Chapter 13_The Foreign Exchange Market

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Chapter 13_The Foreign Exchange Market

  1. 1. Chapter 13 The Foreign Exchange Market
  2. 2. Chapter Preview <ul><li>In the mid-1980s, American businesses became less competitive relative to their foreign counterparts. By the 2000s, though, competitiveness increased. Why? </li></ul><ul><li>Part of the answer can be found in exchange rates. In the 1980s, the dollar was strong, and US goods were expensive to foreign buyers. </li></ul>
  3. 3. Chapter Preview <ul><li>By the 1990s and 2000s, the dollar weakened, so American goods became cheaper and American businesses became more competitive. </li></ul>
  4. 4. Chapter Preview <ul><li>In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include: </li></ul><ul><ul><li>Foreign Exchange Market </li></ul></ul><ul><ul><li>Exchange Rates in the Long Run </li></ul></ul><ul><ul><li>Exchange Rates in the Short Run </li></ul></ul><ul><ul><li>Explaining Changes in Exchange Rates </li></ul></ul>
  5. 5. Foreign Exchange Market <ul><li>Most countries of the world have their own currencies: the U.S dollar., the euro in Europe, the Brazilian real, and the Chinese yuan, just to name a few. </li></ul><ul><li>The trading of currencies and banks deposits is what makes up the foreign exchange market. </li></ul>
  6. 6. What are Foreign Exchange Rates? <ul><li>Two kinds of exchange rate transactions make up the foreign exchange market: </li></ul><ul><ul><li>Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate . </li></ul></ul><ul><ul><li>Forward transactions involve exchanges at some future date, completed at the forward rate . </li></ul></ul>
  7. 7. Foreign Exchange Market <ul><li>The next slide shows exchange rates for four currencies from 1990-2006. </li></ul><ul><li>Note the difference in rate fluctuations during the period. Which appears most volatile? The least? </li></ul>
  8. 9. Why Are Exchange Rates Important? <ul><li>When the currency of your country appreciates relative to another country, your country's goods prices  abroad and foreign goods prices  in your country. </li></ul><ul><ul><li>Makes domestic businesses less competitive </li></ul></ul><ul><ul><li>Benefits domestic consumers (you) </li></ul></ul>
  9. 10. Why Are Exchange Rates Important? <ul><li>For example, in 1999, the euro was valued at $1.18. On April 26, 2006, it was valued at $1.36. </li></ul><ul><ul><li>Euro appreciated 15% (1.36-1.18) / 1.18 </li></ul></ul><ul><ul><li>Dollar depreciated 13% (0.75-0.85) / 0.85 </li></ul></ul><ul><ul><ul><li>Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18 </li></ul></ul></ul><ul><ul><li>We can see exchange rates in the WSJ. </li></ul></ul>
  10. 11. Foreign Exchange Market: Exchange Rates Current foreign exchange rates http://www.federalreserve.gov/releases/H10/hist
  11. 12. How is Foreign Exchange Traded? <ul><li>FX traded in over-the-counter market </li></ul><ul><ul><li>Most trades involve buying and selling bank deposits denominated in different currencies. </li></ul></ul><ul><ul><li>Trades in the foreign exchange market involve transactions in excess of $1 million. </li></ul></ul><ul><ul><li>Typical consumers buy foreign currencies from retail dealers, such as American Express. </li></ul></ul><ul><li>FX volume exceeds $3 trillion per day. </li></ul>
  12. 13. Exchange Rates in the Long Run <ul><li>Exchange rates are determined in markets by the interaction of supply and demand. </li></ul><ul><li>An important concept that drives the forces of supply and demand is the Law of One Price. </li></ul>
  13. 14. Exchange Rates in the Long Run: Law of One Price <ul><li>The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it. </li></ul><ul><li>Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton. </li></ul>
  14. 15. Exchange Rates in the Long Run: Law of One Price <ul><li>Law of one price  E = 100 yen/$ </li></ul>
  15. 16. Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) <ul><li>The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels. </li></ul><ul><li>PPP  Domestic price level  10%, domestic currency  10% </li></ul><ul><ul><li>Application of law of one price to price levels </li></ul></ul><ul><ul><li>Works in long run, not short run </li></ul></ul>
  16. 17. Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) <ul><li>Problems with PPP </li></ul><ul><ul><li>All goods are not identical in both countries (i.e., Toyota versus Chevy) </li></ul></ul><ul><ul><li>Many goods and services are not traded (e.g., haircuts, land, etc.) </li></ul></ul>
  17. 18. Exchange Rates in the Long Run: PPP
  18. 19. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run <ul><li>Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate  </li></ul><ul><li>The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity. </li></ul>
  19. 20. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run <ul><li>Relative price levels: a rise in relative price levels cause a country’s currency to depreciate. </li></ul><ul><li>Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate. </li></ul>
