Determinants

1

• Determinants
• of the Exchange Rate

2
Determinants of the Exchange Rate

• Under a flexible rate system, the exchange rate
  is determined by supply and demand.
• The dollar demand for foreign exchange originates
  from American demand for foreign goods, services,
  assets (real or financial).
• The supply of foreign exchange originates from
  sales of goods, services, assets from Americans
  to foreigners.
• The foreign exchange market brings the quantity
  demanded and quantity supplied into balance.
• As it does so, it brings the purchases by
  Americans from foreigners into equality with the
  sales of Americans to foreigners.

3
Foreign Exchange Market Equilibrium

• The dollar price of the English pound is
  measured on the vertical axis. The horizontal
  axis indicates the flow of pounds to the
  foreign exchange market.

Dollar price of foreign exchange(for pounds)

• The demand and supply of pounds are in
  equilibrium at the exchange rate of 1.50 1
  English pound.

• At this price, quantity demanded equals
  quantity supplied.

1.80

• A higher price of pounds (like 1.80 1
  pound), would lead to an excess supply of
  pounds ...

1.50
1.20
causing the dollar price of the pound to
fall (depreciate).

• A lower price of pounds (like 1.20 1
  pound), would lead to an excess demand for
  pounds

Quantity of foreign exchange (pounds)
Q
causing the dollar price of the pound to
rise (appreciate).
4
Changes in the Exchange Rate

• Factors that cause a currency to depreciate
• A rapid growth of income (relative to trading
  partners) that stimulates imports relative to
  exports.
• A higher rate of inflation than one's trading
  partners.
• A reduction in domestic real interest rates
  (relative to rates abroad).

5
Foreign Exchange Market Equilibrium
Dollar price of foreign exchange(for pounds)

• Other things constant, if incomes increase
  in the United States, U.S. imports of foreign
  goods and services will grow.

S(sales to foreigners)

• The increase in imports will increase the
  demand for pounds (in the foreign exchange
  market)

1.80
causing the dollar price of the pound to
rise from 1.50 to 1.80.
1.50
a
D1
Quantity of foreign exchange (pounds)
Q1
Q2
6
Inflation With Flexible Exchange Rates
Dollar price of foreign exchange(for pounds)

• If prices were stable in England while the
  price level in the U.S. increased by 50 percent
  

S1
the
U.S. demand for British goods (and
pounds) would increase
2.25

as U.S. exports to Britain would be
relatively more expensive they would decline
and thereby cause the supply of pounds to
fall.
1.50
a

• These forces would cause the dollar to
  depreciate relative to the pound.

D1
Quantity of foreign exchange (pounds)
Q1
7
Changes in the Exchange Rate

• Factors that cause a currency to appreciate
• A slower growth rate relative to ones trading
  partners.
• A lower inflation than one's trading partners.
• An increase in domestic real interest rates
  (relative to rates abroad).

