Chapter 13: Exchange Rates and the Foreign Exchange Market
Topics:
Exchange Rates
Foreign exchange market
Asset approach to exchange rates
Interest Rate Parity Conditions
1. Definitions
a) Definition of exchange rate: price of one currency in terms of another. The
conventional way of reporting this in economics is home currency per foreign. In the
U.S. this is $ per foreign currency. For example, it may take $0.90 to buy one
European euro ($/euro). This is the convention in economics and will be used in this
class.
Sometimes you will hear quoted the other way around, often called European terms.
i.e.: 1.11 euro/$.
b) Exchange rates are important for trade because they allow you to compare the cost of
imports to that of domestic goods in common terms. Example: Consider the
Mercedes: suppose the going price is 100 thou DM in Germany and 100 mil Italian
Lira. Would Germans flock to Italy to buy Mercedes cars? It depends on the
exchange rate - comparing DM and Lira is comparing apples and oranges. DM/Lira
exchange rate yesterday was just about .001.
100 mil L * (.001 DM/L) = 100 thou DM.
So 100 mil Lira is about the same as 100 thou DM, and so the auto price is about the
same. We could also do this in reverse.
How did I find the DM/L? The e-rate is often only given in terms of $ /pound or
$/DM. You can divide one by other to find the e-rate you want. In this case: $/L is
.00065 and $/DM is .64, so DM/L = ($/L) / ($/DM) = .001, where the $s cancel out.
c) The way we conventionally define the e-rate can also make it confusing to talk about
changes in the rate, which we call appreciation or depreciation. A currency is
considered to have appreciated relative to another currency if it has grown stronger
relative to the other currency. A currency is considered to have depreciated relative
to another currency if it has grown weaker relative to the other currency.
Suppose the DM/L rate changed from .001 to .0009; we would say that the Lira had
depreciated relative to the DM. Or we could say the DM appreciated relative to the
L. Note that this can be confusing. Given how we define the German exchange rate
as DM/L, if this gets lower, we call this an appreciation in the DM.
It takes fewer DM to buy any given amount of lira, so the DM has grown stronger.
Suppose the e-rate changed as described, but the domestic currency prices of a
Mercedes didn’t change right away. Then while the German price of the Mercedes is
100,000 DM, the Italian price would be only 90,000 DM. Germans would go and
buy Mercedes in Italy to resell them in Germany.
A depreciation (appreciation) of a country’s currency makes its goods cheaper
(more expensive) for foreigners, and makes foreign goods more expensive
(cheaper) for domestic residents.
2. Features of the foreign exchange market.
a) Actors
1) commercial banks: handle most of the exchange market transactions - involve a
company having its commercial bank debit its account, change it into foreign
currency and pay the business partner by depositing this currency in its foreign
bank. Typically, electronic transactions for bank deposits, not a direct exchange
of currency and coins.
Interbank trading: a bank gathers requests of its customers and enters the foreign
exchange market to execute the trade as a unit. These are large transactions, must
be over $1 million. Entering the market is a matter of checking the postings on a
computer network to see the rates at which other banks are willing to trade
currency, then calling on the phone and finalizing a price.
2) corporations: sometimes corporations enter e-market directly. Increasingly
common, since corporations have plants abroad, or buy components from abroad.
3) Nonbank financial institutions: There has been much deregulation of financial
markets, so financial institutions other than banks can compete with banks in
providing services in e market. Could be pension funds, or pure speculation by
fund manager.
.
4) Central banks: We learned in the previous chapter that central banks sometimes
intervene in the e-market to increase or decrease the supply of their currency or
purposefully affect the e-rate. The size of official foreign e interventions is
relatively small, because there is so much private money being thrown around.
It’s questionable whether any central bank is a big enough player to affect things.
b) Characteristics
The volume is enormous: over a trillion dollars a day. Recall that U.S. GDP was
only 6.7 trillion in the whole year of 1994. Banks dealing in the e-market tend to
be concentrated in certain key financial cities, such as London (largest), NY,
Tokyo, Frankfurt and Singapore.
Highly integrated globally: when one major market is closed usually another is
open, so people can trade around the clock, moving from one center to another.
Integration means e-quotes in different centers must be the same. This is
guaranteed by arbitrage (= making a certain riskless profit on a financial trade): If
NY offers more DM for a $ (lower price of DM, higher price of $, E$/DM is low)
than Frankfurt does, people could take their $, sell them in NY for DM, and then
sell these in Frankfurt for $, thereby making a profit.
