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The Foreign Exchange Market

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Title: The Foreign Exchange Market


1
The Foreign Exchange Market
2
Some recent movements
  • In the text, they discuss the US/Euro exchange
    rate, and how it has moved.
  • The euro was introduced at 1.16/ but fell to
    0.895/ by 2001. By 2004 it was back up to
    1.30/ then it fell again slightly by March
    2004.
  • The Canadian/US exchange rate has also shown a
    lot of movement.

3
  • From Jan 05 to Dec 06 the Can/US dollar has moved
    from less than 80 cents to almost 91 cents

4
  • Monthly exchange rates look smoother.
  • Going back to 2000, the variation is even wider,
    from 0.625 to 0.90.

5
Dollar variability
  • Currencies vary widely in value over time.
  • The US dollar has shown weakness from time to
    time, but has so far maintained its position as
    the world reserve currency.
  • The dependence of countries on export-driven
    growth policies help the US dollar.
  • Investment into the US both supports the dollar
    and attests to world confidence in its future
    growth

6
The Exchange Rate
  • The exchange rate is the price of one currency in
    terms of another currency.
  • Example US/ measures how many US it takes to
    buy one Euro.
  • The value of the exchange rate may be fixed (like
    any fixed price), but in many countries it is
    determined by the demand and supply of currency

7
The market
  • The worldwide network of markets and
    institutions that handle the exchange of foreign
    currencies is known as the foreign exchange
    market .
  • There are two main components to the market.
  • the spot market is where current transactions for
    immediate delivery of currency take place
  • the forward and futures markets are where
    transactions for future delivery of currency take
    place.

8
The Basic Foreign Exchange Market
  • Like any market, there is a demand side and a
    supply side to foreign exchange

9
Demand for Foreign Currency (3 types)
  • 1. Demand for goods, services or immediate
    purchases, gifts
  • goods and services from another country
  • demand for currency to send a gift to another
    country
  • demand for currency to pay foreign factors
  • pay investors
  • pay international workers

10
Demand for Foreign Currency (foreign exchange)
  • 2. Demand for financial assets
  • buy stocks from another country
  • buy bonds from another country
  • open a bank account in another country
  • buy a business in another country

11
Demand for Foreign Exchange (3 types)
  • 3. Hedging and speculation
  • If you need to pay a foreign seller in the near
    future, you may buy foreign currency now if you
    are worried that its value will rise by the time
    the payment is due. (hedging)
  • If you want to make a profit off the change in
    value, you may buy the currency today to sell the
    currency tomorrow at a higher value (speculation)

12
The Demand for Foreign currency
  • The sum of the three demands constitute the
    demand for foreign currency
  • These demands correspond to debit items in the
    balance of payments

13
The Supply of Foreign currency
  • The sum of the three demands constitute the
    demand for foreign currency
  • These demands correspond to debit items in the
    balance of payments

14
Supply of Foreign Currency (3 types)
  • 1. Sale of goods, services or immediate
    purchases, gifts
  • goods and services from OUR country
  • demand for OUR currency to send a gift to OUR
    country
  • supply of currency when foreign companies need to
    pay domestic factors
  • pay investors
  • pay workers working abroad

15
Supply of Foreign Currency (foreign exchange)
  • 2. Purchases of OUR financial assets
  • People from other countries
  • buy stocks from OUR country
  • buy bonds from OUR country
  • open a bank account in OUR country
  • buy a business in OUR country

16
Supply of Foreign Exchange
  • 3. Hedging and speculation
  • If a foreign seller needs to pay in Canadian
    dollars in the near future, they may buy OUR
    currency now (selling theirs) if they are worried
    that its value will rise by the time the payment
    is due. (hedging)
  • If speculators want to make a profit off the
    change in value, they may buy OUR currency today
    (selling foreign currency) to sell OUR currency
    tomorrow at a higher value (speculation)

