Chapter 14 Exchange Rates and The Foreign Exchange Market An Asset Approach

Chapter 14
Exchange Rates and

The Foreign Exchange Market:
An Asset Approach
Lectureon3/9/2016
Copyright 2009 Pearson Addison-Wesley. All rights reserved.
13-1
Preview
The basics of exchange rates
Exchange rates and the prices of goods
The foreign exchange markets
The demand of currency and other assets
A model of foreign exchange markets
role of interest rates on currency deposits
role of expectations of exchange rates
Definitions of Exchange Rates

Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency. (on 3/8/2016)
How much can be exchanged for one dollar?
different currencies: NT$32.85/US$1 (direct terms: The price
of a unit of foreign currency in domestic currency terms )
How much can be exchanged for one yen?
different currencies: US$0.0304/NT$1 (indirect terms)
Exchange rates allow us to denominate the cost or price of

a good or service in a common currency.
How much does an ipad air cost? $499
Or, $499 x $32.85 = $16392
14-3
Table 14-1:
Exchange
Rate
Quotations
14-4
Depreciation and Appreciation

Depreciation is a decrease in the value of a currency
relative to another currency.
A depreciated currency is less valuable (less expensive) and
therefore can be exchanged for (can buy) a smaller amount of
foreign currency.
$1.1/1 $1.20/1 means that the dollar has depreciated
relative to the euro. It now takes $1.20 to buy one euro, so
that the dollar is less valuable.
The euro has appreciated relative to the dollar:
it is now more valuable.
14-5
Depreciation and Appreciation (cont.)

Appreciation is an increase in the value of a currency
relative to another currency.
An appreciated currency is more valuable (more expensive)
and therefore can be exchanged for (can buy) a larger amount
of foreign currency.
$1.2/1 $1.1/1 means that the dollar has appreciated
relative to the euro. It now takes
only $1.1 to buy one euro, so that the dollar is more valuable.
The euro has depreciated relative to the dollar:
it is now less valuable.
14-6

A depreciated currency is less valuable, and therefore it can
buy fewer foreign produced goods that are denominated in
foreign currency. (complete exchange rate pass-through)
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0100/1 = $30,000
A depreciated currency means that imports are more

expensive and domestically produced goods and exports
are less expensive.
A depreciated currency lowers the price of exports relative
to the price of imports.
14-7

An appreciated currency is more valuable, and therefore it
can buy more foreign produced goods that are denominated
in foreign currency.
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0090/1 = $27,000
An appreciated currency means that imports are less

expensive and domestically produced goods and exports
are more expensive.
An appreciated currency raises the price of exports relative
to the price of imports.
14-8
Foreign Exchange Markets

The set of markets where foreign currencies and other assets are
exchanged for domestic ones
Institutions buy and sell deposits of currencies or other assets for
investment purposes.
The daily volume of foreign exchange transactions were $0.6 trillion in
1989, $1.9 trillion in 2004, $3.2 trillion in 2007.
In 2004, about 90% of transactions involved US dollars.
In 2007, roughly 86% involving the dollars, 37% involving euros.
Vehicle currency: one that is widely used to denominate
international contracts made by parties who do not reside in the
country that issues the vehicle currency.
14-9
Foreign Exchange Markets

The participants:
1.
2.
3.
4.
Commercial banks and other depository institutions: transactions

involve buying/selling of deposits in different currencies for
investment purposes.
Corporations: conduct foreign currency transactions to buy/sell
goods, services and assets.
Non-bank financial institutions (mutual funds, hedge funds, securities
firms, insurance companies, pension funds): may buy/sell foreign
assets for investment.
Central banks: conduct official international reserves transactions.
14-10
Foreign Exchange Markets (cont.)