8
Growth of Trade and Foreign Exchange Transactions
9
Exchange Rates and Asset Prices
Exchange rates are determined by the relative
supplies and demands for currencies. Since buyers
and sellers are ultimately interested in
purchasing something with the currency - goods,
services, or investments - their prices and
returns must indirectly influence the demand for
a given currency. So far, we have focused on the
relationship between exchange rates and the
demand and supply of goods and services. Now we
turn to the prices that determine the demand for
assets - their returns.
10
Law of One Price for Assets
Assume Absent frictions, identical goods must
trade for identical prices in different countries
when converted into a common currency. The same
condition should hold for assets. One important
difference between goods and assets Price is
not paid immediately - it is paid over time in
the form of returns. This introduces the primary
friction for exchanging assets - a friction not
found in goods.
Risk
11
Law of One Price for Assets
Hence, there must exist a corresponding version
of the Law of One Price for assets which requires
returns to be identical across countries once
this friction has been removed Covered Interest
Parity Covered Interest Parity requires
frictionless markets to offer identical rates of
returns for identical assets.
12
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries. c. Receive an n-period foreign
currency return of 1Rt,tn. d. Eliminate the
currency risk of the foreign return by locking
in an exchange rate of Ft,tn (/FC).
13
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries. c. Receive an n-period foreign
currency return of 1Rt,tn. d. Eliminate the
currency risk of the foreign return by locking
in an exchange rate of Ft,tn (/FC). e. Obtain
an overall n-period return of Ft,tn
(1Rt,tn) st
14
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn
(1Rt,tn) st
Cooked example Rt,tn 5 Rt,tn 4 st
2 / FC What is Ft,tn ?
15
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn (1Rt,tn)
st
Cooked example Rt,tn 5 Rt,tn 4 st
2 / FC What is Ft,tn ? 1Rt,tn Ft,tn
(1Rt,tn) st
16
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn
(1Rt,tn) st Cooked
example Rt,tn 5 Rt,tn 4 st 2 /
FC What is Ft,tn ? 1.05 Ft,tn
(1Rt,tn) st
17
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn
(1Rt,tn) st Cooked
example Rt,tn 5 Rt,tn 4 st 2 /
FC What is Ft,tn ? 1.05 Ft,tn
1.04 st
18
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn
(1Rt,tn) st Cooked
example Rt,tn 5 Rt,tn 4 st 2 /
FC What is Ft,tn ? 1.05 Ft,tn
1.04 2 / FC
19
Covered Interest Parity
Covered Interest Parity maintains that the
returns from strategies 1 and 2 will always be
equal 1Rt,tn Ft,tn
(1Rt,tn) st Cooked
example Rt,tn 5 Rt,tn 4 st 2 /
FC What is Ft,tn ? 1.05 Ft,tn
1.04 2 / FC Ft,tn 2.02 / FC
- Investors in R require a guaranteed currency
appreciation to compensate for lower interest
rate.
20
Real Example
Not so long ago, 90-day U.S. and Japanese
Treasury Notes had the following returns RUS
5.03 RJ 3.77 The spot exchange rate was
st .008585 / Yen. What was the 90-day forward
exchange rate F? .008689 / Yen. Investors
demanded less compensation for holding
Yen-denominated returns since they expected the
Yen to appreciate.
21
Uncovered Interest Parity
The Forward exchange rate is what the market
expects the future spot exchange rate to
be Ft,tn E (stn ). If the market has
rational expectations, then it should predict
the future spot accurately (on average) Ft,tn
E (stn) stn This is know as the Unbiased
Forward Hypothesis. Does the market have rational
expectations? Robert Lucas said yes and won a
prize (Nobel).
22
Uncovered Interest Parity
If so, this implies that an unhedged version of
covered interest parity should hold as well.
23
Uncovered Interest Parity
If so, this implies that an unhedged version of
covered interest parity should hold as well.
If this is the case 1Rt,tn
E(st,tn)(1Rt,tn) st
24
Uncovered Interest Parity
If so, this implies that an unhedged version of
covered interest parity should hold as well.
On average 1Rt,tn st,tn (1Rt,tn)
st
25
Uncovered Interest Parity
If so, this implies that an unhedged version of
covered interest parity should hold as well.
On average 1Rt,tn st,tn (1Rt,tn)
st Which can be closely
approximated by the Uncovered Interest Parity
equation Rt,tn - Rt,tn D st,tn.
26
Uncovered Interest Parity
Example (cooked) If British short-term interest
rates are 5, German short-term interest rates
are 10, and the current exchange rate is 0.5 P/
Euro, what will be the Pound/Euro exchange rate
one year from now? Rt,tn - Rt,tn D
st,tn. The Euro should depreciate by 5 to 0.475
P / Euro. Also, the one-year forward exchange
rate better be 0.475 P / Euro
27
To Review Exchange Rate Arbitrage
Two kinds of Arbitrage 1. Riskless arbitrage
will ensure Covered Interest Parity 1Rt,tn
Ft,tn(1Rt,tn)/st or Rt,tn - Rt,tn
Ft,tn - st If difference between forward and
spot rates do not equal differences in interest
rates, arbitrageurs will make money every time -
relationship holds instantaneously and therefore
is risk-free.
28
Exchange Rate Arbitrage
2. Risky arbitrage should ensure A. Forward rate
