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This chapter introduces the concept of foreign exchange rates and explores how they are determined, their fluctuations over time, and their connection to exchange markets.
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Introduction • Global business includes goods, services, stocks, bonds, etc. around the globe. • To understand the nature of these transactions, we must become familiar with exchange rates. • All cross-border transactions have a buyer and a seller that want to use their own currency. • The exchange rate, at it most basic level, is the tool we use to measure the price of one currency in terms of another.
Introduction • In this chapter we will discuss: • How foreign exchange rates are determined, • What accounts for their fluctuations over days, months, years, and decade, and • The connection of foreign exchange rates and exchange markets.
Foreign Exchange Basics • When you travel to other countries, the providers of the goods and services you buy usually want to be paid in their own currency. • In Europe that is easier because most European countries, at least members of the European Monetary Union, all use euros. • The price of one euro in dollars is called the dollar-euro exchange rate.
The Nominal Exchange Rate • Exchanging dollars for euros is like any other economic transaction: you are using your money to buy something, but in another country. • The price you pay for this currency is called the nominal exchange rate, or simply the exchange rate. • The nominal exchange rate is the rate at which one can exchange the currency of one country for the currency of another country.
The Nominal Exchange Rate • Exchange rates change every day. • Figure 10.3 shows the dollar-euro exchange rate from January 1999 to January 2010. • The figure plots the number of dollars per euro (€), which is conventional way to quote the dollar-euro exchange rate.
The Nominal Exchange Rate • A decline in the value of one currency relative to another is called a depreciation of the currency that is falling in value. • The rise in the value of one currency relative to another is called an appreciation of the currency that is rising in value. • When one currency goes up in value relative to another, the other currency must go down.
The Nominal Exchange Rate • The price of the British pound is quoted in the same ways the euro - the number of dollars that can be exchanged for one pound (£). • The price of Japanese yen (¥) is quoted as the number of yen that can be purchased with one dollar. • Most rates tend to be quoted in the way that yields a number larger than one.
The Real Exchange Rate • When you visit a foreign country you want to know how much you can buy with that currency. • The real exchange rateis the rate at which one can exchange the goods and services from one country for the goods and services from another country. • It is the cost of a basket of goods in one country relative to the cost of the same basket of goods in another country.
The Real Exchange Rate • There is a simple relationship between the real exchange rate and the nominal exchange rate. • For an espresso in the U.S. and in Italy the real exchange rate:
The Real Exchange Rate • This tells us that one cup of Starbucks espresso buys 1.1 cups of Italian espresso. • The real exchange rate has no units of measurement. • Whenever the ratio in this equation is more than one, foreign products will seem cheap.
The Real Exchange Rate • The competitiveness of U.S. exports depends on the real exchange rate. • Appreciation of the real exchange rate makes U.S. exports more expensive to foreigners, reducing their competitiveness. • Depreciation of the real exchange rate makes U.S. exports seem cheaper to foreigners, improving their competitiveness.
The Wall Street Journal carries daily Foreign Exchange column that describes events in the markets, as well as a table reporting the most recent nominal exchange rates between the U.S. dollar and various foreign currencies. • Spot rates are the rates for an immediate exchange (subject to a two-day settlement period). • Forward rates are the rates at which foreign currency dealers are willing to commit to buying or selling a currency in the future.
Foreign Exchange Markets • Because of its liquidity, the U.S, dollar is one side of roughly 85 percent of the currency transactions. • If you want to exchange Thai baht for Japanese Yen, you likely have to perform two transactions: • Thai baht for U.S. dollars and then • U.S. dollars for Japanese yen. • The United Kingdom is home to more than one-third of foreign exchange trades.
Exchange Rates in the Long Run • How are exchange rates determined? • This section will look at the determination of the long-run exchange rate and the forces that drive its movement over an extended period, such as a year or more.
The Law of One Price • The law of one price is based on the concept of arbitrage -- the identical products should sell for the same price. • We can conclude that identical goods and services should sell for the same price regardless of where they are sold. • If they don’t, someone can make a profit.
The Law of One Price • If a specific model of TV is cheaper in Windsor, Ontario than Detroit, someone will buy in Windsor and sell in Detroit for a profit. • This continues until the prices are the same. • Ignoring transportation costs and considering foreign exchange rate, the law of one price tells us that:
The Law of One Price • However, the law of one price fails almost all of the time. Why? • Transportation costs can be significant, especially for heavy items; • Tariffs, the taxes countries charge at their borders, can be high; • Technical specifications can differ; • Tastes differ across countries, leading to different pricing; and • Some things simply cannot be traded.
One justification for investing abroad is that more diversification is always better. • It makes sense to hold a portion of your equity portfolio in foreign stocks, as long as the stocks in the other country do not move in lock step with U.S. stocks. • Evidence shows that holding foreign stocks reduces risk without sacrificing returns, despite the risk of exchange rate fluctuations.
Purchasing Power Parity • The law of one price is extremely useful in explaining the behavior of exchange rates over long periods. • To understand this, we can extend the law from a single commodity to a basket of goods and services. • The result is the theory of purchasing power parity (PPP), which means that one unit of U.S. domestic currency will buy the same basket of good and services anywhere in the world.
Purchasing Power Parity • According to the theory of purchasing power parity: • Thus, purchasing power parity implies that the real exchange rate is always equal to one.
Purchasing Power Parity • If we just showed that a dollar does not buy the same amount of coffee in Italy and the U.S., then how can this be true? • On a given day, it is not. • But over the long term, exchange rates do tend to move, so this concept helps us to understand changes that happen over years or decades.
