Types of Foreign Exchange Rates and Interest rate.

International Transactions and Currency Values The Balance of Payments Measures transactions in the current and capital accounts. The Current Account 1. Merchandise trade - value of exports and imports 2. Service balance - value of exports and imports of services. 3. Unilateral Transfers - gifts and foreign aid to foreign interests. The Capital Account 1. Short-term capital flows - purchase of financial assets in the money market with a maturity of less than one year. E.g. T-bills 2. Direct investments - refers to the purchase of property or the aquisition of ownership shares in order to control a foreign business. 3. Portfolio investments - purchases of securities to hold in order to receive interest, dividends or capital gains. Direct investments and portfolio investments represent purchases of stocks, bonds and other financial assets with a maturity of over 1 year. - Capital market. The BOP = 0 Since the U.S. runs a large current account deficit - over $200 billion in 1997 and expected to reach nearly $300 billion in 1998, there is an offsetting capital account surplus (with a bit of a fudge) This makes the U.S. the world's largest debtor nation when looking at the difference between the value of U.S. fiancial assets held by foreign investors and the value of foreign assets held by U.S. investors.

Foreign investors are attracted to U.S. financial markets because:

Develop production facilities in the U.S. to serve U.S. markets (reduce transporation costs) and to avoid import tariffs and quotas (the average U.S. tariff on imports is about 3.5%). However, the U.S. is more restrictive on auto imports.

The U.S. is very stable politically and economically - this is a major attraction for foreign investors who can purchase U.S. Treasury debt with zero default risk.

If conditions change in the U.S. there could be the same capital flight that has plauged some of the developing countries. In this case we could expect:

higher U.S. interest rates as the supply of loanable funds decreases A sharp devaluation of the dollar A reduction in the current account deficit as U.S. consumers purchase fewer foreign goods since the dollar has devalued. And U.S. goods become cheaper abroad.

Exchange Rate Determination Foreign exchange markets are amoung the largest markets in the world with an annual trading volume in excess of $160 trillion It is an over-the-counter market, with no central trading location and no set hours of trading. Prices and other terms of trade are determined by computerized negotiation. There are three markets for foreign exchange:

Spot market - deals with currency for immediate delivery (within one or two business days)

Forward market - involves the future (one, three or six months from today) delivery of foreign currency

Currency futures and options market - deals in contract to hedge against future changes in foreign exchange rates.

Simple model of spot market exchange rates using supply and demand Current Account Factors

Changes in relative inflation rates, Changes in tastes, Factors that determine comparative advantage.

Capital Account Factors

Changes in interest rates

Exchange rates can be

floating pegged floating peg

Floating exchange rates

Exchange rates are also affected by specualation over future currency values. A currency that is considered undervalued brings forth buy orders. The Forward Market for Currencies Investors, businesses and other involved in foreign currency markets may want to guarentee the exchange rate that they will receive at some time in the future. Take out a forward contract in the forward exchange market. If the customer does not know if they will actually need the foreign currency, they can take out an option forward contract. Methods of measureing and quoting forward exchange rates: Outright rate - defines an exchange rate (e.g. 100 = $1) Express the forward rate as a premium or discount from the spot rate, know as the swap rate. Express the forward rate as an annualized percentage rate above or below the current spot rate Functions of the Forward Exchange Market Commercial Covering For transaction of goods and services that are to be delivered in the future. e.g. U.S. importer of Japanese radios agrees to pay 1 million for the shipment upon receipt in 30 days. if current spot rate is 100 = $1, and stays constant, then will cost importer $10,000 Importer faces the risk that the dollar will depreciate. Takes out a 30-day forward contract for the delivery of 1 million at the forward market rate of $.01/ (or 100 = $1).

When the 1 million payment is due by the importer, the importer also takes delivery of the 1 million yen as given by the forward contract in exchange for $10,000. The 1 million is then used to pay for the radio shipment. Hedging of an Investment Position Suppose there is a U.S.-based mutual fund (e.g. The Japan Fund) that purchases Japanese stocks and bonds for (primarily) U.S. investors. The fund manager faces two types of risk:

market risk - the value of his or her assets will decline, exchange rate risk - since the assets are denominated in yen, but the value of these assets are reported in dollars, a depreciation of the yen will reduce the NAV of the portfolio even if the yen value of the portfolio remains constant.

