3PART. Financial Markets

Transcription

1 Financial Markets 3PART In Part 2, we studied interest rates and the bond market. In Chapters 8 to 11, we extend our analysis to encompass financial markets more broadly. In Chapter 8, we investigate the market for foreign exchange. In this chapter, you will learn how exchange rates are determined and how movements in exchange rates and interest rates are related. In Chapter 9, we examine the operation of derivative markets, look at the services they provide, and study why market prices fluctuate. Chapters 10 and 11 consider how financial markets evaluate and communicate information. In Chapter 10, we theorize about why prices of stocks, bonds, foreign exchange, and derivative instruments contain information about assets fundamental value for savers and borrowers. We also check whether the evidence from financial markets supports the theory. In Chapter 11, we examine the costs imposed on financial markets by asymmetric information and observe how financial markets respond to information problems. Two themes tie together the analysis in Part 3. First, to understand how markets operate, how prices are determined, and what prices mean, we focus on the decisions of individual investors and the ways in which those decisions collectively yield market outcomes. Second, we emphasize how market prices summarize the interaction among market participants and convey information about current and future returns to savers and borrowers. 157

2 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates Web Site Suggestions: fed.org/education/ addpub/usfxm Offers an introduction to foreign exchange markets. Web Site Suggestions: gov/indicators/ index.html Economic Indicators, published by the Council of Economic Advisers, presents data on trade and exchange rates. In September 1997, the global financial system trembled. Currency crises spread from Thailand to Indonesia and rocked Asian financial markets. Japan, weakened by a domestic financial crisis, looked on. Russia teetered, with a currency crisis and internal weakness, and subsequently defaulted on its bonds. Business leaders in the United States fretted about the implications of weak Asian economies for U.S. exports and the vaunted U.S. expansion. A flight to U.S. Treasury securities pushed U.S. interest rates in 1998 to their lowest levels in a generation. Why should foreign currency crises and interest rate fluctuations affect the United States? We can answer this question once we learn how transactions take place in global financial markets. Although the United States uses the dollar as its currency, the dollar is neither a unit of account nor a medium of exchange in Japan, which uses the yen, or in the United Kingdom, which uses the British pound. Most countries have their own currency. Hence to buy goods, physical assets, or financial assets in other countries, people must exchange currencies first. When a U.S. business wants to buy foreign goods, it must exchange dollars for the foreign currency. A similar transaction takes place when a U.S. investor purchases a foreign asset. The dollars that the investor has on deposit in a U.S. bank must be converted to bank deposits in the foreign currency. The exchange rate determines how much one currency is worth in terms of another, and it influences the price of international exchanges. In this chapter we devote our attention to the exchange rate. Specifically, we describe how individuals, businesses, and investors make transactions when the people and organizations are in different countries. In addition to explaining how exchange rates are determined, we learn how and why they change over time. Exchange rates experience long-term trends and short-term fluctuations. Understanding these changes will show you why shifts in U.S. interest rates can cause turmoil in international financial markets and it will demonstrate generally the link between interest rates and exchange rates in global economies. Exchange Rates and Trade In the 2000s, markets for goods, many services, and financial assets are global. For example, about 14% of the goods and services that U.S. consumers, businesses, and governments purchased in 2002 were produced by foreigners, and the United States exported about 10% of U.S. output to foreigners. In 1965, both these proportions were only about 5%. When individuals, businesses, and governments in one country want to trade, borrow, or lend in another country, they must convert their currency into the currency of the other country to complete the transaction. The nominal exchange rate is the price of one country s currency in terms of another s: Japanese yen per U.S. dollar or euros per British pound, for example. The nominal exchange rate is usually called the exchange rate. That is, when someone says, the exchange rate, he or she means the nominal exchange rate. 158

3 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 159 How is buying a foreign good different from buying a domestic good? The dollar price of a foreign good, service, or asset, which is what U.S. consumers and investors care about, has two parts: (1) the foreign currency price and (2) the number of dollars needed to obtain the desired amount of foreign currency. When a U.S. citizen buys a Japanese camera or bond, the two parts determining the dollar price are the price of the camera or bond in yen and the exchange rate between the dollar and the yen ( ). If the Japanese camera sells for 25,000 and if the yen is worth $0.01, then the dollar price of the camera is $250. If U.S. consumers increase their demand for Japanese cameras, they must buy more yen to purchase the camera. As we will see, this action raises the yen s value against the dollar. This simple calculation is complicated by the variation in the exchange rate. Exchange rates change over time because the value of each country s currency changes with respect to the values of other currencies. When exchange rates vary, the price of the foreign good to domestic consumers or investors changes. An increase in the value of a country s currency compared to the currencies of other countries is called appreciation. A decrease in the value of a country s currency compared to the currency of other countries is called depreciation. To see the effect of a change in the value of the currency and the exchange rate, consider how much the camera costs when the yen appreciates to $0.012 from $0.01. The dollar price of the camera is now $300. The yen s appreciation makes Japanese goods more expensive than comparable non-japanese goods. The opposite happens if the yen depreciates relative to the dollar. If the value of the yen falls from $0.01 to $0.008, the dollar price of the Japanese camera will fall from $250 to $200. Japanese goods are now more attractive in foreign markets, and the rising dollar makes U.S. goods less attractive in Japan. When a currency appreciates, the price of that country s goods abroad increases, and the price of foreign goods sold in that country decreases. When a currency depreciates, prices of that country s goods abroad decrease, and prices of foreign goods sold in that country increase. The change in the value of a country s currency can affect domestic manufacturers and workers. When the dollar appreciates significantly, U.S. goods become more expensive abroad, and U.S. exports decline. For firms competing in global markets which includes many companies in today s economy this means lower demand for products and layoffs of workers. But the increased value of the dollar does benefit U.S. consumers because foreign products are cheaper. Nominal versus Real Exchange Rates Nominal exchange rates are the value of one currency in terms of another, as in the Japanese camera example. They do not, however, measure the purchasing power, or real exchange rate, of the currency. For example, suppose that you can exchange $1.00 for 120 Japanese yen ( ). Although 120 may seem like a large number, in Tokyo a hamburger costs 262 and an espresso at a trendy outdoor café costs 500. In other words, the purchasing power of the yen is substantially less than the purchasing power of the dollar. Let s find out why. Real and nominal exchange rates are different concepts, but we can compare them in a simple relationship. Suppose that a Big Mac costs $2.71 in In using the terms appreciation and depreciation, we are treating exchange rates as flexible, or determined purely by market forces. In Chapter 22, we discuss attempts by governments and central banks to fix exchange rates.

