Exchange Rate Determination

1
Exchange Rate Determination

• Chapter Two
• Shapiro

2
Foreign exchange risk

• liquidity in terms of a different currency for
  international transactions
• lags involved (credit transactions)
• exposure from a position in a currency
• an importer holding a payable denominated in a
  different currency
• an exporter holding a receivable denominated in a
  different currency
• http//www.oanda.com/convert/fxhistory

3
Market Participants

• market makers
• banks, foreign exchange dealers, foreign exchange
  brokers
• firms
• exporters, importers
• individuals (investors)
• speculators and arbitragers
• central banks treasuries

4
Market Makers

• Chartered banks the main market
• Hold positions in foreign exchange
• Buy and sell spot and forward
• Sell over-the-counter options
• Hedge open positions buy buying and selling
• Exchange traded options and futures
• Make money on the bid-ask spread
• Exchange dealers
• Hold positions specialize in specific currencies
• Make money on the bid-ask spread
• Exchange brokers
• Broker deals paid commissions

5
Demanders and suppliers of foreign exchange

• Firms (primary demanders)
• Exporters paid in foreign currency want home
  currency
• When you buy foreign, sellers usually demand
  payment in their own currency
• Some exceptions (all oil transactions denominated
  in us dollars)
• Buying home currency both spot and forward
• Individuals (travelers)
• Buying foreign currency spot or forward
  (travelers checks)
• Individuals (investors)
• Buying foreign currency spot

6
Wild Cards in the Market

• Speculators - create volatility?
• Trying to profit from a perceived miss-valuation
  of a currency
• If currency is perceived overvalued
• More of it will be needed in the future to buy
  another currency
• It will be shorted (puts for example)
• Arbitrageurs - create stability?
• Profiting from a riskless arbitrage
• Triangular arbitrage
• Direct price different than price through another
  currency

7
Wild Cards in the Market

• Central banks
• May try to influence the trend of the value of a
  currency
• Buying foreign exchange to prevent depreciation
• Selling foreign exchange to prevent appreciation
• Trying to prevent appreciation or depreciation of
  the currency
• May try to reduce volatility in the markets
• The direction of the trend line is not important
• But the volatility around the trend line is
  important
• Reduce the costs of hedging to exporters and
  importers

8
Thickness of the market

• 1.19 trillion per day (2004)
• spot, forward, and swap transactions
• major centers
• London 700 billion/day
• New York 450 billion/day
• Japan 200 billion/day
• major currencies
• usd 45
• Euro 20
• yen 10

9
The Spot Exchange rate

• Price of one currency in terms of another
• For delivery today (four business days)
• Price fluctuates constantly to reflect market
  conditions

10
Spot rate

• e0 , cd, terms cd/usd 1.1522
• cd cost of the usd
• Canadian terms, European terms, direct
• interbank quotes usually in European terms
• e0 , usd terms usd/cd 0.8679
• usd cost of the cd
• American terms, indirect

http//www.x-rates.com/htmlgraphs/CAD30.html
11
Bid/ask (Offer) quotations

• bid - what the dealer will buy for
• ask (offer) - what the dealer will sell for
• spread
• a function of increased volatility (risk)
• Individual firm risk
• Increased market risk
• Forward exchange rates far into the future
• dealers and banks generate revenues from the
  spread

12
Example - spot rates
Canadian terms, European terms, direct terms
American terms, indirect terms
13
Equilibrium Spot Rate determinants

• Demand for CD by holders of foreign currency
• foreigners want to buy something Canadian
• goods, services, securities, etc.
• Supply from Canadians holding CD demanding
  foreign exchange
• Canadians want to buy something foreign
• goods, services, securities, etc

14
Equilibrium Spot Rate
Supply of cd - Canadians buying foreign
usd/cd
e0
Demand for cd - foreigners buying Canadian
Qcd
Q0
15
Factors affecting money exchange rates

• 1. economic growth
• economic growth increases demand for base
• 2. inflation
• CB controls the supply of base money
• 3. interest rates
• CB controls the bank rate directly
• CB influences term structure of interest rates
  indirectly
• 4. political risk

16
1. Economic Growth
Change in demand for money with growth in the
economy
S
D2
D1
M
17
1. Economic Growth