To reduce exchange rate risk, the fund manager can hedge with currency forwards. Fund manager sells forward contracts of yen. e.g. fear is that the yen will depreciate from 100 = $1 Manager sells forward contracts worth 1 billion ($10m) at exchange rate of 100 = $1. When this forward contract matures, if the spot price of the yen has depreciated to 120 = $1, the fund can buy yen on the spot market and deliver them at the contract price of 100 = $1. Will cost the fund manager $8.3 million to purchase 1 billion and then can sell yen for $10 million. For a profit of $1.7 million on the foreign exchange transaction. If the fund manager sells contracts in an amount that covers both principal and interest or dividends, then the manager has "locked in" their investment return regardless of which way exchange rates go.

If instead the yen were to appreciate, the currency trading losses are offset by the increased dollar value of the portfolio due to the yen's appreciation. Speculation on Future Currency Prices Speculators will buy currency for future delivery if they believe the spot rate will be higher on the delivery date than at the current forward rate (appreciate). Speculators will sell currency forward contracts if they believe the spot rate will be lower on the delivery date than at the current forward rate (depreciate). Covered Interest Arbitrage Arises when an investor invests in foreign securities because the interest rate is higher than on comparable domestic securities. Covered Interest Arbitrage - reduce currency risk by using a forward contract. Currency Futures While forward contracts usually result in the actual delivery of the currency, futures contracts in foreign currency are increasingly used. These contracts are typically zeroed out and the currency is not delivered. e.g. you buy one ton of pork belly futures, rather than taking delivery, you zero out the contract by selling an opposite contract before the first contract matures. Note that as currencies appreciate in the spot market, the market value of currency futures also rise along with the market value of the underlying currency.

The Principle of Interest Rate Parity

the net rate of return to the investor from any foreign investment is equal to the interest earned plus or minus the forward premium or discount on the price of the foreign currency involved in the transaction. Under normal circumstances, the forward discount or premium on one currency relative to another is directly related to the difference in interest rates between the two countries involved. The currency of a nation with the higher market interest rates normally sells at a forward discount in relation to the currency of the nation with lower interest rates. The currency of a nation with the lower market interest rates normally sells at a forward premium in relation to the currency of the nation with lower interest rates. Interest rate parity exists when the interest rate differential between two nations exactly equals the forward discount or premium of the two currencies. When parity exists, the currency markets are in equilibrium and there is no net flow of capital funds between the two countries seeking a higher return. In this case, the higher return from interest rates abroad is fully offfset by the cost of covering currency risk in the forward exchange market. e.g. Interest rates in the U.S. are 3% higher than in Japan. As a result, the dollar, when in equilibrium, sells at a 3% discount in the forward exchange market. While the yen sells at a 3% premium. In this case, once currency risk is covered, there is no yield benefit for Japanese investors to purchase U.S. securities. Unless, they also expected the prices of these U.S. securities to rise. When interest rate parity does not exist, then there are international net capital flows. **** e.g. Interest rates in the U.S. are 3% higher than in Japan.

And the dollar sells at only a 1% discount in the forward exchange market. Money flows from Japan to the U.S. as Japanese investors have a net return of 2% after covering for exchange rate risk. Also the $ appreciates relative to the yen due to the increased demand for dollars. But if the dollar is considered overvalued, then expect it to depreciate back to normal value. Fearing the dollars depreciation, Japanese investors are selling forward contracts on dollar, increasing the discount on these contract and also increasing the premium on contracts to buy yen.