4 160 PART 3 Financial Markets Columbus, Ohio, and 262 in Tokyo. If $1.00 buys 120 on foreign-exchange markets, we find the real exchange rate, or relative purchasing power of yen to dollars, by comparing the costs of the hamburgers in dollar terms. Let: EX = nominal exchange rate in foreign currency per dollar (yen per dollar in our example); P f = foreign-currency price of goods in the foreign country (yen price of a Big Mac in Tokyo); P = domestic-currency price of domestic goods (dollar price of a Big Mac in Columbus, Ohio); EX r = real exchange rate (number of comparable goods that domestic consumers can get by trading for a unit of domestic goods). The real exchange rate EX r is given by the equation Real exhange rate EX r Nominal exchange rate Domestic price Foreign price EX P P f. (8.1) To find the cost of the hamburger in dollar terms, we substitute and solve Eq. (8.1): EX r Hence at the nominal exchange rate used in the example, $2.71 buys one Big Mac in the United States but 1.24 Big Macs in Japan. If we use purchasing power to measure the value of a Big Mac, the real exchange rate is 1.24 Japanese Big Mac per U.S. Big Mac. In purchasing power terms, Big Macs are more expensive in Columbus, Ohio, than in Tokyo. In reality, of course, different countries produce many different goods, so the real exchange rate usually isn t defined by a single good. Instead, it is computed from price indexes, which compare the price of a group of goods in one country with the price of a similar group of goods in another country. The consumer price index and the price deflator for the gross domestic product are two examples of price indexes. Just as we did for nominal exchange rates, we can apply the concepts of appreciation and depreciation to real exchange rates. When a currency s real exchange rate rises (its currency appreciates), the country can trade its goods for more units of foreign goods. When a currency s exchange rate falls (its currency depreciates), the country obtains a smaller volume of foreign goods per unit of domestic goods. The relationship between the nominal and real exchange rates depends on the rates of inflation in the two countries. We know that the real exchange rate EX r is given by Eq. (8.1). We can calculate the percentage change in the real exchange rate EX r /EX r as the percentage change in the numerator of Eq. (8.1) minus the percentage change in the denominator: % change in % change in nominal real exchange rate exchange rate 1 120/$21$2.71/U.S. Big Mac2 262/Japanese Big Mac 1.24 Japanese Big Mac per U.S. Big Mac % change in % change in domestic prices foreign prices

5 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 161 or EX r EX r EX EX P. (8.2) P P f P f The percentage change in domestic prices P/P is the domestic rate of inflation p. Similarly, the percentage change in foreign prices is the foreign rate of inflation p f. Accordingly, we rewrite Eq. (8.2) as EX EX EX r EX r 1p f p2. (8.3) Equation (8.3) shows that the percentage change in the nominal exchange rate has two parts: the percentage change in the real exchange rate and the difference between the foreign and domestic inflation rates. Considering these parts separately reveals two explanations for a rising nominal exchange rate: a rising real exchange rate or a high foreign inflation rate relative to the domestic inflation rate, or both. Similarly, a falling nominal exchange rate reflects some combination of a falling real exchange rate and a high domestic inflation rate relative to the foreign inflation rate. C H E C K P O I N T Bicca and Montblanca are companies in two countries whose currencies are the crown and the royal. Bicca manufactures ballpoint pens that are sold for 2 crowns each. Montblanca manufactures high-quality fountain pens that are sold for 10 royals each. The real exchange rate between Bicca and Montblanca is 10 ballpoint pens per fountain pen. What is the nominal exchange rate? The real exchange rate is 10 ballpoint pens per fountain pen, so, by Eq. (8.1), 20 crowns (the cost of 10 ballpoint pens) equal 10 royals (the cost of one fountain pen), or 1 royal 2 crowns. Foreign-Exchange Markets From the perspective of an individual consumer or investor, exchange rates can be used to convert one currency into another. When you go abroad, you must convert U.S. dollars into Japanese yen, euros, British pounds, or other currencies, depending on the country you visit. If the dollar rises in value, you can buy more of other currencies during your travels, enabling you to savor a fine meal or bring back more souvenirs. Likewise, to buy foreign assets, you must convert U.S. dollars into the appropriate currency. Hence if the dollar appreciates, you can buy large amounts of yen-, euro-, or other currencydenominated assets. Market forces determine the exchange rate that prevails for consumers and investors. International currencies are traded in foreign-exchange markets around the world. Foreign-exchange markets are over-the-counter markets; that is, there is no single physical location at which traders gather to exchange currencies, as there is for many domestic stocks and bonds. Computer networks link traders in commercial banks in many countries. Most foreign-exchange trading takes place in London, New York, and Tokyo, with secondary centers in Hong Kong, Singapore, and Zurich. Just as transactions by buyers and sellers in domestic debt markets determine domestic interest rates, transactions in foreign-exchange markets determine the rates at which

6 162 PART 3 Financial Markets Web Site Suggestions: com/financecurrencies. jhtml Gives up-to-date exchange rates and currency conversions. international currencies are exchanged. Those exchange rates affect costs of acquiring foreign financial assets or foreign goods and services. With daily turnover in the trillions of dollars, the worldwide foreignexchange market is one of the largest financial markets in the world. Major market participants are importers and exporters, banks, investment portfolio managers, and central banks. They trade currencies such as the U.S. dollar ($), euro ( ), British pound ( ), and Japanese yen ( ) around the clock. The busiest trading time is in the morning (U.S. Eastern Standard Time), when the London and New York markets are open for trading, but trading is always taking place somewhere. A trader in New York might be awakened in the middle of the night to adjust foreign-exchange positions in response to events overseas. Two types of currency transactions are conducted in foreign-exchange markets. In spot market transactions, currencies or bank deposits are exchanged immediately (subject to a two-day settlement period). The current exchange rate, or spot rate, is analogous to a price quote on a share of GM stock from your broker the price at which you may buy a share of GM right now. In forward transactions, currencies or bank deposits are to be exchanged at a set date in the future. That is, investors sign the contract today for a given quantity of currency and exchange rate. At a specific future date, the actual exchange will take place at a rate known as the forward rate. Determining Long-Run Exchange Rates We begin by examining how exchange rates are determined in the long run and then apply that understanding to their determination in the short run. Supply and Demand In the long run, exchange rates are set by economic fundamentals such as price levels or productivity levels in different countries. Given values of these economic variables, we can think of the supply and demand for a currency let s say dollars as depending on the price of that currency relative to others the exchange rate. The demand for U.S. dollars represents the demand by domestic residents and foreign residents to buy U.S. goods and financial assets. The lower the exchange rate, the higher is the quantity of dollars demanded. For example, if the British pound/dollar exchange rate falls from $ to $1 0.56, it is cheaper to convert pounds into dollars to buy U.S. goods or financial assets, and the quantity of dollars demanded rises. The supply of U.S. dollars represents the dollars supplied by U.S. and foreign individuals and financial institutions who hold dollars and want to buy non-dollardenominated goods or assets. Suppliers trade dollars for British pounds and other currencies in the foreign-exchange market. As the exchange rate rises (that is, as the dollar appreciates against the pound), the quantity of U.S. dollars supplied rises. This is because at higher exchange rates, the dollars supplied command a higher price in terms of other currencies in the foreign-exchange market. In the long run, the equilibrium exchange rate balances the quantity of dollars demanded and supplied. Changes in the long-run value of the exchange rate are due to the reactions of traders in the foreign-exchange market to changes in economic fundamentals.