  20. 21. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run <ul><li>Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate. </li></ul><ul><li>Productivity: if a country is more productive relative to another, its currency appreciates. </li></ul>
  21. 22. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run <ul><li>The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar. </li></ul>
  22. 23. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run
  23. 24. Exchange Rates in the Short Run <ul><li>In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits. </li></ul><ul><li>Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand. </li></ul>
  24. 25. Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets <ul><li>We will illustrate this with a simple example </li></ul><ul><li>Fran ç ois the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates. </li></ul>
  25. 26. Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets <ul><li>Al the American has a similar problem. He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates. </li></ul>
  26. 27. Exchange Rates in the Short Run: Expected Returns and Interest Parity
  27. 28. Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets <ul><li>What this shows is simple. As the relative expected return on dollar assets increases (decreases), both Fran ç ois and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets. </li></ul><ul><li>This leads us to our formal title for what is going on here: Interest Parity </li></ul>
  28. 29. Exchange Rates in the Short Run: Expected Returns and Interest Parity <ul><li>Interest Parity Condition </li></ul><ul><ul><li>$ and F deposits perfect substitutes </li></ul></ul><ul><ul><li>Example: if i D = 6% (US interest rate) and i F = 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency? </li></ul></ul>(2)
  29. 30. Exchange Rates in the Short Run: Expected Returns and Interest Parity <ul><ul><li>Several things to recognize about the interest rate parity condition: </li></ul></ul><ul><ul><li>Expected returns are the same in both dollars and foreign assets </li></ul></ul><ul><ul><li>Equilibrium condition for the foreign exchange market </li></ul></ul><ul><ul><li>Next, we will develop supply/demand curves to explain how the exchange rate is determined. </li></ul></ul>
  30. 31. Exchange Rates in the Short Run: Expected Returns and Interest Parity <ul><li>To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF. </li></ul><ul><li>Next, we must determine the expected return in terms of dollars on dollar deposits, RD. </li></ul>
  31. 32. Deriving the Demand Curve <ul><li>The demand curve connects these points and is downward sloping because when E t is higher, expected appreciation of the dollar is higher. </li></ul>
  32. 33. Deriving the Supply Curve <ul><li>Deriving the Supply Curve </li></ul><ul><ul><li>There isn’t really anything to derive. We will take the quantity of bank deposits, bonds, and equities as fixed with respect to exchange rates . </li></ul></ul>
  33. 34. Exchange Rates in the Short Run: Equilibrium <ul><li>Equilibrium </li></ul><ul><ul><li>Supply = Demand at E * </li></ul></ul><ul><ul><li>If E t > E *, Demand < Supply , buy $, E t  </li></ul></ul><ul><ul><li>If E t < E *, Demand > Supply , sell $, E t  </li></ul></ul><ul><li>The following figure illustrates this. </li></ul>
  34. 35. Exchange Rates in the Short Run: Equilibrium
  35. 36. Explaining Changes in Exchange Rates <ul><li>To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits. </li></ul><ul><li>We will examine these separately, as well as changes in the money supply and exchange rate overshooting. </li></ul>
  36. 37. Explaining Changes in Exchange Rates: Increase in i D <ul><li>Demand curve shifts right when </li></ul><ul><ul><li>i D  : because people want to hold more dollars </li></ul></ul><ul><li>This causes domestic currency to appreciate. </li></ul>
  37. 38. Explaining Changes in Exchange Rates: Increase in i F <ul><li>Demand curve shifts left when </li></ul><ul><ul><li>i F  : because people want to hold fewer dollars </li></ul></ul><ul><li>This causes domestic currency to depreciate. </li></ul>
  38. 39. Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates <ul><li>Demand curve shifts left when </li></ul><ul><ul><li> : because people want to hold more dollars </li></ul></ul><ul><li>This causes domestic currency to appreciate. </li></ul>
  39. 40. Explaining Changes in Exchanges Rates <ul><li>Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing </li></ul><ul><ul><li>Expected fall in relative U.S. price levels </li></ul></ul><ul><ul><li>Expected increase in relative U.S. trade barriers </li></ul></ul><ul><ul><li>Expected lower U.S. import demand </li></ul></ul><ul><ul><li>Expected higher foreign demand for U.S. exports </li></ul></ul><ul><ul><li>Expected higher relative U.S. productivity </li></ul></ul><ul><li>These are summarized in the following slides. </li></ul>
  40. 41. Explaining Changes in Exchanges Rates
  41. 42. Explaining Changes in Exchanges Rates (cont.)
