Short-Run Exchange Rate Determination

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Short-Run Exchange Rate Determination

• Issues in Global Trade Finance
• Prof. Bryson

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Part IFactors Determining Rates
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Short-run Exchange Rate Determination

• In the Short Run,
• the price of foreign exchange rises when
• 1. The foreign interest rate rises relative to
  ours. Why might this be?
• (Mobile, investment funds follow the higher
  rates. As they change countries, they bid up
  currency values.)

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Short-run Exchange Rate Determination

• The price of foreign exchange also rises when
• 2. The expected future spot exchange rate rises.
  How come?
• (If you expect you will have to pay more for the
  Euros you will need later because you expect the
  Euro/Dollar rate to rise, why not buy now before
  it does? Thus, the increased demand for Euros
  will bid the price up now.)

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How It Works

• Normally, returns on domestic and foreign
  government bonds tend to equality. Why?
• Differences cause investors to reposition their
  portfolios, affecting exchange and interest
  rates.
• Currency rates will rise when people buy in order
  to invest in foreign, short-term funds.

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Determining Factors in Foreign Exchange Prices

• The role of expectations is extremely important
  in forecasting the future. Lacking other
  information, what is the universal law of
  forecasting?
• We extrapolate recent change into the future.
  Lacking other information, the future will look
  like the present.
• The bandwagon effect.

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Determining Factors in Foreign Exchange Prices

• Once expectations are positive and buying goes
  on, we can begin a process of destabilizing
  speculation.
• Friedman and bad speculation (buying high and
  selling low).
• Bad currency speculation can lead to
  overshooting, where speculation may go in the
  right direction, but move past the equilibrium
  point.

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Determining Factors in Foreign Exchange Prices

• Expectations can be based on various kind of news
  on, e.g.,
• policies,
• trade data or performance,
• international political tensions and situations.

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Determining Factors in Foreign Exchange Prices

• An increase in money supply
• drives the interest rates down at first,
• then prices begin to rise (the chasing dollars
  thing, and
• currency values are driven down in the long run.

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Determining Factors in Foreign Exchange Prices

• When movements in exchange rates are not
  explainable as a function of the economic
  situation, they are referred to as speculative
  bubbles.

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Markets, Exchange, and Interest Rates

• Investing abroad has two steps.
• First, get the exchange (DM, F, , , )

P
P
Sell Dollars (P declines). Buy Euros
(P increases).

• Second, invest in foreign government bonds at
  high i rates

Buy European (high i) bonds. Their price rises,
(i falls).
S1 S2
P
P
Sell US (low i) bonds, their p falls (i rises).
D1 D2
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Part II.Short-term Rates and Investment Options
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Short-term Investment Options

• Should we pursue higher interest rates abroad?
  Check out the options
• 1. Invest at .05 ( ius) for 90 days (annual
  yield divided by four) in the U.S. at (1 ius)
• 1 million invested 1,050,000 in 90 days.

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SHORT-TERM INVESTMENT OPTIONS

• 2. Invest at .08 for 1 year in the U.K.
• A. Buy s in spot market at 1/ rs.
• B. Invest at (1 .08)/ rs
• C. At the time of the investment,
  hedge the investment by selling contracted
  earnings in the forward market at rf .

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SHORT-TERM INVESTMENT OPTIONS

• When we hedge the investment by selling
  contracted earnings in the forward market,
• the yield is ( 1 iuk ) ( rf / rs )
• 1,080,000 (0.61/0.63) 1,080,000 (.97)
  1,045,714

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Hot Money Investments

• Where we have
• 1,080,000 (0.61/0.63) 1,080,000 (.97)
  1,045,714,
• if the future rate (1.65) is greater than the
  spot rate (1.63), one expects depreciation.

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Hot Money Investments

• The covered interest differential between the two
  investments is the yield from the (presumably
  higher) foreign investment minus the yield from
  the domestic investment.
• It is
• CD ( 1 iuk ) ( rf / rs ) - (1 ius)
• 1,045,714 - 1,050,000

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Hot Money Investments

• 3. Invest at .08 in UK.
• A. Buy s in spot market at 1/ rs.
• B. Invest at (1 .08)/ rs
• C. Do not hedge, but speculate.
• Wait for the investment to pay out, take the
  yield and at that point (in 90 days or a year)
  purchase dollars with the pounds earned.

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Hot Money Investments

• If the goes up (or the value of the dollar
  vis-à-vis the pound declines, i.e., rs gt rs ,
  (3/ gt 2/ ), we make more money.
• But if the dollar appreciates, the will buy
  back fewer dollars at the end of the investment
  period.

