Chapter 19

Exchange Rate Determination II:

Nominal Exchange Rates and Currency Crises

Objectives

Use interest differentials to price exchange rate futures.

Define uncovered interest parity and explain exchange rate fluctuations.

Nominal Exchange Rate

Quantities of funds exchanged in foreign currency markets far exceed the currency needed for goods trade. Most currency trading is for asset trading or portfolio holding purposes.

Exchange rates are more volatile than goods prices and quantities.

In the short run, currencies behave like financial assets with volatility like financial markets.

Spot vs. Forward Markets

Two basic markets for foreign exchange.

1. Spot Markets – In spot markets, traders agree on terms/rates for currency trades with immediate delivery (within 48 hours).

2. Forward Markets – In forward markets, traders agree on terms/rates for currency trades at some specified future date (usually 30, 90 or 180 days)

Define St as the (Definition 1) exchange rate for currency for immediate trade.

Define Ft as the exchange rate for delivery at a date on period in the future.

Covered Interest Parity

An investor has $1 for saving. Consider two investment strategies:

1. Invest $1 in a domestic bond with interest rate 1+i.

2. Use $1 to buy 1/St foreign dollars in spot markets. Invest 1/St in foreign bonds at interest rate 1+i*. Agree on a forward contract to sell (1+i*)/St foreign currency for domestic dollars.

Arbitrage implies that the two strategies will have the same pay-off.

This implies a forward price.

*(1 )tt

t

F iS

*1 (1 )tt t

t

Fi iS

*1

1t

t tt

iF Si

Uncovered Interest Parity

Forward prices should equal the market’s expectation of future spot rate. If traders think the price of foreign currency >

Ft, then why agree to deliver it at that price. If traders think the price of foreign currency < Ft, why agree to pay that price.

This should imply a term for exchange rate parity

11

1E t

Ft t tt

iS F Si

Implications

We observe that different countries have different interest rates.

UIRP suggests that countries with high interest rates are expected to have their currency depreciate. The only reason not to buy bonds in a high

interest economy is that you expect the value of the currency to drop.

Exchange Rate Determination

UIRP Creates a financial market theory of exchange rate determination

Graph expected returns from investing in domestic and foreign currency.

Exchange Rate equalizes the two returns.

Invest in Domestic Bonds

Invest in Foreign Bonds

1+it 1 (1 )E

Ftt

t

S iS

Equilibrium Exchange Rate

1+i

Return

St

S*

1 (1 )E

Ftt

t

S iS

Exchange Rate Determination Implications:1. Given future exchange

rates, a rise in domestic interest rates or a fall in interest rates will lead to an appreciation.

• A temporary increase in domestic interest rates will lead to appreciation.

2. A rise in the future value of the currency will increase the current value.

• Current exchange rate depends on whole path of future interest rates.

Event Exchange Rate

Temporary

i→

St ↓

Temporary

iF →

St ↑

St+1 ↑ St ↑

Rise in Domestic Interest Rates

1+i

Return

St

S*

1 (1 )E

Ftt

t

S iS

1+i’

S**

Contradiction and Dynamics

If domestic bond yields are higher than foreign yields, we should expect a depreciation of domestic currency over the life of bond.

A temporary increase in domestic yields leads to a domestic currency appreciation.

Is this a contradiction? No, the domestic

currency will immediately appreciate and subsequently depreciate back to the original position.

Time Path: Temporary Rise in Domestic Interest Rates

S

i

time

Rise in Foreign Interest Rates or Future Depreciation

1+i

Return

St

S*

1 (1 )E

Ftt

t

S iS

S***

Time Path: Temporary Rise in Foreign Interest Rates

S

iF

time

Permanent Rise In Interest Rate

Expected Inflation rises permanently leading to a persistent rise in the interest rate.

This should also lead to a permanent increase in the rate of depreciation of the currency. These two affects cancel out on current exchange rate.

Time Path: Permanent Rise in Domestic Interest Rates Due to Inflation

S

i

time

Expansionary Monetary Policy

Expansionary monetary policy will generate an immediate liquidity effect reducing exchange rates.

But it will lead to high future inflation and exchange rate depreciation and high future interest rates.

