Transcript spot exchange rate

Chapter 7
The Foreign Exchange Market
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Foreign Exchange Markets




Exchange rate—price of one currency in terms
of another: EYTL/USD = 1.34 YTL/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
aggreed forward exchange rate
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Foreign Exchange Markets

Appreciation—a currency rises in value relative
to another currency: EYTL/USD decreases.

Depreciation—a currency falls in value relative
to another currency: EYTL/USD increases.

Why is Exchange Rate important?

When a country’s currency appreciates, the country’s
goods abroad become more expensive and foreign
goods in that country become less expensive and vice
versa
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Foreign Exchange Markets
 Over-the-counter
banks.
market mainly

Mostly deposits are traded, not paper
currency.

Global foreign exchange market volume
is ~ $1 trillion per day.
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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 Turkish steel is sold at 134
YTL and 1 ton American steel sold for 100
dollar. So if the exchange rate is 1.34
YTL/dollar, their price is equal (there is
only one price). Assume tariffs and cost of
transportation are zero.
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Exchange Rates in the Long Run

Theory of Purchasing Power Parity

Exchange Rates between any two currencies
adjusts to changes in the price levels of the
two countries. This is a generalization of the
law of one price to all goods.
EYTL / USD
PTUR

PUS
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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%.
Although the theory predicts 84%
appreciation.
 Why does the theory of PPP cannot fully
explain ER movements?

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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 services are
not traded across borders (nontradables) like
houses, haircuts, health services, etc.
Assumes all goods are identical in
both countries. Is Turkish steel the same as
American?
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Factors that Affect Exchange Rates
in the Long Run

Anything that increases demand for
Turkish goods increases the value of YTL
in terms of foreign currency.
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Factors that Affect Exchange Rates
in the Long Run

Relative price levels. If prices of Turkish
goods rise (fall) relative to foreign
goods, demand for Turkish goods fall
(rise), then YTL depreciates
(appreciates).

Trade barriers. If tariffs increase
(decrease), then YTL appreciates
(depreciates). Ex: if tariffs on German
cars decrease, demand for Turkish cars
decrease, YTL depreciates.
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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
YTL depreciates.

Productivity. If Turkey’s productivity
increases, then prices in Turkey decline
and causes YTL to appreciate.
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1/E
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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 (YTL) assets and foreign (dollar) assets
is the expected return on these assets relative to
each other.
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Comparing Expected Returns



YTL denominated assets pay a real interest rate
of iD
Dollar (foreign) assets pay real interest rate of
iF
Expected depreciation of YTL against dollar is
E
e
t 1
 Et
Et
where Et is YTL/dollar exchange rate at time t.
This is also appreciation of dollar against lira.
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Comparing Expected Returns

From a Turkish investor’s perspective,
expected return on holding dollar assets is
equal to
R in terms of liras  i 
F

F
E
e
t 1
 Et
Et
Expected return on holding YTL assets in
terms of liras is iD.
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Comparing Expected Returns II
So relative return of 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 YTL will
depreciate 5% against dollar next year, then
relative return from holding dollar assets is -1%
(1% loss). Relative return from holding YTL
assets is 1%.
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Comparing Expected Returns III

Now think of holding YTL assets from an
American investor’s perspective. Return on
YTL 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 YTL, then loses the above return.
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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 YTL assets.
His return relative to YTL assets is
Relative R in terms of dollars  i  i 
F
F
D
E
e
t 1
 Et
Et
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Comparing Expected Returns III

Result:
relative RF in terms of liras = relative RF in terms
of dollars
 Regardless of the nationality of the investor,
relative returns from holding dollar assets
(which is equal to the minus relative returns
from YTL assets) is the same in terms of dollars
or liras. If relative returns from holding YTL
assets increase, both Turks and Americans will
(buy) hold more YTL assets and (sell) hold less
dollar assets. This causes lira to appreciate.
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Interest Parity Condition
e
E
t 1  Et
D
F
i i 
Et



An equilibrium condition: If both domestic and
foreign assets are held, then expected returns
must be the same on both domestic and
foreign assets. Otherwise everybody would hold
the one with positive relative return. Nobody
will hold the other asset.
Capital mobility with similar risk and liquidity 
the assets are perfect substitutes.
The domestic interest rate equals the foreign
interest rate plus the expected depreciation of
the domestic currency
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Demand
for Domestic 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
YTL demand higher? İf Et= 1,31 YTL/dollar now
or if Et= 1,60 YTL now?
At lower current values of YTL (everything else
equal), the quantity demanded of YTL assets is
higher
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Demand
for Domestic Assets
1/E
1/1,31
1/1,60
D
Quantity of
YTL assets
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Supply of Domestic Assets

Supply


The amount of bank deposits, bonds,
and equities in Turkey. This amount does not
depend on the current exchange rate.
Vertical supply curve
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EQUILIBRIUM
1/E
S
1/1,31
1/1,60
D
Quantity of
YTL assets
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IF REAL INTEREST RATE (iD)
INCREASES IN TURKEY
1/E
S
1/1,20
1/1,31
D’
1/1,60
D
Quantity of
YTL assets
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IF EXPECTED INFLATION
INCREASES IN TURKEY
1/E
S
1/1,20
1/1,31
1/1,60
D
D’
Quantity of
YTL assets
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IF FED INCREASES INTEREST
RATE
1/E
S
1/1,20
1/1,31
1/1,60
D
D’
Quantity of
YTL assets
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IF EXPECTED FUTURE EXCHANGE
RATE Eet+1 APPRECİATES
1/E
S
1/1,20
1/1,31
D’
1/1,60
D
Quantity of
YTL assets
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IF CBRT INCREASES MONEY
SUPPLY

When the CB increases the money supply,
the long run price level will increase. This
means YTL will depreciate in the long run,
due to purchasing power parity theory.
Since the expected value of YTL next year
is smaller, current demand for YTL assets
decline. Causes YTL to depreciate.
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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 YTL declines further.
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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 YTL 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
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Exchange Rate Overshooting
1/E
($/YTL)
1/1,31
1/1,60
1/2
Time
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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 in the US.The recession
still did not finish completely today.
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