Chapter 13Chapter 13
Exchange Rates and TheForeign Exchange Market: AnAsset ApproachExchange Rates and TheForeign Exchange Market: AnAsset Approach
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Chapter 12Chapter 12
1.What is the national income identity foran open economy?1.What is the national income identity foran open economy?
2.What is the national saving for an openeconomy?2.What is the national saving for an openeconomy?
3.What is the fundamental balance ofpayment identity for an open economy?3.What is the fundamental balance ofpayment identity for an open economy?
Chapter 13Chapter 13
1.Explain the interest parity? 1.Explain the interest parity?
2.How changes in the current exchange rateaffect expected return?2.How changes in the current exchange rateaffect expected return?
3.How changes in the euro interest rateaffect the current exchange rate ?3.How changes in the euro interest rateaffect the current exchange rate ?
4.How changes in the dollar interest rateaffect the current exchange rate ?4.How changes in the dollar interest rateaffect the current exchange rate ?
5.How changes in the expectation affect thecurrent exchange rate ?5.How changes in the expectation affect thecurrent exchange rate ?
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
Equilibrium in the Foreign Exchange MarketEquilibrium in the Foreign Exchange Market
Interest Rates, Expectations, and EquilibriumInterest Rates, Expectations, and Equilibrium
SummarySummary
Chapter OrganizationChapter Organization
The demand for a foreign currency bankdeposit is influenced by the sameconsiderations that influence the demandfor any other asset.The demand for a foreign currency bankdeposit is influenced by the sameconsiderations that influence the demandfor any other asset.
Assets and Asset ReturnsAssets and Asset Returns
Defining Asset ReturnsDefining Asset Returns
The percentage increase in value an asset offersover some time period.The percentage increase in value an asset offersover some time period.
The Real Rate of ReturnThe Real Rate of Return
The rate of return computed by measuring assetvalues in terms of some broad representativebasket of products that savers regularly purchase.The rate of return computed by measuring assetvalues in terms of some broad representativebasket of products that savers regularly purchase.
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
Risk and LiquidityRisk and Liquidity
Savers care about two main characteristics ofan asset other than its return:Savers care about two main characteristics ofan asset other than its return:
RiskRisk
The variability it contributes to savers’ wealthThe variability it contributes to savers’ wealth
LiquidityLiquidity
The ease with which it can be sold or exchanged forgoodsThe ease with which it can be sold or exchanged forgoods
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
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Interest RatesInterest Rates
Market participants need two pieces ofinformation in order to compare returns ondifferent deposits:Market participants need two pieces ofinformation in order to compare returns ondifferent deposits:
How the money values of the deposits will changeHow the money values of the deposits will change
How exchange rates will changeHow exchange rates will change
A currency’s interest rate is the amount ofthat currency an individual can earn bylending a unit of the currency for a year.A currency’s interest rate is the amount ofthat currency an individual can earn bylending a unit of the currency for a year.
Example: At a dollar interest rate of 10% per year,the lender of $1 receives $1.10 at the end of theyear.Example: At a dollar interest rate of 10% per year,the lender of $1 receives $1.10 at the end of theyear.
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
Exchange Rates and Asset ReturnsExchange Rates and Asset Returns
The returns on deposits traded in the foreignexchange market depend on interest ratesand expected exchange rate changes.The returns on deposits traded in the foreignexchange market depend on interest ratesand expected exchange rate changes.
In order to decide whether to buy a euro or adollar deposit, one must calculate the dollarreturn on a euro deposit.In order to decide whether to buy a euro or adollar deposit, one must calculate the dollarreturn on a euro deposit.
The Demand forForeign Currency Assets
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A Simple RuleA Simple Rule
The dollar rate of return on euro deposits isapproximately the euro interest rate plus therate of depreciation of the dollar againstthe euro.The dollar rate of return on euro deposits isapproximately the euro interest rate plus therate of depreciation of the dollar againstthe euro.
