Exchange Rates and the Foreign Exchange Market: An Asset Approach

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Chapter 13

• Exchange Rates and the Foreign Exchange Market
  An Asset Approach
• November 2009

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Preview

• The basics of exchange rates
• Exchange rates and the prices of goods
• Foreign exchange markets
• The demand for currency and other assets
• A model of foreign exchange markets
• role of interest rates on currency deposits
• role of expectations about future exchange rates

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Domestic and foreign currencies

• Domestic currency refers to the US dollar
• Foreign currency refers to the Euro, or at times
  to the Yen or the Yuan
• The exchange rate is the price of the foreign
  currency
• The exchange rate is the amount of the domestic
  currency that one unit of the foreign currency is
  worth
• Its symbol is E
• Example if 1 is worth 1.54, then E 1.54

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Definitions of Exchange Rates

• Exchange rates allow us to show the price of a
  good or service in any currency.
• What is the price of a Honda Accord?
• 3,000,000
• Or, 3,000,000 x 0.0098 29,400
• Because 1 is assumed to be worth 0.0098 E
  0.0098

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Depreciation and Appreciation

• Depreciation is a decrease in the (exchange)
  value of a currency (relative to another
  currency).
• A depreciated currency is less valuable (less
  expensive) and therefore can be exchanged for
  (can buy) a smaller amount of foreign currency.
• Appreciation is an increase in the (exchange)
  value of a currency (relative to another
  currency).
• An appreciated currency is more valuable (more
  expensive) and therefore can be exchanged for
  (can buy) a larger amount of foreign currency.

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Depreciation and Appreciation

• Example
• 1 used to be worth 1.
• Now 1 is worth 1.46.
• The euro is now more valuable. It has
  appreciated.
• So, the dollar is less valuable. It has
  depreciated.
• E has increased from 1.00 to 1.46

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Depreciation and Appreciation

• As E is the value of the euro in dollars,
• E? means appreciation of the euro (and
  depreciation of the dollar)
• E? means depreciation of the euro (and
  appreciation of the dollar)

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Depreciation and Appreciation Example

• Suppose the foreign currency is the Japanese yen
• Then E is the dollar value of the yen
• Suppose E increases from 0.0098 to 0.0100.
• A Honda Accord costs 3,000,000. What is it in
  dollars?
• Suppose E 0.0098
• 3,000,000 ? 0.0098 29,400
• Suppose E 0.0100
• 3,000,000 ? 0.0100 30,000
• E? makes foreign goods more expensive

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Depreciation and Appreciation (cont.)

• A depreciated currency is less valuable, and
  therefore it can buy fewer foreign-made goods.
• When our currency depreciates
• imports are more expensive for us, and conversely
• domestically produced goods are less expensive
  for foreigners.
• A depreciated currency lowers the price of
  exports relative to the price of imports.

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Depreciation and Appreciation (cont.)

• Suppose E decreases from 0.0098 to 0.0090.
• How much does a Honda cost? 3,000,000
• 3,000,000 x 0.0098 29,400
• 3,000,000 x 0.0090 27,000
• An appreciated currency is more valuable, and
  therefore it can buy more foreign-made goods.
• An appreciated currency means that imports are
  less expensive and domestically produced goods
  and exports are more expensive.
• An appreciated currency raises the price of
  exports relative to the price of imports.

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How are exchange rates determined?

• The exchange rate (E) is a price
• It may be the price of one currency in units of
  another, but it is a price nevertheless
• And people buy and sell currencies just like they
  trade goods and services
• So, the familiar theory of supply and demand can
  be used to explain what determines the exchange
  rate and what makes the exchange rate fluctuate

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The Foreign Exchange Market

• The main participants
• Commercial banks and other depository
  institutions their transactions involve
  buying/selling of bank deposits in different
  currencies for their clients.
• Non bank financial institutions (pension funds,
  insurance funds) may buy/sell foreign assets.
• Private firms they conduct foreign currency
  transactions to buy/sell goods, assets or
  services.
• Central banks conduct official international
  reserves transactions.
• Private individuals, such as tourists

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In which country should you keep your savings?

• This chapter focuses on currency trades that are
  motivated by our constant search for a good
  return on our savings
• If you think that your savings would grow fastest
  in a European bank, you will need to
• Turn your US dollars into euros
• Deposit your euros in a European bank
• Such trades represent supply and demand in
  currency markets

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Where would you keep a dollar?

• In an American bank

• In a European bank

• Deposit dollar in bank
• A year later, the bank gives you your dollars
  back with interest
• You want R, the domestic interest rate to be high

• Buy euros with dollar
• You want E to be low
• Deposit euros in bank
• A year later, the bank gives you your euros back
  with interest
• You want R, the foreign interest rate to be high
• Sell the euros and get dollars
• Now, you want E to be high

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Where would you keep a dollar?

