Exchange Rates CHAPTER 13 1 Exchange Rates What are they? How does one describe their movements? 2 Exchange Rates The nominal exchange rate is the price of one currency in terms of another. The spot rate applies to trades on the spot. 3 Chapter 13 1
4 Exchange Rate Quotes Currency Trading WSJ Section C, January 11, 2004 US $ equivalent Currency per US $ (E $/ ) (E /$ ) Japan.00940$ 106.37 E = E HC/FC is the home currency value of the foreign currency 5 6 Chapter 13 2
7 Between Jan 2003 and Jan 2004 Which currency appreciated? Did E rise? 8 Who Participates in this Market? Banks and near banks Corporations Central Banks 9 Chapter 13 3
Other Characteristics Volume Vehicle Currencies Spot and Forward Markets 10 What Are the Effects of Changes in E? Gains and losses for international asset holders Changes in price competitiveness in international goods markets 11 Exchange Rates & Imports US import (Japanese car) sells for 2 mill. As the appreciates & the $ depreciates, the price of US imports E $/ E /$ Price of US Import ($).008 125.008(2000000) = $16000.010 100.01(2000000) = $20000.012 83.012(2000000) = $24000 12 Chapter 13 4
Exchange Rates & Exports US export (car) sells for $20000 As the appreciates & the $ depreciates, the price of US exports E $/ E /$ Price of US Export ( ).008 125 125(20000) = 2500000.010 100 100(20000) = 2000000.012 83.3 83.3(20000) = 1666667 13 Forward Rates Spot 30 day 90 day 180 day forward forward forward $ per 1.8486 1.8443 1.8355 1.8219 A forward contract is a contract to trade in the future Forward rates indicate market expectations for the future. 14 Expectations of Mr. Typical E Mar 2004 Probability 1.78 5% 1.79 10% 1.80 20% 1.81 30% E e = 1.81 1.82 20% 1.83 10% 1.84 5% 15 Chapter 13 5
Expectations and Forward Rates Current (six month) forward rate on the : F $/ =1.82 Mr Typical decides to speculate Goes short in the forward market for pounds 16 Expectations and Forward Rates Mr. Typical s plan: Agree to sell $100000 worth of pounds ( 54945= 100000/1.82) in 6 months Next March buy 54945 on the spot market for $99450 (=54945x1.81) and sell it for $100000 as agreed. 17 Expectations and Forward Rates If the market agrees with Mr. Typical s expectation (guess) and acts on it: Lots of sellers of pounds (buyers of dollars) in the forward market and few buyers. F $/ falls until it equals 1.81 ( =E= e ) 18 Chapter 13 6
Is this result based on the notion that everyone thinks E will fall to 1.81? No 19 Expectations of Mr. Bull E next year Probability 1.79 5% 1.80 10% 1.81 20% 1.82 30% E e = 1.82 1.83 20% 1.84 10% 1.85 5% 20 Expectations of Ms. Bear E next year Probability 1.77 5% 1.78 10% 1.79 20% 1.80 30% E e = 1.80 1.81 20% 1.82 10% 1.83 5% 21 Chapter 13 7
Expectations and the Forward Rate Suppose F $/ falls until 1.81 = E e Mr. Bull goes long in the pound (committed to buy at 1.81; hopes to sell at 1.82) Ms. Bear sells the pound short (committed to sell at 1.81; hopes to buy at 1.80) Mr. Typical stays out of the market 22 Expectations and the Forward Rate E e =1.81 means as much money thinks the spot rate will be above 1.81 as thinks that it will be below 1.81 in July If F $/ > 1.81 speculators will flood short side of the market until F $/ = 1.81 If F $/ < 1.81 speculators will flood long side of the market until F $/ = 1.81 23 Who Participates in Forward Markets? Speculators Hedgers 24 Chapter 13 8
Hedging Forward contracts can be used to protect against (hedge) exchange risk Value of 1 Million Pounds in 30 days Value of Value of $ $ Receipts $ 1.60 0.63 $ 1600000 $ 1.80 0.56 $ 1800000 $ 2.00 0.50 $ 2000000 25 Other Contracts An option gives you the right, but not the obligation, to trade currencies in the future A futures contract requires the payment of $ now, in order to receive a specified amount of s in the future. 26 What Makes (spot) Exchange Rates Fluctuate? 27 Chapter 13 9