Obviously, this can’t last. The increased demand for DM in NY would drive up
the price of DM in terms of $. There are computers monitoring such openings
and ready to take advantage of them. So any gaps close up very quickly.
The $ has long been the vehicle currency. Most e-transactions between banks
have taken place in $, even if want to change Lira for French Franc, not dollars.
DM and Yen were also used as vehicles, but less so. This may change with the
euro.
c) Spot and forward rates
The exchange transactions discussed so far take place on the spot market. The
spot rate is the rate for currency transactions that take place basically immediately
(two days for the checks to clear ). Forward exchange rates relate to
arrangements a currency trade at some date in future. This is a way of hedging
against the risk of e-rate changes.
Suppose Best Buy electronics is expecting a shipment of Sony TVs in a month,
for which it needs to pay Yen. It could wait until the shipment to buy the Yen to
pay Sony, but there is uncertainty with respect to the future value of that Yen. If
the Yen appreciates, the $ price the store has to pay to get the TVs could change.
To avoid this risk, it could arrange for a currency trade to be executed later at an
agreed-upon (forward) e-rate.
Swaps: another possibility is to combine a spot with a forward arrangement: i,e.,
have a spot sale, with an arrangement to repurchase in the future at a set rate.
Why do this? Suppose that our electronics store sold some computers in Japan
and received Yen, knew it would need them again in a month to buy Sony TVs,
but didn’t want to hang on the money in Yen for the month, instead wanting to
hold it in dollars for domestic expenses. Most likely there would be lower
brokers fees if both transactions are arrange together. This is the equivalent of a
time spread in stock options.
Futures: like a forward arrangement, except you can sell the contract to someone
else. The currency exchange occurs when the contract comes due, and is
delivered to whoever is holding the contract in the end.
Options: give the right to buy (call) or sell (put) an amount of currency at a
specified e-rate any time before a specified date.
Both futures and options can be bought and sold, without messing around with the
underlying security (currency). This is useful if your opinions about the e-rate
change, and options allow greater leverage. However, this also lends itself to
speculative trading. i.e., if it suddenly looks like $ will appreciate, a contract
specifying dollars be delivered for a given amount of Yen looks more attractive,
and so the price of the contract goes up.
3. Asset approach to exchange rates:
a) How does the foreign exchange market determine what the exchange rate will be?
This text uses the asset approach – which is based upon “interest rate parity.” There
is also a more traditional monetary approach – which is based upon “purchasing
power parity,” and we may discuss it at times.
Recall that most foreign exchange holdings are in form of bank deposits, which are a
type of asset, and these can be analyzed in the same manner as any other asset.
b) Determinants of asset prices: The key element is the expected rate of return:
- In the case of your saving account in dollars, you care about the interest rate.
- In the case of a stock, you care about the dividend and the capital gain: Suppose you
pay $100 for a share of Ford, and you get a dividend payment of $5 and resell the
share in a year for $105. Your rate of return is 10%.
It is important to understand that we are typically dealing with expectations, as the
world is an uncertain place.
In addition to the real rate of return, investors care about two other features: risk
and liquidity.
Risk pertains to uncertainty about the actual rate of return. Even if a stock has a
higher expected payoff than a saving account, the fact that the payoff is uncertain
means it may be less desirable, because people often don’t like risk.
Liquidity: how easy it is to convert the asset to cash; the “thickness” of the market.
c) Foreign currency assets: What is the expected return for the large bank accounts
used in foreign exchange market transactions? The typically do pay an interest rate.
An important additional aspect to consider for an account in a foreign currency is that
changes in thee-rate while holding the currency also affect the value of the asset when
converted back to the domestic currency.
So when you are deciding whether to hold your assets in $ accounts or euro accounts,
you need to consider the interest rates on each deposit option and the expected change
in the exchange rate in the meantime. See the example on pp. 342-3.
d) We can simplify this calculation with a fairly straightforward derivation. Follow
book p. 344 and go over Table 13.3. Note that appreciation and depreciation are flip
sides of the same coin with respect to two compared currencies.
4. Equilibrium in the Foreign Exchange Market
a) The basic equilibrium condition in the foreign exchange market is interest parity.