The rate of depreciation of the dollar against theeuro is the percentage increase in the dollar/euroexchange rate over a year.The rate of depreciation of the dollar against theeuro is the percentage increase in the dollar/euroexchange rate over a year.
The Demand forForeign Currency Assets
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The expected rate of return differencebetween dollar and euro deposits is:The expected rate of return differencebetween dollar and euro deposits is:
R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1) R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1)
where: R$ = interest rate on one-year dollardepositswhere: R$ = interest rate on one-year dollardeposits
R€= today’s interest rate on one-yeareuro deposits R€= today’s interest rate on one-yeareuro deposits
E$/€ = today’s dollar/euro exchange rate(number of dollars per euro) E$/€ = today’s dollar/euro exchange rate(number of dollars per euro)
Ee$/€ = dollar/euro exchange rate (numberof dollars per euro) expected to prevail a yearfrom today Ee$/€ = dollar/euro exchange rate (numberof dollars per euro) expected to prevail a yearfrom today
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
When the difference in Equation (13-1) ispositive, dollar deposits yield the higherexpected rate of return. When it is negative,euro deposits yield the higher expected rateof return.When the difference in Equation (13-1) ispositive, dollar deposits yield the higherexpected rate of return. When it is negative,euro deposits yield the higher expected rateof return.
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
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Return, Risk, and Liquidity in the ForeignExchange MarketReturn, Risk, and Liquidity in the ForeignExchange Market
The demand for foreign currency assetsdepends not only on returns but on risk andliquidity.The demand for foreign currency assetsdepends not only on returns but on risk andliquidity.
There is no consensus among economists aboutthe importance of risk in the foreign exchangemarket.There is no consensus among economists aboutthe importance of risk in the foreign exchangemarket.
Most of the market participants that are influencedby liquidity factors are involved in internationaltrade.Most of the market participants that are influencedby liquidity factors are involved in internationaltrade.
Payments connected with international trade make up avery small fraction of total foreign exchange transactions.Payments connected with international trade make up avery small fraction of total foreign exchange transactions.
Therefore, we ignore the risk and liquiditymotives for holding foreign currencies.Therefore, we ignore the risk and liquiditymotives for holding foreign currencies.
The Demand for Foreign Currency AssetsThe Demand for Foreign Currency Assets
Equilibrium in the Foreign Exchange MarketEquilibrium in the Foreign Exchange Market
Interest Parity: The Basic EquilibriumConditionInterest Parity: The Basic EquilibriumCondition
The foreign exchange market is in equilibriumwhen deposits of all currencies offer the sameexpected rate of return.The foreign exchange market is in equilibriumwhen deposits of all currencies offer the sameexpected rate of return.
Interest parity conditionInterest parity condition
The expected returns on deposits of any twocurrencies are equal when measured in the samecurrency.The expected returns on deposits of any twocurrencies are equal when measured in the samecurrency.
It implies that potential holders of foreign currencydeposits view them all as equally desirable assets.It implies that potential holders of foreign currencydeposits view them all as equally desirable assets.
The expected rates of return are equal when:The expected rates of return are equal when:
R$ = R€ + (Ee$/€ - E$/€)/E$/€ (13-2) R$ = R€ + (Ee$/€ - E$/€)/E$/€ (13-2)
How Changes in the Current ExchangeRate Affect Expected ReturnsHow Changes in the Current ExchangeRate Affect Expected Returns
Depreciation of a country’s currency todaylowers the expected domestic currency returnon foreign currency deposits.Depreciation of a country’s currency todaylowers the expected domestic currency returnon foreign currency deposits.
Appreciation of the domestic currency todayraises the domestic currency return expectedof foreign currency deposits.Appreciation of the domestic currency todayraises the domestic currency return expectedof foreign currency deposits.
Equilibrium in theForeign Exchange MarketEquilibrium in theForeign Exchange Market
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The Equilibrium Exchange RateThe Equilibrium Exchange Rate
Exchange rates always adjust to maintaininterest parity.Exchange rates always adjust to maintaininterest parity.
