Exchange Rates and International Transactions

1. Exchange Rates and International Transactions • Exchange rates translate different countries’ prices into comparable terms: $ Price of French Cognac = ($/€) x (€/Bottle) • Exchange rates are determined in the same way as other asset prices: Supply and Demand • Chapter goal: Show how exchange rates are determined

3. Exchange Rates and International Transactions Depreciation of home country’s currency: $/€ up • Makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic residents Appreciation of home country’s currency: $/€ down • Makes foreign goods cheaper for domestic residents Forward and spot exchange rates move together. • Spot exchange rates: The prices of currencies delivered “on the spot” • Forward exchange rates: Prenegotiated prices of currencies delivered on futures date

4. Exchange Rates and International Transactions Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981-2001

5. The Foreign Exchange Market • Major Players in the Foreign Exchange Market • Commercial banks • International corporations • Nonbank financial institutions • Interbank trading accounts for most activity in the foreign exchange market • 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 opportunities (Buy Low – Sell High) • The $ -- the world’s vehicle currency • In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.

6. Exchange Rates and International Transactions • Foreign Exchange Swaps make up a significant proportion of all foreign exchange trading • Spot sales of a currency combined with a forward repurchase of the currency. • Foreign Exchange Futures Contract • The owner buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future at a specified price. • Foreign Exchange Options Contract • The owner buys the right to buy or sell a specified amount of foreign currency at a specified price (strike price) at any time up to a specified expiration date.

7. The Demand for Foreign Currency Assets Demand for a foreign currencybank deposit depends on • Asset Return: the percent increase in the deposit’s value over some time period. • Returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. • Real Rate of Return: the rate of return measured in terms of some broad representative basket of products that savers regularly purchase  adjust for price inflation • Risk: the variability the deposit contributes to savers’ wealth • Liquidity: the ease with which it can be sold or exchanged for goods

8. Interest Rates on Dollar and Deutschemark Deposits, 1975-1998

9. The dollar rate of return on euro deposits is approximately the euro interest rateplus the rate of depreciation of the dollar against the euro (the euro’s rate of appreciation). Expected rate of return difference between dollar and euro deposits: R$- [R€+(Ee$/€- E$/€)/E$/€]= (R$- R€)- (Ee$/€-E$/€)/E$/€ = the interest rate difference – expected appreciation of the euro 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

10. The Demand for Foreign Currency Assets Comparing Dollar Rates of Return on Dollar and Euro Deposits

11. Interest Parity: The Basic Equilibrium ConditionThe foreign exchange market is in equilibrium when all currencies offer the same expected rate of return. R$= R€+(Ee$/€ - E$/€)/E$/€ • If the $ is expected to depreciate, (Ee$/€ - E$/€)/E$/€ > 0, US interest rates must exceed foreign rates by a like amount to keep funds from fleeing abroad. • Depreciation of the $ today (with the expected future exchange rate unchanged) lowers the expected dollar return on euro deposits. • If the $ becomes cheaper today, US deposits become more attractive  euro deposits become less attractive  euro interest rates must rise relative to the US rate to maintain interest rate parity • Appreciation of the $ today raises the dollar return expected of euro deposits  euro deposits become more attractive

12. Equilibrium in the Foreign Exchange Market Today’s Dollar/Euro Exchange Rate and the Expected DollarReturn on Euro Deposits When Ee$/€ = $1.05 per Euro Note: As the $ appreciates, the expected return on € deposits increases

13. Exchange rate, E$/€ Return on dollar deposits, R$ 2 E2$/€ 1 E1$/€ 3 E3$/€ Expected return on euro deposits R$ Rates of return (in dollar terms) Equilibrium in the Foreign Exchange Market For given R$ , R€ , and Ee$/€

14. Interest Rates, Expectations, and Equilibrium An increase in the US interest rate  $ appreciation An increase in euro interest rates  $ depreciation A rise in the expected future $/€ exchange rate causes a rise in the current exchange rate. • If we expect the $ to depreciate in the future we rush to euros now  the $ depreciates now.

15. Exchange rate, E$/€ Dollar return 1 1' E1$/€ E2$/€ 2 Expected euro return R1$ R2$ Rates of return (in dollar terms) Interest Rates, Expectations, and Equilibrium Rise in the Dollar Interest Rate  Dollar Appreciation

16. Exchange rate, E$/€ Dollar return Rise in euro interest rate 2 E2$/€ E1$/€ 1 Expected euro return R$ Rates of return (in dollar terms) Interest Rates, Expectations, and Equilibrium Effect of a Rise in the Euro Interest Rate  Euro Appreciation

17. Exchange rate, E$/€ Dollar return Rise in Ee$/€ 2 E2$/€ E1$/€ 1 Expected euro return R$ Rates of return (in dollar terms) Interest Rates, Expectations, and Equilibrium Rise in the Expected Future $/€ Exchange Rate  Expected Euro Appreciation  Euro Appreciation Now