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EXCHANGE RATES

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Title: EXCHANGE RATES


1
CHAPTER 13 EXCHANGE RATES AND THE FOREIGN
EXCHANGE MARKET AN ASSET APPROACH
2
International transactions require exchanging
domestic currencies with foreign currencies. The
price of one currency in terms of the another is
called the exchange rate. Examples from the
WSJ
3
EXCHANGE RATES AND INTERNATIONAL TRANSACTIONS Exc
hange rates help us to compare the prices of
goods and services produced in different
countries. Example Exchange rates can be
reported in two ways. 1. Direct (American) term
US/foreign currency unit e.g. .5122/DM 2.
Indirect (European) term foreign currency
units/US e.g. 1.9524 DM/US
4
Exchange Rate Appreciations and
Depreciations Using the first definition, when
the exchange rate E(/DM) goes up, the US
depreciates. If E(/DM) goes down, the US
appreciates. An appreciation of the US makes
the US goods more expensive for foreigners and
reduces US exports. Likewise, foreign goods
become cheaper for US residents. Example Deprec
iation of the US increases US exports and
reduces US imports.
5
THE FOREIGN EXCHANGE MARKET The term foreign
exchange includes bank deposits denominated in a
foreign currency, foreign currency itself (bills
and coins), and other short-term claims on
foreigners expressed in foreign currencies. The
Major Participants in the Foreign Exchange
Market 1. Commercial Banks 2. Corporations 3.
Nonbank Financial Institutions 4. Retail
Customers 5. Foreign Exchange Brokers 6. Central
Banks
6
Characteristics of the Market Foreign exchange
trading takes place in many financial
centers. Most active centers London, New York,
Tokyo, Frankfurt, and Singapore. Daily value
Close to 2 trillion The financial centers are
integrated over 24 hours Financial integration
implies that there can be no significant
difference between the US/DM rate quoted in NY
at 900 AM and the US/DM rate quoted in London
at 300 PM. If there is, arbitrage would
eliminate the difference. Example Vehicle
Currency
7
SPOT RATES AND FORWARD RATES When parties agree
to exchange one currency with another
immediately, the resulting trade is an
on-the-spot trading and the resulting rate is
the spot exchange rate. (The term spot, however,
is somewhat misleading.) If the foreign exchange
deal specifies a value date of 30 days, 90 days,
180 days, or even several days, the exchange rate
quoted is called the forward exchange
rate. Look at the WSJ for forward and spot
exchange rates. Question Why would anyone buy
and sell currencies in the forward foreign
exchange market?
8
Forward Premium Foreign Exchange Swaps A swap
contract is a spot sale of a currency combined
with a forward repurchase of the currency.
Example The swap rate is equal to F - e e
( i - i) where F is the forward rate, e is the
spot exchange rate, i is the domestic interest
rate, and i is the foreign interest rate.
9
Futures and Options A futures contract is a
promise that a specified amount of foreign
currency will be delivered on a specified date in
the future. The contracts are offered through
IMM. A futures contract differs from a forward
contract. (One has to fulfill a forward contract
but can sell a futures contract at a profit or
loss.) A foreign exchange option gives its
owner the right to buy or sell a specified
amount of foreign currency at a specified price
at any time up to a specified expiration date.
10
THE DEMAND FOR FOREIGN CURRENCY ASSETS To
understand how exchange rates are determined, we
first must know how the demand for different
currencies are determined. The two most
important factors determining the demand for
foreign currencies are the interest paid on
foreign deposits and the expected change in the
currencys exchange rate. These factors play a
very important role in determining the value of
the exchange rate.
11
Exchange Rates and Asset Returns Suppose you want
to compare the expected rate of return on dollar
deposits versus DM deposits. If the interest
rate in the U.S. is 6, the expected return on
U.S. deposits will be 6. Suppose you want to
deposit your money in Germany for a year and
bring it back to the U.S. In this case you need
to calculate the dollar rate of return of DM
deposits. To calculate the dollar rate of return
on DM deposits, you need the following
information the interest rate on DM deposits,
the spot exchange rate, and the expected spot
exchange rate one year from now. Example
12
A Simple Rule The dollar rate of return on DM
deposits can be calculated by using the following
formula Return, Risk and Liquidity in the
Foreign Exchange Market Risk and return are also
important factors in determining asset demand.
To simplify our analysis we will assume that
foreign currencies do not differ in terms of risk
and liquidity
13
EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET The
foreign exchange market is in equilibrium when
deposits of all currencies offer the same
expected rate of return. Interest Rate Parity
The Basic Equilibrium Condition The condition
that the expected returns on deposits of any two
currencies are equal when measured in the same
currency is called the interest parity condition,
which is expressed as follows
14
If the expected return on dollar deposits expected return on DM deposits, then there will
be an excess supply of dollar deposits and an
excess demand for DM deposits. This will
depreciate the dollar as the dollar investors
shift their deposits into DMs. Example How
Changes in the Current Exchange Rate Affect
Expected Returns How does a change in the
current spot exchange rate, all else held
constant, affect the expected return on DM
deposits? Example Conclusion A fall in
todays US/DM exchange rate (an appreciation of
the dollar against the DM) always increases
the expected dollar return on DM deposits.
15
Figure The Equilibrium Exchange Rate Exchange
rate always adjusts to maintain interest rate
parity. Figure
16
INTEREST RATES, EXPECTATIONS, AND EQUILIBRIUM 1.
The effect of a change in the US interest rates
on the exchange rate When U.S. interest rates
fall, E(/DM) increases (i.e., the
US depreciates). Figure 2. The effect of a
change in expectations on the exchange rate
When the US is expected to depreciate, E(/DM)
increases (i.e., the US depreciates). Figure
17
3. The effect of a change in German interest
rates on the exchange rate When German interest
rates rise, E(/DM) increases (i.e., the US
depreciates). Figure

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