Exchange Rates

1
Exchange Rates

• Antu Panini Murshid

2
Todays Agenda

• Nominal vs. real exchange rate
• Asset market approach
• Uncovered interest rate parity

3
Currencies and Exchange Rates

• Each country has a currency in which the prices
  of goods and services are quoted
• An exchange rate is the price of one currency in
  terms of another. This is sometimes called the
  nominal exchange rate

4
Exchange Rate Quoting

• An exchange rate can be quoted in two ways
• Direct (American) terms and indirect (European)
  terms
• In this course we will always (unless otherwise
  stated) quote the exchange rate in direct terms

5
Direct Terms

• Price of foreign currency in terms of national
  currency
• How many units of national currency do we need to
  buy a unit of foreign currency
• Example /, /
• Todays dollar-euro exchange rate is 1.07384 per
  euro

6
Indirect Terms

• Price of national currency in terms of foreign
  currency
• How many units of foreign currency do we need to
  buy a unit of national currency
• Example /, /
• Todays euro-dollar exchange rate is 0.931015
  per USD

7
Appreciation and Depreciation of a Currency

• A depreciation of the dollar against the euro
  means that the price of a euro in terms of
  dollars has gone up
• An appreciation of the dollar against the euro
  means that the price of a euro in terms of
  dollars has gone down

8
Appreciation and Depreciation of a Currency

• If the dollar depreciates against the euro this
  must mean that the euro has appreciated against
  the dollar
• If the dollar appreciates against the euro this
  must mean that the euro has depreciated against
  the dollar

9
Appreciation and Depreciation of the Exchange Rate

• An exchange rate depreciation means the domestic
  currency has depreciated and an exchange rate
  appreciation means the domestic currency has
  appreciated
• If the exchange rate depreciates then e?
• If the exchange rate appreciates then e?

10
Example

• If the / exchange rate moves from e1.00 to
  e.95.
• exchange rate has appreciated by 5
• Dollar has appreciated against the euro by 5 (it
  now cost 0.95 as opposed to 1 to buy 1) and
  the euro has depreciated against the dollar by
  approximately 5 (it now costs 1.05 to buy 1)

11
Real Exchange Rate

• Suppose a car in UK costs 30,000, if e1.50,
  then dollar price is 45,000, i.e. the price of
  foreign goods in terms of domestic currency is
  ePf
• Suppose the same car in the US costs 36,000,
  then the price of the foreign car in terms of the
  price of domestic cars is ePf/P1.25

12
Real Exchange Rate

• The real exchange rate (?) gives the price of a
  unit of a foreign goods, in terms of the price of
  domestic goods
• That is ? ePf / P, where P is the domestic
  price level and Pf is foreign price level

13
Real Exchange Rate Appreciation/Depreciation

• If ?? we say that the real exchange rate has
  depreciated
• ?? if either e? P? or Pf?
• If ?? we say that the real exchange rate has
  appreciated
• ?? if either e? P? or Pf?

14
Competitiveness

• If the real exchange rate depreciates, the price
  of foreign goods relative to the price of
  domestic goods increases and exports become more
  competitive while imports become more expensive
• If the real exchange rate appreciates, the price
  of foreign goods relative to the price of
  domestic goods decreases and exports become less
  competitive while imports become cheaper

15
Foreign Exchange Market

• Players in the foreign exchange market
• Commercial banks, large corporations, non-bank
  financial institutions, central banks
• Commercial banks are by far the largest players
  in the foreign exchange market. However large
  corporations like IBM and GE also engage in
  significant transactions. Another groups of
  important players are central banks

16
Foreign Exchange Market

• Characteristics of the market
• The main markets are London, New York, Tokyo
• Daily global value of forex trading 1.7 trillion
• vehicle currency

17
Determination of the Spot Exchange Rate

• What determines the exchange rate?
• Demand and supply
• What factors might affect demand and supply?
• Inflation rates?
• Trade deficits?
• Demand for assets?

