Exchange Rates and

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Chapter 13

• Exchange Rates and
• the Foreign Exchange Market

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Exchange rate

• The price of a currency in terms of another
  currency
• Domestic Currency (DC)
• Foreign Currency (FC)
• The exchange rate can be quoted as
• DC / FC ( per unit of )
• FC / DC ( per unit of )
• We express the exchange rate as E DC / FC.

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Appreciation and Depreciation

• Appreciation increase in value
• Depreciation decrease in value
• An increase in E depreciation of DC
• (or appreciation of FC)
• A decrease in E appreciation of DC
• (or depreciation of FC)

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Example 1

• The current exchange rate of the pound is
  2.000/. A year ago, it was 1.818/.
• Has the pound appreciated or depreciated?
• Calculate the rate of appreciation or
  depreciation of the pound.

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Example 2

• The exchange rate of the Turkish lira was 45,000
  TL/ in 1995 and 107,000TL/ in 1996.
• Had the lira appreciated or depreciated from 1995
  to 1996?
• Calculate the rate of appreciation or
  depreciation of the lira.
• note The exchange rate is expressed in the
  inverse form.

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On the Turkish Lira

• 1966 1 USD 9 lira
• 1980 1 USD 90 lira
• 1988 1 USD 1,300 lira
• 1995 1 USD 45,000 lira
• 1996 1 USD 107,000 lira
• 2001 1 USD 1,650,000 lira
• 2004 1 USD 1,350,000 lira
• 2007 1 USD 1,260,000 (old) lira 1.26 new
  lira

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• Cross rates
• 1 C1.3538 1 120.00
• Then the yen price of C1?
• ( /)/(C/)
• 120.00/1.3538 88.64
• What is the C price of a yen?
• Effective exchange rates the average of several
  exchange rates

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Example

• A US dollar costs 7.5 Norwegian kroner, but the
  same dollar can be purchased for 1.25 Swiss
  franc.
• How many Norwegian Kroners can you get with a
  Swiss franc? (What is the Norwegian kroner/Swiss
  franc exchange rate?)
• Currency codes USD(), CHF, NOK
• NOK/CHF (NOK/USD)/(CHF/USD) __

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Trade Weighted Index of the US dollar

• Top A weighted average of the foreign exchange
  value of the USD against the currencies of a
  broad group of major U.S. trading partners.
• Bottom against a subset of the broad index
  currencies that circulate widely outside the
  country of issue. (major currencies)

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FX Market Participants

• Private firms (exporters and importers)
• Commercial banks
• (Other financial institutions)
• Central banks

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Main characteristics of the market

• Major trading centers London, New York, Tokyo,
  Frankfurt, Singapore.
• The volume of foreign exchange has grown
• in 1989 the daily volume of trading was 600
  billion, in 2007 the daily volume of trading was
  over 2 trillion.
• About 90 of transactions in 2001 involved US
  dollars.

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Exchange rate and Relative prices

• Depreciation of DC makes
• Foreign goods more/less expensive to domestic
  consumers
• Domestic goods more/less expensive to foreign
  consumers
• Appreciation has the opposite effects

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Foreign exchange markets

• Spot market (for immediate delivery and payment)
• immediate means within 2-3 days
• Forward market (for future delivery and payment)
• Forward contract A fixed-price contract
  made today for delivery of a certain amount of a
  currency at a specified future date (settlement
  date).

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• Swaps
• A currency swap combines both a spot and a
  forward transaction into one deal.
• Futures
• A FX futures contract A standardized
  agreement with an organized exchange to buy or
  sell a currency at a fixed price at a certain
  date in the future.
• e. Options
• A FX option is a contract for future
  delivery of a specific currency, in which the
  holder of the option has the right to buy (or
  sell) the currency at an agreed price, the strike
  or exercise price, but is not required to do so.
• Call and put options

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Activities in the FX market

• Arbitrage
• Simultaneous buying and selling (of a
  currency) to take profit from price differential
• Hedging
• Covering from exchange risk due to open
  positions in FX
• Speculation
• Creating and holding an open position to
  profit from the difference in ones expectation
  and markets valuation

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• Examples
• Spatial arbitrage
• Q The pound is priced at 1.50 in NY and 1.45
  in London. What would you do as a currency
  arbitrageur?
• Triangular arbitrage
• Q In FX market (in the same or different
  locations), the foreign exchange rates are
  quoted as follows
• the / rate is 1.5, the / rate is 1.1,
  and the / rate is 1.55.
• Start with a pound, and see how much
  profit can be made if you make a complete 3-way
  trip to the pound?

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Hedging Dealing with foreign exchange risk

• An importer with a payable of 1 million in
  3 months. What options are available?
• (i) Do nothing. Wait 3 months and buy euros spot
  when the payment is due. There is foreign
  exchange risk. Describe it.
• (ii) Buy euros 3-month forward now.
• If the 3-month forward rate .9188
• the importer will pay 1 mil (.9188) in 3
  months.
• (iii) Exchange risk can be covered with futures
  or options.

