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Lecture 6. UNDERSTANDING EXCHANGE RATES (2). Exchange rates in the short run. The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates.

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Exchange rates in the short run

- The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates.
- In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $).

Comparing expected returns across nations

- We consider Euroland the “home country”, and the domestic currency €.
- The USA are the “foreign country” with the foreign currency $.

Euro deposits bearan interest rate i€.

Dollar deposits bearan interest rate i$.

How does Hans, the European, compare the return on dollar deposits abroadwith the return on domesticinvestments in € ?

Comparing expected returns across nations

- If Hans invests in the USA, he must realize that his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €.
- If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%.

Comparing expected returns across nations

- More formally

Comparing expected returns across nations

- If Bill invests in Euroland, he must realize that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $.
- If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€ ), then the expected return is 3% + 10% = 13%.

Comparing expected returns across nations

- More formally

The key point:

RET$ and RET€ are symmetrical (with opposite sign)

As the relative expected return on €-deposits increases, both domestic and foreign residentsrespond in the same way: they want to holdmore €-deposits and fewer deposits in $.

Interest parity condition

- At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk.
- When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:

Why? Arbitrage and liquidity trading

- Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition

Market adjustment: Examples

We assume: i$ = 10%, and wet+1 = 1 $/€.

- When wt = 1.0 $/€, the expected appreciation/ depreciation of the € = 0% and the expected return in € is then equal to i$ = 10% (Point B).
- When wt = 0.95 $/€, wet = 0.052 =5.2%, and the expected return in € = 4.8% (Point A).
- When wt = 1.05 $/€, wet = -0.048 =-4.8%, and the expected return in € = 14.8% (Point C).

D

Equilibrium in forex marketswt ($/€)

RET$

RET€

1.05

C

1.00

B

0.95

A

14.8%

5.2%

10%

Expected return (€)

What happens in disequilibrium

- When w ≠ 1.0, there is a market reaction:
- w > 1: People will try to sell € and buy $.=> “Selling €” and “buying $”
- But no one holding $ will sell at that price, there is “excess supply” of euros;i.e. the price of €-deposits relative to $-deposits must fall.
- The amount of dollars per euro falls, the euro depreciates.

What happens in disequilibrium

- When :
- w < 1: People will try to sell $ and buy €.=> “Selling $” and “buying €”
- But no one holding € will sell at that price, there is “excess supply” of dollars;i.e. the price of $-deposits relative to €-deposits must fall.
- The amount of dollars per euro increases, the euro appreciates.

Change in the foreign interest rate

- If the foreign interest rate increases, the expected return RET$ also increases.
- This leads to a depreciation of the euro.
- The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate).

Change in the domestic interest rate

- An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET€ schedule to the right.
- It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €.

What about inflation ?

- If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific
- Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate.
- On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate.

Volume of trading by groups of actors

Bill. US dollars per day

With traders

With other financial institutions

With non-financial institutions

Actors in forex markets9,74

Deutsche Bank

9,08

Goldman Sachs

7,09

JP Morgan

5,22

Chase Manhattan Bank

4,69

Credit Suisse First Boston

4,10

UBS Warburg

3,55

State Street Bank & Trust

2,99

Bank of America

2,99

Morgan Stanley Dean Witter

2,87

The forex market is highly concentratedAnd will be concentrated even more …

- Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology.
- On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction.

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