7 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 163 Economic Fundamentals and Long-Run Exchange Rate Trends Figure 8.1 shows the long-term trends in the exchange rate between British pounds and U.S. dollars. Four key factors account for long-run trends in the supply of and demand for currencies in the foreign-exchange market: price level differences, productivity differences, consumer preferences, and trade barriers. Price level differences. When the price level increases in the United Kingdom relative to the price level in the United States, U.K. goods or financial assets become more costly compared to similar U.S. goods or financial assets. If the price level rises faster in the United Kingdom than in the United States that is, if inflation is higher in the United Kingdom than in the United States the pound is less useful as a store of value than the dollar. A higher price level in the United Kingdom increases the supply of pounds, causing the equilibrium exchange rate to fall. All else being equal, an increase in the price level relative to price levels in other countries causes the country s currency to depreciate. As Fig. 8.1 illustrates, the excess growth of the U.K. price level over the U.S. price level in the late 1970s led the pound to depreciate against the dollar. Productivity differences. Productivity growth measures the increase in a country s output for a given level of input. When a country has a higher rate of productivity growth, its firms can produce goods more cheaply than its foreign competitors can. As a result, that country s domestic goods can be supplied at prices lower than those of comparable foreign goods, thereby increasing the demand for domestic goods and increasing the demand for domestic currency. But if a country s productivity growth is lower than that of other FIGURE 8.1 Exchange Rate Between the British Pound and Dollar, Over the period from 1973 through 1985, the exchange rate exhibited a generally upward trend (with an exception in the late 1970s), as the dollar appreciated against the pound. This trend was reversed between 1985 and 1992, as the dollar depreciated against the pound. Since 1993, the dollar s value has fallen modestly against the pound. Exchange Rate /$ U.K. price level rises faster than U.S. price level. Productivity growth slower in U.K. than U.S. U.S. consumers increase preference for British goods. /$

8 164 PART 3 Financial Markets USING THE NEWS... Reading Exchange Rates Current spot and forward exchange rates for all major currencies are reported each day in The Wall Street Journal. The first entry for a country is the spot exchange rate. For Japan on July 29, 2003, 100 could be exchanged for $0.8341, or (equivalently) $1.00 = However, the 180-day forward exchange rate is $ per 100, so $1.00 = This slight difference between the forward and spot rates exists because the investors expect the foreign-exchange value of the dollar to fall slightly relative to the yen by about 0.6%, or from to In general, when the forward rate is greater than the spot rate, investors expect the domestic currency to depreciate. When the forward rate is less than the spot rate, investors expect the domestic currency to appreciate. In 1985, $1.00 could be exchanged for ; that is, the foreign-exchange value of the dollar fell by about 50% between 1985 and July Exchange Rates The foreign exchange mid-range rates below apply to trading among banks in amounts of $1 million and more, as quoted at 4 p.m. Eastern time by Reuters and other sources. Retail transactions provide fewer units of foreign currency per dollar. CURRENCY U.S. $ EQUIVALENT PER U.S. $ Country Tue Mon Tue Mon Argentina (Peso)-y Australia (Dollar) Brahrian (Dinar) Brazil (Real) Canada (Dollar) month forward months forward months forward Chile (Peso) China (Renminbi) Colombia (Peso) Czech. Rep. (Koruna)... Commercial rate Denmark (Krone) Ecuador (US Dollar)-e Egypt (Pound)-y CURRENCY U.S. $ EQUIVALENT PER U.S. $ Country Tue Mon Tue Mon Hong Kong (Dollar) Hungary (Forint) India (Rupee) Indonesia (Rupiah) Isreal (Shekel) Japan (Yen) month forward months forward months forward Jordan (Dinar) Kuwait (Dinar) Lebanon (Pound) Malaysia (Ringgit)-b Malta (Lira) Mexico (Peso) New Zealand (Dollar) Norway (Krone) Pakistan (Rupee) Source: The Wall Street Journal, July 30, 2003 pc14. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc Dow Jones and Company, Inc. All Rights Reserved Worldwide. (Quotes are from July 29, 2003.) countries, the goods it sells become more expensive, and all else being equal, its currency will depreciate. An increase in a country s productivity relative to that of other countries leads to higher demand for the domestic currency, causing the real and nominal exchange rate to increase. During the 1970s and much of the 1980s, the rate of productivity growth in the United States exceeded that of the United Kingdom, providing additional upward pressure on the long-run pound/dollar exchange rate. Preferences for domestic or foreign goods. If U.S. consumers demand Britishmade goods (cars, cameras, and so on), they will demand pounds to buy these goods, putting upward pressure on the pound and depreciating the dollar. Conversely, if U.K. consumers demand U.S. goods (clothes, compact discs, and so on), they will buy dollars, increasing the worldwide demand for dollars and causing the dollar to appreciate. Thus the real exchange rate changes in response to a shift in households and firms preferences for domestic or foreign goods. Unless inflation rates change, nominal exchange rates also change. We can hold everything else constant and generalize this connection.

9 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 165 A country s currency appreciates in the long run in response to an increase in demand for its exports. An increase in a country s demand for imports from other countries causes its currency to depreciate in the long run. During the mid-1980s, for example, many U.S. consumers considered some British goods to be higher-quality products than comparable U.S.-produced goods. This shift in preferences increased demand for pounds and contributed to the depreciation of the dollar against the pound in the second half of the decade. Trade barriers. Countries do not always allow goods to be traded freely with no market intervention. One common trade barrier is quotas, or limits on the volume of foreign goods that can be brought into a country. Another trade barrier is tariffs, or taxes on goods purchased from other countries. Suppose, for example, that the United States places a tariff on U.K. leather goods. U.S. consumers then find U.K.-made leather goods more expensive than U.S.-made leather goods. The trade barrier increases cost-conscious U.S. consumers demand for U.S.-made leather goods. As a result, the demand for dollars (to buy U.S.-made leather goods) is higher than if there were no tariff. Hence, all else being equal, with trade barriers, the quantity of U.S.-made leather goods sold will remain high even when the dollar s value on foreign-exchange markets is high. Trade barriers increase demand for the domestic currency, leading to a higher exchange rate in the long run for the country imposing the barriers. As we will see, economists have used information on long-term determinants of the exchange rate to develop a theory of exchange rate levels. The Law of One Price and the Purchasing Power Parity Theory Our analysis of exchange rates in the long run begins using the law of one price. This law states that if two countries produce an identical good, profit opportunities should ensure that its price is the same in both countries, no matter which country produces the good. Suppose that a yard of cloth produced in the United States sells for $10 and that the same type of cloth produced by a British manufacturer costs 5 pounds ( ) per yard. The law of one price says that the exchange rate between the U.S. dollar and the British pound must be 5/$10, or 0.5 per $1. Why? If the exchange rate were 0.25 $1, U.S. cloth would be cheaper than British cloth. British consumers would demand dollars to buy the cloth at a bargain. (In the United Kingdom, U.S. cloth would sell for $ , which is cheaper than the 5 charged by British manufacturers. In the United States, British cloth would sell for 5/0.25 $20 per yard, which is more expensive than U.S.-produced cloth at $10 per yard. As a result, there would be no demand for British cloth.) The demand for dollars would bid up the value of the dollar, and the exchange rate would eventually return to 0.5 per $1. But if the exchange rate were 0.75 per $1, British cloth would be cheaper than U.S. cloth, eliminating the demand for U.S. cloth. The demand for pounds to buy British cloth would rise, pushing up the value of the pound, until the exchange rate was restored to 0.5 per $1. When we compare the international prices for an identical good, the law of one price holds. When we extend the concept and apply it to a group of goods, it becomes the purchasing power parity theory of exchange rate determination. The purchasing There is an important qualification, however: The good should be tradeable, and price differences are allowed to the extent that they reflect transportation costs. In the Big Mac example earlier, trading Big Macs between Tokyo and Columbus would be difficult.