Time Path: Liquidity Effect & Fischer Effect

S

i

time

UIRP & Exchange Rate Volatility

Using UIRP we can write the exchange rate as a function of the future series of exchange rate differentials.

Since forecasts of future variables may be volatile and subject to optimism and pessimism, this may explain a large degree of exchange rate volatility.

2 3

1,...

1

Ft

t tt

iS S

i

1

1,

1

Ft

t tt

iS S

i

11 2

1

1

1

Ft

t tt

iS S

i

1 2 3

1 2 3

1 1 1 1..... ,

1 1 1 1

F F F Ft t t t

t tLRt t t t

i i i iS S

i i i i

Is UIRP true

On average, UIRP does not hold. High interest rate countries do not see their countries currencies deteriorate.

On average, buying bonds in high interest rate countries generates high average returns.

Why don’t investors take advantage of these opportunities? Investors perceive these countries as having

some risk of an exchange rate depreciation and investors are risk averse.

Risk Adjusted UIRP

We might assume that there is a risk premium (either positive or negative) for investing in foreign bonds relative to investing in domestic bonds.

A temporary increase in the risk premium on foreign asset will lead to an appreciation of the domestic currency.

11 (1 )tt t t

t

Si rp i

S

Thai Interest Rates and the Dollar/Baht Rate

0

4

8

12

16

.12

.16

.20

.24

.28

.32

1990 1992 1994 1996 1998 2000

HK$: BahtThai Baht Time Deposit Rate - 1YearHK$ Time Deposits - 1 year

Costs of Exchange Rate Volatility

Volatile exchange rates generate income risk for firms that export goods. This may eliminate some benefits of international trade.

Volatile exchange rates generate liability risk for firms that borrow foreign currency to finance investment projects. This is especially significant for firms in emerging markets.

Means to Fix Exchange Rate

Currency Board: Government/central bank commit to buy or sell foreign currency at a fixed exchange rate. This fixes the exchange rate at that level (example: Hong Kong).

Dollarization: The economy abandons a national currency and uses some foreign currency for all transactions (example: Panama).

Currency Area: A number of countries choose to jointly adopt the same currency (example: Euroland).

Exchange Rate Peg: Central bank buys and sells foreign currency in foreign currency markets to manipulate exchange rate.

Exchange Rate Systems

Impossible Trinity: There are a menu of three policy goals, among which a government can choose at most two.

1. Free International Capital Flows

2. Fixed Exchange Rates

3. Free Interest Rate/Monetary Policy If a country, like HK, chooses 1) and 2) then

domestic interest rates must equal foreign interest rates.

Fixed Exchange Rates/Free Capital Movements If there are free capital flows, then UIRP

holds. A permanent fixed exchange rate St = St+1

implies i = iF. If currencies have constant relative value

over time, then investing in bonds denominated in either one should be equivalent so interest rates should be equivalent.

Exchange Rate Crises & Hong Kong

HK Dollars, as currency, is printed by money center banks Standard Chartered, HSBC, and, now, Bank of China.

During the 1970’s, the banks faced little limitation on money creation. In July of 1982, the HK dollar was depreciating at a rate of 7.7% per year.

In 1983, Britain and the People’s Republic were engaged in talks about the terms on which Hong Kong would be returned to China. Responding to news from these talks, currency traders unloaded there HK dollar positions.

As a response, the Hong Kong dollar depreciated rapidly. By September 1983, the HK dollar was depreciating at a rate of 65% per year.

Policy Response: Currency Board

The government announced that Hong Kong would switch to a currency board system.

A currency board is an arrangement whereby a country can only issue domestic currency if it backed up by central bank holdings of a specific foreign currency.

To give permission to a money center bank to print 7.8 HK dollars, the government would have to acquire US$1.

This has been the monetary policy of Hong Kong ever since.

HK vs. US Interest Rates

0

2

4

6

8

10

12

1992 1994 1996 1998 2000 2002

Exchange Fund Yields US Treasury Bill Yields

HK & US Interest Rates

HK and US interest rates have tracked each other closely since the imposition of the currency board.

When US interest rates rise, HK interest rates must also rise to keep bondholders from selling their HK dollar bonds.

Major exception was in the period immediately following the handover when risk premium was applied to HK bonds (rp < 0).