• In an American bank

• In a European bank

• Deposit dollar in bank
• A year later, the bank gives you your dollars
  back with interest
• You want R, the domestic interest rate, to be
  high

• Buy euros with dollar
• You want E to be low
• Deposit euros in bank
• A year later, the bank gives you your euros back
  with interest
• You want R, the foreign interest rate, to be
  high
• Sell the euros and get dollars
• Now, you want E to be high

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The Demand for Foreign Currency Assets

• The rate of return on a bank deposit denominated
  in the domestic currency is simply the domestic
  interest rate on bank deposits, R.
• The rate of return on a bank deposit denominated
  in the foreign currency is
• the foreign interest rate on bank deposits, R,
  plus
• the expected rate of appreciation of the foreign
  currency (relative to the domestic currency).

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The Demand for Foreign Currency Assets

• Suppose the interest rate on a dollar deposit is
  2.
• R 0.02
• Suppose the interest rate on a euro deposit is
  4.
• R 0.04
• Does a euro denominated deposit yield a higher
  expected rate of return?
• Should you expect your savings to grow faster if
  you exchange your US dollars for Euros and
  deposit them in a European bank?
• Not necessarily!
• The higher interest rate is not the decisive
  factor

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The Demand for Foreign Currency Assets

• Suppose today 1 1 that is, E 1.
• Suppose the exchange rate expected one year in
  the future is 0.97 1 that is, Ee 0.97.
• This means that the euro is expected to
  depreciate by 3 (0.97 1.00)/1.00 0.03.
• In general, the expected rate of increase in E
  is

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The Demand for Foreign Currency Assets

• Again, suppose todays exchange rate is 1 for
  1 that is, E 1.
• Suppose the rate expected one year in the future
  is 0.97 for 1 that is, Ee 0.97.
• 100 can be exchanged today for 100.
• These 100 will yield 104 after one year, as the
  interest rate on euro deposits is 4 (R 0.04).
• These 104, when received a year in the future,
  are expected to be worth 0.97 ? 104 100.88.

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The Demand for Foreign Currency Assets

• So, 100 becomes 100.88 after one year if you
  keep the money in a European bank (that is, in
  Euro denominated assets)
• The rate of return in terms of dollars from
  investing in euro deposits is (100.88
  100)/100 0.0088.
• 0.04 -0.03 0.01 0.0088
• Note that the rate of return on a euro deposit is
  approximately equal to
• the interest rate on euro deposits R, plus
• the expected appreciation of the euro (Ee E)/E

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The Demand for Foreign Currency Assets

• Therefore, the dollar rate of return on Euro
  denominated deposits approximately equals
• the interest rate on euro deposits, R
• plus the expected rate of appreciation on euro
  deposits (Ee E)/E. This is

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Lets compare domestic and foreign rates of
return!

• We have already calculated that your money will
  grow at the annual rate of 0.01 if you keep it in
  a euro bank account (or, in euro-denominated
  assets)
• Lets compare this rate of return with the rate
  of return from a domestic bank deposit, R.
• This rate of return is simply the US interest
  rate 0.02
• The euro deposit has a lower expected rate of
  return all investors will prefer dollar deposits
  and none will hold euro deposits.
• So, even though the foreign interest rate is
  higher, your savings can be expected to grow
  faster in the US!

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The Demand for Foreign Currency Assets
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The Market for Foreign Exchange

• The foreign exchange market is in equilibrium
  when deposits in all currencies offer the same
  expected rate of return.
• This condition is called interest parity

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The Market for Foreign Exchange (cont.)

• Suppose interest parity did not hold.
• Suppose R gt R (Ee E)/E.
• Then no investor would want to hold Euro deposits
• This would drive down the demand for and the
  price of Euros (E?).
• All investors would want to hold dollar deposits,
  driving up the demand for and the price of
  dollars (E?).
• This will increase the right side until equality
  is achieved.

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The Demand for Foreign Currency Assets

• R R (Ee E)/E

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The Market for Foreign Exchange (cont.)

• How do changes in the current exchange rate
  affect expected returns in foreign currency
  deposits?
• If E?, or Ee?, or R?, then the rate of return on
  euro bank deposits ?.
• Therefore, for equilibrium to be maintained, R?.

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The Market for Foreign Exchange (cont.)

• What can the market for foreign exchange tell us
  about exchange rates?
• If R?, or Ee?, or R?, then E?.

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Value of the Euro (E)

• Therefore, E must ? if
• R?
• R?
• Ee?