10 166 PART 3 Financial Markets power parity (PPP) theory is based on the assumption that real exchange rates are constant. Differences in inflation rates in the two countries cause changes in the nominal exchange rate between two currencies. We can demonstrate this relationship by rearranging terms in Eq. (8.1): EX EX r a P f. P b Because the law of one price holds that EX r is constant, increases or decreases in the nominal exchange rate, EX, reflect changes in relative price levels between the two countries. In the U.S. and British cloth example, a 5% expected increase in the U.K. price level relative to the U.S. price level should cause the dollar to appreciate by 5% because EX r is constant: EX EX EX r EX r 1p f p , or 5%. When British expected inflation exceeds U.S. expected inflation and the real exchange rate doesn t change, the dollar rises in value. Under the PPP theory, the dollar s purchasing power has risen relative to that of the pound. In general, the PPP theory of exchange rate determination suggests that whenever a country s price level is expected to fall relative to another country s price level, its currency should appreciate relative to the other country s currency. In the preceding example the dollar appreciated by 5% relative to the British pound. Conversely, whenever a country s price level is expected to rise relative to another country s price level, its currency should depreciate, as the U.K. currency did in the example. Does the Theory Match Reality? While the PPP theory generally predicts correctly the long-run direction of changes in the exchange rate, researchers have found that actual exchange rate movements reflect more than differences in price levels. That is, movements in exchange rates are not completely consistent with the PPP theory. Part of this failure results from characteristics of the goods traded. Some commodities (oil, steel, and wheat, for example) are pretty much the same regardless of where they are produced, whereas most other goods are differentiated, or not identical. For example, Kodak and Nikon both manufacture cameras, but their products characteristics are different, and so the prices may differ. For differentiated products, the law of one price doesn t hold. Another measurement problem with the PPP theory is that not all goods and services are traded in international markets. It might be cheaper to get your shoes repaired in Berlin than in New York, but not many New Yorkers would fly to Berlin for that purpose. Similarly, other services such as child care and haircuts or goods such as meals in restaurants and houses are not tradeable internationally. Thus significant differences in prices of nontraded goods and services in various countries are not completely reflected in exchange rates. Finally, the PPP theory s underlying assumption that the real exchange rate is constant is not reasonable. As we noted above, the real exchange rate can vary if there are shifts in preferences for domestic or foreign goods and if there are trade barriers. If inflation rates do not change, these factors also can explain shifts in nominal exchange rates.

11 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 167 C H E C K P O I N T Suppose that U.S. consumers follow a Buy American strategy in their purchases for a long period of time. Predict the consequences for the nominal exchange rate and the value of the dollar. If other determinants of the nominal exchange rate are held constant, an increased preference for domestic goods over imports will raise the nominal exchange rate. The domestic currency will appreciate. Determining Short-Run Exchange Rates Returning to Fig. 8.1, note that if we examine shorter intervals, we see that the exchange rate is very volatile. Indeed exchange rates can fluctuate by several percentage points even during a single day. Hence there must be other reasons that influence nominal exchange rates that we have not accounted for in the purchasing power parity theory and the analysis of changes in demand for domestic and foreign goods. Figure 8.2 shows that, during the early 1980s, the value of the dollar generally increased substantially relative to other major currencies. The strong dollar was a boon to U.S. tourists, who flocked across the Atlantic to travel in Europe. The strong dollar also enabled U.S. investors to buy more foreign assets. But in the late 1980s and early 1990s, the dollar s value lost ground to other leading currencies, and large numbers of tourists from other countries descended on the United States. To understand why these fluctuations FIGURE 8.2 Nominal Exchange Rate: U.S. Dollars versus Other Major Currencies, The U.S. dollar exchange rate rose in the first half of the 1980s, generally declined through the mid-1990s, and rose again in the late 1990s. In the early 2000s, the dollar strengthened, then weakened against other major currencies Exchange rate (dollar) Exchange rate (yen) '80 '83 '86 '89 '92 '95 '98 '00 '02 (a) Canada Year 80 '80 '83 '86 '89 '92 '95 (b) Japan '98 '00 '02 Year Exchange rate (pound) '80 '83 '86 '89 '92 '95 (c) United Kingdom '98 '00 '02 Year Exchange rate (March 1973 = 100) '80 '83 '86 '89 '92 '95 '98 '00 '02 Year (d) Multilateral Trade-weighted Index

12 168 PART 3 Financial Markets in nominal exchange rates occurred over short periods of time, we first need to focus on the way in which exchange rates are determined in the market for international currencies. In addition to trade in domestic and foreign goods, financial assets are traded in global financial markets. Because these markets are linked by sophisticated telecommunications systems and trading can occur around the clock, investors in financial assets can trade rapidly and adjust their views of currency values almost instantaneously. Traders of financial assets change their positions as expectations of the currency s value or returns on foreign assets change. In this section, we focus on the factors that cause the exchange rate to have a particular value at one point in time (the short run). We describe how actions of buyers and sellers of domestic and foreign financial assets and traders in the foreign exchange market determine the short-run equilibrium value of the exchange rate. In the next section, we discuss what might cause this value to vary from one point in time to another. In the short run, we can express the exchange rate as the price of financial assets in one currency relative to the price of similar financial assets in another currency. In particular, the nominal exchange rate represents the price of domestic financial assets (bank deposits or Treasury bills) denominated in domestic currency in terms of foreign financial assets (foreign bank deposits or government bonds) denominated in foreign currency. For example, if the United States and Japan have an exchange rate of 120/$1, a $100 U.S. bank deposit costs 12,000. By treating the exchange rate as the price of one asset relative to the price of another, we can use the determinants of portfolio choice (introduced in Chapter 5) to show how exchange rates are determined in the short run. Comparing Expected Returns on Domestic and Foreign Assets Let s begin with an example of how exchange rate movements affect your comparison of interest rates on financial instruments in different countries. Suppose that you want to invest $1000 for one year. You narrow your choices to a U.S. Treasury bill or a Japanese government bond. The U.S. instrument pays interest and principal in dollars with a nominal interest rate of 5% per year. The Japanese instrument pays interest and principal in yen and carries a nominal interest rate of 5% per year. If the risk, liquidity, and information characteristics of the two instruments are comparable, which one should you buy? The theory of portfolio allocation tells you that if both instruments are denominated in the same currency, you should invest in the one with the higher return. However, because the two assets are denominated in different currencies, you also have to estimate whether the exchange rate between the U.S. dollar and the Japanese yen will change during the year in predicting your return. How can you allow for a change in exchange rates in making an investment decision? You need to measure the return on the two instruments, using dollars as a common yardstick. To do so, express expected returns on both securities in dollars. If you invest $1000 in the U.S. Treasury bill, you will receive an interest return of $50, so your investment will be worth $1050 after one year. For the Japanese bond, you first must convert your $1000 into yen; a year from now, you must convert your principal and interest from yen back into dollars to compare the return with that from the U.S. bond. Suppose that the current nominal Recall that the theory of portfolio allocation tells us that investors should compare expected returns on assets with similar risk, liquidity, and information characteristics. Comparing the expected return on a U.S. Treasury bond with that on a debt security for a high-risk Japanese firm, for example, would not be appropriate.