Exchange Rate Determination What makes E rise and fall? Supply and Demand (of course) What makes Supply and Demand fluctuate? Most exchanges of currency are used to finance the purchase of foreign assets not foreign goods 28 Interest Parity Why Should Interest Rates be Different in Different Countries? 29 Equilibrium Exchange Rate Asset market approach to E E is determined by financial factors. International trades of assets are far larger than international trades of goods The value of the foreign currency (E) depends on interest rates here & abroad, R HC, & R FC, and expectations of the future 30 Chapter 13 10
Demand For Foreign Currency Assets Factors influencing this decision Interest rates at home & abroad, R HC & R FC Exchange rate now, E Expected exchange rate in the future, E e. Because the (expected) return on foreign bonds is [(1 + R FC )E e /E] - 1 R FC + (E( e - E)/E The (known) return on domestic bonds is R HC 31 Equilibrium E E $/ R $ 1 E 1 $R R Graph determines E as a function of E e, R $, & R 32 Equilibrium E R $ = 7% R = 5% E $/ = 1.00 Should an American investor put her funds in German assets? Depends on what she expects to happen to E by the time she repatriates her funds 33 Chapter 13 11
Equilibrium E Suppose she expects the euro to rise to 1.08 by next year (8% appreciation) E e $/ = 1.08 Expected return from investing abroad is [(1 + R )E e /E] - 1 = 13.4% R + (E( e - E)/E = 13% 34 Interest Parity Foreign assets look like a good deal (13% is better than 7%) Of course the euro might not go up that much and the domestic return is certain Go for it! 35 Equilibrium E If she takes the plunge, what about everyone else? They will too if they share her opinion that the dollar will fall by 8% 36 Chapter 13 12
Equilibrium E If lots of American do this they will be selling dollars (buying euros) on the spot market for foreign exchange Lots of sellers put downward pressure on the $ (upward pressure on the euro) E will rise, but how far? 37 Equilibrium E E e E R + (E( e -E)/E R $ 1.08 1.00 13% 7% 1.08 1.02 11% 7% 1.08 1.04 9% 7% 1.08 1.06 7% 7% 1.08 1.08 5% 7% 1.08 1.10 3% 7% 38 Equilibrium E E $/ R $ 1 E 1 $R R Graph determines E as a function of E e, R $, & R 39 Chapter 13 13
Equilibrium E R $ is the US interest rate, vertical because the R $ is independent of E. E $R is the $ return on German bonds, R + (E( e - E)/E $R depends negatively on E. As current value of the (E),, the future expected appreciation of,, & the $R. 40 Equilibrium E The equilibrium condition is called interest parity, and requires the equality of expected $ returns. R $ = $R = R + (E e - E)/E What if R $ < $R = R + (E e - E)/E? What if R $ > $R = R + (E e - E)/E? 41 Interest Parity to German Investors E e E R $ - (E e -E)/E R 1.08 1.00-1% 5% 1.08 1.02 1% 5% 1.08 1.04 3% 5% 1.08 1.06 5% 5% 1.08 1.08 7% 5% 1.08 1.10 9% 5% 42 Chapter 13 14
Interest Parity E e = 1.08 this the typical expectation Maybe euro bulls expect 1.10 and euro bears expect 1.06 How do they invest? 43 Interest Parity If Mr. Bull is American, what does he do? Best guess is a 9% return overseas Buy foreign assets Buy euros on the spot market (enough sellers?) 44 Interest Parity If Ms. Bear is American, what does she do? Best guess is a 5% return overseas Buy domestic assets Stay out of the foreign exchange market 45 Chapter 13 15
Interest Parity If Mr. Typical is American, what does he do? Best guess is a 7% return overseas Buy domestic assets (same return, no exchange risk) Stay out of the foreign exchange market 46 Interest Parity If Herr Bull is German, what does he do? Best guess is a 3% return overseas (in U.S.) Buy domestic (German) assets Stay out of the foreign exchange market 47 Interest Parity If Herr Typical is German, what does he do? Best guess is a 5% return overseas (in U.S.) Buy domestic assets (same return, no exchange risk) Stay out of the foreign exchange market 48 Chapter 13 16
