LECTURE 2: Exchange Rates

1
LECTURE 2 Exchange Rates Currency Markets
(Krugman Obstfeld International Macro Theory
and Policy, ch. 13)

• The (nominal) exchange rate is the price of 1
  unit of foreign exchange
• Example on June 30, 2002 1.53/1 (USD/GBP)
• Exchange rates and relative prices
• appreciation US PM down, PX up
• depreciation US PM up, PX down
• A stronger dollar makes exports less competitive
  and imports cheaper
• A weaker USD brings imported inflation (How?)

2
The Foreign Exchange (FX) Market

• By far the biggest of all financial markets
• Average daily turnover gt 1.5 trillion
• The players commercial banks, corporations,
  non-banks (pension funds, investment banks) and
  central banks
• FX trading centres Tokyo, HK/Singapore,
  Frankfurt, London, NY
• The market that never sleeps
• Spot versus forward exchange rates
• Derivatives markets futures and options

3
Asset Returns, Interest Rates and Risk

• Nominal rates of return nominal interest rates
  i performance in money terms
• definition P(t)-P(t-1)/P(t-1) x 100
• Real rates of return performance in real terms
  r
• Ex ante (expected inflation) versus ex post
  (realized inflation)
• Risk Expected ?? Realized (actual) return
• Price risk the risk that prices move over time
• Liquidity risk the risk that you cannot sell
• Political risk
• Credit risk (for bonds) defaultdowngradelegal

4
Managing (hedging) risk using financial
derivatives markets

• Impact of Hedging on the Expected Cash Flows of
  the Firm

5
Exchange rate equilibrium using INTEREST RATE
PARITY

• Assume that international investors care only
  about expected rates of return they are
  risk-neutral
• Expected rates of return, in , of investing in
  and over the same time period are equal when
• R R (Ee/- E/)/E/
• For example R10, R5 and (Ee/- E/)/E/
  5, the expected depreciation of the dollar
• Now, fixing Ee/ at, say, 1.05 /, and R at,
  say, 5 we get an inverse relationship between
  todays exchange rate E/ and R (Ee/-
  E/)/E/
• If we then also know the fixed US dollar interest
  rate R we can find the equilibrium exchange rate
  when is true. This mechanism is known as
  interest rate parity.

6
Example The equilibrium / exchange rate
E/
2
1
Expected return on euro deposits
3
R
Rates of return in dollars
7
How does equilibrium change over time?

• Remember the expected future Ee/ exchange rate
  level is fixed for now (so expected depreciation
  also)
• Changing stance of US monetary policy
• R rises vertical shifts right -gt appreciates
  now ( depreciates)
• R falls vertical shifts left -gt depreciates
  now ( appreciates)
• Changing stance of the euro-zones monetary
  policy
• R rises sloping line shifts out -gt
  appreciates now ( depreciates)
• R falls sloping line shifts in -gt depreciates
  now ( appreciates)
• Now suppose that currency market sentiment
  changes Ee/ can vary
• Ee/ rises sloping line shifts out -gt
  depreciates now
• Ee/ falls sloping line shifts in -gt
  appreciates now

8
Interest Rate Differential between Dollar- and
Peso-Denominated Deposits in Argentina (basis
points 1/100 of a percent)

• Interest Differential on Dollar- and
  Peso-Denominated Deposits in Argentina (basis
  points 1/100 of a percent)

9
Summary (and caveat)

• Interest rates and exchange rates can be closely
  linked in the short term (lt1 year)
• Exchange rates are very difficult to forecast
• Random walks may perform better than
  macroeconomic models
• Risk was not included. In reality investors are
  risk-averse prefer less risk w/same Ereturn
• We need risk premia (p), especially for emerging
  markets, to capture political risk etc
• R - R (Ee/- E/)/E/ p
• Be careful about interpreting the sign of p !