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More Generally, Uses of the Future

• Future
• Change earnings in
  90 days at rs
• Future Change earnings forward
  (covered) Future
• Invest in UK
• Invest in U.S.
• Borrow in UK
• Borrow or
• sell assets
• in U.S.
• Present
• US Current
  currencies Current UK

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Part III.Exchange Rates in the Long Run
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Purchasing Power ParityMoney and Exchange Rates
in the Long Run

• The money supply determines the rate of
  inflation, which impacts the value of a currency.
  What is the impact?
• Why must an inflating currency depreciate in
  value (or be devalued)?

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Purchasing Power ParityMoney and Exchange Rates
in the Long Run

• Demand for a currency will decline if the
  commodities it will purchase are continually
  increasing in price.
• Currency demand f(transactions demands).

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Purchasing Power ParityMoney and Exchange Rates
in the Long Run

• People must hold money balances to make
  purchases. In general, Md for a particular
  national currency shows that holding money is
  like holding tickets for the GNP.
• Md f (national GDP/yr).

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Money and Exchange Rates in the Long Run

• The Quantity Theory of Money
• The Cambridge or Marshallian Quantity Theory
• M k (P) (y) y real national or
  domestic product
• Mf kf ( Pf ) (yf) k behavioral ratio
• (coefficient) related to velocity
• f foreign
• M Money Supply
• P Price level

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Money and Exchange Rates in the Long Run

• The Quantity Theory of Money
• In M k (P) (y) and Mf kf ( Pf ) (yf)
• If k and kf are fixed, these quantity equations
  determine domestic and foreign price levels, the
  price ratio between national money and national
  product.

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Price levels and exchange rates

• Internationally traded goods will have similar
  price movements when measured in the same
  currency through trades arbitrage effect.

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Price levels and exchange rates

• non-traded goods (e.g.,
• those with large transport
• costs will not necessarily
• converge in price terms.

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Price levels and exchange rates connected by
Purchasing Power Parity

• P rs ( Pf )
• where rs exchange rate,
• or, rewriting rs P/ Pf,
• We saw above that M k (P) (y),
• and solving for P, P M/ky. So
• substitute M/ky for P and we have
• rs M/( k y)
• Mf/(kf yf )

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Exchange rates and Purchasing Power Parity

• The nation with slower Ms growth and faster
  expansion of productive capacity, should have a
  currency rising in value.
• Rapid Ms growth and slow capacity expansion would
  lead to a depreciating currency.

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Exchange rates and Purchasing Power Parity

• This theory has proved empirically reliable for
  the long run only. For the short run, this is
  not a good predictor. Expectations and
  speculative movements affect the short run and
  non-traded goods also have an impact.

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Interest Rates and Foreign Exchange

• Foreign investors want to take advantage of high
  interest rates only if the real rates are high.
• They will not want to hold foreign assets, and
  the spot rate of currencies will not be bid up,
  if real returns are not available because only
  nominal interest rates are high.

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Interest Rates and Foreign Exchange

• If interest rates rise merely because prices are
  increasing as the money supply expands, the
  currency value must decline.
• The real interest rate is the nominal rate minus
  the rate of inflation.
• Real rate nominal rate - inflation.
• Example 5 16 - 11.

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Hopper on What Determines the Exchange Rate?

• A fundamental belief exchange rates are
  affected by fundamental economic forces, such as
  money supplies, interest rates, real output
  levels, or the trade balance.

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Hopper on What Determines the Exchange Rate?

• But these fundamentals dont affect the exchange
  rate in the short run.
• The best forecast of the exchange rate, at least
  in the short run, is whatever it happens to be
  today.

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Hopper on What Determines the Exchange Rate?

• The monetary model fails empirically except
  perhaps in unusual periods such as
  hyperinflations. (p. 251)
• After it was apparent that the model couldnt be
  substantiated, economists tried to develop other
  ideas.

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Hopper on What Determines the Exchange Rate?

• Hopper discusses attempts to extend the monetary
  model Dornbusches overshooting model, the
  portfolio balance model. Not much empirical
  support for these ideas has been found.
• Econometricians found that a naïve strategy of
  using todays exchange rate as a forecast works
  at least as well as any of the statistical models.

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Hopper on What Determines the Exchange Rate?

• Hopper concludes that if we look backward or
  forward over periods of up to a year, the
  fundamentals dont seem to explain the exchange
  rate, contrary to what standard models in
  international finance textbooks implyperhaps
  economists will discover a model that works in
  the future. (p. 253)

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Hopper on What Determines the Exchange Rate?

• The alternative view is that exchange rates are
  determined, at least in the short run (under two
  years) by market sentiment. Market participants
  take the fundamentals very seriously when forming
  exchange-rate expectations. Economists are just
  starting to build models of market sentiment.

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Hopper on What Determines the Exchange Rate?

• The exchange rates are determined in the long run
  by fundamentals. The empirical models do better
  here.
• Long-term market forces, the fundamentals, tend
  gradually to outweigh short-term irrational or
  unpredictable speculative forces in exchange
  markets.