Comparing Expected returns on domestic and foreign assets Assume that the spot exchange rate is 100 = $1 and the expected exchange rate in one year (EXe) is 105 = $1, a 5% increase in the value of the dollar. Assume that the present yield on a one-year 100,000 Japanese government bond equals 5%. If you buy this bond, the cost in dollars is $1,000 that is then converted to yen. After one year, the value of the investment equals 105,000. The expected dollar value of the investment is: 105,000/105 = $1,000 A general formula to compare total returns from investing $1 in a domestic or foreign asset. Value of $1 investment after one year = EX ( 1 + if ) / EXe where:

i = interest rate on the domestic security

if = interest rate on the foreign security EX = current exchange rate EXe = expected future exchange rate

in this example: (100 = $1)(1.05) / (105 / $1) = $1.00 can rewrite the formula so it divides the return into two parts, interest and expected exchange rate change: Value of $1 investment after one year = 1 + if (change)EXe / EX

in our example the expected change in the exchange rate was 5% as the yen depreciated from 100 = $1 to 105 = $1 Foreign-exchange Market Equilibrium Would a situation in which investors could earn a higher expected rate of return from buying Japanese rather than U.S. assets persist for a long time? The opportunity for traders in the foreign exchange market to make a profit eliminates these opportunities. If a U.S. asset has a higher expected return than a comparable Japanese asset, traders would sell Japanese assets and buy the U.S. assets, increasing the demand for dollars. As a result, the dollar will appreciate relative to the yen to the point at which investors are indifferent between holding U.S. or Japanese assets.

The concept is illustrated in the above graph.

The y-axis measures the current exchange rate (EX) The x-axis is the expected rate of return, in dollar terms from investing in a U.S. or Japanese asset.

o o

for U.S. assets, the expected rate of return, R, equals the U.S. interest rate i the expected rate of return on foreign assets in dollar terms, Rf , equals if - (change)EXe / EX.

For Japanese assets, the expected rate of return, Rf equals the Japanese interest rate if less the expected appreciation of the dollar. R is a vertical line because the return on U.S. assets is the same regardless of the exchange rate. Assume a U.S. interest rate of 5% To graph Rf against the exchange rate, we must first specify the expected future yen/dollar exchange rate. This is done by calculating the dollar's expected rate of appreciation, a component of Rf .

If the current yen/dollar spot rate exceeds that expected future exchange rate, investors believe that the dollar is unually strong and it will eventually depreciate. For a given expected exchange rate, a graph of Rf against the current exchange rate slopes upward; as the yen/dollar exchange rate rises, the dollar's expected rate of appreciation falls, pushing up Rf . the more the yen depreciates, the less we expect it to depreciate in the future. e.g assume that the future yen/dollar exchange rate is expected to be 100 and that Japanese interest rates are 5%. a. If the current exchange rate is also 100/$1, no dollar appreciation is expected and Rf equals the 5% Japanese interest rate. b. If the current exchange rate is 105/$1, the dollar is expected to depreciate back to 100/$1 (for a decrease of 4.8%) and Rf equals the 5% Japanese interest rate plus the appreciation of the yen of 4.8% for a total of 9.8%. c. If the current exchange rate is 97/$1, the dollar is expected to appreciate back to 100/$1 (for an increase of 3.1%) and Rf equals the 5% Japanese interest rate minus the depreciation of the yen of 3.1% for a total of 1.9%. connecting these three points yields the Rf line. The equilibrium exchange rate is the one that equates R and Rf . In this case it is 100/$1 Suppose the exchange rate is 97/$1. The dollar is expected to appreciate by 3.1% Since the rate of return on Japanese assets is 1.9%, investors switch to U.S. assets. The increased demand for dollars leads to a dollar appreciation. The appreciation of the dollar continues as long as the relative yield on U.S. assets is higher. Finally the yields are in equilibrium at 100/$1.

Interest Rate Parity The exchange rate market condition described here is known as the interest rate parity condition. Given identical characteristics regarding risk, liquidity, time to maturity, etc, domestic and foreign assets should have identical nominal returns. Any difference in the nominal rate of return between identical assets in two countries reflects expected currency appreciation or depreciation. When the domestic interest rate is higher than the foreign interest rate, the domestic currency is expected to depreciate. Equilibrium condition is: Expected return on domestic asset - Expected return on foreign asset i = if - (change)EXe / EX This does not imply that nominal interest rates are the same throughout the world. Rather that expected nominal returns on comparable domestic and foreign assets are the same. In real terms, the real interest rate parity condition is: i + r = (1 + rf )(EXr / EXer ) Expected real return on domestic investment = expected real return on foreign investment. Exchange Rate Fluctutations Changes in domestic real interest rates