Interest Parity If Frau Bear is German, what does she do? Best guess is a 7% return overseas (in U.S.) Buy foreign (American) assets Sell euros (to Mr. Bull) in spot market 49 Interest Parity E e = 1.08 and typical investors sees approximately equal returns in foreign and domestic assets American euro bulls (dollar bears ) invest in German assets and buy s from German euro bears (dollar bulls ) in the spot market to finance the investment 50 Increased Interest Rates at Home (R $ ) E $/ R 1 $ E 1 1 E 2 R $ 2 2 $R R 51 Chapter 13 17
Increased Interest Rates at Home (R $ ) Fed worries about inflationary pressures and pushes R $ Bond traders move out of & into $ s depreciates (E ) $ appreciates 52 Increased Interest Rates Abroad (R ) E $/ R $ 1 E 1 1 $R 1 R 53 Increased Interest Rates Abroad (R ) ECB becomes worried about inflation & pushes R. Which way do bond traders move? What happens to the value of the? What happens to the value of the $? 54 Chapter 13 18
55 Increased Future Value of the Euro (E (E $/ e ) E $/ R $ 1 E 1 1 $R 1 R 56 Increased Future Value of the Euro (E (E $/ e ) Future German budget deficits likely to, future R likely to,, future E e $/. Which way do bond traders move? What happens to the value of the? What happens to the value of the $? 57 Chapter 13 19
58 Covered Interest Parity Our earlier interest parity condition was HC = R FC + (E( e - E)/ E R HC This is called uncovered interest parity, we are not covered against exchange risk 59 Covered Interest Parity Covered interest parity is R $ = R + (F $/ - E $/ )/ E $/ Forward rate replaces the expected spot rate We are covered against exchange risk. 60 Chapter 13 20
Covered Interest Parity Suppose R HC HC < R FC + (F - E)/ E How could you make a riskless profit with no money tied up? 61 Covered Interest Parity Suppose R $ = 4% R = 8% E $/ = 1.85 F $/ = 1.80 R + (F $/ - E $/ )/ E $/ = 5.3% > R $ 62 Covered Interest Parity The PLAN: Borrow $10000000 for 1 year at 4% Buy 5410000 on the spot market at 1.85 Buy 5410000 of 1 year British bonds at 8% Sell 5840000 on the forward market at 1.80 63 Chapter 13 21
Covered Interest Parity Next year: Take 5840000 (principal plus interest) and fulfill the forward contract receiving $10510000 Repay $10400000 (principal plus interest) Buy a Porsche with the remaining $110000 64 Covered Interest Parity Since R $ < R + (F $/ - E $/ )/ E $/ Borrow at 4% and lend at 5.3% You get income risk free with no commitment of your own funds Too good to be true? (too good to last long) 65 R $ < R + (F $/ - E $/ $/ )/E $/ Borrowing on U.S. credit market increases» R $ tends to rise Purchases of pounds on the spot market increase» E tends to rise Sales of pounds on the forward market increase» F tends to fall Lending in the British credit market increases» R tends to fall 66 Chapter 13 22
Covered Interest Parity These pressures continue as long as there is a profit to be made. Markets adjust until: R $ = R + (F $/ - E $/ $/ )/E $/ Covered interest parity is restored rapidly if deviations from parity appear 67 Figure 13-2 Interest Rates on Dollar and Deutschemark Deposits, 1975-2000 68 Figure 15-3 The Dollar/DM Exchange Rate and Relative U.S./German Price Levels, 1964-2000 69 Chapter 13 23
70 71 72 Chapter 13 24
Interest Rates in Argentine Banks Deposits in Pesos Dollars May 22 2000 9.0% 7.1% 73 Exchange Rate Risk Why do peso deposits in Argentine banks pay higher interest than dollar deposits in the same banks? Exchange risk Depositors think there is a greater chance of peso depreciation than appreciation 74 Interest Rates in Argentine Banks Deposits in Pesos Dollars May 22 2000 9.0% 7.1% Sep 6 2001 26.7% 17.7% 75 Chapter 13 25
Risk Premium Why do dollar debts of the Argentine government pay high interest than U.S. debt? Default risk Bond holders think there is a greater chance the Argentine government will be unable to repay its debts 76 Risk Premium R PESO = R $ + (E e PESO/$ - E PESO/$ )/ E PESO/$ + ρ ρ = risk premium ρ > 0 for Argentina (compared to U.S.) ρ < 0 for U.S. (compared to Argentina) 77 Chapter 13 26