Chapter 13 Section II. Equilibrium in the Foreign Exchange Market. Factors affecting the demand for FX. To construct the model, we use two factors: 1. demand for (rate of return on) dollar denominated deposits R$
Equilibrium in the Foreign Exchange Market
1. demand for (rate of return on) dollar denominated deposits R$
2. demand for (rate of return on) foreign currency denominated deposits to construct a model of the foreign exchange market = R*+x
R$ = R€ + (Ee$/€ - E$/€)/E$/€
Note: UIRP assumes investors only care for expected returns: they don’t need to be compensated for bearing currency risk.
To determine the equilibrium exchange rate, we assume that:
Mathematically, we want to solve the UIRP condition for E$/€ . That is the same as asking how the RHS and the LHS of the UIRP condition change with E$/€ , and then looking for an ‘intersection.’
Current exchange foreign currency?
Expected dollar return
on dollar deposits, R$
R$The spot e.r and the Exp Return on $Deposits
No one is willing to foreign currency?
hold euro deposits
No one is willing to
hold dollar depositsDetermination of the Equilibrium e.r.
A depreciation foreign currency?
of the euro is
of the dollar.A Rise in the $ Interest Rate
The expected return from holding € assets is > than $assets.
Investors get out of $ assets into € assets, sell $ to buy €, the $ depreciates or € appreciates. This creates an expected appreciation of the dollar (x↓), thus a fall in the expected return from holding € assets
expect the euro to appreciate
Suppose that when investing $1 in a deposit in euros, instead of planning to convert euros back into dollars at an exchange rate of Ee$/€ one year from now, I enter now a contract to sell euros forward at the rate F$/€.
My return from such investment then is:
So, you buy the € deposit with $ To avoid exchange rate risk by buying the € with $, at the same time sell the proceeds of your investment (principal+interest) forward for $ → you have covered yourself.
R$= R€+ (F$/€-E$/€)/E$/€
where F$/€ = the forward exchange rate. This is called “covered” parity because it involves no risk-taking by investors: unlike UIRP, CIRP is a true arbitrage relationship.
Forward discount of $ on £ is increasing but on € decreasing.