Purchasing Power Parity • If we quote the price of a basket of goods in the U.K in pounds instead of dollars, then: • Purchasing power parity implies that when prices change in one country but not in another, the exchange rate should change as well.
Purchasing Power Parity • If inflation occurs in one country but not in another, the change in prices creates an international inflation differential. • The currency of a country with high inflation will depreciate. • We can confirm this by looking at a plot of: • The historical difference between inflation in other countries and inflation in the U.S., and • The percentage change in the number of units of other countries’ currencies required to purchase one dollar.
Purchasing Power Parity • Figure 10.4 presents data for 71 countries drawn from files maintained by the International Monetary Fund. • The solid 45-degree line is a line consistent with the theoretical prediction of purchasing power parity. • On the 45-degree line, exchange rate movements exactly equal differences in inflation.
Purchasing Power Parity • The data in Figure 10.4 tell us that purchasing power parity held true over the 25-year period. • Over weeks, months, and even years, nominal exchange rates can deviate substantially from the levels implied by purchasing power parity. • This means PPP does not help us explain short-term movements.
Purchasing Power Parity • We often hear of currencies being undervalued or overvalued. • When people use these terms, they have in mind a current market rate that deviates from what they consider to be purchasing power parity. • If we think one dollar should purchase one euro, the “correct” long run exchange rate, and one dollar purchases only 0.90 euro, it is undervalued relative to the euro.
By the end of the 20th century, the Big Mac was available in 11 countries and was always defined the same way. • The Economist magazine saw this as an opportunity. • Using Big Mac prices as a basis for comparison, the Big Mac index shows the extent to which each country’s currency was undervalued or overvalued relative to the U.S. dollar.
Exchange Rates in the Short Run • To explain short-run exchange rates, we turn to an analysis of supply and demand for currencies. • Because, in the short-run, prices don’t move much, these nominal exchange rate movements represent changes in the real exchange rate.
The Supply of Dollars • We will use the U.S. dollar as the domestic currency. • This means we will discuss the number of units of foreign currency that it takes to purchase one dollar. • The supply of dollars slopes upward. • The higher the price a dollar commands in the market, the more dollars are supplied. • The more valuable the dollar, the cheaper are foreign-produced goods and foreign assets relative to domestic ones in the U.S. Markets.
The Demand for Dollars • Foreigners who want to purchase American-made goods, assets, or services need dollars to do so. • The demand curve for dollars slopes downward. • The cheaper the dollar--the lower the dollar-euro exchange rate--the more attractive are U.S. investments and the higher is the demand for dollars with which to buy them.
Should you try to turn a profit on changes in the exchange rate? • No. • Having a good sense of what should happen in the long run doesn’t help much in the short run. • Looking at forward markets for major currencies show that forward rates are virtually always within one or two percent of current spot rates. • The best forecast of the future exchange rate is usually today’s exchange rate.
Equilibrium in the Market for Dollars • The equilibrium exchange rate is the rate that equates supply and demand for dollars. • Because the values of all the major currencies in the world float freely, they are determined by market forces. • Fluctuation in their value are the consequences of shifts in supply or demand.
Shifts in the Supply of and Demand for Dollars • What shifts the supply of dollars? • Americans wanting to purchase products from abroad to buy foreign assets will supply dollars to the foreign exchange market. • Anything that increases their desire to import goods and services from abroad, or their preference for foreign stocks and bonds, will increase the supply of dollars.
Shifts in the Supply of and Demand for Dollars A rise in the supply of dollars can be caused by: • An increase in Americans’ preference for foreign goods. • An increase in the real interest rate on foreign bonds (relative to U.S. bonds). • An increase in American wealth. • A decrease in the riskiness of foreign investments relative to U.S. investments. • An expected depreciation of the dollar.
Shifts in the Supply of and Demand for Dollars • An increase in supply leads to a depreciation of the dollar. • The number of euros per dollar fall.
Shifts in the Supply of and Demand for Dollars To understand shifts in the demand for dollars, we can look at the previous list from the point of view of a foreigner: • Foreigners prefer more American-made goods. • The real yield on U.S. bonds rises (relative to foreign bonds). • When foreigner wealth increases. • When the riskiness of American investments falls. • When the dollar is expected to appreciate.
Exchange Rate in the Short-run:Shifts in Demand • An increase in demand leads to an appreciation of the dollar. • The number of euros per dollar fall.
During the crisis of 2007-2009, some non-U.S. banks faced a sudden threat to their survival: • When the interbank market dried up, they found it difficult to borrow the U.S. dollars needed to fund their dollar loans and securities. • Banks face currency risk if they borrow in one currency and lend in another. • The U.S. central bank arranged a series of extraordinary dollar swaps with 10 other central banks.
Explaining Exchange Rate Movements • There was a 30 percent appreciation of the dollar relative to the euro that occurred between January 1999 and October 2000. • Our model allows us to conclude that the cause was either a decrease in the dollars supplied by Americans or an increase in the dollars demanded by foreigners.
Explaining Exchange Rate Movements • During this period, Americans increased their purchases of foreign goods, increasing the supply of dollars. • At the same time, investment funds were pouring into the U.S. from abroad, increasing the demand for dollars. • The increase in demand was greater than the increase in supply, leading to an increase in the exchange rate.
S0 S1 E0 Number of Euros per Dollar E1 D1 D0 Quantity of Dollars Traded Explaining Exchange Rate Movements
Government Policy and Foreign Exchange Intervention • Currency appreciation drives up the price foreigners pay for a country’s exports and reduces the price residents of the country pay for imports. • This shift in foreign versus domestic prices hurts domestic businesses. • Government officials can intervene in foreign exchange markets in several ways.