17
The market for Foreign Exchange
  • The foreign currency market defines demand an
    supply of a foreign currency.
  • Therefore, when the demand for foreign currency
    increases, the price of foreign currency rises,
    this means
  • the value of our currency falls!
  • The following slide shows the demand and supply
    of foreign currency

18
The Basic Foreign Exchange Market
e /
S
S
eeq
D
D
Euros ()
Qeq
19
Movement in the market
  • An increase in demand for the foreign currency
    results in a rightward shift of the demand curve.
  • It now takes more domestic currency to buy the
    foreign currency.
  • Therefore, when e rises, the value of the foreign
    currency rises and the value of OUR currency
    falls. We call this an appreciation of the
    foreign currency or a depreciation of OUR
    currency in relation to the foreign currency

20
The Basic Foreign Exchange Market
e /
S
e
eeq
D
D
Euros ()
Qeq
Q
21
Increase in supply of foreign currency
  • When foreign currency supply increases, the
    supply curve shifts right
  • the price of the foreign currency falls
  • This means the value of our own currency rises,
    (our currency appreciates and the foreign
    currency depreciates)

22
The Basic Foreign Exchange Market
e /
S
S
eeq
e
D
Euros ()
Q
Qeq
23
Demand and supply and the current account
  • The demand and supply of foreign exchange can be
    broken into 2 components
  • Goods services (current account)
  • financial transactions
  • These sum to total demand and supply
  • The equilibrium exchange rate is determined by
    the total demand and supply

24
Demand and supply and the current account
  • In the following slide, the equilibrium exchange
    rate is lower than the rate needed for a current
    account balance
  • (our exchange rate would be more valuable than
    would be the case if there were only current
    account transactions)
  • Therefore, there is a current account deficit
    (shown as Q2 Q1)
  • this deficit is also the surplus in financial
    transactions. (Qeq-Q1) (Qeq-Q2)Q2-Q1

25
Demand and supply and the current account
SGS
e
STotal
eeq
DTotal
DGS
Qeq
Q2
Q1
Foreign Ex
26
Concept checks
  • The market for international currency is called
    the

27
Concept checks
  • The market for current transactions of foreign
    exchange to be delivered immediately is called..

28
Concept checks
  • The two markets for future transactions in
    foreign exchange are called

29
Concept checks
  • The three sources of demand for foreign exchange
    are

30
Concept checks
  • An increase in demand for foreign currency
    results in __________ of our currency and
    ___________________ of the foreign currency

31
Concept checks
  • If the foreign exchange rate is too high for our
    current account transaction, this means we will
    have a current account __________
    (surplus/deficit) and a capital account
    ______________ (surplus/deficit)

32
The Spot Market
  • The spot market is the day-to-day purchase and
    sale of foreign exchange
  • The largest players in the spot market are the
    commercial banks, followed by
  • Multi-national corporations
  • large nonbank financial institutions, like
    insurance companies
  • government agencies including central banks
  • (not in order of importance)

33
The Spot Market
  • Most transactions take place with crediting and
    debiting accounts
  • Therefore, the bulk of currency transactions are
    in the Interbank market
  • Transactions made by brokers who receive a small
    fee for trading
  • this is why you always lose a bit if you sell a
    currency then buy it back

34
Arbitrage
  • Arbitrage is the act of buying and selling
    something in two different markets and making a
    profit from it.
  • With many different currencies, the most common
    kind of arbitrage is triangular arbitrage
  • this occurs when an actor in the exchange market
    can use trade between three currencies to make a
    profit

35
Arbitrage
  • If I can use US dollars, sell them to buy euros,
    sell euros and buy yen, then sell yen and buy US
    dollars, and make a profit, I have succeeded at
    triangular arbitrage
  • Example
  • dollar sterling rate 1.60/
  • dollar Swiss franc rate is 0.70/Sfr
  • and Sfr/ 2 Sfr/
  • an arbitrageur would use to buy 2 francs (need
    1.40), then buy 1 then buy and make 0.20
    profit.

