International Monetary Economics

Transcription

1 International Monetary Economics Lecture 3: Forex Markets, Arbitrage Master d Affaires Publiques SciencesPo Spring 2013 Pierre-Olivier Gourinchas

2 Roadmap Exchange Rates and the Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the Foreign Exchange Market Interest Rates, Expectations, and Equilibrium Summary Slide 3-2

3 The Nominal Exchange Rate Definition: The nominal exchange rate is the amount of currency needed to buy one unit of another currency Example: EUR/GBP (as of 02/07/13) means that you can exchange 1 for We denote the exchange rate E (to be more specific, E ) An exchange rate can be quoted in two ways. Standard or Direct: The price of the foreign currency in terms of euros Indirect: The price of euros in terms of the foreign currency Convention: we always use the direct quotation. This is the natural way to quote: this is how we express goods prices as well. Other countries use different conventions. For instance, countries of the commonwealth use the indirect convention. To complicate matters further, US forex traders adopt whatever convention is adopted in the other country!! Slide 3-3

4 The Nominal Exchange Rate Feb 7 Table 3-1: Exchange Rate Quotations DOLLAR EURO POUND Closing Day s Closing Day s Closing Day s Currency Mid Change Mid Change Mid Change Argentina (Peso) Australia (A$) Bahrain (Dinar) Bolivia (Boliviano) Brazil (R$) Canada (C$) Chile (Peso) China (Yuan) Colombia (Peso) Costa Rica (Colon) Czech Rep. (Koruna) Denmark (DKr) Egypt (Egypt ) Hong Kong (HK$) Hungary (Forint) India (Rs) Indonesia (Rupiah) Iran (Rial) Israel (Shk) Japan (Y) One Month Three Month One Year Kenya (Shilling) Kuwait (Dinar) Malaysia (M$) Mexico (New Peso) New Zealand (NZ$) Nigeria (Naira) Norway (NKr) Pakistan (Rupee) Peru (New Sol) Philippines (Peso) DOLLAR EURO POUND Closing Day s Closing Day s Closing Day s Currency Mid Change Mid Change Mid Change Poland (Zloty) Romania (New Leu) Russia (Rouble) Saudi Arabia (SR) Singapore (S$) South Africa ( R) South Korea (Won) Sweden (SKr) Switzerland (SFr) Taiwan (T$) Thailand (Bt) Tunisia (Dinar) Turkey (Lira) U A E (Dirham) UK (0.6368)* ( ) One Month Three Month One Year Ukraine (Hrywnja) Uruguay (Peso) USA ($) One Month Three Month One Year Venezuela (Bolivar Fuerte) Vietnam (Dong) Euro (0.7469)* (Euro) One Month Three Month One Year SDR Rates are derived from WM/Reuters at 4pm (London time). * The closing mid-point rates for the Euro and against the $ are shown in brackets.the other figures in the dollar column of both the Euro and Sterling rows are in the reciprocal form in line with market convention. Currency redenominated by Some values are rounded by the F.T. The exchange rates printed in this table are also available on the internet at Euro Locking Rates: Austrian Schilling , Belgium/Luxembourg Franc , Cyprus , Finnish Markka , French Franc , German Mark , Greek Drachma , Irish Punt , Italian Lira , Malta , Netherlands Guilder , Portuguese Escudo , Slovenia Tolar , Spanish Peseta Slide 3-4

5 Exchange Rates and Prices Two types of changes in exchange rates: Depreciation of home country s currency A rise in the home currency prices of a foreign currency E increases It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents. Appreciation of home country s currency A fall in the home price of a foreign currency E decreases It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents. Slide 3-5

