Transcript Chapter 7 presentation.

Chapter 7
The Foreign Exchange Market
1
Foreign Exchange Markets




Exchange rate—price of one currency in terms
of another: ETL/USD = 1.75 TL/dollar
Foreign exchange market—the financial market
where exchange rates are determined
Spot transaction—immediate (two-day)
exchange of bank deposits at spot exchange
rate
Forward transaction—the exchange of bank
deposits at some specified future date at the
agreed forward exchange rate
2
Foreign Exchange Markets

Appreciation—a currency rises in value
relative to another currency: ETL/USD decreases.

Depreciation—a currency falls in value
relative to another currency: ETL/USD increases.

Why is Exchange Rate important?

When a country’s currency appreciates
(depreciates), the country’s goods abroad
become more expensive (cheaper) and
foreign goods in that country become
cheaper (more expensive). Its exports fall
(rise), imports rise (fall), trade deficit
increases (falls). Rate of Inflation falls
(rises).
3
Foreign Exchange Markets

Over-the-counter market, mainly banks
and other financial inst.’s.


Mostly deposits are traded, not paper
currency.
“Average daily global foreign-exchange
turnover has grown to $4.71 trillion according
to a Dow Jones Newswires analysis,
underscoring how currencies continue
attracting liquidity and growing as an asset
class despite the uncertain state of the
economy…” WSJ, July 26 2011
4
02.01.2006
02.01.2002
02.01.1998
02.01.1994
02.01.1990
02.01.1986
02.01.1982
02.01.1978
02.01.1974
02.01.1970
02.01.1966
02.01.1962
02.01.1958
02.01.1954
02.01.1950
TL/$ exchange rate
10000000
1000000
100000
10000
1000
100
10
1
5
Value of Lira against Dollar
1950 -1960: 2.82 TL / $
 1960 – August 1970: 9.08 TL / $
 August 1970 – December 1971: 15.15
TL/$
 December 1971 – May 1974: 14.30 TL / $
 After 1980 variable (depreciations).

6
7
Exchange Rates in the Long Run

Law of one price. Price of the same good
must be the same in different countries.
Assume 1 ton steel is sold at 134 TL in
Turkey and 1 ton steel is sold for 100
dollar in US. According to the law of one
price, exchange rate must be 1.34
TL/dollar. We assume tariffs and costs of
transportation are zero.
8
Exchange Rates in the Long Run

Theory of Purchasing Power Parity (PPP)

Exchange Rates between any two currencies
adjusts to changes in the price levels of the
two countries. PPP is a generalization of
the law of one price to all goods and services
PTUR
ETL / USD 
PUS
9
PPP theory


EX: The currency of the Country whose rate of
inflation is larger than the r.o.w. _______ against
other currencies.
Ex: suppose 2000-2011 average rate of inflation
is 10% in Turkey, 15% in Argentina, 3% in Euro
area and 3% in the US. Order the rate of
depreciation of each currency from largest depr.
to smallest depr.
10
11
Exchange Rates in the Long Run
Btw 1973-2005, British price level rose
84% relative to the US price level. Dollar
appreciated against the pound by 43%.
But the theory predicts 84% appreciation?
 Why does the theory of PPP cannot fully
explain ER movements?

12
Exchange Rates in the Long Run

Why does the theory of PPP cannot fully
explain ER movements?




Assumes trade barriers (tariffs and quotas)
and transportation costs are zero.
Assumes all goods are tradable across borders.
But in practice many goods and especially
services are not traded across borders
(nontradables) like houses, haircuts, health
services, etc.
Assumes all goods are identical across
countries. Is Turkish steel the same as
American steel?
Ignores expectations and exp. asset returns.
13
Factors that Affect Exchange Rates
in the Long Run

Anything that increases demand for a
country’s goods, services, securities, etc.
anything sold in terms of that country’s
currency => increases the demand for
and hence the value of that country’s
currency against other currencies.

If demand for TR bonds fall in London market,
TL ______ against other currencies. Interest
rates on these bonds ______.
14
Factors that Affect Exchange Rates
in the Long Run

Relative price levels. If prices of Turkish
goods or securities rise (fall) relative to
foreign goods, demand for Turkish goods
fall (rise), then TL depreciates
(appreciates). But notice the reverse
feedback correction…

Trade barriers. If import tariffs increase
(decrease), then TL appreciates
(depreciates). Ex: if tariffs on imported
German cars decrease, demand for
Turkish cars decrease, TL depreciates.
15
Factors that Affect Exchange Rates
in the Long Run

Preferences for domestic versus
foreign goods. If Turks start to like Italian
furniture more than Turkish furniture then
TL depreciates.

Productivity. If Turkey’s productivity
increases, then prices in Turkey decline
and this causes TL to appreciate.
16
1/E
17
Exchange Rates in the Short Run

An exchange rate is the price of domestic assets
in terms of foreign assets

Using the theory of asset demand —the most
important factor affecting the demand for
domestic curr. (TL) denominated assets and
foreign curr.(dollar) denominated assets is the
expected returns on these assets relative to each
other.
18
Comparing Expected Returns



TL denominated assets pay a real interest rate
of iD
Dollar (foreign curr.) denominated assets pay
real interest rate of iF
Expected depreciation of TL against dollar is
E
e
t 1
 Et
Et
where Et is TL/dollar exchange rate at time t. This
is also exp. appreciation of dollar against lira.
19
Comparing Expected Returns

From a Turkish investor’s perspective,
expected return from holding dollar assets
is equal to
R in terms of liras  i 
F