36
Arbitrage
  • The role of arbitrage in the market is to drive
    all rates toward equality.
  • In the previous example, the undervalued currency
    (franc-sterling price) would be pushed up, and
    the overvalued currency (dollar-sterling price)
    would be pushed down by arbitrage transactions.

37
Measures of the Spot rate
  • The spot rate is sometimes called the nominal
    exchange rate, nominal meaning in name
  • There are various kinds of information missing
    when we look at the spot rate between two
    countries, and so we build other measures to
    capture this information

38
Measures of the Spot rate
  • The missing information is
  • How does one currency value change against the
    value of currencies of all its trading partners?
  • How does the currency value change in relation to
    purchasing power, when each country may have a
    different inflation rate?

39
Measures of the Spot rate
  • First problem
  • We can measure the value of a currency against
    all of its partners by
  • building an index using a trade-weighted average
    for changes in the value of the currency.
  • This is called the Nominal Effective Exchange
    Rate (NEER)

40
Measures of the Spot rate
  • We pick a year against which to measure, and let
    this equal 1.
  • Then we see how each currency changes over time.
  • Then we find the average change, using each
    change in exchange rate times the value of
    exports and imports from that country

41
Measures of the Spot rate - example
  • Using 3 countries (partly fictitious)

42
Example
  • NEER (1.056x0.4) 0.94x 0.38 1.027x0.22
  • 1.006

43
Example.
  • In this example, the US dollar has stayed very
    stable, appreciating very slightly against its
    trading partners.
  • Note, the countries included in the basket
    matter.
  • We included only 3 largest trading partners.
  • You repeat this calculation with 5.

44
  • NEER

45
  • NEER
  • 1.006

46
The NEER
  • The NEER is good for measuring nominal changes
    against all trading partners.
  • The next problem is to take account of changes in
    prices as well as changes in nominal exchange
    rates, in order to see if the purchasing power of
    a country has changed.

47
The Real Exchange Rate (RER)
  • The real exchange rate adjusts for changes in
    prices in the two countries.
  • It is simply the exchange rate times the ratio of
    price indices (example, the consumer price index)
    for the countries
  • Example yen / dollar
  • RER2003 e/,2003 X(U.S. price index 2003)
  • (Jap. price index 2003)

48
RER
  • Using 1995 as the base year, (base year 100)
  • the Japanese price index in 2003 is 101.0
  • The US price index 2003 is 120.7
  • recall, yen/ ex rate is 115.94
  • RER115.94 x (120.7/101.0)138.55

49
RER
  • RER138.55
  • Note, the exchange rate in 1995 was 94.06
  • This means that the US dollar appreciated by 47.3
    percent from 94.06 to 138.55.
  • This means that US purchasing power has
    increased, and that US goods have become much
    more expensive relative to Japanese goods.

50
REER
  • The Real Effective Exchange Rate
  • This measures the changes in the real exchange
    rate against a weighted average of all countries.

51
Purchasing Power Parity
  • PPP (absolute) says that what we buy in one
    country should cost the same in another country,
    once you adjust for the exchange rate.
  • PPP (relative) says that if prices in the home
    country are rising faster than prices in the
    partner country, then the home country currency
    should depreciate.

52
Purchasing Power Parity
  • PPP (absolute) rarely holds.
  • PPP (relative) sometimes holds.
  • The explanations for this range from the
    influence of sticky prices (we will see later) to
    the effect of the non-traded sector and
    distribution services within a country affecting
    home prices.

53
Foreign Exchange
  • 2nd half

54
Foreign Exchange
  • Last class we talked about the exchange rate and
    the spot exchange rate.
  • At the end of class, we were introduced to the
    idea of purchasing price parity (PPP), which says
    that goods that trade should cost roughly the
    same in all countries.
  • The PPP value of a currency is the exchange rate
    that would exist if PPP held.

