Foreign Exchange Markets
The Foreign-Exchange
Market and
Exchange Rates
Why do we care about exchange rate
markets?
• Countries have different currencies and
exchange is denoted in these different
currencies
• For trade to occur, you need to be able
to buy and sell in the currency of your
trading partner.
• Why not just one currency?
Appreciation and Depreciation
• Appreciation: when your currency becomes
more expensive in terms of other currencies.
(For example If 1 USD cost 1 Euro and then
went up to 1.2 Euros you have an
appreciation
• Depreciation: when your currency becomes
less expensive in terms of other currencies.
(For example if the USD cost 1 Euro and then
went down to .8 Euros you have a
depreciation)
Exchange Rates
• The nominal exchange rate is the price of one
country’s exchange rate in terms of another’s.
• Example: In India, if you want to buy a dollar,
it costs 50 Rupees on the market- so, the
nominal exchange for dollars is 1/50=.02
dollars per rupee in India. In the U.S, the
nominal exchange rate for a rupee is 50
rupees to the dollar.
Real Exchange Rate
• The real exchange rate is the purchasing
power of a currency relative to the purchasing
power of other currencies.
• Things cost different amounts in each
country. For example, to take the Indian case
with 50 rupees to the dollar. A shirt in India
may cost 250 rupees, while in the U.S it costs
10 dollars. Are you better off buying in India
or in the U.S? To check, we have to calculate
the real exchange rate
Real E.R
• Formula: EXr=[EX X P]/Pf
• Real E.R= (Nominal ER X Domestic Price)/Foreign
Price
• = (Rs.50/$1 )*($10)/Rs.250=2 Indian Shirts/1 U.S
Shirt
• So shirts are in real terms, twice as expensive in the
U.S as they are in India
Price indices
• In reality, we compare not prices of any
particular good, but general prices
(price indices) (basket of goods
containing lots of common items)
• So we compare general price levels
Relationship between Nominal and
Real Exchange Rates over time
• Formula: EXr=[EX * P]/Pf
So, in percentages
DEXr/EXr= DEX/EX+DP/P-DPf/Pf
%change in RE=% change in nominal+
percentage change in price level
domestically- percentage change in
price level in the foreign country
Example
DEXr/EXr= DEX/EX+DP/P-DPf/Pf
Let us take our previous example and say that
that shirts cost more in the US- (now they are
$15). The RER is now
• (Rs.50/$1 )*($15)/Rs.250=3 Indian Shirts/1
U.S Shirt
• The change in EX=0, in P=50% in Pf=0
• Change in EXr=50%
Foreign-Exchange Markets
• Spot market transactions involve immediate
exchanges of currency or bank deposits.
Example: I exchange one dollar for 45 rupees
today
• Forward transactions involve future
exchanges of currencies or bank deposits.
Example: I buy a contract today to exchange
$1 for 45 rupees 3 months from now? Why?
• Zero sum game.
Causes of Higher Long-run Exchange Rates
• A decrease in a country’s relative price level (If U.S
goods are cheaper than in India, more people will buy
U.S goods, and bid up the price of the dollar)
• An increase in a country’s relative productivity
• (If U.S goods are made more productively, they will
be cheaper than in India, more people will buy U.S
goods, and bid up the price of the dollar)
• A decrease in a country’s demand for foreign goods
or a rise in foreign demand for a country’s exports (If
people think that Indian goods are not of the same
quality, they will buy more U.S goods…etc)
• An increase in a country’s tariffs (foreign goods
become costlier)
Rearranging our Equation
DEX/EX = DEXr/EXr + pf-p
p refers to inflation
Nominal E.R change = Real E.R change+
difference in foreign and domestic
inflation rates
Purchasing Power Parity/Law of One
Price
• Law of One Price: LOOP-if two countries produce an
identical good, if the good is tradable, if there is free
trade and there are no transactions /transportation
costs, then the price should be the same in both
countries. In the shirt example, U.S consumers
would buy Indian shirts, buy more rupees, causing an
appreciation of the Indian rupee and making it
relatively more costly to buy the shirt. This would go
on till the RER= 1 shirt India/1 shirt US
• Purchasing power parity (PPP) theory applies the law
of one price to a group of goods. Under LOOP, RER
is always constant, (percentage change is zero) so
according to PPP, changes in N.E.R reflect inflation
rate differences cause changes in the nominal
exchange rate.