6 The Foreign Exchange Market Bid/Ask Rates You face different prices if you buy or sell a currency You sell dollars for yen at JPY/USD 93.1 You buy dollars for yen at JPY/USD 93.3 The rate at which the bank will buy foreign currency from you is the bid rate The rate at which the bank will sell foreign currency to you is the ask rate Buy at the ask, sell at the bid When exchange rates are quoted in the standard way: the bid rate is lower than the ask. The difference between the bid and the ask is the spread. spread = E ask E bid Slide 3-6

7 The Foreign Exchange Market Exchange rates are determined in the foreign exchange market. The market in which international currency trades take place No centralized trading, clearing mechanism, fixed hours The Players Tiered market Retail tier: where you and I buy foreign exchange (Travelex America) Wholesale market: informal network of hundreds of: Commercial banks Non-bank financial institutions International corporations Central banks Slide 3-7

8 The Foreign Exchange Market Markets by delivery dates Spot market (E) Exchange market for immediate payment and delivery ( on the spot ). Forward market (F): Exchange market for payment and delivery at some future date, preagreed upon. Forward and spot exchange rates, while not necessarily equal, do move closely together. (More on this later) Swap market: Market for combined spot/forward or forward/forward transactions Slide 3-10

9 The Foreign Exchange Market 2.2$ Figure 3-2: Dollar/Pound Spot and Forward Rates, $ 1.8$ 1.6$ 1.4$ 1.2$ 1993$ 1994$ 1995$ 1996$ 1997$ 1998$ 1999$ 2000$ 2001$ 2002$ 2003$ 2004$ 2005$ 2006$ 2007$ 2008$ 2009$ 2010$ 2011$ 2012$ 2013$ spot$ 31mo$forward$ Slide 3-11

10 The Foreign Exchange Market Figure 3-3: A spot transaction (purchase foreign currency) HC t Buy FC: 1/E t FC t Slide 3-12

11 The Foreign Exchange Market Figure 3-4: A forward transaction (sell FC) HC T Sell FC: F T FC T Slide 3-13

12 The Foreign Exchange Market Figure 3-5: A swap spot/forward transaction HC t Buy FC: 1/E t FC t HC T Sell FC: F T FC T Slide 3-14

13 The Foreign Exchange Market Table 3-2: US Fed s Reciprocal Currency Arrangements (mil. of USD) Slide 3-16

14 The Foreign Exchange Market Figure 3-6: A swap spot/forward transaction HC t FC t Lend: 1+i t Borrow: 1+i t * HC T FC T Slide 3-18

15 The Foreign Exchange Market Table 3-3: Average Daily Turnover (billions US$), by transaction Markets Spot Transactions Outright Forward Foreign Exchange Swaps Total traditional turnover Source: BIS Triennal report, 2010, table E18 Average Daily Turnover (Billion $), by transaction Slide 3-19

16 The Foreign Exchange Market Figure 3-7: The Phenomenal Growth in Financial Transactions Foreign Exchange Turnover 400 Trade World GDP Source: BIS (2010) and WDI Slide 3-20

17 The Foreign Exchange Market Table 3-4: Average daily turnover (billions, US$), by country Average Daily Turnover (Billion $), by country Markets % Share New York % London % Tokyo % Frankfurt % All % Source: BIS Triennal report, 2010, does not net out cross border double counting. Table E10 Slide 3-22

18 The Foreign Exchange Market Table 3-6: Currency Distribution (percentage of daily turnover) Currency Distribution (percentage share of average daily turnover) Markets US dollar Euro DM other EMS currencies Japanese yen Pound Sterling Source: BIS Triennal report, Since two currencies enter each transactions, sum of percentages totals 200%. Table E.1 Slide 3-23

19 The Foreign Exchange Market Characteristics of the Foreign Exchange Market Average daily turnover is very large ($5tr) The market is always open! Financial centers Vehicle currency A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Slide 3-24