55
Big Mac Index
  • The Economist publishes something called The Big
    Mac Index which compares prices of Big Mac
    hamburgers
  • If the Big Mac is overpriced in a market, the
    currrency is overvalued.
  • For example, if the US price is 3, and the
    Canadian price is C3.20, but our exchange rate
    is 11, then the Canadian dollar is higher in
    value than implied by the price of the Big Mac.

56
Big Mac Index
  • To calculate the Big Mac PPP value for the
    currency, simply divide the price of the Big Mac
    in the foreign currency by the U.S. price.
  • This tells us what the currency would be valued
    at, if PPP held.
  • This is compared to the actual value of the
    currency to predict whether the currency should
    rise of fall in the near future.
  • Conceived in fun, the index has proven to be a
    useful indicator of future exchange rate
    movements.

57
More PPP
  • The Big Mac PPP is an absolute measure of PPP.
  • The relative PPP exchange rate can be calculated
    using a base exchange rate and relative prices.

58
More PPP
  • For countries 1 and 2, we calculate the PPP1/2rel
    by
  • PPP1/2rele1/2base X PI1cur/PI2cur
  • where rel relative
  • base is base year
  • current is current year
  • Using Table 1 (corrected). Japan/US
  • 2003PPP/rel 113.7/ X (101.0/120.7) 95.14
  • This means Japans currency should have
    appreciated, not depreciated to 115.94 by 2003

59
More PPP
  • The prediction that Japans currency should have
    appreciated aligns with the fact that the RER
    shows that the US dollar has appreciated more in
    real terms than in nominal terms, as shown last
    class.
  • Enough on PPP, lets turn now to dates of
    transactions in currency and forward and futures
    markets

60
Some terminology for spot market
  • Exchange rates vary by the moment, but most
    transactions take place 2 days from the day the
    contract was struck. This is called the value
    date.
  • The difference between a purchase price for
    currency and a sale price is called
  • the retail spread or
  • the retail trading margin.

61
Forward and future markets
  • Often contracts to buy or sell something are made
    now, but delivery isnt for a long time.
  • For example, a Winnipeg window producer may
    contract to buy machinery for US100,000 for
    delivery in 3 months.
  • If the exchange rate is 1.3 C/US, then the
    cost is C130,000

62
Forward and future markets
  • The exchange rate can change dramatically in 3
    months.
  • If the purchaser simply waits and pays the spot
    rate on the day of the transaction, then they are
    taking an uncovered or open position on the
    currency and bearing all the risk of currency
    change.

63
Forward and future markets
  • If the purchaser is risk averse, they may buy the
    currency now and hold it until the purchase date.
  • This is costly because, money is tied up until in
    our example, 130,000 would be tied in US
    currency waiting for a future transaction.

64
Forward market
  • An alternative to holding currency is to buy it
    in the forward market.
  • This allows for a contract to be written today
    that will be executed on a set day in the future,
    (usually 1 month, 2 months, etc.)
  • Forward exchange rates are posted every day.

65
Forward market
  • If the forward rate is higher than the spot rate,
    there is a forward rate premium.
  • This means that the currency represented in the
    denominator is expected to appreciate.
  • If the forward rate is lower than the spot rate,
    there is a forward discount.
  • The currency in the denominator is expected to
    depreciate.

66
Forward market
  • In the next slide you will see a table of US/C
    forward exchange rates posted by the Pacific
    Exchange Rate service.
  • The first column is the time period,
  • The second shows the forward rate
  • The third shows the premium in basis points
    (1/100th of a cent). The premium shows that the
    Canadian dollar is expected to appreciate, and
    also reflects volatility of the dollar.

67
Forward market
  • The fourth column shows the Implied Forward
    Interest Rate Differential
  • This is the difference in interest rates implied
    by the change in the exchange rates.
  • We will get back to this later in the class.

