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Chapter 13: Krugman and Obstfeld Introduction Exchange Rates – Descriptive Material The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the Foreign Exchange Market Interest Rates, Expectations, and Equilibrium Summary Chapter 13: Krugman and Obstfeld

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chapter 13 krugman and obstfeld
Chapter 13: Krugman and Obstfeld
  • Introduction
  • Exchange Rates – Descriptive Material
  • The Foreign Exchange Market
  • The Demand for Foreign Currency Assets
  • Equilibrium in the Foreign Exchange Market
  • Interest Rates, Expectations, and Equilibrium
  • Summary
slide2

Chapter 13: Krugman and Obstfeld

  • Readings:
    • Krugman and Obstfeld Chapter 13
    • Economic Report of the President 2007 – Ch 7
    • The Basics of Foreign Trade and Exchange
introduction
Introduction
  • The exchange rate is a price
    • It lets us covert different currencies to a common unit.
  • Exchange rates are determined in the same way as other asset prices.
    • Supply
    • Demand
    • What a surprise!
  • Get into the specifics – exchange rate determination and international foreign exchange markets.
exchange rates
Exchange Rates
  • An exchange rate either coverts foreign prices to dollars or dollar prices to foreign.
  • Domestic and Foreign Prices
    • If we know the exchange rate between two countries, we can compute the price of one country’s goods in terms of the other country’s money.
      • Example: The dollar price of a C$50 sweater with a dollar exchange rate of $1.05 per CAD is (1.02 $/C$) x (C$50) = $52.50
      • One year earlier: The dollar price of a C$50 sweater with a dollar exchange rate of $0.86 per CAD is (0.86 $/C$) x (C$50) = $43.50
exchange rates6
Exchange Rates
  • Depreciation of home country’s currency
    • A rise in the home price of a foreign currency – more dollars for each Canadian dollar.
    • For fixed domestic prices, home goods become cheaper in foreign markets
      • Reduced demand?
      • Increased supply?
      • Difference between goods and money?
  • Appreciation of home country’s currency
    • A fall in the home price of a foreign currency – less dollars for each Canadian dollar.
    • For fixed domestic prices, home goods become more expensive in foreign markets
      • Same questions different sign.
exchange rates7
Exchange Rates
  • Import and export demands are influenced by relative prices. But, don’t forget relative prices are influenced by import and export demand.
  • Appreciation of a country’s currency:
    • Raises the relative price of its exports and lowers the relative price of its imports.
    • Will exports and imports increase or decrease?
  • Depreciation of a country’s currency:
    • Lowers the relative price of its exports and raised relative price of imports.
    • Will exports and imports increase or decrease?
slide8

Example

  • The Canadian Dollar appreciated  the price of the Canadian sweater went up. Do we buy fewer Canadian sweaters?
  • The dollar price of Canadian sweaters increased.
    • Price effect makes us want to consumer fewer sweaters.
  • BUT! Why did the price increase?
    • The CAD might have appreciated BECAUSE we wanted to buy more Canadian sweaters (its cold there; they know a thing or two about sweaters).
      • Does it matter if we like U.S. sweaters less?
    • The CAD might have appreciated BECAUSE we love Canadian oil.
slide9

Transition

  • Talk about the foreign exchange market itself.
    • Who trades in the foreign exchange market?
    • Where do the trades take place?
  • Discuss demand for assets driving exchange rate.
    • Does it matter if it is demand for assets or demand for goods which determines the exchange rate?
    • Why do people buy assets?
  • Interest parity.
the foreign exchange market
The Foreign Exchange Market
  • Exchange rates are determined in the foreign exchange market.
    • The market in which international currency trades take place
  • The major players in the foreign exchange market are:
      • Commercial banks
      • International corporations
      • Nonbank financial institutions
    • Most important player
      • Central banks – completely control the supply of money – at the end of the day this is the primary determinant of the value of a currency.
type of transactions
Type of Transactions
  • Interbank trading
    • Foreign currency trading among banks
    • It accounts for most of the activity in the foreign exchange market.
type of transactions12
Type of Transactions
  • Characteristics of the Market
    • The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years.
    • New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).
    • The integration of financial centers implies that there can be no significant arbitrage.
      • The process of buying a currency cheap and selling it dear.
type of transactions13
Type of Transactions

