the foreign exchange market and exchange rates
Download
Skip this Video
Download Presentation
The foreign Exchange market and exchange rates

Loading in 2 Seconds...

play fullscreen
1 / 22

The foreign Exchange market and exchange rates - PowerPoint PPT Presentation


  • 78 Views
  • Uploaded on

The foreign Exchange market and exchange rates. Lecture 18. Introduction. In September 1997, global financial system trembled Currency crisis rocked Asian financial markets  capital flight to US fell and so did US Exports

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' The foreign Exchange market and exchange rates' - sybill-lowe


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
introduction
Introduction
  • In September 1997, global financial system trembled
  • Currency crisis rocked Asian financial markets  capital flight to US fell and so did US Exports
  • How investors, and individuals, make transactions when people and organizations are in different countries
  • Determination of exchange rates and what causes them to change overtime
exchange rates and trade
Exchange Rates and Trade
  • 1990’s markets for goods and services and financial assets were global because of imports and exports
  • When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!
how is buying a domestic good different from buying a foreign good
How is buying a domestic good different from buying a foreign good?
  • Buy Pakistani good, pay in Re
  • Buy a US good, buy $ and then pay in $
  • Buy too many US goods, buying too many $ that raises $ value against Re
  • An increase in currency’s value as compared to that of another is Appreciation
  • A fall in value is depreciation
  • Change in currency’s value can affect domestic manufacturers and workers… How?
example
Example
  • 1DM = $0.5
  • 1DM = $0.6
  • Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!
nominal vs real exchange rate
Nominal Vs. Real Exchange Rate
  • Nominal ER doesn’t measure real purchasing power of the currency
  • Nominal: Re 1 = $1/84 = $0.0012
  • RER = NER x P/Pf
real er
REAL ER
  • Big Mac Example
  • Domestic Price: Rs 300
  • Foreign Price: $2.56
  • NER = $0.0012/Re
  • EXr = 0.0012 x 300/2.56 =

0.14 US BM/Pak BM

real er1
REAL ER
  • EXr is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another
  • CPI or Inflation Rates as the ratio of P/Pf
real er2
Real ER
  • If EXr increases,more units of foreign goods could be traded per unit of domestic goods
  • Relationship between EX and EXr depends on the Rates of Inflation
  • %Δ ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf
  • ΔEX/EX = ΔEXr/EXr + (πf – π)
foreign exchange market
Foreign Exchange Market
  • Market forces determine exchange rates that prevail for consumers and investors
  • International currencies traded in forEx markets
  • ForEx markets are over-the-counter markets
  • Currencies transactions in ForEx Markets: Spot Market and Forward Market
determine lr exchange rates
Determine LR Exchange rates
  • Forces of Demand and Supply
    • 1$ = Rs 60  1$ = Rs 50
    • Rs appreciated and $ depreciate; Qd of $ increases and Qs of Rs increased!
  • Price level differences  P > Pf
  • Productivity differences  Prod > Prodf
  • Preferences (For foreign goods)
  • Trade Barriers
example1
Example

DM/$

PUS > PGER

Long Run ER

purchasing power parity theory
Purchasing Power Parity Theory
  • Law of one price: PPP
    • Comparison of international price of identical good, PPP holds
    • When extend the concept to a group of goods, it becomes PPP theory of ER determination
    • Assume: EXr are constant
    • EX = EXr x Pf / P
does the theory match reality
Does the Theory match Reality?
  • Actual ER movements are just not a reflection of changing price levels
  • The assumption that EXr are constant is not realistic
  • All goods can’t be traded because of different barriers
  • However, PPP is a good measure for LR determination of exchange rates
model for sr exchange rate determination
Model for SR Exchange Rate Determination
  • Pakistan: Domestic, US: Foreign
  • Rs 10000 @ 5%
  • Year End  10000(1+0.05) = Rs 10500
  • Suppose Re 1 = $0.0125  Rs10000 = $125
  • $125 @ 5%, Year End  125(1+0.05) = $ 131.25
  • Convert them to Rs: $0.0125*1.05 = $0.013125 / Re
  • $131.25/0.013125 = Rs 10000
cont d
Cont’d
  • Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i)
  • Rs (1+0.05) = Rs 1.05
  • Re 1 invested abroad, Rs [EX (1+if)] / EXe
  • 0.0125(1.05)/0.013125 = Re 1
  • Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets
  • 1+i = EX(1+if)/EXe
  • Assume:
    • Identical risks, liquidity and info characteristics
  • 1+i = 1+ if – ΔEXe / EX
model comparing exp returns on domestic and foreign assets
Model: Comparing Exp Returns on domestic and foreign assets

Yen/$

R = i

  • If EX = 97 Yen/$
    • R > Rf
    • Investors should buy local assets
  • If EX = 105 Yen/$
    • R < Rf
    • Investors should buy foreign assets

Rf = if – ΔEXe / EX

100

5%

Exp Return in DC

er fluctuations
ER Fluctuations

Yen/$

R0

R1

  • Increase in domestic ‘i’
  • EX appreciates
  • As return falls, EX depreciates

Rf

100

5%

Exp Return in DC

er fluctuations1
ER Fluctuations

Yen/$

R0

R1

  • Increase in Pe
  • i = ier + Pe
  • EXe appreciation falls
  • Rf increases and EX depreciates

Rf

Rf1

100

5%

Exp Return in DC

er fluctuations2
ER Fluctuations

Yen/$

R0

  • Rf increased
  • EX depreciates
  • Rf falls, EX appreciates

Rf

Rf1

100

5%

Exp Return in DC

er fluctuations3
ER Fluctuations

Yen/$

R0

  • EXe increases  Rf falls
  • EX appreciates

Rf1

Rf

100

5%

Exp Return in DC

currency premiums in forex markets
Currency Premiums in ForEx Markets
  • It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency
  • i = if – ΔEXe / EX – hf,d
ad