68
Forward Rates(Pacific Exchange Rate Service)
69
The Forward Market
  • The next slide shows a graph of Canadian dollar
    premiums over time, based on the previous table.
  • It shows that, the longer into the future a
    purchaser would like to reserve Canadian currency
    for, the more they will need to pay.

70
Canadian premiums measured in US
71
Speculation
  • Speculators may buy or sell in the forward market
    depending on whether they expect a currency to
    appreciate or depreciate.
  • If a speculator expects that the actual spot rate
    will be higher than the posted forward rate will
    buy a currency. This is called taking a long
    position in the currency.
  • (note, here we are using US/C for the Canadian
    exchange rate Canada is the foreign currency
    in this case)

72
Speculation
  • If a speculator expects that the actual spot rate
    will be lower than the posted forward rate will
    sell the currency in the forward market
    (expecting to buy it back at a lower rate). This
    is called taking a short position in the
    currency.
  • (note, here we are using US/C for the Canadian
    exchange rate Canada is the foreign currency
    in this case)

73
Speculation and currency
  • The more a currency fluctuates, the higher will
    be the premium to buy at a future date.
  • The forward market is a market of individual
    buyers and sellers (though these may be brokers)
  • The forward market provides an easy way to hedge
    for investors unfamiliar with the foreign
    currency market

74
Futures Contracts
  • Futures contracts are like forward contracts with
    the following differences
  • they are entered into through the Chicago
    Mercantile Exchange
  • the contracts are for standard amounts
  • the contracts are for standard dates (third
    Wednesday of March, June, Sept, Dec.)
  • a margin deposit is required. A margin is a fixed
    percent of the contract
  • the futures contract is resalable up to maturity

75
Futures Contracts
  • Because of the resalability and the standardized
    nature of the contract, future contracts may
    appeal more to small investors and speculators.
  • Speculators buy on margin and this margin is
    all that is paid to the broker.
  • The change in the exchange rate times the percent
    they paid (minus broker fees) represents their
    daily gain or loss.

76
Foreign currency option
  • This is a contract that gives the option
    purchaser the opportunity to buy currency at a
    fixed price on a given date.
  • In this case, if the currency in question is more
    expensive than the option cost, the buyer will
    exercise the option.
  • If the currency spot rate is lower than the
    option cost, the buyer will not exercise the
    option
  • The cost of the option is a fee for the right to
    exercise the option.

77
Foreign currency option
  • Our window manufacturer could buy a forward or
    future contract on US dollars to be paid on or
    before the date of delivery of equipment, or
  • they could buy an option to purchase US dollars
  • In this case, they would only exercise the option
    if the price of US dollars in the option contract
    is lower than the spot rate at the time the
    currency is needed.

78
Foreign currency option
  • There are two types of options
  • Call option gives the purchaser of the option
    the right to purchase currency at a future date.
  • Put option gives the purchaser of the option the
    right to sell a currency at a future date.
  • The cost of the option is called the premium

79
Foreign currency option
  • A participant in this market could take four
    different actions
  • 1. Buy a call option purchase an option to buy
    a currency
  • 2. Buy a put option purchase the option to sell
    a currency
  • 3. Sell a call option sell another actor the
    option to buy a currency
  • 4. Sell a put option sell another actor the
    option to sell a currency.

80
Foreign currency option
  • The most the purchaser of an option can lose is
    the premium. The purchaser can gain if the option
    price differs from the spot rate in her favour.
  • The most the seller can gain is the premium. The
    net gain (or loss) will again depend on the
    spread between the option rate and the spot rate
    at the time the option is exercised.