F
E
e
t 1
 Et
Et
Expected return from holding TL assets in
terms of liras is iD.
20
Comparing Expected Returns II
So expected relative return from holding dollar
assets is equal to
e
E
t 1  Et
F
F
Relative R in terms of liras  i 
 iD
Et
•For example, if iD is 9%, iF is 3%, and TL is
exp. to depreciate 5% against dollar next year,
then relative return from holding dollar assets
is -1% (1% loss). Relative return from holding
TL assets is +1%. (Note: assume inflation is
zero)
21
Comparing Expected Returns III

Now think of holding TL assets from an
American (or int’l) investor’s perspective.
Return on TL assets for him is
R in terms of dollars  i 
D

D
E
e
t 1
 Et
Et
If the American holds dollar assets instead
of TL, then loses the above return, but
gains iF.
22
Comparing Expected Returns III

If the American holds dollar assets, then
his return is iF . But he loses the return he
could have earned by holding TL assets.
Exp. Return of holding dollars relative to
TL assets is
Relative R in terms of dollars  i  i 
F
F
D
E
e
t 1
 Et
Et
23
Comparing Expected Returns III


Result: Regardless of where the investor is
from or which currency you start with, exp.
relative returns from holding dollar assets
(which is the negative of the exp. relative
return from holding TL assets) ARE EQUAL.
If exp. relative returns from holding TL assets
increase, both Turkish and American investors
will “buy” or “hold more” TL assets and “sell” or
“hold less” dollar assets. This causes lira to
appreciate, dollar to depreciate.
24
Interest Parity Condition
e
E
t 1  Et
D
F
i i 
Et

An equilibrium condition: If both domestic and
foreign assets are held in eqbm, then expected
returns must be the same on both domestic
and foreign assets. Otherwise everybody would
hold the one with positive exp. relative return.
Nobody will hold the other asset.

In other words relative returns from holding
each currency should be zero.
25
Interest Parity Condition

Capital mobility with similar risk and
liquidity 
the assets are perfect substitutes.

The domestic (real) interest rate equals
the foreign interest rate plus the
expected depreciation of the domestic
currency
26
Interest Parity Condition


But in an actual economy, we do not fully
observe the interest parity because of “country
risk premium”. Country risk p. is the uncertainty
regarding what is going to happen in Turkey in
the future, like political instability.
For example, Garanti Bankası pays TL account
%9, pays dollar %2. But does this mean people
expect that TL will depreciate against dollar %7
during the next year? Not necessarily, part of the
difference is due to the higher risk perceived of
TL due to the bigger uncertainty in Turkish
economy. This is called “country risk p.”.
27
Demand
for Domestic (curr. denom.) Assets

Demand increases if relative expected return
increases.
Relative R  i  i 
D


D
F
E
e
t 1
 Et
Et
Suppose Eet+1 = 1,45 . In which case is your TL
demand higher? İf Et= 1,31 TL/dollar now or if
Et= 1,80 TL now?
At lower current values of TL (everything else
equal), the quantity demanded of TL assets is
higher
28
Demand
for Domestic Assets
1/E
($/TL)
1/1,5
1/1,80
D
Quantity of TL
assets
29
Supply of Domestic Assets

Supply


The amount of bank deposits, bonds,
and equities, all securities denom. in TL. This
amount does not depend on the current
exchange rate.
Vertical supply curve
30
EQUILIBRIUM
1/E
S
($/TL)
1/1,5
1/1,60
D
Quantity of TL
assets
31
IF REAL INTEREST RATE (iD)
INCREASES for TL-denom assets
S
1/E
($/TL)
1/1,20
1/1,5
D’
1/1,60
D
Quantity of TL
assets
32
IF EXPECTED INFLATION
INCREASES IN TURKEY
S
1/E
($/TL)
1/1,20
1/1,5
1/1,60
D
D’
Quantity of TL
assets
33
IF FED INCREASES INTEREST
RATE
S
1/E
($/TL)
1/1,20
1/1,5
1/1,60
D
D’
Quantity of TL
assets
34
IF EXPECTED FUTURE EXCHANGE
RATE APPRECİATES
1/E
S
($/TL)
1/1,20
1/1,5
D’
1/1,60
D
Quantity of TL
assets
35
36
37
IF CBRT INCREASES MONEY
SUPPLY

When the CB increases the money supply,
the long run price level will increase. This
means TL will depreciate in the long run,
due to purchasing power parity theory.
Since the expected value of TL next year
is smaller, current demand for TL assets
decline. Causes TL to depreciate. (first
effect)
38
Exchange Rate Overshooting


Monetary Neutrality in the long run
 In the long run, a one percent increase in
the money supply is matched by the same
one percent increase in the price level
But in the short run, price level cannot increase
immediately. Prices are “sticky”. So, M/P (real
money supply) increases. This causes domestic
real interest rate to fall (liquidity preference
theory). Demand for TL declines further.
(second effect)
39
Exchange Rate Overshooting
1/E
($/TL)
1/1,5
1/1,60
1/2
Time
40
Exchange Rate Overshooting
S
1/E
($/TL)
1/1,20
1/1,5
D
1/1,60
D’
D’’
Qty of TL
assets
41
Exchange Rate Overshooting

But in the long-run, prices increase, M/P
decreases back to original level and
interest rate goes up again. This increases
demand for TL assets. But not completely
because prices are higher than before.

The exchange rate depreciates more in
the short run than in the long run

Helps to explain why exchange rates exhibit so
much volatility
42
The EURO’S FIRST SEVEN
YEARS

Euro initially depreciated in 1999&2000.
Strong US growth and poor growth & low
real interest rates in Europe. But after
2001, euro started to appreciate because
of the recession and low interest rates
(1%) in the US.The recession still did not
finish completely today.
43
44