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# Econ 592F16.3 Exchange Rates

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on 12 September 2016

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#### Transcript of Econ 592F16.3 Exchange Rates

Exchange Rates
The rate at which one currency exchanges for another
How many units of the numerator currency do you need to buy one unit of the denominator currency.
How many units of the numerator currency you get for selling one unit of the denominator currency.
Ex:
= 0.76
= 1.32
= 0.65
= 1.55
How much is this worth?
Using Exchange Rates
Exchange rates are useful when converting prices into a common currency:
A bike produced in Spain costs €300
How much does that bike cost in the U.S.?
= 1.32
= €300*1.32\$/€ = \$396
Exchange rate appreciations and depreciations can lead to changes in export and import prices.
Suppose that the euro appreciates to E(\$/€) = 1.8 and E(€/\$) = 0.55
= €300*1.8\$/€ = \$540
How much would an American made iPhone that normally retails for \$600 in the US now cost in Spain?
= \$600*0.55€/\$ = €330
Who holds Foreign Currency?
Retail Customers
Commercial Banks
FX Brokers
Middlemen between buyers and sellers of FX
Central Banks
Buy and sell FX for exchange rate interventions
The Foreign Exchange Market
Trading occurs mostly in major financial cities: London (41%), New York (19%), Singapore (5.7%), Tokyo (5.6%), and Hong Kong (4.1%)
Increased volume of FX transactions
1989: Daily trading volume was \$600 billion
2001: Daily trading volume was \$1.2 trillion
2013: Daily trading volume exceeded \$5 trillion
About 90% of transactions in 2001 involved the US dollar.
The US dollar share fell to 87% by 2013
Foreign exchange markets are highly integrated, with information rapidly transmitted between trading centers.
Very little opportunity for arbitrage between markets.
Spot and Forward Exchange Rates
Spot exchange rates are offered for currency exchanges “on the spot” – when trading is executed in the present
Forward exchange rates are offered for currency exchanges that will occur in the future...30, 60, 90, 180, and 360 day forward contract are the most common, though any term length is possible
A fixed rate is negotiated between buyers and sellers. This rate is honored, even if the spot rate on the day the contract is due is different from the forward rate.
Suppose the spot rate today is 1.2 \$/€, while the 90 day forward rate is 1.4 \$/€.
People are predicting that the dollar will depreciate (go down in value) against the euro.
In 90 days time, any contracts using the forward rate will be honored at the exchange rate of 1.4 \$/€. This is true even if the spot rate in 90 days is not equal to 1.4 \$/€!
Different Kinds of Forward Contracts
Forward exchange rate contracts are useful in reducing currency risk. They are not costless, however.
Several mechanisms are used to reduce transaction costs
Foreign Exchange Swaps
Combine a spot sale with a forward repurchase, both negotiated between individual institutions. Lowers costs by combining two transactions into one
Options/Futures Contracts
Option: You have the option to buy a set amount of foreign currency at a set price up until the option expiration date.
Futures: You buy a promise that a set amount of foreign currency will be delivered at some future date.
These derivatives can be bought and sold, with only the current owner obliged to fulfill the contract terms
The Demand for Foreign Currency: Asset Markets
If we think of foreign currency as an asset, we can define the demand for foreign currency as a function of several factors:
The rate of return earned on assets denominated in that currency
The risk and liquidity of assets in that currency
The expected change in the value of that currency relative to other currencies.
The rate of return on an asset
Define the nominal rate of return as the percentage change in the value of an asset over a given period of time.
Ex: You buy a US Treasury Note for \$100 today and sell it for \$104 next year.
The annual rate of return is the % change in the value = (\$104 - \$100)/\$100 = 4%
What is the annual rate of return on a share of Apple stock purchased last year for \$400 and sold this year for \$500?
Return = (\$500-\$400)/\$400 = \$100/\$400 = 25%
The real rate of return computes the percentage change in the
of an asset
We control for this by subtracting the inflation rate from the nominal rate of return
For example, if inflation was 5%, then the real return on the Apple stock above would have only been 20% (still good, but not as high!)
* In this section, we assume that prices are fixed in the short run and thus the nominal and real rates of return are identical.
All else being equal, investors prefer safer and more liquid assets to risky illiquid assets.
Factors that affect the risk of an asset include the ability of the borrower to pay back their debts, the willingness of the borrower to pay debt, the legal framework governing the loan contract, and the quality of information on both sides of the financial transaction.
As the riskiness of an asset increases, lenders must be compensated for this risk. Thus, risky assets must pay a higher rate of return than safer assets.
Liquidity refers to the ease at which an asset may be converted into money. Thus, cash and bank deposits are very liquid assets. Things like real estate and antiques tend to be highly illiquid.
The less liquid an asset, the higher the return that asset must pay to compensate lenders for the inconvenience of lost liquidity.
* We will assume that risk and liquidity are equal across assets, meaning that assets will solely be compared on rates of return and expected exchange rate changes.
How changes in exchange rates affect the demand for assets
Suppose you bought a bond issued by the Bank of England