Assume that the dollar interest rate R$, theeuro interest rate R€, and the expected futuredollar/euro exchange rate Ee$/€, are all given.Assume that the dollar interest rate R$, theeuro interest rate R€, and the expected futuredollar/euro exchange rate Ee$/€, are all given.
Equilibrium in theForeign Exchange MarketEquilibrium in theForeign Exchange Market
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R$
Return on
dollar deposits
Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Rates of return
(in dollar terms)
Exchange rate, E$/€
E2$/€
2
1
E1$/€
E3$/€
3
Expected return
on euro deposits
Equilibrium in theForeign Exchange MarketEquilibrium in theForeign Exchange Market
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The Effect of Changing Interest Rates onthe Current Exchange RateThe Effect of Changing Interest Rates onthe Current Exchange Rate
An increase in the interest rate paid ondeposits of a currency causes that currency toappreciate against foreign currencies.An increase in the interest rate paid ondeposits of a currency causes that currency toappreciate against foreign currencies.
A rise in dollar interest rates causes the dollar toappreciate against the euro.A rise in dollar interest rates causes the dollar toappreciate against the euro.
A rise in euro interest rates causes the dollar todepreciate against the euro.A rise in euro interest rates causes the dollar todepreciate against the euro.
Interest Rates, Expectations, and EquilibriumInterest Rates, Expectations, and Equilibrium
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Dollar return
R$
Figure 13-6: Effect of a Rise in the Euro Interest Rate
Rates of return
(in dollar terms)
Exchange rate, E$/€
1
E1$/€
2
E2$/€
Rise in euro
interest rate
Expected
euro return
Interest Rates, Expectations, and EquilibriumInterest Rates, Expectations, and Equilibrium
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The Effect of Changing Expectations onthe Current Exchange RateThe Effect of Changing Expectations onthe Current Exchange Rate
A rise in the expected future exchange ratecauses a rise in the current exchange rate.A rise in the expected future exchange ratecauses a rise in the current exchange rate.
A fall in the expected future exchange ratecauses a fall in the current exchange rate.A fall in the expected future exchange ratecauses a fall in the current exchange rate.
Interest Rates, Expectations, andEquilibriumInterest Rates, Expectations, andEquilibrium
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SummarySummary
Exchange rates play a role in spendingdecisions because they enable us totranslate different countries’ prices intocomparable terms.Exchange rates play a role in spendingdecisions because they enable us totranslate different countries’ prices intocomparable terms.
A depreciation (appreciation) of acountry’s currency against foreigncurrencies makes its exports cheaper(more expensive) and its imports moreexpensive (cheaper).A depreciation (appreciation) of acountry’s currency against foreigncurrencies makes its exports cheaper(more expensive) and its imports moreexpensive (cheaper).
Exchange rates are determined in theforeign exchange market.Exchange rates are determined in theforeign exchange market.
SummarySummary
An important category of foreignexchange trading is forward trading.An important category of foreignexchange trading is forward trading.
The exchange rate is most appropriatelythought of as being an asset price itself.The exchange rate is most appropriatelythought of as being an asset price itself.
The returns on deposits traded in theforeign exchange market depend oninterest rates and expected exchange ratechanges.The returns on deposits traded in theforeign exchange market depend oninterest rates and expected exchange ratechanges.
SummarySummary
Equilibrium in the foreign exchangemarket requires interest parity.Equilibrium in the foreign exchangemarket requires interest parity.
For given interest rates and a givenexpectation of the future exchange rate, theinterest parity condition tells us the currentequilibrium exchange rate.For given interest rates and a givenexpectation of the future exchange rate, theinterest parity condition tells us the currentequilibrium exchange rate.
A rise in dollar (euro) interest rates causesthe dollar to appreciate (depreciate)against the euro.A rise in dollar (euro) interest rates causesthe dollar to appreciate (depreciate)against the euro.
Today’s exchange rate is altered bychanges in its expected future level.Today’s exchange rate is altered bychanges in its expected future level.