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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

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Chapter 13 l.jpg

Chapter 13

Exchange Rates and the Foreign Exchange Market: An Asset Approach

November 2009


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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

    • role of interest rates on currency deposits

    • role of expectations about future exchange rates


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Domestic and foreign currencies

  • 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


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Definitions of Exchange Rates

  • 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


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Depreciation and Appreciation

  • 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.


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Depreciation and Appreciation

  • 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)


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Depreciation and Appreciation (cont.)

  • 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.


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Depreciation and Appreciation (cont.)

  • 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.


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How are exchange rates determined?

  • 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


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The Foreign Exchange Market

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


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In which country should you keep your savings?

  • 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

    • Turn your US dollars into Canadian dollars

    • Deposit your Canadian dollars in a Canadian bank

  • Such trades represent supply and demand in currency markets


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The Demand for Foreign Currency Assets

  • 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).


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The Demand for Foreign Currency Assets

  • 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


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The Demand for Foreign Currency Assets

  • 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:


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The Demand for Foreign Currency Assets

  • 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.


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The Demand for Foreign Currency Assets

  • 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]


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The Demand for Foreign Currency Assets

  • 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:


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Let’s compare domestic and foreign rates of return!

  • 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!


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The Market for Foreign Exchange

  • 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


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The Market for Foreign Exchange (cont.)

  • 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.


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current

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


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The Market for Foreign Exchange (cont.)

  • 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↑.


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The Market for Foreign Exchange (cont.)

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

If R↓, or Ee↑, or R*↑, then E↑.


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R

(–)

E

(+)

R*

(+)

Ee

Value of the Euro (E)

  • Therefore, E must ↓ if:

    • R↑

    • R*↓

    • Ee↓


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