The expected return on domestic bonds depends on the interest rate i. That interest rate is the sum of the expected real rate of interest and the expected rate of inflation Holding expected inflation constant, an increase in the domestic interest rate increases the expected rate of return on domestic assets, shifting the R curve to the right. The increased demand for dollars leads to an appreciation of the dollar. Changes in domestic expected inflation

Hold foreign real rate of return Rf constant If domestic inflatonary expectations increase, then domestic currency loses purchasing power, causing it to depreciate. Two things happen: 1. The higher domestic nominal interest rate shifts the expected rate of return to the right (foreign investors will not be affected by the domestic inflation increase but have the benefits of higher return on assets). As a result, the current exchange rate rises. 2. An increase in expected inflation reduces expected appreciation of the domestic currency, so the expected foreign rate of return shifts to the right, increasing the attractiveness of foreign assets to consumers. Although the two effects work in opposite directions, we can usually expect the domestic currency to depreciate with higher inflation. Changes in foreign interest rates

An increase in the foreign real interest rate shifts the foreign expected rate of return from Rf0 to Rf1 because at any exchange rate, the foreign rate of return increases. Currency depreciates as money moves abroad. Changes in the Expected Future Exchange Rate

If the expected future exchange rate increases, expected appreciation of the domestic currency rises. Since an appreciation of the domestic currency is good for the value of domestic assets, investors increase their demand for the domestic currency. And the expected rate of return on the foreign assets falls due to the relative depreciation of that currency shift inward the return on foreign assets. Resulting in an increase in the actual exchange rate. Currency Premiums in Foreign-Exchange Markets The interest rate parity condition is based on the assumption that domestic and foreign assets with similar attributes are perfect substitutes. But if we allow for imperfect substitutability, we can modify the equation to allow for a currency premium where investors have a preference for the financial assets denominated in one currency over the other. i = if - (change)EXe / EX - hf,d For example, assume that the one year T-bill rate in the U.S. is 8% and the one-year government bond rate in Germany is 5%. Also assume that investors expect the dollar to depreciate against the mark by 4% over the coming year. The one-year mark/dollar currency premium is 8% = 5% - ( -4%) - hf,d , or hf,d = 1% This implies that investors require a 1% higher expected rate of return on the German bond relative to the U.S. T-bill to make the two financial assets equally attractive.

If hf,d is positive, it implies that investors prefer the domestic currency asset. In this case, investors will not buy a foreign bond if the expected rate of return just equals that of a domestic bond. Investors require an additional incentive to buy the foreign asset, the currency premium in the form of a higher yield on foreign assets. The size of the currency premium depends on:

investors aversion to currency risks, differences in liquidity in markets information about foreign investment opportunities investors' belief that one currency is more stable or safer than another.

Traditional view of exchange rates results in adjustments to international trade in goods. Other approaches include the capital account as a determinent of exchange rates. Explore the role of financial assets. Monetary Approach to the Balance of Payments The basic premise of the MABP is that any balance-of-payments disequilibrium is based on monetary disequilibrium. The exchange rate between any two currencies is determined by relative money demand and money supply between the two countries. Monetary disequilibrium implies a difference exists between the amount of money people wish to hold and the amount supplied by the monetary authorities.

If people demand more money than is supplied domestically by the central bank, then the excess demand for money would be satisfied by inflows of money from abroad. In contrast, an oversupply of money domestically, leaves the economy for other countries. The Fed controls the money supply by altering base money (equal to banking reserves plus currency in circulation). Increases in the monetary base leads to increases in the money supply. The monetary base can be divided into domestic and international components:

domestic component is comprised of domestic credit. the remainder is comprised of international reserves. (money items that can be used to settle international debts, primarily foreign exchange)

Example: A U.S. exporter receives payment in foreign currency

payment is presented to a commercial bank to be converted into dollars and deposited in the firm's account.

If the commercial bank has no use for the foreign currency, the bank will exchange the foreign currency for dollars with the Fed.

The Fed creates new money to buy the foreign currency by increasing the commerical bank's reserve deposit with the Fed (part of required reserves).

