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# Chapter 13 - PowerPoint PPT Presentation

Chapter 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach November 2009 Preview The basics of exchange rates Exchange rates and the prices of goods Foreign exchange markets The demand for currency and other assets A model of foreign exchange markets

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### Chapter 13

Exchange Rates and the Foreign Exchange Market: An Asset Approach

November 2009

• The basics of exchange rates

• Exchange rates and the prices of goods

• Foreign exchange markets

• The demand for currency and other assets

• A model of foreign exchange markets

• role of interest rates on currency deposits

• role of expectations about future exchange rates

• Domestic currency refers to the US dollar

• Foreign currency refers to the Euro, or at times to the Yen or the Yuan

• The exchange rate is the price of the foreign currency

• The exchange rate is the amount of the domestic currency that one unit of the foreign currency is worth

• Its symbol is E

• Example: if €1 is worth \$1.54, then E = 1.54

• Exchange rates allow us to show the price of a good or service in any currency.

• What is the price of a Honda Accord?

• ¥3,000,000

• Or, ¥3,000,000 x \$0.0098 = \$29,400

• Because ¥1 is assumed to be worth \$0.0098: E = 0.0098

• Depreciation is a decrease in the (exchange) value of a currency (relative to another currency).

• A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.

• Appreciation is an increase in the (exchange) value of a currency (relative to another currency).

• An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

• Example: €1 used to be worth \$1. Now €1 is worth \$1.46.

• The euro is now more valuable. It has appreciated.

• So, the dollar is less valuable. It has depreciated.

• Note that E has increased from 1.00 to 1.46

• Note that E is the value of the euro in dollars.

• E↑ means appreciation of the euro (and depreciation of the dollar)

• E↓ means depreciation of the euro (and appreciation of the dollar)

• Example: Suppose the foreign currency is the yen. Suppose E increases from 0.0098 to 0.0100.

• A Honda Accord costs ¥3,000,000. What is it in dollars?

• 3,000,000 0.0098 = \$29,400

• 3,000,000 0.0100 = \$30,000

• A depreciated currency is less valuable, and therefore it can buy fewer foreign-made goods.

• When our currency depreciates:

• imports are more expensive for us, and conversely

• domestically produced goods are less expensive for foreigners.

• A depreciated currency lowers the price of exports relative to the price of imports.

• Suppose E decreases from 0.0098 to 0.0090.

• How much does a Honda cost? ¥3,000,000

• 3,000,000 x 0.0098 = \$29,400

• 3,000,000 x 0.0090 = \$27,000

• An appreciated currency is more valuable, and therefore it can buy more foreign-made goods.

• An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.

• An appreciated currency raises the price of exports relative to the price of imports.

• The exchange rate (E) is a price

• It may be the price of one currency in units of another, but it is a price nevertheless

• And people buy and sell currencies just like they trade goods and services

• So, the familiar theory of supply and demand can be used to explain what determines the exchange rate and what makes the exchange rate fluctuate

The main participants:

• Commercial banks and other depository institutions: their transactions involve buying/selling of bank deposits in different currencies for their clients.

• Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets.

• Private firms: they conduct foreign currency transactions to buy/sell goods, assets or services.

• Central banks: conduct official international reserves transactions.

• Private individuals, such as tourists

• This chapter focuses on currency trades that are motivated by our constant search for a good return on our savings

• If you think that your savings would grow fastest in a Canadian bank, you will need to

• Such trades represent supply and demand in currency markets

• The rate of return on a bank deposit denominated in the domestic currency is simply the domestic interest rate on bank deposits, R.

• The rate of return on a bank deposit denominated in the foreign currency is

• the foreign interest rate on bank deposits, R*, plus

• the expected rate of appreciation of the foreign currency (relative to the domestic currency).

• Suppose the interest rate on a dollar deposit is 2%.

• R = 0.02

• Suppose the interest rate on a euro deposit is 4%.

• R* = 0.04

• Does a euro denominated deposit yield a higher expected rate of return?

• Should you expect your savings to grow faster if you exchange your US dollars for Euros and deposit them in a European bank?

• Not necessarily!

• The higher interest rate is not the decisive factor

• Suppose today \$1 = €1: that is, E = 1.

• Suppose the exchange rate expected one year in the future is \$0.97 = €1: that is, Ee = 0.97.

• This means that the euro is expected to depreciate by 3%: (0.97 – 1.00)/1.00 = – 0.03.

• In general, the expected rate of increase in E is:

• Again, suppose today’s exchange rate is \$1 for €1: that is, E = 1.

• Suppose the rate expected one year in the future is \$0.97 for €1: that is, Ee = 0.97.

• \$100 can be exchanged today for €100.

• These €100 will yield €104 after one year, as the interest rate on euro deposits is 4% (R* = 0.04).

• These €104, when received a year in the future, are expected to be worth 0.97  104 = \$100.88.

• So, \$100 becomes \$100.88 after one year if you keep the money in a European bank (that is, in Euro denominated assets)

• The rate of return in terms of dollars from investing in euro deposits is (\$100.88 – \$100)/\$100 = 0.0088.

• 0.04 + -0.03 = 0.01 ≈ 0.0088

• Note that the rate of return on a euro deposit is approximately equal to:

• the interest rate on euro deposits [R*], plus

• the expected appreciation of the euro [(Ee – E)/E]

• Therefore, the dollar rate of return on Euro denominated deposits approximately equals

• the interest rate on euro deposits, R*

• plus the expected rate of appreciation on euro deposits (Ee – E)/E. This is:

• We have already calculated that your money will grow at the annual rate of 0.01 if you keep it in a euro bank account (or, in euro-denominated assets)

• Let’s compare this rate of return with the rate of return from a domestic bank deposit, R.

• This rate of return is simply the US interest rate: 0.02

• The euro deposit has a lower expected rate of return: all investors will prefer dollar deposits and none will hold euro deposits.

• So, even though the foreign interest rate is higher, your savings can be expected to grow faster in the US!

• The foreign exchange market is in equilibrium when deposits in all currencies offer the same expected rate of return.

• This condition is called interest parity

• Suppose interest parity did not hold.

• Suppose R > R* + (Ee – E)/E.

• Then no investor would want to hold Euro deposits

• This would drive down the demand for and the price of Euros (E↓).

• All investors would want to hold dollar deposits, driving up the demand for and the price of dollars (E↓).

• This will increase the right side until equality is achieved.

exchange rate

expected

exchange rate

interest rate

on euro deposits

expected rate of return = interest rate on dollar deposits

expected rate of appreciation of the euro

expected rate of return on euro deposits

The Demand for Foreign Currency Assets

• R = R* + (Ee – E)/E

• How do changes in the current exchange rate affect expected returns in foreign currency deposits?

• If E↓, or Ee↑, or R*↑, then the rate of return on euro bank deposits ↑.

• Therefore, for equilibrium to be maintained, R↑.

What can the market for foreign exchange tell us about exchange rates?

If R↓, or Ee↑, or R*↑, then E↑.

(–)

E

(+)

R*

(+)

Ee

Value of the Euro (E)

• Therefore, E must ↓ if:

• R↑

• R*↓

• Ee↓