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Foreign Exchange Market Exchange Rate Appreciation/Depreciation Effective Exchange Rate Trade Weighted Dollar Real Exchange Rate Interbank Market: Dealers / Brokers Spot Market Bid Rate / Ask Rate / Spread Cross Exchange Rates Exchange Arbitrage: 2 point / 3 point Forwards/Futures/Swaps Discount / Premium Covered Interest Arbitrage Uncovered Interest Arbitrage Options Call/Put Duration/Strike Price Hedging Speculation: Long position / Short position Stabilizing Speculation Destabilizing Speculation Supply and Demand for a Currency Interest rates Overshooting Expectations Income/Preferences/Policies Purchasing Power Parity (PPP) Monetary Approach to the Exchange Rate

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Flavors of exchange rates and contracts Spot rates: for currency exchanges on the spot Forward rates: for currency exchanges that will occur at a future (forward) date. Forward contracts can be customized. Forward dates are typically 30, 90, 180, or 360 days in the future. Rates are negotiated between two parties in the present, but the exchange occurs in the future. Foreign exchange swaps: a combination of a spot sale with a forward repurchase. Futures contracts: designed by a third party for a standard amount of foreign currency delivered/received on a standard date. Contracts can be bought and sold in markets Only the current owner is obliged to fulfill the contract. Options contracts: designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. Pay a premium for the option, but not obligation, to buy (call option) or sell a currency (put option) at a strike price before the options expiration date.

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Covered Interest Arbitrage 1)purchase foreign currency at spot rate and use it to finance purchase of foreign assets (bonds) 2)contract in the forward market to sell amount of foreign currency that will be received because of activity in the forward market such investment opportunities quickly disappear

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Uncovered Interest Arbitrage o moving funds into foreign currency to take advantage of higher rate of return without forward contract o Extra return: UK U.S. Percentage = Interest - Interest Appreciation/Depreciation Rate Rate of Pound

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Factors influencing exchange rates: Supply and Demand for a Currency Short run financial transactions Market fundamentals Current account balances Real interest rates Market expectations News about future market fundamentals Speculative opinion about future exchange rates

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Factors influencing exchange rates Medium run Real income business cycle Monetary policy and fiscal policy Product availability Long run Inflation rates Consumer preferences for domestic or foreign products Productivity changes affecting production costs and prices Profitability and riskiness of investments Government trade policy

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Impact of interest rate differentials: drop in US interest rate $ depreciation Dollars per Yen S0S0 A D0D0.0080.0075 B D1D1 S1S1

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An increase in the U.S. real interest rate increases the expected return on dollar assets, such as Treasury bills and certificates of deposit. This increase encourages flows of foreign investment into the United States, thus causing the dollars exchange value to appreciate. Conversely, a decrease in the U.S. real interest rate reduces the expected profitability on dollar assets, which promotes a depreciation of the dollars exchange value. 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use 8 Interest rate differentials and exchange rates FIGURE 12.6

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Impact of expectations: expectation of $ depreciation $ depreciation Dollars per Pound S0S0 A D0D0 1.70 1.50 B D1D1 S1S1

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Overshooting Exchange Rate Volatility From Uncovered Interest Arbitrage : Expected depreciation of $ = i us i uk From S-D analysis, if i us falls, the $ depreciates But why hold any $ assets if i us < i uk ? Only if you expect $ to appreciate in the future. How can you expect $ to appreciate in the future when it depreciates owing to the drop in i us ? If $ depreciates so much when i us falls that, looking into the future, $ can be expected to appreciate Immediate $ depreciation overshoots eventual depreciation.

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Impact of real income differentials: increase in US income $ depreciation Dollars per Pound S0S0 A D0D0 1.60 1.50 B D1D1

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Impact of inflation rate differentials: high US inflation $ depreciation Dollars per Pound S0S0 A D0D0 1.70 1.50 B D1D1 S1S1

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Purchasing power parity (PPP): The Law of One Price A good should cost the same in all countries (aside from tariffs or transportation costs) Exchange rates should make prices equal across countries P = ER x P* ($/bourbon) = ($/) x ( /scotch) = ($/scotch) If two countries have different inflation rates, exchange rates will move keep prices the same The currency of the high inflation country will depreciate (P/P*) ER ($/)

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This figure suggests that the predictive power of the purchasing-power-parity theory is most evident in the long term. In the short term, the theory has negligible predictive power. 15 Purchasing power parity: United States - United Kingdom, 19732003

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16 Inflation differentials and the dollars exchange value

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Alternative approaches to exchange rates Monetary approach In long run, exchange rate depends on Demand for money, M d = L(Y, P, i) M d depends on real income, prices, interest rates Supply of money, M s M s is controlled by central banks M s $ depreciates Real income M d $ appreciates Interest rate M d $ depreciates ??!? Why should i rise in long-run? Inflation and expectations of inflation! It follows that $ will depreciate if i rises

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Nominal and Real Exchange Rates Real Exchange Rate Index = Nominal Index x (Our CPI/Their CPI) If our prices are rising faster than foreign prices yet our nominal exchange rate hasnt depreciated, were really getting a better deal

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The Dollars Exchange Rate: The Floating Rate Era Basket of major currencies per dollar: Up $ appreciation Down $ depreciation