  42. 43. Applications <ul><ul><li>Our analysis allows us to take a look at the response of exchange rates to a variety of macro-economic factors. For example, we can use this framework to examine (1) the impact of changes in interest rates, and (2) the impact of money growth. </li></ul></ul>
  43. 44. Application: Interest Rate Changes <ul><li>Changes in domestic interest rates are often cited in the press as affecting exchange rates. </li></ul><ul><li>We must carefully examine the source of the change to make such a statement. Interest rates change because either (a) the real rate or (b) the expected inflation is changing. The effect of each differs. </li></ul>
  44. 45. Application: Interest Rate Changes <ul><li>When the domestic real interest rate increases, the domestic currency appreciates. We have already seen this situation in Figure 4 (slide 37). </li></ul><ul><li>When the domestic expected inflation increases, the domestic currency reacts in the opposite direction – it depreciates. This is shown on the next slide. </li></ul>
  45. 46. Explaining Changes in Exchange Rates: Response to i  Because π e 
  46. 47. Application: Interest Rate Changes <ul><li>Changes in domestic money supply are a bit more complicated. We summarize the results on the next slide. However, you may want to read the text on this section to fully digest the effects. </li></ul>
  47. 48. Explaining Changes in Exchange Rates: Changes in the Money Supply <ul><li>M s  , P  , E e t +1  , shifting demand curve from D 1 to D 2 . </li></ul><ul><li>In long run, i D returns to old level, and demand shifts from D 2 to D 3 ( exchange rate overshooting) </li></ul>
  48. 49. Exchange rate volatility <ul><li>Exchange rate overshooting is important because it helps explain why foreign exchange rates are so volatile. </li></ul><ul><li>Another explanation deals with changes in the expected appreciation of exchange rates. As anything changes our expectations (price levels, productivity, inflation, etc.), exchange rates will change immediately. </li></ul>
  49. 50. Applications <ul><ul><li>Our analysis also allows us to take a look at the weak dollar in the 1980s, and (partially) explain why it became stronger in the 1990s and 2000s. We present a summary in Figure 9, on the next slide. </li></ul></ul>
  50. 51. The Dollar and Interest Rates <ul><li>Value of $ and real rates rise and fall together, as theory predicts </li></ul><ul><li>No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises </li></ul>Daily foreign exchange rate http://quotes.ino.com/exchanges/?e=FOREX
  51. 52. Case: The Euro’s First Nine Years <ul><li>The euro debuted in 1999 at $1.18 / euro. It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of 2007. </li></ul><ul><li>Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro. </li></ul>
  52. 53. Reading the WSJ <ul><li>The figure on the next slide shows the “Currency Trading” column from the Wall Street Journal on July 11, 2007. </li></ul><ul><li>Some highlights include: </li></ul><ul><ul><li>Warnings from Home Depot and other sectors that the economy is weakening – signaling possible Fed rate cuts (did that happen?) </li></ul></ul><ul><ul><li>Dollar returns expected to be lower in the future – dollar expected to depreciate </li></ul></ul>
  53. 55. The Practicing Manger: Profiting from FX Forecasts <ul><li>Forecasters look at factors discussed here </li></ul><ul><li>FX forecasts affect financial institutions managers' decisions </li></ul><ul><li>If forecast yen appreciate, yen depreciate, </li></ul><ul><ul><li>Sell franc assets, buy euro assets </li></ul></ul><ul><ul><li>Make more euros loans, less yen loans </li></ul></ul><ul><ul><li>FX traders sell yen, buy euros </li></ul></ul>
  54. 56. Chapter Summary <ul><li>Foreign Exchange Market: the market for deposits in one currency versus deposits in another. </li></ul><ul><li>Exchange Rates in the Long Run: driven primarily by the law of one price as it affects the four factors discussed. </li></ul>
  55. 57. Chapter Summary (cont.) <ul><li>Exchange Rates in the Short Run: short-run rates are determined by the demand for assets denominated in both domestic and foreign currencies. </li></ul><ul><li>Explaining Changes in Exchange Rates: factors leading to shifts in the demand and supply schedules were explored. </li></ul>

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