DEX/EX = DEXr/EXr + pf-p under PPP DEX/EX = pf-p
Another Determinant of Exchange Rates
• The flow of goods and services (called trade) is not
the only thing that moves between countries
• Capital flows too (financial flows between countries).
• Just like with trade, borrowers need finance in their
local currency and sellers need repayment in their
own currency, so they need foreign exchange
markets.
• How does this explain the fact that while the U.S has
a constant and huge trade deficit, its currency isn’t
depreciating fast?
-$40,000
110
100
-$45,000
90
-$50,000
80
-$55,000
70
60
-$60,000
Trade Weighted Exchange Index:
Major Currencies
(Right Scale: 2000=100)
-$65,000
-$70,000
50
40
Trade Deficit (Dollars)
30
$600,000
Net Foreign Ow ned Assets Millions
$500,000
$400,000
$300,000
$200,000
$100,000
$0
2000:I
2000:III
2001:I
2001:III
2002:I
2002:III
2003:I
2003:III
2004:I
2004:III
2005:I
2005:III
2006:I
9/1/06
8/1/06
7/1/06
6/1/06
5/1/06
4/1/06
3/1/06
2/1/06
1/1/06
12/1/05
11/1/05
10/1/05
9/1/05
8/1/05
7/1/05
6/1/05
5/1/05
4/1/05
3/1/05
2/1/05
1/1/05
12/1/04
11/1/04
10/1/04
9/1/04
8/1/04
7/1/04
6/1/04
5/1/04
4/1/04
3/1/04
2/1/04
20
1/1/04
-$75,000
Determining Short-run
Exchange Rates
• Investors compare the return on a
domestic asset with the return on a
foreign asset evaluated in terms of
domestic currency.
Example in the Book
• Two assets with equal risk- Japanese Bonds
and U.S Bonds each offering 5% return.
• Basic point- overall return (R) depends on
both interest rate and exchange rate
• The return on a domestic asset (1 + i) should
be compared with the return on a foreign
asset evaluated in terms of domestic currency
(1+ if – ∆EXe/EX). Note Exe= expected
change
• If Japanese yen depreciates by 5% over the
year the return to the U.S bond is
1+.05=1.05=5% return, while to the Japanese
bond=1+.05-.05=1= 0% return
The graph shows the expected rate of return on a Japanese bond.
Let the expected exchange rate one year from now be 100. If
current ER is 105, then actual R=.05+5/105=.098=9.8%
If current ER is 97, then actual R=.05+ (-3/97)=1.9%
Rules
• Nominal interest rate parity: ceteris paribus, the
nominal returns of domestic and foreign assets must
be equal.
• International capital mobility results in an exchange
rate market equilibrium reflecting the nominal
interest rate parity condition: When domestic and
foreign assets have identical risk, liquidity, and
information characteristics, their nominal returns
(measured in the same currency) also must be
identical (i = if – ∆EXe/EX).
• Real interest rate parity: expected real rates of
interest are equal. (1 + r) = (1 + rf)(EXrr/EXre ).
Other comparative statics:
1. Effect of a Change in the Domestic Real Interest Rate
Effect of an Increase in Domestic
Expected Inflation
Effect of a Change in the Foreign
Interest Rate
Effect of Changes in
Exchange Rate Expectations
Play ball!
• You are a currency speculator. Choose
(as soon as you can) what currency,
Yen or the Dollar, you would under the
following bits of news…
Choices
• “Japanese productivity continues to increase”
• “U.S announces unilateral tariffs on all
Japanese products”
• “U.S products seen to be of better quality”
• “Japanese raise interest rates”
• “Higher expected inflation in the U.S”
• “Moody’s downgrades Japanese bonds”
• “U.S trade deficit continues to rise”