13 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 169 exchange rate is 100/$1 and that you expect the exchange rate to rise by 5% during the coming year. The expected future exchange rate, EX e, then, is ( 100)(1.05)/$1 105/$1. When you convert $1000 into yen at the current exchange rate, you have 100,000 for investment. After receiving a 5% interest return, your investment is worth 105,000 after a year. You expect the exchange rate at that time to be 105/$1, so the expected dollar value of your investment will be 105,000/105 $1000. Hence, even though the Japanese bond pays the same stated rate of interest as the U.S. Treasury bill, it carries a lower expected return: $0 instead of $50. From the example, we can write a general equation an investor can use to compare total returns from investing $1 in a domestic or a foreign asset. Let i and i f represent the interest rate for the domestic and the foreign security, respectively. Investing $1 in the domestic security yields $(1 i) after a year. Now let EX represent foreign-currency units per dollar; that is, $1 will buy EX of the foreign security. At the end of a year, the amount invested yields a total of EX(1 i f ) in the foreign-currency units. If we convert back to dollars, the total expected value of the investment after a year will be EX(1 i f )/EX e, where EX e is the expected future exchange rate. Returning to the example of the one-year Japanese government bond, we have Value of $1 investment after one year EX11 i f / $1.00, EX e 105/$1 or $1000 for an investment of $1000, as we calculated previously. For simplicity, we can approximate this expression with one that divides the return into two parts, interest and expected exchange rate change: Value of $1 investment after one year 1 i f Interest EX e EX, Expected exchange rate change where EX e /EX represents the expected percentage change in the exchange rate for the year. In our example, EX e /EX 5%, so Value of $1 invested in a Japanese bond for 1 year $1.00, or the same zero return that we calculated before. When deciding between domestic and foreign investments, investors consider both the interest rate and the expected change in the exchange rate during the investment time horizon. The decision-making process is guided by the following reasoning: For each $1 you invest in a U.S. Treasury bill, you get back $1 plus 5 in interest, or ( ) $ 1 Earns i Yielding 1 i. Interest Investing $1 in a Japanese bond requires more steps. First, you exchange your $1 for 100. That 100 earns interest of 5% for the year. At the end of the year, you must This result is analogous to the difference between the current yield and total return for domestic assets, given the possibility of capital gains and losses, which we discussed in Chapter 4.

14 170 PART 3 Financial Markets convert the principal and interest back to dollars at the exchange rate at that time (which you expect to be $1 105). Thus Exchanged for foreign currency Earns Yielding $1 EX if EX( 1 if). Interest When you exchange EX(1 i f ) for domestic currency at the expected future exchange rate, Converts to ( f ) EX 1 i ( f ) e EX 1 + i EX Yielding approximately 1 i f e EX. EX Now you can compare these two investments in terms of dollars: Proceeds from domestic asset 1 i Proceeds from foreign asset 1 i f EXe EX As was the case in the example, you would prefer to invest in U.S. Treasury bills if your return, 1 i, were greater than the return you would get from investing in Japanese bonds, 1 i f EX e /EX. However, you would prefer to invest in Japanese bonds if your return, 1 i f EX e /EX, were greater than the return, 1 i, you would get from investing in U.S. Treasury bills. If the returns on the U.S. and Japanese financial instruments were equal that is, if i i f EX e /EX you would be indifferent between investing in either. This result is analogous to the comparisons investors make between short-term and long-term debt instruments in the domestic market. In that case, when buying a long-term bond, investors consider both the current interest rate and the expected future interest rates. Foreign-Exchange Market Equilibrium Today s global economy is characterized by a high degree of international capital mobility that is, the ability of investors to move funds among international markets easily. Hence investors can buy financial assets (with similar risk, liquidity, and information characteristics) denominated in many different currencies in many markets around the world. Would a situation in which investors could earn a higher expected rate of return from buying Japanese rather than U.S. assets persist for a long time? To anticipate a bit, the answer is no. Let s assume that the U.S. and Japanese assets have identical risk, liquidity, and information characteristics. The theory of portfolio allocation suggests that investors should be indifferent between Japanese and U.S. assets. In other words, the expected returns on the two assets should be the same. In reality, the opportunity for traders in the foreign-exchange market to make a profit ensures this result. If the Japanese asset has a higher expected rate of return than the U.S. asset, traders around the world recognize a chance to make a profit by selling U.S. Treasury bills to buy Japanese bonds. (Because the two assets are similar, investors and traders have no reason not to do so.) Now, what effect do these buying and selling transactions have on the expected returns? As investors and traders sell

15 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 171 dollar-denominated assets (Treasury bills) and buy yen-denominated assets (Japanese bonds), they increase the demand for yen. This higher demand for yen pushes up the yen s value relative to the dollar to the point at which investors are indifferent between holding U.S. or Japanese assets. What does international capital mobility imply about the relationship of expected returns from different international investment strategies? Let s look at how market forces equalize expected returns on domestic and foreign assets. We use a graph to illustrate the process for the U.S. versus Japanese investment example and to show, in general, how exchange rates are determined in the short run. Figure 8.3 compares the expected returns on a U.S. bond and a Japanese bond with similar characteristics. The y-axis is the current exchange rate, or the number of yen per dollar. The x-axis is the expected rate of return, in dollar terms, from investing in a U.S. or Japanese asset. For U.S. assets, the expected rate of return R equals the U.S. interest rate i. The expected rate of return on foreign assets in dollar terms R f equals i f EX e /EX. Hence for Japanese assets, the expected rate of return R f equals the Japanese interest rate i f less the expected appreciation of the dollar. A graph of R against the current yen/dollar exchange rate is simply a vertical line because the return on a U.S. asset in dollar terms is the same regardless of the exchange rate. (It is paid in dollars.) The diagram assumes a U.S. interest rate of 5%. To graph R f against the exchange rate, we must first specify the expected future yen/dollar exchange rate. We do this by calculating the dollar s expected rate of appreciation, a key component of R f. Whenever the current yen/dollar exchange rate exceeds that expected future level, investors believe that the dollar is unusually strong and that it will eventually command fewer yen. That is, they expect the dollar to depreciate. Thus, for a given expected exchange rate, a graph of R f against the current exchange rate slopes upward; as the yen/dollar exchange rate rises, the dollar s expected rate of appreciation falls, pushing up R f. FIGURE 8.3 Determining the Exchange Rate in Financial Markets In the short run, financial markets determine the exchange rate. At the equilibrium exchange rate EX* 100, investors expected rate of return on domestic assets, R, equals the expected rate of return on foreign assets, R f. Current exchange rate, EX ( /$) 105 R = i Investor should buy Japanese asset. R f = i f EX e /EX R < R f 100 R = R f 97 R > R f Investor is indifferent between U.S. and Japanese assets. Investor should buy U.S. asset. 1.9% 5% 9.8% Expected rate of return (in $ terms)

