INTERNATIOANAL
INTERNATIOANAL
FINANCE
FINANCE
CHAPTER 2
Exchange Rates and the Foreign
Exchange Market :
An Asset Approach
Relative Concepts
Exchange rate: 汇率
the price of one currency in terms of another
Quotations
Unit currency
Pricing currency
直接标价法
Direct quote
foreign currency
domestic currency
间接标价法
Indirect
quote
domestic currency
foreign currency
Direct quote:
the price of one unit foreign currency
in terms of domestic currency
Indirect quote: the price of one unit domestic currency
in terms of foreign currency
Examples
Direct Quotation
In Shanghai
In Frankfort
美元
人民币
USD100=CHY810.565
USD1=EUR0.8245
欧元
Indirect Quotation
In London
英镑
GBP1=USD1.7575
In New York
USD1=EUR0.8245
Depreciation and Appreciation
贬值 与 升值
All else equal, a depreciation
of a country’s
___________
currency makes its goods cheaper for foreigners.
All else equal, a appreciation
of a country’s
___________
currency makes its goods dearer for foreigners.
Foreign Exchange Market
外汇市场
Defination:
the market in which international
currencies are traded.
Major actors of the FX market:
• Commercial bank
• Corporations
• Nonbank financial institutions • Central banks
Framework of the Market (I)
Central bank
----
Buying domestic
currency with
foreign currency
------A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ···
-------
buying
foreign
currency
-------
··· ··· N
-------
banks
----
Commercial
Buying foreign
currency with
domestic currency
selling
foreign
currency
Corporations (importors & exporters)
Nonbank financial institutions Other users (eg.international tourists )
Framework of the Market (II)
Central bank
----
Commercial
----
Intervenient
trading
----
Interbank
market
or
银行间市场
Wholesale
market
A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N
----
----
commercial
trading
----
banks
Corporations(importors & exporters)
Nonbank financial institutions
Other users (eg.international tourists )
Over-thecounter
market
or
柜台交易市场
Retail
market
New York
London
Paris
Frankfort
Shanghai
Tokyo
What’s
you
spot )
Buy
USD1(
million
USD JPY, pls ?
140.20/30
OK, done.
Framework of FX market (III)
Singapore
Hongkong
Sydney
Characteristics of the Market
• Foreign exchange trading takes place in many financial centres.
• These major forex trading centres forms a round-o’clock market
as they are linked by direct phones, fax and internet.
arbitrage
• Most FX deals between banks involve exchanges of nondollar
currencies for U.S. dollars.
examples a vehical currency
Spot Rates & Forward Rates
即期汇率与远期汇率
Spot Exchange Rates:
 Exchange rates governing such “on-thespot” trading. (two days after a deal is
struck)
 Forward Exchange Rates:
 Exchange rates deals sometimes specify a
value date farther away than 2days-30days , 90days,180days,or even several
years.

Foreign Exchange Swaps

Foreign Exchange Swaps:
 a spot sale of a currency combined with a
forward repurchase of the currency
Currency Futures

Futures:
 a future contract means a promise that a
specified amount of foreign currency will
be delivered on a specified date in the
future
Currency Options

Options:
 gives its owner the right to buy or sell a
specified amount of foreign currency at a
specified price at a specified expiration
date
Demand for
Foreign Currency Assets
Asset & Asset Returns
 Interest Rates
 Exchange Rates & Asset Returns
 A Simple Rule
 Return, Risk, and Liquidity in the Foreign
Exchange Market

Exchange Rate & Asset Returns
Rate of return: The percentage increase in
value it offers over some period.
 Invest 100$ to buy a share of stock and the
dividend is 1$.
 If the price rise to 109 $ or drop to 89 $.
 (109 +1)/100 –1 = 10%
 (89 + 1)/100 –1 = – 10%
 Expected rate of return (P.334)

