International Finance Review of previous lecture January 16, 2018 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 1 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Convention we follow: Home currency per unit of foreign currency. For US Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Convention we follow: Home currency per unit of foreign currency. For US dollar per euro Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Convention we follow: Home currency per unit of foreign currency. For US dollar per euro dollar per yen Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Convention we follow: Home currency per unit of foreign currency. For US dollar per euro dollar per yen Dollar per euro is inverse of euro per dollar E $/euro = 1 E euro/$ Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Exchange rate Bilateral; e.g., dollar per euro or euro per dollar Convention we follow: Home currency per unit of foreign currency. For US dollar per euro dollar per yen Dollar per euro is inverse of euro per dollar The rate of depreciation (%) E $/euro = 1 E euro/$ 100 E t+1 E t E t = 100 E E Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 2 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation 100 0.05 1.10 = 4.5% Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% A negative rate means that the dollar appreciated... Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% A negative rate means that the dollar appreciated... This of course is a result of the convention. We express exchange rate as dollar per euro; in three months we need less dollars to buy the same euro. Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% A negative rate means that the dollar appreciated... This of course is a result of the convention. We express exchange rate as dollar per euro; in three months we need less dollars to buy the same euro. Euro became cheaper, i.e., Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% A negative rate means that the dollar appreciated... This of course is a result of the convention. We express exchange rate as dollar per euro; in three months we need less dollars to buy the same euro. Euro became cheaper, i.e., dollar became expensive, i.e., Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples Question 1. E t = 1.1; E t+1 = 1.05; the rate of depreciation How about the annual rate? 100 0.05 1.10 = 4.5% A negative rate means that the dollar appreciated... This of course is a result of the convention. We express exchange rate as dollar per euro; in three months we need less dollars to buy the same euro. Euro became cheaper, i.e., dollar became expensive, i.e., dollar appreciated. Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 3 / 9
Examples How about euro vis à vis dollar? Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 4 / 9
Examples How about euro vis à vis dollar? Answer: depreciated Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 4 / 9
Examples How about euro vis à vis dollar? Answer: depreciated by how much? 4.5%? Approximately? Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 4 / 9
Examples How about euro vis à vis dollar? Answer: depreciated by how much? 4.5%? Approximately? Question 2. From euro area perspective, E t = 1 1.1 ; E t+1 = 1 1.05 100 0.05 1.05 = 4.76% Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 4 / 9
Multilateral exchange rates US trades with many countries. How do we get an overall picture of dollar s strength/weakness? Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 5 / 9
Multilateral exchange rates US trades with many countries. How do we get an overall picture of dollar s strength/weakness? Use trade weights. Suppose US trades with two countries/continents, China and euro area, with trade volumes Trade 1 and Trade 2. Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 5 / 9
Multilateral exchange rates US trades with many countries. How do we get an overall picture of dollar s strength/weakness? Use trade weights. Suppose US trades with two countries/continents, China and euro area, with trade volumes Trade 1 and Trade 2. Then trade shares with China and Euro area are, respectively T 1 T 2 and T 1 + T 2 T 1 + T 2 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 5 / 9
Multilateral exchange rates US trades with many countries. How do we get an overall picture of dollar s strength/weakness? Use trade weights. Suppose US trades with two countries/continents, China and euro area, with trade volumes Trade 1 and Trade 2. Then trade shares with China and Euro area are, respectively T 1 To get a multilateral index use T 2 and T 1 + T 2 T 1 + T 2 T 1 T 1 + T 2 E 1 E 1 + T 2 T 1 + T 2 E 2 E 2 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 5 / 9
Multilateral exchange rates Question 3: E 1 E 1 = 10; E 2 E 2 = 4.5 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 6 / 9
Multilateral exchange rates E Question 3: 1 E 1 = 10; E 2 E 2 = 4.5 trade shares T 1 T = 0.4; 1 = 0.6 T 1 + T 2 T 1 + T 2 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 6 / 9
Multilateral exchange rates E Question 3: 1 E 1 = 10; E 2 E 2 = 4.5 trade shares T 1 T = 0.4; 1 = 0.6 T 1 + T 2 T 1 + T 2 Effective depreciation E eff E eff = 6.7% Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 6 / 9
Comparing prices What if the exchange rate moves to 1.25 $/pound, i.e., dollar appreciates Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 7 / 9
Comparing prices What if the exchange rate moves to 1.25 $/pound, i.e., dollar appreciates In UK the jeans now cost only 30 1.25 = 37.5$ Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 7 / 9
Comparing prices What if the exchange rate moves to 1.25 $/pound, i.e., dollar appreciates In UK the jeans now cost only 30 1.25 = 37.5$ For a British person, US jeans now cost 45 = 36 pounds 1.25 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 7 / 9
Comparing prices What if the exchange rate moves to 1.25 $/pound, i.e., dollar appreciates In UK the jeans now cost only 30 1.25 = 37.5$ For a British person, US jeans now cost 45 = 36 pounds 1.25 When dollar appreciates US goods become expensive and vice versa.. Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 7 / 9
Arbitrage example Exchange rates are E $/pound = 1.3528; E $/euro = 1.2038 Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 8 / 9
Arbitrage example Exchange rates are E $/pound = 1.3528; E $/euro = 1.2038 The question is E euro/pound? Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 8 / 9
Arbitrage example Exchange rates are E $/pound = 1.3528; E $/euro = 1.2038 The question is E euro/pound? 1 You are a US person. Use a dollar to buy 1 another dollar to buy 1.2038 euros. 1.3528 pounds and use Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 8 / 9
Arbitrage example Exchange rates are The question is E euro/pound? E $/pound = 1.3528; E $/euro = 1.2038 1 You are a US person. Use a dollar to buy 1.3528 pounds and use 1 another dollar to buy 1.2038 euros. Since you spent the same amount of dollar for the two transactions, arbitrage requires that 1 1.3528 pounds = 1 1.2038 euros Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 8 / 9
Arbitrage example Exchange rates are The question is E euro/pound? E $/pound = 1.3528; E $/euro = 1.2038 1 You are a US person. Use a dollar to buy 1.3528 pounds and use 1 another dollar to buy 1.2038 euros. Since you spent the same amount of dollar for the two transactions, arbitrage requires that Or 1 1.2038 1 1.3528 1 1.3528 pounds = 1 1.2038 euros = 1.3528 1.2038 euros/pound = 1.1238 euros/pound Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 8 / 9
Arbitrage example Suppose not. Suppose the direct exchange rate is 1.2 euros/pound. 1 Then use a dollar to buy 1.3528 pounds and then sell it in the direct 1.2 exchange market to get 1.3528 euros Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 9 / 9
Arbitrage example Suppose not. Suppose the direct exchange rate is 1.2 euros/pound. 1 Then use a dollar to buy 1.3528 pounds and then sell it in the direct 1.2 exchange market to get 1.2 Then sell 1.3528 euros to get 1.3528 euros 1.2038 1.2 1.3528 = 1.0678$ Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 9 / 9
Arbitrage example Suppose not. Suppose the direct exchange rate is 1.2 euros/pound. 1 Then use a dollar to buy 1.3528 pounds and then sell it in the direct 1.2 exchange market to get 1.2 Then sell 1.3528 euros to get 1.3528 euros 1.2038 1.2 1.3528 = 1.0678$ You made a cool 6.78% profit instantaneously. Why not use billions of dollars to get rich? Review of previous lecture () Econ 457 Spring 2018 January 16, 2018 9 / 9