The foreign exchange market and exchange rates
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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

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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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

DM/$

PUS > PGER

Long Run ER


Purchasing power parity theory
Purchasing Power Parity Theory foreign good?

  • 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? foreign good?

  • 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 foreign good?

  • 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 foreign good?

  • 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 foreign good?

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 foreign good?

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 foreign good?

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 foreign good?

Yen/$

R0

  • Rf increased

  • EX depreciates

  • Rf falls, EX appreciates

Rf

Rf1

100

5%

Exp Return in DC


Er fluctuations3
ER Fluctuations foreign good?

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 foreign good?

  • 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