Equilibrium in the FX Market
Interest Parity
利息平价
: The basic equilibrium condition
The foreign exchange market is in equilibrium when deposits
of all currencies offer the same expected rate of return.
Asset Market Linkages
dollar money market $ • (1+R$ ) = $f
$
Spot FX
market
(1+R$ )
$f
Ee$/€
E$/€
Future spot
FX market
$f / Ee$/€ = €f
€ • E$/€ = $
€
(1+R€ )
€f
Euro money market € • (1+R€ ) = €f
f???€fR
e=10%,
e.g.
e.g.R
E$€$/€
=
1.2,
ۥ
E$/€
R$€$1200000=$
)/€1000000=
E$ef$/€132000=
= € •€f$(1+
=•(1+
6%,
1000000=
=1.245,
? €)
$/€
f10 6000
$€1200000
$f1000000×(1+
132000/1.245=6%)=
1000000×1.2×(1+10%)/1.245=1000000×(1+
6%)
€€1000000×1.2=
$1200000×(1+10%)=$
€ff10
1320000
60000
Derivation of Interest Parity Condition
e
•
(1+R
)
/E
€ • E利息平价条件
$
$/€ = € • (1+R€ )
$/€
e
f
(1+R$ )
$
$
E$/€ (1+R$ ) / E $/€ = (1+R€ )
Interest Parity Condition
e
)/(1+R
)
E$/€E$/€
+E=$/€E•e$/€
R$ (1+
= EeR
+E
$/€€
$/€ •$ R€
e
(E
-E$/€ )/ E$/€ = eeRe $ -R€
e
$/€ )/
e
e
e
E $/€ (E(E E-E-E-E
E$/€
=E
E=R
• R$€-(E
-E$/€
•RR$/€
E$/€$/€• R€
)/E
-R
$/€
$/€$=R
$-E
$/ۥ-E
€ €/ )/E
$/€$/€$/€$/€$/€$/€$/€
$/€
________________
or
∵ (Ee$/€ -E$/€ )/ E$/€ • R€ is a small number
e
R
=
R
+(E
-E$/€ )/ E$/€
$
€
$/€
f
€ ∴ (Ee -E )/ E = R -R
(1+R€ )
€
or
$/€
$/€
$/€
$
€
• The change in the expected
future exchange rate is roughly
e
= R€ +(Ebetween
interestrates.
parity condition )
$/€ -E$/€ )/
equal to theR$difference
theE$/€
two(interest
• The expected rate of return on one asset must equal that
of the other asset when measured in the same currency.
Forward Exchange Rates & Covered Interest Parity
$
E$/€
€
(1+R$ )
远期汇率与抵补的利息平价
f
$
Let Ee$/€ =Ef$/€ , expected future FX market
f f Parity
Covered
Interest
•
(1+R
)
€
•
E
/E
==€(1+R
• (1+R
)
E
(1+R
)
$
$/€
$/€$/€
is seen as
forward$ FX/ Emarket.
€ )€
$/€
ff+E=E
f= R
f
(E
-E$/€
)/
E
-R
E
•
(1+
R
)/(1+R
E
•
R
=
E
+E
$/€
$/€
$/€
$
€ €• )R€
f
$/€
$
$/€
$/€
$
$/€
$/€
e
E
E $/€
$/€
f
fIf
f -E
f >f E
E
-E
=E
•
R
-E
•R
or
(E
R
-E
>
R
)/
E
,
then
=R
E
•
R
;/€ E$/€• R
$/€$ $/€ $/€€ $/€$/€ $ $$/€
$/€
f
f
$/€
$/€
$/€
€)/E
(E $/€ -E$/€ )/E$/€=R$-R€-(E
-E
$/€
$/€
$/€
€
________________
f
f
If
R
=
R
,
then
E $/€ )/
= E$/€
R
=
R
+(E
$
€
$/€ ;
$
€
$/€ -E$/€
f
€
(1+R€ )
∵ (Ef$/€ If
-ER$/€f$ <)/ R
E$/€
•then
R€ Eisf $/€
a small number
,
.
€
(E $/€ -E$/€ )/ E$/€ = R$<-ER$/€
€
f
∴ (E $/€
-E$/€ )/ E$/€
= R$ -Rrate
or at a
€
•
The
currency
with
a
lowerer
interest
sells
Let P stand for premium , then P = R$ – R€ .
f
R$ =in
R€the
+(E
E$/€ ( covered
interest parity )
premium
forward
market.
升水$/€ -E$/€ )/exchange
, then
D=–P
= R€ – R
with
a higher
interest
rate
Let●DThe
standcurrency
for discount
$ . sells at a
discount in贴水
the forward exchange market.
How changes in E affect expected returns (I)
R$= R€ + (Ee$/€- E$/€)/ E$/€
Expected dollar return
on euro deposits
R€ + (Ee$/€/ E$/€ -1)
current depreciation
R$> R€ + (Ee$/€- E$/€)/ E$/€
capital inflow
E$/€
Dollar appreciates.
R$= R€ + (Ee$/€- E$/€)/ E$/€
Expected dollar return
Interest parity condition holds again.
How changes in E
affect expected returns (II)
> R€ + (Ee$/€/ E$/€ - 1)
R$ =
Other things equal , depreciation of a country’s currency today
lowers the expected domestic currency return on foreign currency
deposits.
R$ <= R€ + (Ee$/€/ E$/€ - 1)
