

What determines the exchange rate? Demand and supply What factors might affect demand and supply?

Inflation rates? Trade deficits? Demand for assets?

Expected Returns

Expected rate of return Risk and liquidity We will abstract from risk and liquidity for now and assume that these characteristics are the same across different assets. If this is the case, we will prefer to hold assets offering the highest expected rate of return

How Do We Compare Returns on Various International Assets?

$-assets pay returns in dollars -assets pay returns in euros In order to compare these returns, we need to measure all returns in terms of one currency

How Do We Compare Returns on Various International Assets?

But why does it matter, isnt 5% interest in the US just the same as 5% in Germany? Nobecause the exchange rate between dollar and the euro may change

Example

Suppose the $/ exchange rate is 1.00 The interest rate in the US is 10% The interest rate in Germany is 5% Expect $/ exchange rate to be 1.10 Which asset offers the highest rate of return?

Example

Gross return on $1 deposited at a US bank is $1.10 What is the gross return on $1 deposited in a German bank?

Example

1. Convert dollars to euros:

$1 1 Gross return 1.05 1.05 $1.15

2. Invest in Germany:

3. Convert back to dollars

Return on -asset is 15% = if+E(%De)

Equilibrium Exchange Rate

If the rate of return on dollar assets is greater than the dollar rate of return on euro assets there will be an excess demand for dollar assets If the rate of return on dollar assets is less than the dollar rate of return on euro assets there will be an excess demand for euro assets Only when the rate of return on dollar assets is equal to the rate of return on euro assets will the exchange rate be in equilibrium

Uncovered Interest Rate Parity Condition

The UCIP condition states that the return to investing in domestic assets must equal the expected return on investing in foreign assets (when the returns are measured in the same currency)

i if + %E(e)

Example: UCIP Holds

i = 10% (US rate), if = 5% (German rate), et = 1.00 ($/) and E(et+1) = 1.05

Expected return to a $100 investment in -denominated German asset is:

1. Convert $ to : $100/e = 100 2. Receive 105 in 1 year 3. Covert back to $: (105 )*1.05 $110 UIPC holds

Example: UCIP Doesnt Hold

i = 10% (US rate), if = 8% (German rate), et = 1.00 ($/) and E(et+1) = 1.05

Expected $-return in -denominated German asset is 8%+5%=13% > 10% ($return on US asset) Demand for -deposits/assets

$ depreciates immediately (e) e = 1.03. Since E(et+1) = 1.05, %E(e)=2% Hence %E(e)+if=8%+2%=10%=i

Example: UCIP Doesnt Hold

Suppose now instead that the domestic interest rate increases such that i = 12% (US rate). If if = 5% (German rate), et = 1.00 ($/) and E(et+1) = 1.05, then the demand for US assets increases and the dollar appreciates to et = 0.98. Thus %E(e)=7%, so UCIP is again restored

$-Return on Foreign Assets and the Exchange Rate

$/ e

$/ (et) .95 1.00 1.05 1.10

%E(e) if+%E(e) (et+1= 1.05) 10 0 0 -5 15 10 5 0

1.10 1.05 1.00 0.95 Expected $-return on assets

10

15

$-rate of return on assets

Equilibrium Exchange Rate Graphical Representation

$/ e

Rate of return on dollar assets

e2 e1 e3

UIPC holds equilibrium exchange rate Expected return on assets

$-rate of return on assets

Effect of an Increase in Domestic Interest Rates

$/ e Original equilibrium Domestic interest rate increases e1 e2 New equilibriumthe exchange rate appreciates today and UCIP is restored

Expected return on assets

i1 i2 $-rate of return on assets

Effect of an Increase in Foreign Interest Rates

$/ e New equilibrium Original equilibrium Foreign interest rate increases

e2

e1

Expected return on assets

i

$-rate of return on assets

Effect of a Change in Expectations

$/ e New equilibrium Original equilibrium Rise in expected future price of euros

e2

e1

Expected return on assets

i

$-rate of return on assets