Exchange Rate Determination Asset Approach ECO 328-International Economics II Lecture Notes A.Yasemin Yalta Hacettepe University Asset Approach (Note: This week’s notes are based on Krugman, Obstfeld, Melitz’s book, chapter 14.) Asset approach is a short run model of exchange rate determination. Assumptions: • Perfect capital mobility • Assets denominated in domestic currency and foreign currency are perfect substitutes. An investor living in Turkey has two choices: • Invest in TL denominated asset. • Invest in dollar denominated asset. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach Example: Suppose that investor has 100 TL. The interest rate on a TL deposit is 5% and the interest rate on a dollar deposit for one year is 2 %. The current exchange rate is 1 dollar= 4 TL, and the expected exchange rate next year is 1 dollar=5 TL. • If the investor invests in a TL denominated asset, after one year he will have 105 TL. (100 + (100x0.05= 105) • If the investor decides to invest in a dollar denominated asset, he must first convert 100 TL into dollars, put in an account for a year, earn interest and after one year convert dollars into TL again. With 100 TL, the investor purchases only 25 dollars. Put this in a bank account and earn 25.5 dollar. But, at the end of the year he should convert this into TL again at new exchange rate. Thus, 25.5 dollars = 127.5 TL Here, we see that in addition to the interest income, the investor has a gain because of the chanage in exchange rate! Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach In both cases the investor has a return: 1) If the investor invests in a TL denominated asset, the return from this investment is only the interest rate. Thus, the expected return on domestic currency denominated asset (π ππΏ ) is equal to the interest rate: π ππΏ = π ππΏ 2) If the investor invests in a dollar denominated asset, he should convert this into TL at the end of the maturity. Thus, the expected return of foreign currency denominated asset (π ππππππ ) has two parts: Interest earned on dollar denominated asset and the amount of change in the TL/dollar exchange rate. Therefore: π πΈπ‘+1 − πΈπ‘ π ππππππ = πππππππ + πΈπ‘ π where πΈπ‘+1 is expected exchange rate and πΈπ‘ is current exchange rate. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach π πΈπ‘+1 −πΈπ‘ shows the amount of change in exchange rate. πΈπ‘ π πΈπ‘+1 −πΈπ‘ If > 0, domestic currency is expected to depreciate. πΈπ‘ π πΈπ‘+1 −πΈπ‘ If < 0, domestic currency is expected to appreciate. πΈπ‘ Note that in the above example TL is expected to depreciate from 4 to 5. 5−4 = 0.25 4 Therefore, TL is expected to depreciate. Copyright 2020 A.Yasemin Yalta, Hacettepe University Interest Parity At the equilibrium, the expected rate of return on TL denominated assets should be equal to the expected rate of return on dollar denominated asset. This is called interest parity theorem. (Asset approach is also known as interest parity). Interest parity theorem implies that deposits in all currencies are perfect substitutes and arbitrage in the foreign exchange market is not possible. Interest parity has two types: a) Uncovered interest parity b) Covered interest parity Copyright 2020 A.Yasemin Yalta, Hacettepe University Interest Parity Uncovered interest rate parity In this type, the investors do not hedge their foreign exchange transactions. At the equilibrium, π ππΏ = π ππππππ Therefore, interest rate parity is written as follows: π πΈπ‘+1 − πΈπ‘ π ππΏ = πππππππ + πΈπ‘ Copyright 2020 A.Yasemin Yalta, Hacettepe University Interest Parity Interest rate parity suggests that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. π πΈπ‘+1 − πΈπ‘ π ππΏ − πππππππ = πΈπ‘ Example: If interest rate is 10 % in Turkey, while it is 6 % in the U.S., Turkish Lira is expected to depreciate by 4 %. (Note that the right handside of the equation represents a depreciation when the term is positive). Copyright 2020 A.Yasemin Yalta, Hacettepe University Covered Interest Parity When investors make investment decisions regarding buying and selling of foreign exchange, they hedge their investment to reduce the risks resulting from uncertainities. Then, instead of uncovered interest parity, we talk about covered interest parity. Covered interest parity considers forward exchange rate instead of expected exchange rate: Uncovered: π πΈπ‘+1 −πΈπ‘ π ππΏ = πππππππ + πΈπ‘ Covered: π ππΏ = πππππππ + πΉπππ€πππ ππ₯πβππππ πππ‘π−πΈπ‘ πΈπ‘ Copyright 2020 A.Yasemin Yalta, Hacettepe University Covered Interest Parity • Spot rates are exchange rates in current period (or on the spot). • Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date. Forward rates are negotiated between two parties in the present, but the exchange occurs in the future (30, 90, 180, 360 days later). Covered positions involving forward rate reduces the risk of losing as a result of changes in exchange rate in the future. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach Example: Cases πππππππ = π ππππππ 1 0.10 0.06 0.00 2 0.10 0.06 0.04 3 0.10 0.06 0.08 4 0.10 0.12 -0.04 πππ’ππ πΈπ‘+1 − πΈπ‘ πΈπ‘ π ππ’ππ 0.06 (=0.06+0. 00) 0.10 (=0.06+0. 04) 0.14 (=0.06+0. 08) 0.08 (=0.120.04) Source: Krugman, Obstfeld, Melitz, International Economics, 9th edition, Pearson. Copyright 2020 A.Yasemin Yalta, Hacettepe University π ππππππ − π ππ’ππ 0.04 (0,10-0,06) 0.00 (0,10-0,10) -0.04 0.02 Asset Approach In the table, there are different cases. The investor should calculate the return on dollar and euro denominated assets. The investor should invest in a dollar denominated asset for cases 1 and 4 because π ππππππ > π ππ’ππ . For case 3, the investor should invest in euro because π ππππππ < π ππ’ππ . For case 2, the investor is indifferent. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach Source: Krugman, Obstfeld, Melitz, International Economics, 9th edition, Pearson. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach • In this figure, current exchange rate is denoted on the vertical axis and the return is shown on the horizontal axis. The figure is drawn based on the assumption that dollar is the domestic currency while the euro is foreign currency. • The return for domestic currency is a vertical line because the interest rate is determined by the central bank. • The return on euro deposits is negatively sloped because as exchange rate increases, return on foreign currency decreases. Recall the formula for return on foreign asset π πΈπ‘+1 − πΈπ‘ π ππ’ππ = πππ’ππ + πΈπ‘ In this formula, when πΈπ‘ increases, π ππ’ππ decreases. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate According to asset model (or interest rate parity theorem), exchange rate changes in the following cases: 1. When there is a change in the return of domestic currency. 2. When there is a change in the return of foreign currency. The return of foreign currency changes in two situations: a) When interest rate on foreign currency denominated asset changes π b) When expected exchange rate (πΈπ‘+1 ) changes. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in the return of domestic currency on Current Exchange Rate • Assuming that everthing else stays the same, when the interest rate on domestic currency increases, investors try to convert foreign currency into domestic currency to take advantage of high interest rates. • As expected return for domestic currency increases, the return for domestic currency curve shifts to the right. • Exchange rate decreases from point 1 to point 2, meaning that domestic currency appreciates. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in the return of domestic currency on Current Exchange Rate Source: Krugman, Obstfeld, Melitz, International Economics, 9th edition, Pearson. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in the interest rate of foreign currency on Current Exchange Rate • Assuming that everthing else stays the same, when the interest rate on foreign currency increases, expected return on foreign currency increases. • The return for foreign currency curve shifts to the right. Equilibrium exchange rate moves from point 1 to point 2. Exchange rate increases and domestic currency loses value. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in the interest rate of foreign currency on Current Exchange Rate When the interest rate on foreign currency increases, domestic currency loses value. Source: Krugman, Obstfeld, Melitz, International Economics, 9th edition, Pearson. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in Expected Exchange Rate on Current Exchange Rate Assuming that everthing else stays the same, an increase in expected exchange rate (i.e. when domestic currency is expected to lose value), leads to an increase in current exchange rate. Recall that: π πΈπ‘+1 − πΈπ‘ π ππ’ππ = πππ’ππ + πΈπ‘ π πΈ −πΈ π When expected exchange rate πΈπ‘+1 increases, π‘+1 π‘ increases. πΈ π‘ Therefore, π ππ’ππ increases. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate Effect of Change in Expected Exchange Rate on Current Exchange Rate When expected exchange rate increases (i.ei when domestic currency is expected to lose value), domestic currency loses value. Source: Krugman, Obstfeld, Melitz, International Economics, 9th edition, Pearson. Copyright 2020 A.Yasemin Yalta, Hacettepe University Changes in Exchange Rate According to asset approach, current exchange rate is determined by the following: Domestic interest rate increases → E ↓→ domestic currency appreciates Domestic interest rate decreases → E ↑ → domestic currency depreciates Foreign interest rate increases → E ↑ → domestic currency depreciates Foreign interest rate decreases → E ↓ → domestic currency appreciates Expected foreign exchange rate decreases → E ↓→ domestic currency appreciates Expected foreign exchange rate increases → E ↑ → domestic currency depreciates Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach: An Application • Carry Trade: A financial investment strategy in which investors borrow in low-interest currencies and use this borrowed amount to invest in higher-yielding currencies and instruments. • A common type of carry trade was seen in terms of Japanese Yen between 2003-2008 during which Yen was losing value. But in recent years, the currencies of emerging market economies also attracted attention for carry trade activities. • Because of the low interest rates in Japan, speculators borrowed in Japan and invested in high interest paying countries. These speculators converted their money into Japanese yen to pay their debt in Japan. • However, for this strategy to be successful, Japanese Yen had to depreciate. Copyright 2020 A.Yasemin Yalta, Hacettepe University Asset Approach: An Application Example: Suppose that an investor borrows 100000 Yen for a year from a Japanese bank when 1 dollar = 104 Yen. The investor converts the Yen into dollar. The investor can purchase 961 dollars with this money. The investor puts this money in a bank account in the US and earn interest for a year. Let’s say at the end of the year, the investor has 1000 dollars. At the end of the year, the investor should convert dollar into Yen. If at the end of the year Yen gains value and 1 dollar= 90 Yen, the investor can purchase only 90.000 yen. If Yen loses value and 1 dollar = 110 Yen, the investor can purchase 110000 Yen. As you see, when Yen appreciates, the investor is worse off. Asset Approach: An Application What does the existence of carry trade suggest regarding the validity of interest parity theorem? • Interest parity theorem suggests that any difference in interest rates will be compensated by the change in exchange rate and there should not be an arbitrage opportunity. • However, carry trade activities show that arbitrage opportunity is actually possible. • This example suggests that interest parity theorem may not hold in short run because of the changes in risk and liquidity in the market. Copyright 2020 A.Yasemin Yalta, Hacettepe University Relation Between Exchange Rate and Interest Rate • Last week, we discussed monetary approach and concluded that when interest rate increases in Turkey, exchange rate increases and TL depreciates. • However, according to the asset approach, when interest rates in Turkey increases, TL appreciates. • Why do we have these two contradictory results in two approaches? Copyright 2020 A.Yasemin Yalta, Hacettepe University Relation Between Exchange Rate and Interest Rate • The explanation is related with the fact that asset approach is a short run model, while monetary approach is a long run model. • In short run, prices are fixed. Therefore, when money supply decreases, interest rate increases. • However, in long run, prices are flexible. When money supply changes, price level is expected to change as well. • For example, when money supply increases, agents will think that inflation will increase. As a result, domestic currency depreciates. • Therefore, the key point is the interest rate differential and inflation differential across countries. Copyright 2020 A.Yasemin Yalta, Hacettepe University International Fisher Effect Recall relative purchasing power parity equation π πΈπ‘+1 −πΈπ‘ ∗ = π − π πΈπ‘ Now, recall interest parity condition: π πΈπ‘+1 − πΈπ‘ π ππΏ = πππππππ + πΈπ‘ Rearrange the above equation: π πΈπ‘+1 − πΈπ‘ π ππΏ − πππππππ = πΈπ‘ When we combine two equations, we see that: π ππΏ − πππππππ = π − π ∗ This equation suggests that when inflation differential increases, interest rate differential must also increase. This is called «international Fisher Effect».
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