16 172 PART 3 Financial Markets For example, suppose that the future yen/dollar exchange rate is expected to be 100 and that Japanese interest rates are 5%. If the current exchange rate also is 100, no appreciation is expected, and R f equals the 5% Japanese interest rate. If the current exchange rate is 105/$1 and the future exchange rate is expected to be 100 $1, the dollar is expected to depreciate. In this case, investors predict that a dollar will bring only 100 in the future, not 105 as it does now. This expected 4.8% depreciation of the dollar (from 105/$1 to 100/$1) increases R f to 9.8% (the 5% interest rate minus the 4.8% expected appreciation of the dollar). Alternatively, if the yen/dollar exchange rate falls to 97, the dollar is expected to appreciate 3.1% (from 97/$1 to 100/$1), and R f falls to 1.9% (the 5% interest rate minus 3.1% expected appreciation). If we place these points on the graph and connect the three combinations of exchange rate and expected rate of return, we get the upward-sloping R f line in Fig Which exchange rate prevails in the market for foreign exchange? It is the rate that equates R and R f. The intersection of R and R f occurs at 100/$1, at which both R and R f equal 5%. At any other current exchange rate, the expected appreciation or depreciation of the dollar causes R f to differ from R. What guarantees that the equilibrium current exchange rate is 100/$1? Suppose, for example, that the current yen/dollar exchange rate is 97. Hence the dollar is expected to appreciate by 3.1%. The expected rate of return on Japanese assets in dollar terms is 1.9% (the 5% interest rate minus 3.1% expected appreciation). Traders then will sell Japanese assets and buy U.S. assets because the U.S. interest rate is 5%. The increase in the demand for dollars puts upward pressure on the current yen/dollar exchange rate. Only when the current yen/dollar exchange rate rises to 100 will investors again be indifferent between Japanese and U.S. assets. Now, suppose that the current yen/dollar exchange rate is 105/$1 and we expect the exchange rate to fall to 100 $1. Hence the dollar is expected to depreciate by 4.8%. The expected rate of return on Japanese assets in dollar terms is 9.8% (the 5% interest rate minus the 4.8% expected appreciation). In this case, investors will sell U.S. assets and buy Japanese assets because the U.S. interest rate is only 5%. The increase in the demand for yen puts downward pressure on the current yen/dollar exchange rate. Only when the current yen/dollar exchange rate falls to 100 will investors again be indifferent between holding U.S. and Japanese assets. Interest Rate Parity The exchange rate market equilibrium we just described is called the nominal interest rate parity condition: When domestic and foreign assets have identical risk, liquidity, and information characteristics, their nominal returns (measured in the same currency) also must be identical. Thus any difference between the nominal interest rates on U.S. assets and those on Japanese assets reflects expected currency appreciation or depreciation. When the domestic interest rate is higher than the foreign interest rate, the domestic currency is expected to depreciate. When the domestic interest rate is lower than the foreign interest rate, the domestic currency is expected to appreciate. Using the expressions for domestic and foreign expected returns, we have the following: Expected return on domestic asset Expected return on foreign asset, or i i f EXe EX. (8.4)

17 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 173 The nominal interest rate parity condition does not imply that nominal interest rates are the same around the world. Rather, it says that expected nominal returns on comparable domestic and foreign assets are the same. If domestic and foreign assets are perfect substitutes, international investors are willing to hold outstanding domestic and foreign assets only when the expected returns on those assets are equivalent. Again, if we let R represent the expected rate of return on the domestic asset in dollar terms (equal to i) and R f represent the expected rate of return on the foreign asset in dollar terms (equal to i f EX e /EX ), the nominal interest rate parity condition implies that R R f. (8.5) We can also express interest rate parity in terms of the expected real interest rates in the domestic country, r, and that in the foreign country, r f, and the current and expected values of the real exchange rate, EX r and EXr e, respectively. The real interest rate parity condition states that expected real rates of interest measured in terms of the same group of goods are equal, or Expected gross real return on domestic investment Expected gross real return on foreign investment, or 1 r 11 r f 2 a EX r b. EX e r (8.6) The domestic real interest rate, r, and the foreign real interest rate, r f, do not have to be equal to be consistent with real interest rate parity. Equation (8.6) requires that the two real interest rates be equal when measured in the same group of goods. C H E C K P O I N T Suppose that the current euro/dollar exchange rate is 1.0 and that investors expect the dollar to appreciate to 1.1/$1 during the next year. If the current U.S. nominal interest rate is 7% per year, what should be the interest rate on a euro financial instrument with similar risk, liquidity, and information characteristics to maintain nominal interest rate parity? The nominal interest rate parity condition indicates that the U.S. interest rate minus the expected appreciation of the euro equals the euro interest rate. The deutsche mark is expected to depreciate ( )/1.0, or 10%. With the U.S. interest rate at 7%, the euro interest rate would be 7% ( 10%), or 17%. Exchange Rate Fluctuations So far, we have explained the forces that determine what the exchange rate will be at a point in time, but we have not explained the exchange rate fluctuations that we observe in the short run. That explanation is our objective in this section. Exchange rate fluctuations can cause problems for households, businesses, and policymakers. For example, the soaring dollar in the early 1980s reduced the demand for U.S. exports, hurting U.S. exporters and workers. If there were only one good, EX r EX e r 1 and r r f. This corresponds to the world real interest rate discussed in the analysis of lending, borrowing, and interest rate determination in Chapter 6.

18 174 PART 3 Financial Markets We use the graph of the exchange rate and rates of return on domestic and foreign assets (Fig. 8.4) to identify the reasons why exchange rates fluctuate in the short run. Changes in Domestic Real Interest Rates The expected return on domestic bonds depends on the interest rate i on those instruments. That interest rate is the sum of the expected real rate of interest and the expected rate of inflation. As Fig. 8.4(a) shows, if expected inflation is held constant, an increase in the domestic real interest rate increases the expected rate of return on domestic assets, shifting the R curve to the right from R 0 to R 1. Because of the higher return on domestic assets, investors increase their demand for dollars to buy domestic assets, resulting in an increase in the exchange rate from EX 0 to EX 1. But, as Fig. 8.4(b) shows, a decrease in the domestic real interest rate causes the expected real rate of return to shift to the left, from R 0 to R 1. The lower return on domestic assets increases investors demand for foreign assets and thus for foreign currency. The higher demand for foreign currency exerts downward pressure on the current exchange rate, which falls from EX 0 to EX 1. To summarize, if nothing else changes, an increase in the domestic real interest rate causes the domestic currency to appreciate. A decrease in the domestic real interest rate causes the domestic currency to depreciate. Changes in Domestic Expected Inflation A change in the domestic nominal interest rate also can be caused by a change in expected inflation for any real rate of interest. In making our graphical analysis in Fig. FIGURE 8.4 Effect of a Change in the Domestic Real Interest Rate on the Exchange Rate The (a) portion of this graph shows the following: 1. An increase in the domestic real interest rate shifts R to the right from R 0 to R The domestic currency appreciates from EX 0 to EX 1 ; the exchange rate rises. The (b) portion of this graph shows the following: 1. A decrease in the domestic real interest rate shifts R to the left from R 0 to R The domestic currency depreciates from EX 0 to EX 1 ; the exchange rate falls. Exchange rate, EX 2. Exchange rate rises. R 0 R 1 Rf Exchange rate, EX R 1 R 0 1. Domestic real interest rate falls. 2. Exchange rate falls. R f EX 1 1. Domestic real interest rate rises. EX 0 EX 0 EX 1 Expected rate of return (in $ terms) (a) Expected rate of return (in $ terms) (b)