is unbiased - it differs from spot by expected
exchange rate changes Ft,tn - st
E(?st,tn), B. That these expectations are
rational E(?st,tn) ?st,tn C. So that
Uncovered Interest Parity holds on average
Rt,tn - Rt,tn Ft,tn - st E(?st,tn)
?st,tn
29
Exchange Rate Arbitrage
2. Risky arbitrage should ensure A. Forward rate
is unbiased - it differs from spot by expected
exchange rate changes Ft,tn - st
E(?st,tn), B. That these expectations are
rational E(?st,tn) ?st,tn C. So that
Uncovered Interest Parity holds on average
Rt,tn - Rt,tn Ft,tn - st E(?st,tn)
?st,tn Differences between interest rates
forecast exchange rate changes.
30
Exchange Rate Arbitrage
2. Risky arbitrage should ensure A. Forward rate
is unbiased - it differs from spot by expected
exchange rate changes Ft,tn - st
E(?st,tn), B. That these expectations are
rational E(?st,tn) ?st,tn C. So that
Uncovered Interest Parity holds on average
Rt,tn - Rt,tn Ft,tn - st E(?st,tn)
?st,tn Differences between interest rates
forecast exchange rate changes. Why?
31
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt D st,tn) arbitrageurs
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars). 3. Deposit in the
high-interest rate currency. 4. Convert back to
repay low-interest rate loan at an
insufficiently appreciated exchange rate. 5.
Earn a profit - on average - of RUSt,tn -
RJt,tn - ?st,tn
32
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn Example RUS
5.03 RJ 3.77 st .008585 /
Yen. Ft,tn says Yen should appreciate to
.008689 / Yen. But if, on average, stn st,
can a speculator can make profits, on average? Of
course By borrowing in Yen at 3.77, depositing
in Dollars at 5.03, and converting after 1 year
back into yen at the same exchange rate. This
will earn - on average - 1.26 on a zero-wealth
investment.
33
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects 1. Increase demand for dollars
currency at time t - causing st (/Yen) to
decline. 2. Increase demand for U.S. deposits -
causing RUSt,tn to decline. 3. Increase
demand for Japanese borrowing - causing RJt,tn
to increase. 4. Increase demand for Yen at time
tn - causing stn to increase.
34
Key International Relationships
35
Key International Relationships
Relative Inflation Rates
Exchange Rate Change
36
Key International Relationships
RPPP P - P Ds Inflation differentials are
offset by changes in spot exchange rate.
Relative Inflation Rates
Exchange Rate Change
37
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Exchange Rate Change
38
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Forward Exchange Premium
39
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
CIP Ft,tn - st R - R Forward differs from
spot by interest rate differential
Forward Exchange Premium
40
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Covered Interest Parity
Forward Exchange Premium
41
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Covered Interest Parity
Forward Exchange Premium
42
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Ft,tn - st E(Dst,tn)
Forward differs from spot by expected change in
spot
Covered Interest Parity
Forward Exchange Premium
43
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
44
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
45
Key International Relationships
Fisher Effect 1R (1r)(1E(P)) Nominal
interest rate equals real rate plus expected
inflation
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
46
Key International Relationships
1R (1r)(1E(P))
Relative Inflation Rates
R - R E(P) - E(P) With RIP, interest rates
reflect expected inflation differential.
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
47
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
48
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Forward Exchange Premium
Ft,tn - st R - R
49
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Forward Exchange Premium
Ft,tn - st R - R
Ft,tn - st E(Dst,tn)
50
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Uncovered Interest Parity R - R Ds Exchange
rate changes offset interest differentials
Relative Interest Rates
Exchange Rate Change
Forward Exchange Premium
Ft,tn - st R - R
Ft,tn - st E(Dst,tn)
51
Key International Relationships
Relative Inflation Rates
1R (1r)(1E(P))
R - R E(P) - E(P)
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
52
Key International Relationships
Relative Inflation Rates
1R (1r)(1E(P)) R - R E(P) - E(P)
P - P Ds
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
53
Key International Relationships
Relative Inflation Rates
1R (1r)(1E(P)) R - R E(P) - E(P)
P - P Ds
Uncovered Interest Parity R - R Ds Exchange
rate changes offset interest differentials
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
54
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Uncovered Interest Parity
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Premium
55
Key International Relationships
These relationships are at the heart of
international financial management. They are
used in many dimensions of a multinationals
operations. 1. Deciding which currency to borrow
or lend in. 2. Determining an appropriate project
rate of return. 3. Analyzing a firms foreign
exchange exposure. 4. etc...