• Growth increases the demand for money
• demand for money curve shifts up
• Assume CB keeps money supply constant
• no change in the vertical supply curve
• the value of money increases
• prices and value of money inversely related
• domestically - deflation
• internationally - exchange rate appreciation

18
2. Money Supply
S1
S2
Supply curve after CB increase money supply
D
M
19
2. Money Supply

• Central Bank increases supply of money
• supply curve shifts out
• Assuming no change in demand for money
• the demand for money curve remains stationary
• the value of money decreases
• prices and value of money inversely related
• domestically - inflation
• internationally - exchange rate depreciation

20
3. Term Structure of Interest Rates
iT
New term structure of interest rates after CB
increases bank rate
Term to maturity
21
3. Shift in Term Structure of Interest
Rates

• Central bank changes the bank rate
• only rate directly controlled by CB
• least risky rate in the economy
• no default risk
• little interest rate risk - overnight funds rate
• other rates will ratchet up relative to risk
• default - ability to pay
• interest rate risk - relative to term to
  maturity

22
4. Political Risk

• party in power makes the rules
• distribution of income and wealth
• tax law
• transfers
• regulatory environment
• increase or decrease frims costs of doing
  business
• change of party in power
• change in the rules
• for example PQ in power in Québec

23
4. Jump Shift in Term Structure
iT
Jump in term structure after a large change in
political risk
Term to maturity
24
4. Jump Shift in Term Structure

• Small change in power structure
• new rules
• some increase in uncertainty about future
• small discrete change in market risk premium
• Large change in power structure
• systemic change in the economy
• large increase in uncertainty about future
• large discrete change in market risk premium

25
Fluctuations in the spot rate

• Demand for the cd increases - appreciation
• cd buys more foreign currency
• it cost more in foreign currency to buy the cd
• Supply of the cd increases - depreciation
• cd buys more foreign currency
• it costs less in foreign currency to buy the cd

26
Asian flu (1997)

• Countries involved
• Thai baht, Indonesian rupiah, Malaysian Ringgit,
  Philippine peso, S. Korean wan
• Over cooked economy
• Government guaranteed risky loans
• BOT surplus, exchange rate appreciation
• Chinese yuan depreciated 25
• Chinese goods more competitive
• Trade went to China
• Asian rim countries lost market
• Financial crisis as multiple bankruptcies

27
New Equilibrium Spot Rate
Foreigners increase their demand for Canadian
goods
S
usd/cd
en, 0, cd
D2
eo, 0, cd
D1
Qcd
Qo, cd
Qn, cd
28
Percent change
Calculation of percentage change
negative change means appreciation
positive change means depreciation
29
Year end exchange rates
30
An Example - direct terms

• assume

The cd cost of the usd has decreased in one year
by -4.3, the cd has appreciated, the usd has
depreciated
31
An Example - indirect terms

• assume

The usd cost of the cd has increased in one year
by 4.5 The cd has appreciated, the usd has
depreciated
32
cd appreciation

• it costs less cd to buy the usd
• 1.1522 cd/usd versus 1.2036 cd/usd
• consequently cd prices of US goods decrease
• this means that the cd appreciates or increases
  in value relative to the usd

33
Second example - direct terms
The cd price of the usd has decreased in four
years by 27.8
The cd price of the usd decreased annually on
average by 7.8
34
Second example - indirect terms
The usd price of the cd has increased in four
years by 32.2
The usd price of the cd increased annually on
average by 6.8
35
cd appreciation

• it costs less cd to buy the usd
• 1.1522 cd/usd versus 1.5968 cd/usd
• consequently cd prices of US goods decrease
• this means that the cd appreciates or increases
  in value relative to the usd

36
The Spot Exchange rate

• Price for current delivery
• Price of one currency in terms of another
• Delivery no later than four business days
• Price market determined
• fluctuates to reflect new information

37
Equilibrium Spot Rate

• Current demand for CD by holders of foreign
  currency
• foreigners want to buy something Canadian
• Current supply from Canadians holding CD
  demanding foreign exchange
• Canadians want to buy something foreign

38
Spot rate

• e0 , Can terms CD/USD 1.1522
• e0 , us terms USD/CD 0.8679

39
Changes in the spot rate

• Positive change
• Costs more CD tp buy the USD
• Costs more CD to buy US goods
• CD depreciates
• Negative change
• Costs less CD to buy USD
• Costs less CD to buy US goods
• CD appreciates