19 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 175 CASE STUDY Should You Bank on International Investment? Yields on government bonds in selected countries are reported in The Wall Street Journal. The top table of international bond data shows that yields in local currency terms vary significantly between countries. Should you move your savings into foreign bonds to take advantage of interest rate differences? Let s see. Though not shown in the table, on July 29, 2003, a U.S. Treasury bond maturing in the year 2008 has a yield of 3.62% in U.S. dollar terms. The Japanese bond maturing in the year 2008 has a yield of 0.34% in yen terms, whereas the British bond maturing in 2008 has a yield of 4.01% in pound terms. If international investors and traders are indifferent between Japanese or British bonds, they must expect that the yen will appreciate against the pound. Using Eq. (8.4) we obtain: 0.34% 4.01% Expected appreciation of yen, or Expected appreciation of the / exchange rate 4.01% 0.34% 3.67%. Comparing the two foreign bonds with the U.S. bond, we see that investors and traders expect the yen and the pound to appreciate against the dollar. The bottom table shows that local currency and dollar total rates of return from international bonds over a time period differ substantially. Look at the 3 mos column, which presents total rates of return measured in local currency terms and in dollars. Note, for example, that the total rate of return in yen from holding Japanese bonds in April July 2003 was 1.2%, and the corresponding total rate of return in dollars was 0.72%. This difference indicates that payments in yen bought more dollars by the end of this period, meaning that the yen appreciated against the dollar. To summarize, if you are thinking of putting some of your savings in assets denominated in a foreign currency, be sure to consider the consequences of exchange rate changes. International Government Bonds MATURITY COUPON MO/YR PRICE CHANGE YIELD* JAPAN (3 p.m. Tokyo) 3.00% 09/ % 09/ % 06/ % 06/33 UNITED KINGDOM (5 p.m. London) 8.50% 5.00% 8.00% 4.25% 12/05 03/08 09/13 06/ *Equivalent to semi-annual compounded yields to maturity % % Total Rates of Return on International Bonds In percent, based on J.P. Morgan Government Bond Index, Dec. 31, 1987 = 100 INDEX VALUE LOCAL CURRENCY TERMS 1 DAY 3 MOS SINCE 12/ INDEX VALUE U.S. DOLLAR TERMS 3 MOS SINCE 12/ Japan Britain Germany MO DAY MO Source: The Wall Street Journal, July 30, Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc Dow Jones and Company, Inc. All Rights Reserved Worldwide. (Quotes are from July 30,2003.) 8.4 of the effect of changes in the domestic real interest rate on the current exchange rate, we assumed that the foreign expected rate of return, R f, did not shift. However, when domestic expected inflation changes, the expected change in the exchange rate likely is affected. Why? An increase in domestic expected inflation erodes the currency s purchasing power, causing it to depreciate, or lose value against other currencies. Conversely, a decrease in domestic expected inflation raises the domestic currency s purchasing power, causing the domestic currency to appreciate.

20 176 PART 3 Financial Markets Figure 8.5 shows that two effects are at work when the domestic interest rate increases because of an increase in expected inflation. First, the higher domestic nominal interest rate shifts the expected rate of return to the right from R 0 to R 1. Because returns on U.S. assets become more attractive relative to returns on foreign assets, investors increase their demand for dollars, and the current exchange rate rises. Second, an increase in expected inflation reduces expected appreciation of the domestic currency, so the expected foreign rate of return shifts to the right, from R f0 to R f1, and foreign assets become more attractive for investors. Hence the demand for dollars decreases, and the current exchange rate falls. These two effects pull the current exchange rate in opposite directions. Which effect dominates? Most analyses indicate that the decline in the anticipated appreciation of the domestic currency is greater than the increase in the domestic interest rate from the increase in expected inflation. Hence, for any current exchange rate, the expected return on domestic assets rises by less than the expected return on foreign assets. As shown in Fig. 8.5, the shift from R 0 to the right to R 1 is smaller than the shift from R f0 to R f1, causing the exchange rate to decline from EX 0 to EX 1. To summarize, an increase in the domestic interest rate in response to an increase in domestic expected inflation leads to depreciation of the domestic currency. A decrease in the domestic interest rate in response to a decrease in domestic expected inflation leads to appreciation of the domestic currency. Changes in Foreign Interest Rates In 2002, when eurozone short-term real interest rates rose relative to U.S. short-term real interest rates, domestic tourist industry groups expected that the dollar s value in the Eurozone would fall, raising the cost of European vacations. Indeed, the dollar s exchange value against the euro did drop. How could the tourist industry anticipate that this would happen? FIGURE 8.5 Effect of an Increase in Domestic Expected Inflation on the Exchange Rate 1. For a constant domestic real interest rate, an increase in expected inflation raises the domestic nominal interest rate from R 0 to R At the same time, the higher domestic expected inflation reduces the expected appreciation of the domestic currency. The R f curve shifts to the right from R f 0 to R f1. 3. Most empirical studies show that the second effect dominates the first, so the current exchange rate falls from EX 0 to EX 1. Exchange rate, EX EX 0 EX 1 1. Increase in expected inflation increases domestic interest rate. 3. Exchange rate falls. R 0 R 1 R f 0 R f 1 2. Expected appreciation falls. Expected rate of return (in $ terms) This effect is a feature of models of exchange rate determination in asset markets. See, for example, Rudiger Dornbusch, Expectations and Exchange Rate Dynamics, Journal of Political Economy, 84: , 1976.

21 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 177 To answer that question, let s explore the general case. The expected rate of return for foreign assets depends on both the foreign interest rate and the expected change in the exchange rate. Figure 8.6(a) shows that an increase in the foreign real interest rate shifts the foreign expected rate of return R f0 to the right to R f1 because, at any exchange rate, the foreign rate of return increases. As a result, the current exchange rate falls. Because the rate of return on foreign assets has gone up, investors and traders buy more foreign currency to buy foreign assets. The availability of a higher expected rate of return on foreign assets increases the demand for those assets relative to domestic assets, increasing the demand for foreign currency and decreasing the demand for domestic currency. As a result, the domestic currency depreciates. If the foreign real interest rate declines instead, as Fig. 8.6(b) shows, the expected rate of return on foreign assets declines. That shifts the expected rate of return R f0 to the left to R f1 and increases the exchange rate, leading to an appreciation of the domestic currency. Investors and traders now buy more domestic currency to buy domestic assets because the rate of return on domestic assets has gone up. To summarize, a rise in the foreign real interest rate causes the domestic currency to depreciate. A fall in the foreign interest rate causes the domestic currency to appreciate. Changes in the Expected Future Exchange Rate As our analysis of the interest rate parity condition showed, the expected appreciation or depreciation of the domestic currency also affects the expected rate of return on foreign assets. Changes in the current exchange rate account for movements in the foreign FIGURE 8.6 Effect of a Change in the Foreign Interest Rate on the Exchange Rate The (a) portion of this graph shows the following: 1. An increase in the foreign real interest rate shifts R f to the right from R f 0 to R f The exchange rate falls; the domestic currency depreciates. The (b) portion of this graph shows the following: 1. A decrease in the foreign real interest rate shifts R f to the left from R f 0 to R f The exchange rate rises; the domestic currency appreciates. Exchange rate, EX R R f 0 R f 1 R R f 1 R f 0 Exchange rate, EX EX 1 1. Foreign real interest rate falls. EX 0 1. Foreign real interest rate rises. EX 0 EX 1 2. Exchange rate falls. 2. Exchange rate rises. Expected rate of return (in $ terms) (a) Expected rate of return (in $ terms) (b)

