Loading...

PPT – Exchange Rates PowerPoint presentation | free to view - id: 1f4e0-MjFlZ

The Adobe Flash plugin is needed to view this content

Exchange Rates

- Antu Panini Murshid

Todays Agenda

- Nominal vs. real exchange rate
- Asset market approach
- Uncovered interest rate parity

Currencies and Exchange Rates

- Each country has a currency in which the prices

of goods and services are quoted - An exchange rate is the price of one currency in

terms of another. This is sometimes called the

nominal exchange rate

Exchange Rate Quoting

- An exchange rate can be quoted in two ways
- Direct (American) terms and indirect (European)

terms - In this course we will always (unless otherwise

stated) quote the exchange rate in direct terms

Direct Terms

- Price of foreign currency in terms of national

currency - How many units of national currency do we need to

buy a unit of foreign currency - Example /, /
- Todays dollar-euro exchange rate is 1.07384 per

euro

Indirect Terms

- Price of national currency in terms of foreign

currency - How many units of foreign currency do we need to

buy a unit of national currency - Example /, /
- Todays euro-dollar exchange rate is 0.931015

per USD

Appreciation and Depreciation of a Currency

- A depreciation of the dollar against the euro

means that the price of a euro in terms of

dollars has gone up - An appreciation of the dollar against the euro

means that the price of a euro in terms of

dollars has gone down

Appreciation and Depreciation of a Currency

- If the dollar depreciates against the euro this

must mean that the euro has appreciated against

the dollar - If the dollar appreciates against the euro this

must mean that the euro has depreciated against

the dollar

Appreciation and Depreciation of the Exchange Rate

- An exchange rate depreciation means the domestic

currency has depreciated and an exchange rate

appreciation means the domestic currency has

appreciated - If the exchange rate depreciates then e?
- If the exchange rate appreciates then e?

Example

- If the / exchange rate moves from e1.00 to

e.95. - exchange rate has appreciated by 5
- Dollar has appreciated against the euro by 5 (it

now cost 0.95 as opposed to 1 to buy 1) and

the euro has depreciated against the dollar by

approximately 5 (it now costs 1.05 to buy 1)

Real Exchange Rate

- Suppose a car in UK costs 30,000, if e1.50,

then dollar price is 45,000, i.e. the price of

foreign goods in terms of domestic currency is

ePf - Suppose the same car in the US costs 36,000,

then the price of the foreign car in terms of the

price of domestic cars is ePf/P1.25

Real Exchange Rate

- The real exchange rate (?) gives the price of a

unit of a foreign goods, in terms of the price of

domestic goods - That is ? ePf / P, where P is the domestic

price level and Pf is foreign price level

Real Exchange Rate Appreciation/Depreciation

- If ?? we say that the real exchange rate has

depreciated - ?? if either e? P? or Pf?
- If ?? we say that the real exchange rate has

appreciated - ?? if either e? P? or Pf?

Competitiveness

- If the real exchange rate depreciates, the price

of foreign goods relative to the price of

domestic goods increases and exports become more

competitive while imports become more expensive - If the real exchange rate appreciates, the price

of foreign goods relative to the price of

domestic goods decreases and exports become less

competitive while imports become cheaper

Foreign Exchange Market

- Players in the foreign exchange market
- Commercial banks, large corporations, non-bank

financial institutions, central banks - Commercial banks are by far the largest players

in the foreign exchange market. However large

corporations like IBM and GE also engage in

significant transactions. Another groups of

important players are central banks

Foreign Exchange Market

- Characteristics of the market
- The main markets are London, New York, Tokyo
- Daily global value of forex trading 1.7 trillion
- vehicle currency

Determination of the Spot Exchange Rate

- What determines the exchange rate?
- Demand and supply
- What factors might affect demand and supply?
- Inflation rates?
- Trade deficits?
- Demand for assets?

Expected Returns

- Expected rate of return
- Risk and liquidity
- We will abstract from risk and liquidity for now

and assume that these characteristics are the

same across different assets. If this is the

case, we will prefer to hold assets offering the

highest expected rate of return

How Do We Compare Returns on Various

International Assets?

- -assets pay returns in dollars
- -assets pay returns in euros
- In order to compare these returns, we need to

measure all returns in terms of one currency

How Do We Compare Returns on Various

International Assets?

- But why does it matter, isnt 5 interest in the

US just the same as 5 in Germany? - Nobecause the exchange rate between dollar and

the euro may change

Example

- Suppose the / exchange rate is 1.00
- The interest rate in the US is 10
- The interest rate in Germany is 5
- Expect / exchange rate to be 1.10
- Which asset offers the highest rate of return?

Example

- Gross return on 1 deposited at a US bank is

1.10 - What is the gross return on 1 deposited in a

German bank?

Example

- 1. Convert dollars to euros
- 1? 1
- 2. Invest in Germany
- Gross return 1.05
- 3. Convert back to dollars
- 1.05 ? 1.15
- Return on -asset is 15 ifE(De)

Equilibrium Exchange Rate

- If the rate of return on dollar assets is greater

than the dollar rate of return on euro assets

there will be an excess demand for dollar assets - If the rate of return on dollar assets is less

than the dollar rate of return on euro assets

there will be an excess demand for euro assets - Only when the rate of return on dollar assets is

equal to the rate of return on euro assets will

the exchange rate be in equilibrium

Uncovered Interest Rate Parity Condition

- The UCIP condition states that the return to

investing in domestic assets must equal the

expected return on investing in foreign assets

(when the returns are measured in the same

currency) - i if E(?e)

Example UCIP Holds

- i 10 (US rate), if 5 (German rate), et

1.00 (/) and E(et1) 1.05 - Expected return to a 100 investment in

-denominated German asset is - 1. Convert to 100/e 100
- 2. Receive 105 in 1 year
- 3. Covert back to (105 )1.05 110
- UIPC holds

Example UCIP Doesnt Hold

- i 10 (US rate), if 8 (German rate), et

1.00 (/) and E(et1) 1.05 - Expected -return in -denominated German asset

is 8513 gt 10 (-return on US asset) - Demand for -deposits/assets ?
- depreciates immediately (e?) e 1.03.
- Since E(et1) 1.05, E(?e)2
- Hence E(?e)if8210i

Example UCIP Doesnt Hold

- Suppose now instead that the domestic interest

rate increases such that i 12 (US rate). If

if 5 (German rate), et 1.00 (/) and

E(et1) 1.05, then the demand for US assets

increases and the dollar appreciates to et

0.98. Thus E(?e)7, so UCIP is again restored

-Return on Foreign Assets and the Exchange Rate

/ e

1.10

Expected -return on assets

1.05

1.00

0.95

5

0

10

15

-rate of return on assets

Equilibrium Exchange RateGraphical Representation

/ e

Rate of return on dollar assets

e2

UIPC holdsequilibrium exchange rate

e1

Expected return on assets

e3

-rate of return on assets

Effect of an Increase in Domestic Interest Rates

/ e

Original equilibrium

New equilibriumthe exchange rate appreciates

today and UCIP is restored

Domestic interest rate increases

e1

e2

Expected return on assets

i1

i2

-rate of return on assets

Effect of an Increase in Foreign Interest Rates

/ e

New equilibrium

Original equilibrium

e2

Foreign interest rate increases

e1

Expected return on assets

i

-rate of return on assets

Effect of a Change in Expectations

/ e

New equilibrium

Original equilibrium

e2

Rise in expected future price of euros

e1

Expected return on assets

i

-rate of return on assets