Buying and selling in the foreign exchange market are
dominated by commercial and investment banks.
Inter-bank transactions of deposits in foreign currencies
occur in amounts $1 million or more per transaction.
Central banks sometimes intervene, but the direct effects of
their transactions are small and transitory in many countries.
14-11

Characteristics of the market:
The largest financial market in the world.
Computer and telecommunications technology transmit information
rapidly and have integrated markets.
Traded globally, 24 hours.
Liquidity of the market: The more willing buyers and sellers there are,
the more liquid a market is.
The spot markets for heavily traded currencies such as the euro, the
British pound, and the Japanese yen are very liquid.
A currencys liquidity affects the ease with which a corporation can
obtain or sell that currency.
14-12

The integration of markets implies that there is no
significant arbitrage between markets.
Arbitrage: buying at a low price and selling at a high price
for a profit.
If dollars are cheaper in New York than in Hong Kong, what do
you predict will happen?
When other factors are the same, people will buy assets in
New York and stop buying them in Hong Kong, so that their
price in New York rises and their price in Hong Kong falls,
until they are equal in the two markets.
Spot Rates and Forward Rates

Spot rates are exchange rates for currency exchanges on
the spot, or when trading is executed in the present.
Forward rates are exchange rates for currency exchanges
that will occur at a future (forward) date.
Forward dates are typically 30, 90, 180, or 360 days in the
future.
Rates are negotiated between two parties (corporations and
commercial banks) in the present, but the exchange occurs in
the future.
14-14
Forward contracts
Forward contracts: (most often used)
- specifies the amount of a particular currency that will be
purchased or sold by corporations.
- a specified future point in time.
- a specified exchange rate.
Commercial banks accommodate the corporations that desire
forward contracts. (contracts between commercial banks and
corporations)
To hedge the future payment that the corporations expect to
make or receive in a foreign currency. (do not worry about
fluctuations in the spot rate)
If, you sell pounds for dollars on a future date at a forward rate agreed
on today bought pound forward and sold pound forward.
Forward contracts
How to use the forward to hedge? An example:
Radio Shack (a retailer in US) knows that in 30 days, it must pay yen to a
Japanese supplier for a shipment of computer chips arriving then. RS can
sell each radio for $100 and must pay its supplier 9,000 per radio.
a. The current spot rate is $0.0105 per yen,
RS would pay ($0.0105 per yen)* 9000 per radio=$94.5 per radio.
profit of $5.5 per radio.
b. If the dollar unexpectedly depreciates to $0.0115 per yen,
RS would pay ($0.0105 per yen)* 9000 per radio=$103.5 per radio.
loss of $3.5 per radio
Forward contracts
To avoid the risk, RS can make a 30-day forward exchange deal with
Bank of America (BOA).
~ If BOA agrees to sell yen to RS in 30 days at a rate of $0.0107
~ RS is assured of paying exactly
($0.0107 per yen)*( 9000 per radio)=$96.3 per radio to the supplier.
A profit of $3.7 per radio is guaranteed.
The forward contracts help RS hedge its foreign currency risk.
The forward contracts are associated with the covered interest parity
condition (CIP).
Fig. 14-1: Dollar/Pound Spot and Forward

Exchange Rates, 19832011
Source:Datastream.Ratesshownare90dayforwardexchangeratesandspotexchangerates,atendofmonth.
14-18
NTD/USD Spot Rates, Annual average, 1960

2014
Source:CentralBankofRepublicChina
NTD/Euro, Spot Rates, 2000-2014

NTD/Euro (Spot Rates)
50
45
40
35
30
25
NTD/Pound, Spot Rates, 2000-2010

NTD/Pound (Spot Rates)
70
65
60
55
50
45
40
NTD/Yen, Spot Rates, 2000-2014

NTD/Yen ( Spot Rates)
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
NTD/USD Spot and Forward Exchange Rates,

20002014
Other Methods of Currency Exchange (other

currency derivatives)
Foreign exchange swaps: a combination of a spot sale with a forward
repurchase.
A spot transaction along with a corresponding forward contract that

will ultimately reverse the spot transaction.
~ A spot sale of a currency combined with a forward repurchase of
the currency.
Swaps often result in lower fees or transactions costs because they

combine two transactions, and they allow parties to meet each others
needs for a temporary amount of time.
Swaps make up a significant proportion of all foreign exchange
trading.
14-24
Foreign exchange swaps
Example: Soho, Inc. needs to invest $1m euro in its German subsidiary
for the production of additional products today. It wants the subsidiary
to repay the euros in one year.
~Soho wants to lock in the rate at which the euro can be converted back
into dollars in one year -> it can use a one-year forward contract for
this purpose.
** Soho contacts its bank and requests the following swap transaction:
Today: The bank should withdraw dollars from Sohos US account,
convert the dollars to euro in the spot market, and transmit the euros to
the subsidiarys account.
In one year: The bank should withdraw $1m euros from the subsidiarys
account, convert them to dollars at todays forward rate, and transmit
them to Sohos US account.
Currency Futures Contracts
Futures contracts: a contract designed by a third party for a standard