20 Equilibrium in the Foreign Exchange Market Bloomberg, (02/08/ :40pm GMT+1) -- The euro was poised for its biggest five-day drop in seven months after European Central Bank President Mario Draghi said recent currency gains may slow inflation and growth, damping demand for the region s assets. Bloomberg, (02/07/ :33pm GMT+1)-- Brazil s real rallied the most among emerging-market currencies as the central bank said high inflation requires attention, spurring speculation that policy makers will let the currency strengthen to contain prices. Bloomberg, (02/07/ :21pm GMT+1)-- Canada s dollar fell from the strongest in two weeks against its U.S. counterpart as investor risk appetite shrank after the European Central Bank signaled concern the euro s strength may hurt its 17-nation region. Slide 3-32

21 The Demand for Foreign Currency Assets The demand for a foreign currency bank deposit is influenced by the same considerations that influence the demand for any other asset. Asset Returns Risk Liquidity Slide 3-33

22 3-months Eurodeposits (percent per year) The Demand for Foreign Currency Assets Figure 3-12: Interest Rates on Dollar and Yen Deposits, Dollar rate Yen rate Slide 3-35

23 The Demand for Foreign Currency Assets Exchange Rates and Asset Returns The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. In order to decide whether to buy a Yen or a Dollar deposit, one must calculate the Dollar return on a Yen deposit. Slide 3-36

24 The Demand for Foreign Currency Assets Figure 3-13: Calculating the Dollar return on a Yen deposit HC t Buy FC FC t Lend HC T Sell FC FC T Slide 3-37

25 The Demand for Foreign Currency Assets Final return: (1+i t* )E T /E t -1 i t* + (E T - E t )/E t A Simple Rule The Dollar rate of return on Yen deposits is approximately: The yen interest rate plus the rate of depreciation of the dollar against the yen. This return is uncertain since E T is unknown as of time t. Slide 3-38

26 The Demand for Foreign Currency Assets Covered Interest Parity: It is possible to obtain a certain return by using a forward transaction; Denote F t,t the forward rate at time t for delivery of dollars against yen at time T. Let s replace the last leg of the transaction by a forward sale of (1+i*)/E t euros at time T at price F t,t. Slide 3-39

27 The Demand for Foreign Currency Assets Figure 3-14: Calculating the Dollar return on a Yen deposit HC t Buy FC: 1/E t FC t Lend: 1+i t Lend: (1+i t *)/E t HC T Sell FC: (1+i t *) F t,t /E t FC T Slide 3-40

28 The Demand for Foreign Currency Assets Covered Interest Parity (CIP): : Since this is a riskless return, it should equal the return on dollar deposit (US interest rate) : (1+i t* )F t,t /E t = 1+i t Returns are equated: i t = (1+i t* )F t,t /E t -1 i t* + (F t,t - E t )/E t Slide 3-41

29 The Demand for Foreign Currency Assets When the position is uncovered (i.e. risky), Earn i t* + (E T e - E t )/E t on the yen deposit, on average Earn i t on the domestic deposit If we ignore risk considerations: Uncovered Parity i t = i t * - (E T e -E t )/E t Slide 3-42

30 Equilibrium in the Foreign Exchange Market Interpreting the Uncovered Interest Parity Condition: i t = i t * + (E Te - E t )/E t When i t > i t * : (E Te - E t )/E t > 0. The dollar is expected to depreciate. Why? When i t < i t * : (E Te - E t )/E t < 0. The dollar is expected to appreciate. Why? Slide 3-46

31 Equilibrium in the Foreign Exchange Market How Changes in the Current Exchange Rate Affect Expected Returns (given E e T ) Depreciation of a country s currency today lowers the expected domestic currency return on foreign currency deposits. Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits. Slide 3-48

32 Figure 3-15: The Relation Between the Current Dollar/Yen Exchange Rate and the Expected Dollar Return on Yen Deposits Today s dollar/yen exchange rate, E Equilibrium in the Foreign Exchange Market Expected dollar return on yen deposits, i* + (Ee T - E)/E Slide 3-50