81
Foreign Exchange Markets and Financial Markets
  • The spot market, forward market and futures
    market all interact with the financial markets to
    determine both the exchange rates and the
    interest rates in various countries
  • This is because investment flows are determined
    by rates of return in different countries

82
Foreign Exchange Markets and Financial Markets
  • Investor considers 3 elements when deciding where
    to invest
  • domestic interest rate or expected rate of return
  • foreign interest rate or expected rate of return
  • expected changes in the exchange rate

83
Foreign Exchange Markets and Financial Markets
  • This creates a relationship between these
    variables
  • It does NOT lead to interest rate equality across
    countries

84
Foreign Exchange Markets and Financial Markets
  • The investor wants equal return whether investing
    in the home or foreign country.
  • For example, investing in New York or London for
    a 90-day period, the investor would like the same
    yield on every 1
  • 1(1iNY)(1/e)(1iLondon)E(e)

85
Foreign Exchange Markets and Financial Markets
  • 1(1iNY)(1/e)(1iLondon)E(e)
  • LHS earnings in New York
  • RHS earnings in London changed back to US .
  • E(e) is the expected spot rate in 90 days
  • We can rewrite this as
  • 1(1iNY)(1)(1iLondon)E(e)/e

86
Foreign Exchange Markets and Financial Markets
  • 1(1iNY)(1)(1iLondon)E(e)/e
  • Example
  • At 8 interest per year, 90-day earning is 2.
    Investing 1000 in New York would yield 1020 in
    90 days.
  • Now, if money is invested in London

87
Foreign Exchange Markets and Financial Markets
  • 1(1iNY)(1)(1iLondon)E(e)/e
  • Current spot rate is 1.60/, interest rate is 12
    percent (90-day 3 )
  • Investment yields
  • 1000/(1.60/1)(1.03)643 in 90 days
  • If the 90-day expected spot rate is
  • 1.5845/, then the yield is
  • (643)(1.5845/) 1020.

88
Foreign Exchange Markets and Financial Markets
  • We can rewrite this equality to find a slightly
    different relationship between interest rates and
    exchange rates.
  • 1(1iNY)(1)(1iLondon)E(e)/e
  • E(e)/e is the expected appreciation of the
    foreign currency
  • Let E(e)/e 1xa

89
Foreign Exchange Markets and Financial Markets
  • Start with
  • (1iNY)/(1iLondon)(1xa)
  • Rearrange
  • (1iNY)(1iLondon) 1 xa
  • (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
    xa
  • (iNY iLondon)/ (1 iLondon) xa
  • which is almost the same as
  • (iNY iLondon) xa

90
Foreign Exchange Markets and Financial Markets
  • (iNY iLondon) xa
  • Because investor is bearing all the risk of
    changes in the exchange rate, this is called
  • uncovered interest rate parity (UIP)
  • If (iNY iLondon) gt xa , then investments in the
    US are more attractive,
  • If (iNY iLondon) lt xa , then investments in
    London are more attractive

91
Foreign Exchange Markets and Financial Markets
  • (iNY iLondon) xa
  • However, there are many types of risk involved in
    foreign investment,
  • There may be a risk in earning the return or
    repatriating funds.
  • Therefore the difference in interest rates may
    need to be higher than xa .

92
Foreign Exchange Markets and Financial Markets
  • We incorporate a risk premium into the previous
    equation as
  • (iNY iLondon) xa RP
  • If iNY 6 and the RP 2, then
  • (iLondon xa ) must equal 8 for the New York
    investor to invest in the UK.
  • Changes in the risk premium can affect investment
    flows as well as changes in interest rates and
    expected changes in the currency values

93
Foreign Exchange Markets and Financial Markets
  • We incorporate a risk premium into the previous
    equation as
  • (iNY iLondon) xa RP
  • If iNY 6 and the RP 2, then
  • (iLondon xa ) must equal 8 for the New York
    investor to invest in the UK.
  • Changes in the risk premium can affect investment
    flows as well as changes in interest rates and
    expected changes in the currency values

94
Covered Interest Parity
  • Foreign investors do not need to take chances
    with the future spot rate, of course.
  • They can cover their exchange rate risk by
    transactions on the forward market

95
Covered Interest Parity
  • The link between the current exchange rate and
    the forward rate is discussed in terms of premium
    and discount
  • The foreign currency is at a premium if the
    forward rate is higher than the current spot rate
  • The foreign currency is at a discount if the
    forward rate is lower than the current spot rate

96
Covered Interest Parity
  • Let
  • p efwd/e 1
  • p is the premium, measured in percentage terms.
  • p gt 0 if the currency is at a premium,
  • p lt 0 if the currency is at a discount.