Vehicle currency

  • A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency.
    • Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.
type of transactions14
Type of Transactions
  • Spot Rates and Forward Rates
    • Spot exchange rates
      • Apply to exchange currencies today.
    • Forward exchange rates
      • Apply to exchange currencies on some future date at a prenegotiated exchange rate.
    • Forward and spot exchange rates, while not necessarily equal, almost always move closely together.
type of transactions16
Type of Transactions
  • Foreign Exchange Swaps
    • Spot sales of a currency combined with a forward repurchase of the currency.
    • They make up a significant proportion of all foreign exchange trading.
    • Why would you want a foreign exchange swap?
    • What is the difference between a foreign exchange swap and simply purchasing a foreign exchange forward contract?
type of transactions17
Type of Transactions
  • Futures and Options
    • Futures contract
      • The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.
    • Foreign exchange option
      • The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.
    • For what purpose would you use a foreign exchange option?
    • Why would you prefer an option to a futures contract or to an outright forward purchase?
slide18

Type of Transactions

  • Hedging versus transaction derived demand.
  • Hedging: Offsetting the risk of a specific foreign currency exposure.
  • Transaction derived demand: I need a specific amount of foreign currency at a specific future date.
slide19

Type of Transactions

  • Almost all foreign exchange transactions are conducted as a swap.
the demand for currency
The Demand for Currency
  • Demand for foreign currency exactly the same as the demand for IBM stock.
    • You don’t care about IBM you only want more goods tomorrow.
    • Increase in return buy more. Decrease buy less.
  • Assets and Asset Returns
    • Defining Asset Returns
      • Nominal return – how much money do I have tomorrow for investing money today.
    • The Real Rate of Return
      • The amount of goods you can buy with the money you make. Wheat today versus wheat tomorrow. Inflation really matters.
the demand for currency21
The Demand for Currency
  • Risk and Liquidity
    • Risk
      • An asset that pays off either 100 or 0 tomorrow with equal probability is not the same asset as one which pays off 50 with certainty.
    • Liquidity
      • The ease with which it can be sold or exchanged for goods. Cash is the most liquid asset. A high (notional) rate of return is useless if I can’t sell the asset.
the demand for currency22
The Demand for Currency
  • Choosing an investment currency.
    • All things equal, choose the currency with the highest interest rate.
    • All things equal, choose the currency with the largest expected appreciation.
  • Hmm? Do you expect to make money (excess return) by investing in foreign money markets?
carry trade
Carry Trade
  • Borrow in a low interest rate economy (Japan) and invest in a high interest rate economy (New Zealand).
    • Seems like a great way to get rich.
  • Questions which must be asked
    • Is this a risk free investment?
    • What keeps other people from making the investment?
the demand for currency26
The Demand for Currency
  • Exchange Rates and Asset Returns
    • The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.
    • In order to decide whether to buy a euro or a dollar deposit, one must calculate the dollar return on a euro deposit.
the demand for currency27
The Demand for Currency
  • A Simple Rule
    • The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro.
      • Therate of depreciationof thedollar against the euro is the percentage increase in the dollar/euro exchange rate over a year.
slide28

The Demand for Currency

  • What is the return on investing in euros?
    • Take $100 dollars, convert into euros today.
      • $100 * €/$ = €70.9 (if exchange rate is 1.41 $/€)
    • Deposit €70.9 in a euro-area bank
      • €70.9 * (1+r) = €73.96 (if interest rate is 3.86%)
    • Convert €73.96 into dollars.
      • Which exchange rate to use? Use the interest rate prevailing one year from now.
      • €73.96*$/ € F= $103.86 (if forward rate is 1.41 $/€)
    • If U.S. interest rate is 4.14%, which currency should we invest in. But then, what does that mean for the exchange rate?  Euro is expected to appreciate to 1.43 $/€
the book gives this interest parity eq
The Book Gives this Interest Parity Eq
  • If interest parity holds, the following equation must also hold:

R$ = R€- (Ef$/€-E$/€)/E$/€

where:

R$ = interest rate on one-year dollar deposits

R€ = today’s interest rate on one-year euro deposits

E$/€= today’s dollar/euro exchange rate (number of dollars per euro)

