Foreign Exchange Markets

1
Foreign Exchange Markets

• Lecture 6
• Part II
• Explaining Changes in FX Rates

2
Main Contents

• Demand and supply curves
• Exchange rates equilibrium

3
Demand and Supply Curves for Domestic Assets

• With the help of demand and supply analysis, we
  also can explain changes in exchange rates.
• The foundation is the following relative expected
  return of domestic assets over foreign assets
• Domestic interest rate
• Foreign interest rate
• Expected appreciation rate of the
  domestic currency,

4
Demand and Supply Curves for Domestic Assets

• Suppose that you are an investor in HK and
  interested in assets denominated in Japanese Yen.
  The current annual interest rates in both places
  are 2. You expect in 1 year the Hong Kong dollar
  will drop to 13 yen per dollar.
• Under which scenario in the following two, you
  are more interested in saving money in Hong Kong?
• The current exchange rate is 17 yen per dollar
• The current exchange rate is 15 yen per dollar

5
Demand and Supply Curves for Domestic Assets

• When everything else is fixed, the higher the
  current exchange rate (how many foreign
  currencies per domestic currency), the lower
  demand for domestic assets.
• Exchange rate
• JPY/HKD
• 
  Quantity of HKD assets

6
Demand and Supply Curves for Domestic Assets

• Supply of domestic assets is affected little by
  the exchange rates. People usually use a vertical
  line to describe the supply.
• Exchange rate
• JPY/HKD
• 
  
• 
  Quantity of HKD assets

7
Equilibrium in the Foreign Exchange Market

• Like what we did in studying interest rates, the
  equilibrium of foreign exchange is also reached
  at the intersection of supply and demand curves.
• Exchange rate
• JPY/HKD
• 
  
• 
  Quantity of HKD assets

Equilibrium
8
Shifts in the Demand for Domestic Assets

• Domestic interest rate
• An increase in domestic interest rate will
  shift the demand curve to the right and cause the
  domestic currency to appreciate.
• Exchange rate
• JPY/HKD
• 
  
  Quantity of
• 
  HKD
  assets

New Equilibrium
Old Equilibrium
9
Shifts in the Demand for Domestic Assets

• Foreign interest rate
• An increase in foreign interest rate will
  shift the demand curve to the left and cause the
  domestic currency to depreciate.
• Exchange rate
• JPY/HKD
• 
  
  Quantity of
• 
  HKD
  assets

Old Equilibrium
New Equilibrium
10
Currency Carry Trade

• The interest rate in Japan has been very low
  since 1990 because Japan has been trapped in a
  prolonged economic recession.
• The economy in some resource rich countries such
  as Australia and New Zealand has been boosted by
  high prices in recent commodity markets. These
  countries also experience high inflation. The
  central banks set interest rates high to tame
  inflation.

11
Currency Carry Trade

• These two factors lead to a sharp appreciation of
  Australian dollar over Japanese Yen.

12
Shifts in the Demand for Domestic Assets

• Expectations about the future value of the
  exchange rate also play an important role in
  shifting the current demand curve and thus
  changing the current exchange rate.
• A rise in the expected future exchange rate
  causes an appreciation of the domestic currency.
• One example Renminbi