amount of foreign currency delivered/received on a standard date.
similar to the forward contracts in terms of obligations, but differ
from forward contracts in the way they are traded.
but the future contracts are sold on an exchange market.
standardized contracts: a standard volume of a particular currency to
be exchanged on a specific settlement date.
mostly traded by speculators who hope to capitalize on their
expectations of exchange rate movements.
Contracts can be bought and sold in markets, and only the current
owner is obliged to fulfill the contract. (buyer vs. seller)
Other Methods of Currency Exchange

Options contracts: a contract designed by a third party for a standard
amount of foreign currency delivered/received on or before a standard
date.
Contracts can be bought and sold in markets:
Call option: the right to buy a specific currency price (the strike price
or exercise price) within a specific period of time.
Put option: the right to sell a specific currency price within a specific
period of time.
A contract gives the owner the option, but not obligation, of buying
or selling currency if the need arises. can elect not to exercise
the option ~ more flexible.
Traded on an exchange.
14-27
The Demand for currency deposits

Same as the factors that influence other assets
Asset Demand (such as stocks, bonds, cash, real estate, rare
mines, diamonds,)
For general assets:
The objective of acquiring wealth-of-saving is to transfer
purchasing power into the future
(Nominal) Rate of return : the percentage increase in value.
The asset offers over some period of time
14-28
The Demand of Currency Deposits (cont.)

Ex : in 2009, you pay $100 for a share of stock
in 2010, the stock pays you $1 for dividends & the
stocks price rises to $109
The expected real rate of return : the rate of return

computed by measuring asset values in terms of some
broad representative basket of products that savers
regularly purchase
Ex : 10% ROR, but inflation rate=10%, then real ROR=0
14-29

Risk : An assets real return is usually unpredictable
Ex: the expected real rate of return
= (expected rate of increase in the investments dollar
value) - (expected rate of increase in dollar prices)
14-30

Liquidity: Assets differ according to the cost and speed at
which savers can dispose of them
Cash is the most liquid of assets always acceptable at
face value as payment for goods or other assets
Savers prefer to hold some liquid assets as a precaution
against unexpected pressing expenses that might force
them to sell less liquid assets at a loss
14-31

Demand for deposits of different currencies:
Factors that influence the return on assets determine the
demand of those assets.
But we assume that risk and liquidity of currency
deposits in foreign exchange markets are essentially the
same, regardless of their currency denomination.
Risk and liquidity are only of secondary importance when
deciding to buy or sell currency deposits.
Importers and exporters may be concerned about risk and
liquidity, but they make up a small fraction of the market.
Thus, rate of return can be more crucial in determining the
demand for currency deposits.
14-32

Expected rate of return:
a. how the money values of the deposits will change
interest rates: measures the return on deposits of a
currency
b. how exchange rate will change so that they can translate
rates of return measured in different currencies into
comparable terms
expected change in the exchange rates
14-33

A currency deposits interest rate is the amount of a
currency that an individual or institution can earn by
lending a unit of the currency for a year.
The rate of return for a deposit in domestic (foreign)
currency: the domestic (foreign) interest rate that the
deposit earns.
To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider
the interest rate for the foreign currency deposit
the expected rate of appreciation or depreciation of the
foreign currency relative to the domestic currency.
14-34

Ex: the dollar (domestic) rate of return on euro (foreign)
deposits is approximately the euro interest rate plus the rate
of depreciation of the dollar against the euro
The expected rate of return on a euro deposit measured in

terms of dollars:
14-35

The expected return is what must be compared with the
interest rate on one year dollar deposits, in deciding
whether dollar on euro deposits offer the higher expected
rate of return
in terms of the dollar (home currency):
if >0 : dollar deposits yield the higher expected rate of

return
if <0 : euro deposits yield the higher expected rate of return
14-36

in terms of the foreign currency:
14-37

Suppose the interest rate on a dollar deposit is 2%.
Suppose the interest rate on a euro deposit is 4%.
Does a euro deposit yield a higher expected rate
of return?
Suppose today the exchange rate is $1/1, and the expected
rate one year in the future is $0.97/1.
$100 can be exchanged today for 100.
These 100 will yield 104 after one year.
These 104 are expected to be worth $0.97/1 x 104 =
$100.88 in one year.
14-38