97
Covered Interest Parity
  • We can perform similar arithmetic to the
    uncovered case to show that the difference
    between interest rates in two countries should
    equal the exchange rate premium.

98
Covered Interest Parity
  • Recall the uncovered interest rate equality
    starting point.
  • 1(1iNY)(1)(1iLondon)E(e)/e
  • E(e)/e can be replaced with efwd/e
  • efwd/e p 1
  • and

99
Covered Interest Rate Parity
  • Start with
  • (1iNY)/(1iLondon)(1p)
  • Rearrange
  • (1iNY)(1iLondon) 1 p
  • (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
    p
  • (iNY iLondon)/ (1 iLondon) p
  • which is almost the same as
  • (iNY iLondon) p

100
Covered Interest Parity
  • Start with
  • (1iNY)/(1iLondon)(1p)
  • Rearrange
  • (1iNY)(1iLondon) 1 p
  • (1iNY)/(1iLondon) - (1iLondon)/ )(1iLondon)
    p
  • (iNY iLondon)/ (1 iLondon) p
  • which is almost the same as
  • (iNY iLondon) p

101
Covered Interest Parity
  • As the title of the last few slides suggest, the
    equality
  • (iNY iLondon) p
  • is called covered interest parity
  • Covered interest parity tells us that there is a
    45 degree line that relates the difference in
    interest rates to the forward premium

102
Covered Interest Parity
iNY iLondon ()
CIP
p (-)
p ()
iNY iLondon (-)
103
Covered Interest Parity
  • Note
  • If the interest rate in New York is higher than
    that expected for interest rate parity, we would
    expect the interest rate difference to fall, or
    the exchange rate premium to rise, or both.
  • If the interest rate in New York is lower than
    that expected for interest rate parity, we would
    expect the interest rate difference to rise, or
    the exchange rate premium to fall, or both.
  • There is some room for transactions costs, and so
    the equality will be approximate.

104
Covered Interest Parity and Uncovered Interest
Parity
  • We could do the same graph for uncovered interest
    parity, simply changing p to xa.
  • There is some room for transactions costs, and so
    the equality will be approximate.
  • If CIP holds the foreign currency premium is
    equal to the difference in interest rates between
    the two countries
  • If UIP also holds, it means the expected
    appreciation of the foreign currency is also
    equal to the difference between the two interest
    rates.
  • If this is the case, we say we have an efficient
    foreign exchange market

105
Market adjustments
  • We now have linked
  • interest rates in New York to
  • interest rates in London,
  • the spot exchange rate and the
  • forward exchange rate.
  • Lets consider a disequilibrium situation and see
    how the markets adjust.
  • If iNY iLondon gt p .

106
Market adjustments
  • In the London money market there would be an
    decrease in supply of money as investment flows
    to New York
  • In the London exchange market there would be an
    increase in supply of currency as investors sell
    s to buy s to invest in New York

107
Market adjustments
  • In the New York money market there would be an
    increase in supply of money as investment flows
    to New York
  • In the forward exchange market there would be an
    increase in demand for currency as investors want
    to buy s in the future to repatriate s invested
    in New York

108
Market adjustments
  • In the investment markets, the decrease in supply
    of funds in London and the increase of supply of
    funds in New York push the interest rates to
    decrease the differential.
  • In the currency market, the increase in supply of
    currency in the spot market and increased demand
    in the forward market cause the premium to rise.
  • Both these moves would get the markets back to
    CIP.

109
You do
  • Reproduce the four graphs from the book for the
    case where
  • iNY iLondon gt p
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