Thus the Fed is accumulating international reserves, and this process expands the monetary base.

Note: the Fed make undertake currency sterilization by using monetary policy tools to absorb the increase in reserves from the banking system. The Model: Assume a small open economy that has no effect on the international price of goods or the interest rate it faces in foreign markets. The demand for money equals:

L = kPY where:

L = money demand P = domestic price level Y = real income or wealth k = constant fraction indicating how much money demand will change given a change in P or Y

If increase P and/or Y will increase L The supply of money equals: M=R+D where:

M = money supply R = international reserves D = domestic credit

Assume equilibrium in the money market of M = L The adjustment mechanism that ensures equilibrium of M = L will vary with the exchange rate regime.

With fixed exchange rates, money supply adjusts to money demand through international flows of money via balance-of-payments imbalances.

With flexible exchange rates, money demand will be adjusted to a money supply set by the central bank via exchange rate changes.

With a floating peg, there are both international monetary flows and exchange rate changes.

skipping some mathematical steps, we have:

With Flexible Exchange Rates: - E = PF + Y - D

PF = foreign prices

all variables are in percentage changes (e.g. E is percentage change in the exchange rate) (note the negative before the E) and assume reserve flows (R) equal zero Implications: E is measured in domestic currency units per foreign currency unit, as increase in E means that foreign currency is becoming more expensive or appreciating in value and the domestic currency is depreciating. e.g. at E0, $1 = 100 at E1, $1 = 90 In the equation, E has a positive relation to changes in D and an inverse relation to changes in PF and Y. an increase in the domestic credit (D) given a constant PF and Y (so that the demand for money is constant) will result in a depreciation of the domestic currency. The increase in the money supply leaves the country. An increase in PF will increase the domestic demand for money as imports become more costly. With constant domestic credit, there is an excess demand for money. Individuals try to increase their money balances, increasing the demand for domestic currency. There is a decrease in E or an appreciation of the domestic currency. With Fixed Exchange Rates:

R - E = PF + Y - D all variables are in percentage changes (e.g. E is percentage change in the exchange rate)

R = international reserves

This is the same as before, but reserves are used to offset changes in the exchange rate. If a currency is devaluing below desired levels, the central bank will intervene buy purchasing its domestic currency with some of its foreign currency reserves. for example, an increase in domestic credit, D, everything else constant, will lead to a decrease in international reserves as the central bank buys the domestic currency to support its value. Portfolio-balance Approach to the Balance of Payments In the monetary approach, the exchange rate between any two currencies is determined by relative money demand and money supply between the two countries. Relative supplies of domestic and foreign bonds are not a factor. The portfolio-balance approach allows for both relative money market condition and for bond markets to determine the exchange rate. The monetary approach assumes that domestic and foreign bonds are perfect substitutes and thus investors are indifferent as to which ones they hold. Bond holders only care about relative rates of return and require no risk premium to hold foreign bonds. In the portfolio-balance approach foreign and domestic bonds are imperfect substitutes. Savers have preferences in how they distribute their portfolio over different country's assets. As investors increase their allocation of portfolio assets in a given country, their risk rises and they desire a greater risk premium to compensate. The PB approach assumes that assets are imperfect substitutes internationally because investors percieve foreign exchange risk to be attached to foreign-currency-denominated bonds. The spot exchange rate is modified to:

- E = PF + Y - D - B + BF all variables are in percentage changes B = percentage change in the supply of domestic bonds BF = percentage change in the supply of foreign bonds If the supply of domestic bonds rises relative to the supply of foreign bonds (increase B holding BF constant), there will be an increased risk premium on the domestic bonds that will cause the domestic currency to depreciate in the spot market.

But we also need to consider adjustments to international trade in financial assets. Since financial assets are traded almost continuously, exchange rates constantly adjust as changes in demand and supply of financial assets in diffierent nations change. Assume perfect capital mobility => capital will flow freely between nations because there are no significant transactions costs or capital controls that act as barriers to investment. In this case, spot and forward exchange rates will adjust instantly to changing financial market conditions.

In this case, relative bond supplies and demands as well as relative money market conditions determine the exchange rate.

Conclusion The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.