The rate of return in terms of dollars from investing in euro
deposits is ($100.88-$100)/$100 = 0.88%.
Lets compare this rate of return with the rate of return
from a dollar deposit.
The rate of return is simply the interest rate.
After 1 year the $100 is expected to yield $102:
($102-$100)/$100 = 2%
The euro deposit has a lower expected rate of return: thus,

all investors should be willing to hold dollar deposits and
none should be willing to hold euro deposits.
14-39
Table 14-3: Comparing Dollar Rates of Return

on Dollar and Euro Deposits
14-40
Model of Foreign Exchange Markets

We use the
demand of (rate of return on) dollar denominated deposits
and the demand of (rate of return on) foreign currency
denominated deposits
to construct a model of foreign exchange markets.

This model is in equilibrium when deposits of all
currencies offer the same expected rate of return: interest
parity.
Interest parity implies that deposits in all currencies are
equally desirable assets.
Interest parity implies that arbitrage in the foreign exchange
market is not possible.
14-41
Model of Foreign Exchange Markets (cont.)

Interest parity: R$ = R + (Ee$/ - E$/)/E$/
Why should this condition hold? Suppose it didnt.
Suppose R$ > R + (Ee$/ - E$/)/E$/
Then no investor would want to hold euro deposits, driving
down the demand and price of euros.
Then all investors would want to hold dollar deposits, driving
up the demand and price of dollars.
The dollar would appreciate and the euro would depreciate,
increasing the right side until equality was achieved:
R$ > R + (Ee$/ - E$/)/E$/
14-42

How do changes in the current exchange rate affect the
expected rate of return of foreign currency deposits?
14-43

Depreciation of the domestic currency today lowers the
expected rate of return on foreign currency deposits. Why?
When the domestic currency depreciates, the initial cost of
investing in foreign currency deposits increases, thereby
lowering the expected rate of return of foreign currency
deposits.
Appreciation of the domestic currency today raises the

expected return of deposits on foreign currency deposits.
Why?
When the domestic currency appreciates, the initial cost of
investing in foreign currency deposits decreases, thereby
lowering the expected rate of return of foreign currency
deposits.
14-44
Table 14-4: Todays Dollar/Euro Exchange Rate and

the Expected Dollar Return on Euro Deposits When
Ee$/ = $1.05 per Euro
14-45
Fig. 14-3: The Relation Between the Current

Dollar/Euro Exchange Rate and the Expected Dollar
Return on Euro Deposits
14-46
The Current Exchange Rate and the Expected

Rate of Return on Dollar Deposits
Current exchange
rate, E$/
1.07
1.05
1.03
1.02
1.00
0.031
0.050
R$
0.069
0.079 0.100
Expected dollar return
on dollar deposits, R$
14-47
Fig. 14-4: Determination of the Equilibrium

Dollar/Euro Exchange Rate
No one is willing to
hold euro deposits
No one is willing to
hold dollar deposits
14-48
Model of Foreign Exchange Markets

The effects of changing interest rates:
an increase in the interest rate paid on deposits denominated
in a particular currency will increase the rate of return on
those deposits.
This leads to an appreciation of the currency.
Higher interest rates on dollar-denominated assets causes the
dollar to appreciate.
Higher interest rates on euro-denominated assets causes the
dollar to depreciate.
14-49
Fig. 14-5: Effect of a Rise in the Dollar

Interest Rate
A depreciation
of the euro is
an appreciation
of the dollar.
14-50
Fig. 14-6: Effect of a Rise in the Euro Interest