18
Expected Returns

• Expected rate of return
• Risk and liquidity
• We will abstract from risk and liquidity for now
  and assume that these characteristics are the
  same across different assets. If this is the
  case, we will prefer to hold assets offering the
  highest expected rate of return

19
How Do We Compare Returns on Various
International Assets?

• -assets pay returns in dollars
• -assets pay returns in euros
• In order to compare these returns, we need to
  measure all returns in terms of one currency

20
How Do We Compare Returns on Various
International Assets?

• But why does it matter, isnt 5 interest in the
  US just the same as 5 in Germany?
• Nobecause the exchange rate between dollar and
  the euro may change

21
Example

• Suppose the / exchange rate is 1.00
• The interest rate in the US is 10
• The interest rate in Germany is 5
• Expect / exchange rate to be 1.10
• Which asset offers the highest rate of return?

22
Example

• Gross return on 1 deposited at a US bank is
  1.10
• What is the gross return on 1 deposited in a
  German bank?

23
Example

• 1. Convert dollars to euros
• 1? 1
• 2. Invest in Germany
• Gross return 1.05
• 3. Convert back to dollars
• 1.05 ? 1.15
• Return on -asset is 15 ifE(De)

24
Equilibrium Exchange Rate

• If the rate of return on dollar assets is greater
  than the dollar rate of return on euro assets
  there will be an excess demand for dollar assets
• If the rate of return on dollar assets is less
  than the dollar rate of return on euro assets
  there will be an excess demand for euro assets
• Only when the rate of return on dollar assets is
  equal to the rate of return on euro assets will
  the exchange rate be in equilibrium

25
Uncovered Interest Rate Parity Condition

• The UCIP condition states that the return to
  investing in domestic assets must equal the
  expected return on investing in foreign assets
  (when the returns are measured in the same
  currency)
• i if E(?e)

26
Example UCIP Holds

• i 10 (US rate), if 5 (German rate), et
  1.00 (/) and E(et1) 1.05
• Expected return to a 100 investment in
  -denominated German asset is
• 1. Convert to 100/e 100
• 2. Receive 105 in 1 year
• 3. Covert back to (105 )1.05 110
• UIPC holds

27
Example UCIP Doesnt Hold

• i 10 (US rate), if 8 (German rate), et
  1.00 (/) and E(et1) 1.05
• Expected -return in -denominated German asset
  is 8513 gt 10 (-return on US asset)
• Demand for -deposits/assets ?
• depreciates immediately (e?) e 1.03.
• Since E(et1) 1.05, E(?e)2
• Hence E(?e)if8210i

28
Example UCIP Doesnt Hold

• Suppose now instead that the domestic interest
  rate increases such that i 12 (US rate). If
  if 5 (German rate), et 1.00 (/) and
  E(et1) 1.05, then the demand for US assets
  increases and the dollar appreciates to et
  0.98. Thus E(?e)7, so UCIP is again restored

29
-Return on Foreign Assets and the Exchange Rate
/ e
1.10
Expected -return on assets
1.05
1.00
0.95
5
0
10
15
-rate of return on assets
30
Equilibrium Exchange RateGraphical Representation
/ e
Rate of return on dollar assets
e2
UIPC holdsequilibrium exchange rate
e1
Expected return on assets
e3
-rate of return on assets
31
Effect of an Increase in Domestic Interest Rates
/ e
Original equilibrium
New equilibriumthe exchange rate appreciates
today and UCIP is restored
Domestic interest rate increases
e1
e2
Expected return on assets
i1
i2
-rate of return on assets
32
Effect of an Increase in Foreign Interest Rates
/ e
New equilibrium
Original equilibrium
e2
Foreign interest rate increases
e1
Expected return on assets
i
-rate of return on assets
33
Effect of a Change in Expectations
/ e
New equilibrium
Original equilibrium
e2
Rise in expected future price of euros
e1
Expected return on assets
i
-rate of return on assets