This means that deposits of all currencies receive the same expected rate of return
(ignores risk and liquidity issues, among others). Given a certain interest rate on $
deposits (R$), a certain interest rate on euro deposits (REU), and given certain
expectations about the future exchange rate (Ee$/EU), then the interest parity condition
tells us the current spot exchange rate that balances demand and supply in the foreign
exchange market.
Equilibrating process: For example, suppose a case where the total return on euro
assets are less than on $ assets, given the current spot exchange rate and given our
expectation for the future spot exchange rate. In this case, holding euro assets is less
attractive than holding $ assets, and people will try to sell their euro and buy $. This
excess supply of euro will immediately bid down the current value of euro and bid up
the value of $; in other words the current spot exchange rate E$/EU will fall.
But since we still are expecting the same future value of the exchange rate in the
future (a rather dubious assumption), the fact that the current spot rate is lower means
we expect a larger EU appreciation over the time we are holding the EU asset. This
very fact raises the total return on the EU asset, and makes it more attractive than
before. This process will continue until the current spot rate falls enough that the
expected EU appreciation over time makes the total EU return exactly equals the
return on the $ asset. At this point there is no excess supply of EU foreign exchange,
and the spot exchange rate has reached its equilibrium level.
b) Effect of changing interest rates: If any of the underlying conditions change, then this
will require a change in the spot exchange rate. If R$ rises, this shifts the vertical line
(dollar returns) to the right, which means the equilibrium exchange rate E$/EU is lower
(the EU is worth less).
The intuition goes like this: a rise in R$ makes $ deposits more attractive than before,
so there is an excess demand for dollars that drives up the current value of the dollar
and drives down the current value of the EU (E$/EU falls). Similarly, if REU rises, this
shifts the EU-returns curve to the right. Now the EU assets become more attractive
and there is excess demand for EU. This bids up the current value of the EU, which is
a rise in E$/EU.
In general we see that if the interest rate rises in a country, then this tends to increase
the value of that country’s currency. We can also consider the effects of a change in
the expected future exchange rate. If Ee$/EU rises, this shifts the EU-return curve to the
right just like case above and raises the current spot exchange rate. The idea is that if
you expect EU currency to rise in value over time, EU assets become more attractive
for this reason, and there is excess demand for EU, which bids up their current value.
In future sessions, we will discuss some of the economic reasons for why these cases
might arise, that is, why interest rates or expectations might change.
c) Empirical tests on interest parity: It is difficult to test the interest rate parity
condition, because it is difficult to get a measure of people’s expectations. Some
economists have used the actual future exchange rate as a proxy for expectations in
the past, assuming that people correctly predict the future rate. Some economists have
used survey data on expectations – they call people who take part in the foreign
exchange market and ask them what rates they expect. Both sets of tests tend to find
the interest parity condition does not hold well. But this may simply reflect the fact
that the expected future exchange rate component of the equation was measured with
error, not that the theory was wrong.
Another reason why the tests may reject the interest parity condition is the role of
risk. There is some risk involved because you do not know ahead of time what the
future exchange rate will be; if your expectations turn out to be wrong, the payoff
from your investment scheme may be different from what you expected. This may
make people require an additional expected return on EU deposits as compensation
for uncertainty. In this case there would be an extra term in the interest parity
equation: RP representing the risk premium:
R$ = REU + (Ee$/EU - E$/EU)/ E$/EU – RP
(Note: RP can in principle be either positive or negative, depending on how the risk is
perceived both by people trading EU for $ and those trading $ for EU, since both
groups are exposed to risks of different types).
d) Covered interest parity: If exchange risk is the problem, isn’t there a way to get rid of
that? Yes, use a forward contract to create a risk-free version of the interest parity
relation.
Denote the forward rate: F$/EU
This suggests a risk-free version of interest rate parity, called covered interest rate
parity:
R$ = REU + (F$/EU - E$/EU)/ E$/EU
The old equation then is often called “uncovered” interest rate parity. Empirical
evidence supports covered interest parity. In fact, it seems this is how forward rates
are determined. Dealers scan current E and F, and if see if there is an immediate
arbitrage, thereby closing the window of opportunity..
Does this imply that the forward rate F is the expected future value of the spot
exchange rate? (Does F$/EU = Ee$/EU?) This is true only if both uncovered and covered
interest rate parity conditions hold.