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Demand for Foreign Currency Assets

• Demand for an asset depends on
• Rate of return () The percentage increase in
  value an asset offers over a given time period.
• Risk (-) The variability it contributes to
  savers wealth
• Liquidity () The ease with which it can be sold
  or exchanged for goods
• The sign indicates the direction of the
  relationship between the variable and asset
  demand.

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Rate of return

• Defining Asset Returns
• The percentage increase in value an asset offers
  over a given time period.
• Interest (or Dividend) valuation change
• The Real Rate of Return
• The rate of return computed by measuring asset
  values in terms of some broad representative
  basket of products that savers regularly
  purchase.
• Equals the nominal rate of return minus the rate
  of inflation

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Rate of return for foreign assets

• Suppose
• Todays exchange rate 1.10/
• Next years expected exchange rate 1.165/
• The expected appreciation of the euro 5.9
• The interest rate on dollar deposits 10
• The interest rate on euro deposits 5
• Which deposit, dollar or euro, offers the higher
  return?

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Rate of return for foreign assets

• Dollar deposit
• 1 today will be worth 1.10 next year
• This is a 10 return.

• Euro deposit
• 1 today will be worth 1.05 next year.
• (In dollar terms) 1.10 today will be worth
  (1.05)(1.165) 1.2233
• This is a 11.2 return.

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A Simple Rule

• 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 rate of depreciation of the dollar against
  the euro is the percentage increase in the
  dollar/euro exchange rate over a year.
• In symbol, R (Ee - E)/E
• where
• R foreign interest rate
• E todays exchange rate (remember DC per FC!)
• Ee the exchange rate expected a year from today

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R (Ee - E)/E

• The above equals R Ee /E 1.
• Depreciation of the domestic currency today
  lowers the expected return on deposits in foreign
  currency.
• A current depreciation of domestic currency will
  raise the initial cost of investing in foreign
  currency, thereby lowering the expected return in
  foreign currency.
• In the case of appreciation, change the direction
  of the underlined words.

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Expected Returns on Euro Deposits when Ee
1.05/
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The Current Exchange Rate and the Expected
Return on Euro Deposits
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The Current Exchange Rate and the Expected Return
on Dollar Deposits
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Equilibrium Exchange Rate

• Equilibrium in the FX market obtains when
• R R (Ee - E)/E
• (Uncovered) Interest Parity condition
• If R gt R (Ee - E)/E ? DC assets are more
  attractive and the DC appreciates.
• If R lt R (Ee - E)/E ? FC assets are more
  attractive and the DC depreciates.

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Determination of the Equilibrium Exchange Rate
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Changes in R, R, and Ee

• The domestic currency
• appreciates (E?) if the domestic interest rate
  rises (R ?).
• _____ (E__) if the foreign interest rate rises
  (R ?).
• _____ (E__) if the domestic currency is expected
  to depreciate (Ee ?).

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The Effect of a Rise in the Dollar Interest Rate
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The Effect of a Rise in the Euro Interest Rate
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The Effect of an Expected Appreciation of the Euro
People now expect the euro to appreciate
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Problem

• (13-4) Calculate the dollar rates of return on
  the following assets
• A 10,000 deposit in a London bank in a year when
  the interest rate on pounds is 10 and the /
  exchange rate moves from 1.50/ to 1.38/.

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Problem

• (13-6) Suppose the dollar interest rate and the
  pound sterling interest are the same, 5 per
  year.
• What is the relation between the current
  equilibrium / exchange rate and its expected
  future level?
• Suppose the expected future / exchange rate
  remains constant at 1.52/ as Britains interest
  rate rises to 10. If the US interest rate also
  remains constant, what is the new equilibrium /
  exchange rate?

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Fig. 13-1 Dollar/Pound Spot and Forward Exchange
Rates, 19812007
Source Datastream. Rates shown are 90-day
forward exchange rates and spot exchange rates,
at end of month.
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Summary

• The_____ is the price of foreign currency in
  terms of domestic currency.
• (Appreciation/Depreciation) of a countrys
  currency means that it is more valuable and goods
  denominated in it are more expensive exports
  become more expensive and imports cheaper.
• Commercial and investment banks that invest in
  deposits of different currencies dominate the
  foreign exchange market. ______ are most
  important in determining the willingness to hold
  these deposits.

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Summary (cont.)

• What is the expected rate of return on foreign
  deposits? Write it down in symbol. _____.
• Equilibrium in the FX market the rates of
  returns on deposits in domestic currency and in
  foreign currency are equal this condition is
  called _____.
• Depreciation of the DC (increases/decreases) the
  expected return on FC deposit.
• An increase in the domestic interest rate
  (appreciates / depreciates) the domestic
  currency.