33 Equilibrium in the Foreign Exchange Market The Equilibrium Exchange Rate Exchange rates always adjust to maintain interest parity. Assume that the dollar interest rate is i, the yen interest rate is i*, the expected future dollar/yen exchange rate E Te, Slide 3-51

34 Equilibrium in the Foreign Exchange Market Figure 3-16: Determination of the Equilibrium Dollar/Yen Exchange Rate Exchange rate, E Return on dollar deposits E 2 2 E 1 E Expected return on yen deposits i Rates of return (in dollar terms) Slide 3-52

35 Equilibrium in the Foreign Exchange Market Figure 3-17: Effect of a Rise in the Dollar Interest Rate Exchange rate, E Return on dollar deposits E 1 1 Expected return on yen deposits i Rates of return (in dollar terms) Slide 3-53

36 Interest Rates, Expectations, and Equilibrium The Effect of Changing Interest Rates on the Current Exchange Rate An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies. But remember that we keep the future expected exchange rate (E Te ) and the foreign interest rate (i*) constant. Slide 3-55

37 Equilibrium in the Foreign Exchange Market Figure 3-18: Effect of a Rise in the Yen Interest Rate Exchange rate, E Return on dollar deposits E 1 1 Expected return on yen deposits i Rates of return (in dollar terms) Slide 3-56

38 Equilibrium in the Foreign Exchange Market Figure 3-19: Effect of a Rise in the expected future dollar/yen rate (E Te ) Exchange rate, E Return on dollar deposits E 1 1 Expected return on yen deposits i Rates of return (in dollar terms) Slide 3-58

39 Interest Rates, Expectations, and Equilibrium The Effect of Changing Expectations on the Current Exchange Rate A rise in the expected future exchange rate causes a rise in the current exchange rate. A fall in the expected future exchange rate causes a fall in the current exchange rate. The exchange rate behaves like any asset-price (stocks) : Its value today is influenced by expectations of its value tomorrow. Slide 3-60

40 Empirical Evidence on Covered Interest Parity Covered Interest Parity should hold unless: Counterparty/Liquidity risk Political risk (capital controls ) In general, it holds really well. But there are episodes with significant deviations: August 2007: euro area banks need dollar funding but cannot borrow in the US anymore. Try to obtain dollars through euro-borrowing + swap. September 2008: following the collapse of Lehman Brothers, counterparty risk increases enormously. Central banks put in place reciprocal currency arrangements (swap lines) In general, CIP holds really well, but in times of global stress, it can fail significantly. Slide 3-61

41 Empirical Evidence on Covered Interest Parity Figure 3-20: The Breakdown of Covered Interest Partity in Slide 3-62

42 Empirical Evidence on Covered Interest Parity Notoriously difficult to predict exchange rates, especially at short horizons. Exchange rate behaves like an asset price. Predictable movements from interest rates swamped by news about long run exchange rates. This forms the basis for carry trade : Borrow in low interest rate currency (Yen, Swiss Franc, funding currency) Invest in high interest rate currency (Icelandic Krona, Australian dollar, target currency) Then pray that the funding currency doesn t appreciate against the target! Can destabilize foreign exchange markets At longer horizons, uncovered interest parity provides a good guide for exchange rate movements. Slide 3-63

43 Summary Exchange rates play a role in spending decisions because they enable us to translate different countries prices into comparable terms. Exchange rates are determined in the foreign exchange market. Slide 3-65

44 Summary An important category of foreign exchange trading is forward trading. The exchange rate is most appropriately thought of as being an asset price itself. The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. Slide 3-66

45 Summary Equilibrium in the foreign exchange market requires interest parity. For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate. A rise in dollar (euro) interest rates causes the dollar to appreciate (depreciate) against the euro. Today s exchange rate is altered by changes in its expected future level. Covered Interest Parity holds really well except in times on financial stress. Deviations from Uncovered Interest Parity form the basis for carry-trade. Slide 3-67