Ee$/€ = dollar/euro exchange rate (number of dollars per euro) expected to prevail a year from today

slide30

We can use the easier and correct Interest Parity Eq

  • If interest parity holds, the following must also hold:

R$= (1+r€ )Ef$/€/E$/€

where:

R$ = interest rate on one-year dollar deposits

R€ = today’s interest rate on one-year euro deposits

E$/€= today’s dollar/euro exchange rate (number of dollars per euro)

Ef$/€ = dollar/euro exchange rate (number of dollars per euro) expected to prevail a year from today

the demand for currency31
The Demand for Currency
  • Return, Risk, and Liquidity in the Foreign Exchange Market
    • The demand for foreign currency assets depends not only on returns but on risk and liquidity.
      • There is no consensus among economists about the importance of risk in the foreign exchange market.
      • Most of the market participants that are influenced by liquidity factors are involved in international trade.
        • Payments connected with international trade make up a very small fraction of total foreign exchange transactions.
        • But they may be the marginal demanders of a currency.
    • We will for the most part ignore the risk and liquidity motives for holding foreign currencies.
      • But, it likely really matters.
equilibrium in the foreign exchange market
Equilibrium in the Foreign Exchange Market
  • Interest Parity: The Basic Equilibrium Condition
    • The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.
    • What about our Carry Trade example.
    • Interest parity condition
      • The expected return is the same no matter where you deposit your money.

R$= (1+r€ )Ef$/€/E$/€

equilibrium in the foreign exchange market33
Equilibrium in the Foreign Exchange Market
  • According to the text:
    • Depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits.
    • Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits.
  • Do you expect that this is true?
equilibrium in the foreign exchange market35
Equilibrium in the Foreign Exchange Market
  • The Equilibrium Exchange Rate
    • Exchange rates (or interest rates) always adjust to maintain interest parity.
    • Assume that the dollar interest rate R$, the euro interest rate R€, and the expected future dollar/euro exchange rate Ee$/€, are all given.
equilibrium in the foreign exchange market36
Equilibrium in the Foreign Exchange Market

Exchange rate, E$/€

Return on

dollar deposits

2

E2$/€

1

E1$/€

3

E3$/€

Expected return

on euro deposits

R$

Rates of return

(in dollar terms)

Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate

interest rates expectations and equilibrium
Interest Rates, Expectations, and Equilibrium
  • The Effect of Changing Interest Rates on the Current Exchange Rate
    • An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies.
      • A rise in dollar interest rates causes the dollar to appreciate against the euro.
      • A rise in euro interest rates causes the dollar to depreciate against the euro.
interest rates expectations and equilibrium38
Interest Rates, Expectations, and Equilibrium

Exchange rate, E$/€

Dollar return

1

1\'

E1$/€

E2$/€

2

Expected

euro return

R1$

R2$

Rates of return

(in dollar terms)

Figure 13-5: Effect of a Rise in the Dollar Interest Rate

interest rates expectations and equilibrium39
Interest Rates, Expectations, and Equilibrium

Exchange rate, E$/€

Dollar return

Rise in euro

interest rate

2

E2$/€

E1$/€

1

Expected

euro return

R$

Rates of return

(in dollar terms)

Figure 13-6: Effect of a Rise in the Euro Interest Rate

interest rates expectations and equilibrium40
Interest Rates, Expectations, and Equilibrium
  • The Effect of Changing Expectations on the Current Exchange Rate
    • A rise in the expected future exchange rate causes a rise in the current exchange rate.
    • A fall in the expected future exchange rate causes a fall in the current exchange rate.
summary
Summary
  • Exchange rates play a role in spending decisions because they enable us to translate different countries’ prices into comparable terms.
  • A depreciation (appreciation) of a country’s currency against foreign currencies makes its exports cheaper (more expensive) and its imports more expensive (cheaper).
  • Exchange rates are determined in the foreign exchange market.
summary42
Summary
  • An important category of foreign exchange trading is forward trading.
  • The exchange rate is most appropriately thought of as being an asset price itself.
  • The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.
summary43
Summary
  • Equilibrium in the foreign exchange market requires interest parity.
    • For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate.
  • A rise in dollar (euro) interest rates causes the dollar to appreciate (depreciate) against the euro.
  • Today’s exchange rate is altered by changes in its expected future level.
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