Rate
14-51
The Effect of an Expected Appreciation of the

Euro
Individuals and
institutions now
expect the euro to
appreciate
14-52
The Effect of an Expected Appreciation

of the Euro
If people expect the euro to appreciate in the future, then
euro-denominated assets will pay in valuable euros, so that
these future euros will be able to buy many dollars and
many dollar-denominated goods.
The expected rate of return on euros therefore increases.
An expected appreciation of a currency leads to an actual
appreciation (a self-fulfilling prophecy).
An expected depreciation of a currency leads to an actual
depreciation (a self-fulfilling prophecy).
14-53
Covered Interest Parity

Covered interest parity relates interest rates across
countries and the rate of change between forward exchange
rates and the spot exchange rate:
R$ = R + (F$/ - E$/)/E$/
where F$/ is the forward exchange rate.
It says that rates of return on dollar deposits and covered
foreign currency deposits are the same.
How could you earn a risk-free return in the foreign
exchange markets if covered interest parity did not hold?
Covered positions using the forward rate involve little risk.
14-54
Summary
1. Exchange rates are prices of foreign currencies in terms
of domestic currencies, or vice versa.
2.
Depreciation of a countrys currency means that it is less

expensive (valuable) and goods denominated in it are
less expensive: exports are cheaper and imports more
expensive.
A depreciation will hurt consumers of imports but help

producers of exports.
14-55
Summary
3.
Appreciation of a countrys currency means that it is

more expensive (valuable) and goods denominated in it
are more expensive: exports are more expensive and
imports cheaper.
4.
An appreciation will help consumers of imports but hurt

producers of exports.
Commercial and investment banks that invest in deposits

of different currencies dominate the foreign exchange
market.
Expected rates of return are most important in determining

the willingness to hold these deposits.
14-56
Summary (cont.)
5.
Rates of return on currency deposits in the foreign

exchange market are influenced by interest rates and
expected exchange rates.
6.
Equilibrium in the foreign exchange market occurs when

rates of returns on deposits in domestic currency and in
foreign currency are equal: interest rate parity.
7.
An increase in the interest rate on a currencys deposit

leads to an increase in its expected rate of return and to
an appreciation of the currency.
14-57
Summary (cont.)
8.
An expected appreciation of a currency leads to an

increase in the expected rate of return for that currency,
and leads to an actual appreciation.
9.
Covered interest parity says that rates of return on

domestic currency deposits and covered foreign
currency deposits using the forward exchange rate are the
same.
14-58
AdditionalChapterArt
14-59
Table 14-2: $/ Exchange Rates and the Relative

Price of American Designer Jeans and British
Sweaters
14-60
Fig. 14-2: Interest Rates on Dollar and Yen

Deposits, 19782011
Source:Datastream.Threemonthinterestratesareshown.
14-61

Chapter 14 Exchange Rates and The Foreign Exchange Market An Asset Approach

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Chapter 14 Exchange Rates and The Foreign Exchange Market An Asset Approach

Загружено:

Авторское право:

Доступные форматы

Chapter 14

Exchange Rates and

Definitions of Exchange Rates

Exchange rates allow us to denominate the cost or price of

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Depreciation and Appreciation

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Depreciation and Appreciation (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Depreciation and Appreciation (cont.)

A depreciated currency means that imports are more

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Depreciation and Appreciation (cont.)

An appreciated currency means that imports are less

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets

Commercial banks and other depository institutions: transactions

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets (cont.)

Spot Rates and Forward Rates

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 14-1: Dollar/Pound Spot and Forward

NTD/USD Spot Rates, Annual average, 1960

NTD/Euro, Spot Rates, 2000-2014

NTD/Pound, Spot Rates, 2000-2010

NTD/Yen, Spot Rates, 2000-2014

NTD/USD Spot and Forward Exchange Rates,

Other Methods of Currency Exchange (other

A spot transaction along with a corresponding forward contract that

Swaps often result in lower fees or transactions costs because they

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Foreign exchange swaps

Currency Futures Contracts

Futures contracts: a contract designed by a third party for a standard

Other Methods of Currency Exchange

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand for currency deposits

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

The expected real rate of return : the rate of return

The Demand of Currency Deposits (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

The Demand of Currency Deposits (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

The expected rate of return on a euro deposit measured in

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

The Demand of Currency Deposits (cont.)

if >0 : dollar deposits yield the higher expected rate of

The Demand of Currency Deposits (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights reserved.