An appreciation of the pound against the dollar will increase the dollar return on your foreign asset
If the dollar appreciates against the pound, the dollar return on the British asset will fall.
Thus, you are more likely to buy a British asset if you expect that the pound will appreciate against the dollar in the future.
Ex: An American bond costs \$100 and pays a 4% interest rate. An equally risky/liquid Mexican bond costs 1000 pesos and pays a 10% rate of return. Can we definitively say that the Mexican bond is the better deal?
We cannot! We would need to know the expected change in the value of the dollar against the peso.
Suppose that the dollar is expected to appreciate by 8% against the peso. The American bond is actually the better deal, even with the lower interest rate in dollars.
Comparing the common currency return on two country's assets.
The home currency return on a foreign asset is equal to the return in the foreign currency plus the expected appreciation of the foreign currency.
In the preceding example, a Mexican bond paid a 10% return in pesos, but the Mexican peso was expected to depreciate (go down in value) by 8% against the dollar.
Thus, the dollar return on a Mexican asset is equal to the 10% you earn in pesos minus the 8% you lose when converting back to dollars for a total of 2%.
Similarly, we can compute the peso return on an American asset that pays 4% in dollars. We would add this dollar return to the 8% expected appreciation of the dollar for a peso return on an American asset of 12%!
The Exchange Rate Adjusted Rate of Return
The home currency return on foreign assets is a function of two things:
The foreign currency interest rate
The expected change in the value of the foreign currency.
Exchange rate changes affect this return through two channels:
They change the baseline value of the asset
They change the value of interest earned on that asset.
* We will ignore this second channel as it is usually much smaller than the first.
The domestic currency return on a foreign asset is equal to the foreign currency return on the foreign asset plus the expected appreciation of the foreign currency.
Now suppose that the US interest rate is 6%...what is the pound return on an American asset?
Interest Rate Parity
Assuming no barriers to international financial markets, people are free to lend or borrow from any market in the world.
Assuming equal risk/liquidity, then investors will seek out the asset that pays the highest common currency return.
Ex: An American asset pays a 5% return in dollars, a German asset pays a 2% return in euros and the dollar is expected to appreciate by 1% against the euro.
The American asset is the better deal, since it pays a 6% return in euros (the German asset pays only a 1% return in dollars)
Given this scenario, we would expect investors to sell German assets and purchase American assets.
This will cause the
CURRENT
value of the dollar to rise against the euro.
As the dollar rises in value today, the expected appreciation of the dollar will fall.
This process will continue until the common currency return on both countries' assets are identical.
This happens when the expected appreciation of the dollar is -3%!
Interest Rate Parity
The interest rate parity condition states that the current (spot) exchange rate will adjust until the common currency returns on two countries (identical) assets are the same.
Example: What must the expected appreciation of the peso be if the dollar return on an American bond is 7%, while the peso return on a Mexican bond is 2%?
If the expected exchange rate is 0.2 dollars per peso, what must the current exchange rate be to satisfy interest rate parity?
Interest Rate Parity Exercises
Mexican and US interest rates are both at 5%. New discoveries of gold in Mexico make investors expect a 6% appreciation of the peso. What will happen to the value of the US dollar?
The interest rate on Australian assets is 4% above that on American assets. People expect the Australian dollar to depreciate by 7% against the US dollar. Will the US dollar appreciate or depreciate?
The expected depreciation of the dollar against the yen is 2%. The U.S. central bank announces that it will cut interest rates to 3%. The Central Bank of Japan offers a 1% interest rate on assets. Will the yen rise or fall against the US dollar?
The return on a Mexican bond is 7%, while the return on a German bond is 3%. The spot exchange rate is 20 pesos per euro and the forward exchange rate is 20.8 pesos per euro. Does IRP hold?
The return on a Canadian bond is 5%. The current exchange rate is 1.5 Canadian dollars per Swiss Franc. The forward exchange rate is 1.56 CDN/CHF. What Swiss interest rate would satisfy interest rate parity?
The return on a German bond is 8%. The return on a French bond is 4%. What does IRP suggest should happen to the France/Germany exchange rate?
Diagramming Interest Rate Parity
The expected return on a foreign asset is a function of three variables:
The return in the foreign currency
The current exchange rate
The expected future exchange rate

The expected return on a foreign asset will increase if...
The foreign currency return increases
The current value of the foreign currency falls
The expected future value of the foreign currency rises

IRP states that any difference in the common currency return between two assets will be offset by the current exchange rate
We can show this in action by drawing the domestic currency return on both a domestic and a foreign asset on a chart with returns on the horizontal axis and the current exchange rate on the vertical axis.
The equilibrium exchange rate is the one that sets the two returns equal (i.e. the intersection of R_D,D and R_D,F)
USD Exchange Rates, January 1999 + September 2016
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