40
The Forward Exchange rate

• Price for future delivery
• Price of one currency in terms of another
• Delivery date to be determined if contracted
• Price market determined
• fluctuates to reflect new information

41
Equilibrium Forward Rate

• Future demand for CD by holders of foreign
  currency expressed in todays markets
• foreigners contracting to buy something Canadian
  today
• But will pay for it at a future date
• Current supply from Canadians holding CD
  demanding foreign exchange expressed in todays
  markets
• Canadians contracting to buy something foreign
  today
• But expect to pay for it in the future

42
Forward exchange rates
43
Forward rate

• f180 , can terms CD/USD 1.1619
• f180 , us terms USD/CD 0.8607

44
Forward premium/discount
45
Central Banks

• Monetary policy
• Bank rate (interest rate adjustments)
• Money supply (2 inflation)
• Regulation of the banking system
• Exchange rate policy
• Bank rate (attract foreign capital?)
• Reduce volatility
• Monetize the debt???

46
Fixed exchange rates

• Advantages
• reduces short-run exchange rate volatility
• reduce costs of international trade
• Disadvantages
• Externally mandated discipline (loss of
  sovereignty
• Monetary policy
• Fiscal policy
• Impede relative price adjustments

47
Means to manage exchange rates

• Currency Boards
• Central Bank Intervention
• devalutaion/revaluation
• Joint Intervention

48
China Currency Board
Liabilities
Assets

• gold, silver
• dollar assets
• (T-bills) 80
• 400 billion
• some foreign exchange

• Yuan cash currency
• Commercial Bank reserves

49
Dollarization

• Countries adopt a currency not their own
• Informally
• Black and grey markets exist in which the medium
  of exchange is the dollar
• Formally
• Panama, Ecuador
• Lose all sovereignty with regard to monetary and
  exchange rate policy

50
Euro-Zone (Currency Unification)

• Independent European Central Bank
• convergence criteria
• nominal inflation lt 1.5 above
• avg of 3 with lowest in previous year
• long-term interest lt 2.0 above
• avg of 3 with lowest in previous year
• fiscal deficit no more than 3 of GDP
• debt no more than 60 of GDP

51
Countries in the Euro

• Belgium (franc)
• Germany (deutschemark)
• Spain (peseta)
• France (franc)
• Ireland (punt)
• Luxembourg (franc)
• Italy (lira)

• Netherlands (guilder)
• Austrian (shilling)
• Portugal (escudo)
• Finland (markka)
• Vatican City (lira)
• Greece (drachma)
• Slovenia (tolar)

52
EU Countries not in Euro zone

• Bulgaria (Lev)
• Cyprus (Pound)
• Czech Republic (Koruna)
• Denmark (krone)
• Estonia (Kroon)
• Hungary (Forint)
• Latvia (Lats)

• Lithuania (Litas)
• Malta (Lire)
• Poland (Zloty)
• Romania (Leu)
• Slovakia (Koruna)
• Sweden (krona)
• United Kingdom (pound)

53
Candidate countries for the EU

• Croatia
• Macedonia
• Turkey

54
Free Float
Foreigners increase their demand for Canadian
goods
usd/cd
S1
en, 0, cd
D2
eo, 0, cd
D1
Qcd
Qo, cd
Qn, cd
55
Intervention
Foreigners increase their demand for Canadian
goods
S1
usd/cd
S2
en, 0, cd
B of C buys usd
eo, 0, cd
D2
D1
Qcd
Qo, cd
56
Unsterilized Intervention

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
Canadian dollar liability increases
57
Domestic Affects of an Unsterilzed Intervention

• Base money increases by amount of purchase
• pressure exerted on prices to increase
• inflation in the economy
• Canadian goods cost more in cd

58
Foreign Affects of anUnsterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• higher Canadian inflation
• US goods cost relatively less to Canadians
• Canadian goods cost relatively more to US
  consumers
• exchange rate remains relatively constant

59
Sterlized Intervention

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
No increase in B of C liabilities
B of C sells equal value in other assets
60
Domestic Affects of an Sterilzed Intervention

• Base money remains constant
• prices remain constant

61
Foreign Affects of anSterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• pressure remains on exchange rate to depreciate
• BOT deficit remains
• eventually the cd price of the usd will increase