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# Chapter 13 Section II - PowerPoint PPT Presentation

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\$

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### Chapter 13Section II

Equilibrium in the Foreign Exchange Market

• To construct the model, we use two factors:

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

• The FX market is in equilibrium when deposits of all currencies offer the same expected rate of return: uncoveredinterest parity: R\$=R*+x.

• interest parity implies that deposits in all currencies are deemed equally desirable assets.

• Uncovered Interest parity (UIRP) says:

R\$ = R€ + (Ee\$/€ - E\$/€)/E\$/€

• Why should this condition hold? Suppose it didn’t.

• Suppose R\$ > R€ + (Ee\$/€ - E\$/€)/E\$/€ .

• no investor would want to hold euro deposits, driving down the demand and price of euros.

• all investors would want to hold dollar deposits, driving up the demand and price of dollars.

• The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved.

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:

• Exchange rates always adjust to maintain interest parity.

• Interest rates, R\$ and R€, and the expected future dollar/euro exchange rate, Ee\$/€, are all given.

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.’

How do changes in the spot e.r affect expected returns in foreign currency?

• Depreciation of the domestic currency today (E↑) lowers the expected return on deposits in foreign currency (expected RoR*↓).

Why?

• E↑ will ↑ the initial cost of investing in foreign currency, thereby ↓ the expected return in foreign currency.

• E↑ then x ↓ hence R*+x ↓

• Appreciation of the domestic currency today (E ↓) raises the expected return of deposits in foreign currency (expected Ror* ↑).

Why?

• E ↓ wil lower the initial cost of investing in foreign currency, thereby ↑ expected return in foreign currency.

• E ↓ then x ↑, hence R*+x↑

Expected Returns on foreign currency?€ Deposits when Ee\$/€ = \$1.05 Per €

Current exchange foreign currency?

rate, E\$/€

1.07

1.05

1.03

1.02

1.00

0.031

0.050

0.069

0.079

0.100

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 deposits

Determination of the Equilibrium e.r.

The effects of changing interest rates foreign currency?

• An increase in the interest rate paid on deposits denominated in a particular currency will increase the RoR on those deposits to an appreciation of the currency.

• A rise in \$ interest rates causes the \$ to appreciate: ↑ in R\$ then ↓E(\$/€)

• A rise in € interest rates causes the \$ to depreciate: ↑ in R€ then ↑E(\$/€)

• A change in the expected future exchange rate has the same effect as a change in interest rate on foreign deposits:

A depreciation foreign currency?

of the euro is

an appreciation

of the dollar.

A Rise in the \$ Interest Rate

• See slide 3 for intuition

A Rise in the foreign currency?€ Interest Rate

• R\$ < R€ + (Ee - E)/E

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

An Expected Appreciation of the Euro foreign currency?

People now

expect the euro to appreciate

An Expected Appreciation of the Euro foreign currency?↑Ee

• If people expect the € to appreciate in the future, then investment will pay off in a valuable (“strong”) €, so that these future euros will be able to buy many \$ and many \$ denominated goods.

• The expected return on €s therefore increases: ↑ROR€.

• ↓Ee (expected appreciation of a currency) leads to an actual appreciation: a self-fulfilling prophecy.

• ↑Ee (expected depreciation of a currency) leads to an actual depreciation: a self-fulfilling prophecy.

Covered Investment foreign currency?

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:

R€+ (F\$/€-E\$/€)/E\$/€

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.

CIRP foreign currency?

• Since I could invest the same \$1 domestically at R\$ , the forward market is in equilibrium when the Covered Parity Condition (CIRP) holds:

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.

• Covered interest parity relates interest rates across countries and the rate of change between forward exchange rates,F and the spot exchange rate, E. It says that ROR on \$ deposits and “covered” foreign currency deposits are the same.

Remarks: foreign currency?

• Unlike UIRP, CIRP holds well among major exchange rates quoted in the same location at the same time, and even across different locations in integrated capital markets.

• CIRP fails when comparing markets segmented by current or expected capital controls: investors in a country subject to “political risk” require higher interest rates as compensation.

• For UIRP = CIRP , F\$/€should = Ee\$/€ (the spot rate expected one year from now).

• In fact, empirically, the forward rate moves closely with the current spot rate, rather than the expected future spot rate:

• f = ( foreign currency?F\$/€-E\$/€)/E\$/€ is called the “forward premium” (on euros against dollars).

• f>0 the dollar is sold at discount (euro at premium)

• f<0 the dollar is sold at premium (euroa at discount)

• f=0 domestic and foreign currency interest rates are equal.

• Exemple: Data from Financial Times, February 9, 2006

• E(\$/€)=1.195, F(\$/€)=1.22 (1-year from now)

• i\$=5.03%, i€=2.9%. i\$-i€=2.13% expected depreciation of the \$US a year from now.

• f = (F\$/€-E\$/€)/E\$/€ = (1.22/1.195)-1=2.1%. The dollar is sold at 2.1% discount in the forward market.

Expected exchange rates and the term structure (TS)of interest rates

• There is no such a thing as “the” interest rate for a country. Rates vary with investment opportunities and maturity dates.

• In bond market, there are 3-month, 6-month, 1-year, 3-year, 10-year, 30-year bonds.

• Term structure is described by the slope of a line connecting the points in time when we observe interest rates.

• R rises with term to maturity→a rising TS

• R same with all maturities →flat TS

• R falls with term to maturity → inverse TS

Different types of term structure interest rates

• TS1: rising term structure

• TS2: flat term structure

• TS3: inverted term structure.

• In International finance we can use the TS on different currencies to infer the expected change in the exchange rate.

Remarks interest rates

• Usually, the forward rate, F, is considered a market forecast of the future spot rate Ee (even though empirically F moves more closely with the spot exchange rate, E).

• Even if there is not a forward exchange market in a currency, at each point on the TS, the interest differential i-i* allows us to infer the directions of the expected change in E for the two currencies by the markets.

Differentials between term structures interest rates

• Constant differential: x=(Ee-E)/E=0. Currencies will appreciate or depreciate against each other at a constant rate.

• Diverging: x>0 or f>0. High interest currency expected to depreciate at an increasing rate.

• Converging: x>0, f>0 but decreasing. High interest currency expected to depreciate at a decreasing rate.

Practical application interest rates: wwww.bloomberg.com/markets/index.html: Rates and Bonds

Forward discount of \$ on £ is increasing but on € decreasing.