Other things equal , appreciation of a country’s currency today
raises the expected domestic currency return on foreign currency
deposits.
How changes in E
affect expected returns (III)
Figure 13-3 The Relation Between the Current E $/€ and the
Expected Dollar Return on Euro Deposits
Today's E $/€
E
2
E
1
E
$/€
$/€
3
$/€
2
1
3
Excepted
return on
euro return
Rates of return
(in dollar terms)
With fixed Ee$/€ and
R€, the relation
between today’s E$/€
and the expected
dollar return on euro
deposits defines a
download-sloping
schedule.
How changes in E
affect expected returns (IV)
Figure 13-3 The Relation Between the Current E $/€ and the
Expected Dollar Return on Euro Deposits
Today's E $/€
E $/€
1
2
E $/€
$/€
Excepted
return on
euro return
Rates of return
(in dollar terms)
Given Ee$/€ and R€ ,
an appreciation of
the dollar against
the euro deposits,
measured in terms
of dollars, and vice
versa.
The Equilibrium Exchange Rate
Figure 13-4 Determination of the Equilibrium Dollar/Euro
Exchange Rate
Exchange rate,
E $/€
Return on
dollar deposits
E 2 $/€
2
E 1 $/€
E
3
R$= R€ + (Ee$/€- E$/€)/
E$/€
1
$/€
3
R$
Excepted
return on
euro return
Rates of return
(in dollar terms)
Equilibrium in the
FX market is at
point 1, where the
expected dollar
return on dollar
and euro deposits
are equal.
Interest Rates, Expectations & Equilibrium (I)
Figure 13-5 Effect of a Rise in the Dollar Interest Rate
The Effect
of Changing
Interest Rates on
the Current
Exchange Rate
Exchange
Dollar return
rate,E $/€
R$
1
E 1 $/€
1'
2
E 2 $/€
Excepted
euro return
Conclusion:
R
1
$
R
2
$
Rates of return
(in dollar terms)
All else equal, an increase in the interest paid on deposits of
a currency causes that currency to appreciate against foreign
currency, and vice versa.
Interest Rates, Expectations & Equilibrium (II)
18
Figure 13-6 Effect of a rise in the Euro Interest Rate
Exchange rate
E $/€
The Effect of Changing
Interest Rates on the
Current Exchange Rate
E
2
Rise in
R€
2
$/€
E 1 $/€
1
Excepted
euro return
R€
Conclusion:
Rates of return
(in dollar terms)
All else equal, a rise in the foreign interest rate causes
the domestic currency to depreciate against the foreign
currency, and vice versa.
Interest Rates, Expectations & Equilibrium (III)
Figure 13-7 Effect of a rise in expected future exchange rate
Exchange rate
E $/€
The Effect of Changing
expectations on the
Current Exchange Rate
E e $/€
E
2
E
1
$/€
2
$/€
1
Excepted
euro return
Conclusion:
Rates of return
(in dollar terms)
All else equal ,a rise in the expected future exchange rate
causes a rise in the current exchange rate, and vice versa.
Interest Rates, Expectations & Equilibrium (IV)
Figure 13-7 Effect of a change in the dollar or euro Interest Rate
Exchange rate
E $/€
R$
R€
E e $/€
E 12 $/€
12
Excepted
euro return
Rates of return
(in dollar terms)
increase
in foreign
the interest
paid on
deposits
of
All else
else equal,
equal,
a rise
in the
interest
rate
causesrate
equal an
,a
expected
future
exchange
a the
currency
that
to appreciate
foreign
domestic
currency
to depreciate
against
thevice
foreign
causes
a causes
rise in
the currency
current
exchange
rate,against
and
versa.
currency,
andand
vice
versa.
currency,
vice
versa.
Question
Thanks