22 178 PART 3 Financial Markets rate of return, R f. Changes in the expected future exchange rate can account for shifts in R f. Let s examine how this process works by tracing the market forces. If the expected future exchange rate increases, expected appreciation of the domestic currency rises. Investors increase their demand for the domestic currency; all else being equal, the exchange rate rises, as Fig. 8.7(a) shows. Hence the expected rate of return on foreign assets falls, thereby shifting the expected rate of return from R f0 to the left to R f1 and increasing the exchange rate. If instead the expected future exchange rate decreases, expected dollar appreciation declines, shifting the expected rate of return from R f0 to the right to R f1, as Fig. 8.7(b) shows. Investors now expect a higher return from investing in foreign assets, because they will be able to exchange foreign currency for more units of domestic currency. As foreign assets now have a higher expected rate of return, R f shifts to the right in Fig. 8.7(b), and the exchange rate falls. In September 1992, for example, international investors and foreign exchange traders belief that the foreign exchange value of the British pound would soon fall pushed the current exchange rate down. The British government was forced to abandon its efforts to stabilize the value of the pound against other European currencies. An increase or decrease in the expected future exchange rate reflects shifts in one or more of the underlying determinants of the exchange rate differences in price levels, differences in productivity growth, shifts in preferences for domestic or foreign goods, and differences in trade barriers as well as changes in expected future interest rates. FIGURE 8.7 Effect of Changes in Exchange Rate Expectations on the Exchange Rate The (a) portion of this graph shows the following: 1. An increase in the expected future exchange rate decreases the expected return on foreign assets, causing R f to shift to the left from R f 0 to R f The current exchange rate rises. The (b) portion of this graph shows the following: 1. A decrease in the expected future exchange rate increases the expected return on foreign assets, causing R f to shift to the right from R f 0 to R f The current exchange rate falls. Exchange rate, EX R R f1 R f 0 Exchange rate, EX R R f 0 R f1 EX 1 EX 0 1. Expected future exchange rate rises. 2. Exchange rate rises. EX 0 1. Expected future exchange rate falls. EX 1 2. Exchange rate falls. Expected rate of return (in $ terms) Expected rate of return (in $ terms) (a) (b)

23 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates 179 Factors that increase the expected future exchange rate shift the foreign expected rate of return to the left and cause the domestic currency to appreciate. Factors that decrease the expected future exchange rate shift the foreign expected rate of return to the right and cause the domestic currency to depreciate. Currency Premiums in Foreign-Exchange Markets The nominal interest rate parity condition in Eq. (8.4) is based on the assumption that domestic and foreign investments are perfect substitutes. This assumption is similar to the concept in the expectations theory of the term structure of interest rates (Chapter 7): If we hold default risk, liquidity, information costs, and taxation constant, assets of different maturities have perfect substitutability. That is, you should be indifferent between holding a long-term Treasury bond and holding a sequence of three-month Treasury bills, one after the other. When we discussed the term structure, we pointed out that the preferred habitat theory allows for imperfect substitutability of assets so that differences in yield partially reflect a term premium. For example, investors might require a higher rate of return to induce them to hold long-term bonds. We can modify the nominal interest rate parity condition by incorporating into it imperfect substitutability between domestic and foreign currency assets. We do this with a currency premium. The currency premium is a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in another. That is, i i f EXe EX h f, d, (8.7) where h f,d is the currency premium. For example, suppose that the one-year Treasury bill rate in the United States is 8% and the one-year government bond rate in the Euro area is 5%. Suppose also that investors expect the dollar to depreciate against the euro by 4% over the coming year. Using Eq. (8.7), we find that the one-year euro/dollar currency premium is 8% 5% 1 4%2 h f, d, or h f, d 1%. That is, investors require a 1% higher expected rate of return on the Euro-denominated bond relative to the U.S. Treasury bond to make the two financial instruments equally attractive. If h f,d is positive, the modified nominal interest rate parity condition, Eq. (8.7), implies that investors prefer the domestic-currency asset, assuming that nothing else changes. In other words, investors will not buy a foreign bond if the expected rate of return just equals that of a domestic bond. The foreign bond is less preferable, so investors must receive something extra a currency premium to offset their hesitancy. The size of the currency premium depends on investors aversion to currency risks, differences in liquidity in markets, a lack of information about foreign investment opportunities, and investors belief that one country is more stable or safer than another. These three factors contribute to currency risk and make investors prefer to hold domestic assets rather than foreign assets. Shifts in currency risk premiums can lead to large gains and losses on investments. For example, Long Term Capital Management, a large U.S. hedge fund, had to be rescued in September 1998, when major increases in currency premiums in emerging markets led to large losses.

24 180 PART 3 Financial Markets OTHER TIMES, OTHER PLACES... Interest and Exchange Rates in the 1980s Our analysis of the relationship between exchange rates and interest rates suggests that shifts in the real interest rate in the United States, relative to other countries, can affect the exchange rates. The accompanying figure shows the real interest rate and the exchange rate index, which is a trade-weighted exchange rate calculated by the Fed. As you can see in the figure, the real interest rate and the exchange rate both increased during the early 1980s. Both peaked in 1985 and fell for the next three years, rising somewhat again in What events caused these fluctuations? The rise in the real interest rate reflects shifts in international lending and borrowing. In the early 1980s, a rising stock market, probusiness policies of the Reagan administration, and a cut in taxes on investment made the United States an attractive place in which to invest. In addition, many international investors were concerned that less developed countries (LDCs) had borrowed too much from the international capital market in the 1970s, and they wanted to shift funds from those countries. At the same time, large U.S. budget deficits increased government borrowing. This combination of events increased the real interest rate and demand for U.S. assets, raising the exchange rate. Thus the U.S. real interest rate exceeded foreign real interest rates in the early 1980s. The interest rate parity condition, Eq. (8.4), implies the dollar would appreciate. This did indeed happen. In the second half of the 1980s, real interest rates in the United States were generally lower than in the first half and were not significantly greater than those in other industrial countries (in part because of an increase in investment demand abroad). With this change of events, the demand for Real interest rate (%) Saving and investment shifts increase U.S. real interest rate. Increase in demand for dollar assets raises exchange rate. dollar-denominated assets declined relative to assets denominated in other currencies. Using the interest rate parity condition, we would predict a decline in the exchange rate, which subsequently materialized. These events in the international capital market teach us two lessons. First, understanding shifts in the underlying determinants of lending and borrowing is important for explaining changes in real interest rates around the world. Second, movements in interest rates and exchange rates are related and should be examined together. Exchange Rate Real interest rate and exchange rate fall. Real Interest Rate Year Exchange rate (index 1973 = 100) A (Big) New Kid on the Block: The Euro Beginning in 1999, the European monetary union gave birth to the euro, a common currency for Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. The British pound remains separate. Since January 4, 1999, exchange rates of these 11 countries have been fixed against one another and against the euro (worth about $1.15 in July 2003). Colorful new euro notes and coins appeared in The new eurozone is a large market whose gross domestic product approaches that of the United States. The euro s debut makes life simpler for travelers, eliminating the need to change money and pay transaction fees at each border crossing. In financial markets, the U.S. dollar is the most important currency for foreign-exchange transactions, though many analysts believe that the euro has strong potential to compete with the U.S. dollar as the most widely traded currency.