Transcript Topic_11a_Forex_Market

TOPIC 13
FOREIGN EXCHANGE
MARKET
1/38
Chapter Preview
 We develop a modern view of exchange rate
determination that explains the behavior of
exchange rate in the foreign exchange
market. Topics include:
1.
Foreign Exchange Market
2.
Exchange Rate Determination
3.
Explaining Changes in Exchange Rates
1. The Foreign
Exchange Market
Foreign Exchange Market
 What is forex market?

Countries have their own currencies. When trades happen
between them, domestic currencies will be exchanged
with foreign currencies

Forex market is where trading of currencies and banks
deposits denominated–currency takes place
 Nominal exchange rate is the price of one country’s
exchange rate in terms of another’s.
 Real exchange rate is the purchasing power of a
currency relative to the purchasing power of other
currencies.
4/34
Foreign Exchange Market:
Historical Exchange Rates
Figure 13.1: Exchange Rates, 1990–2004
Forex Market

What is forex rate?
1.
2.
3.


Price of a currency in terms of another
Determined by transactions conducted in forex market
These rates determine the cost of purchasing foreign goods and
financial assets
Types of forex rate:
1.
Spot ER: ER for the current transaction; immediate (2 day)
exchange of bank deposits. OTC; bid-ask spread
2.
Forward ER: ER for forward transaction; exchange of bank
deposits at some specified future dates. Contract to buy/sell FX at
a specified price and future date; hedging instrument
Changes in forex rate:
1.
2.
3.
Appreciation
Depreciation
Devaluation?
6/34
Foreign Exchange Market

Why ERs are important? They affect the relative price of
domestic goods and foreign goods

When currency appreciates, country’s goods become
more expensive abroad and foreign goods become
cheaper in the country

Currency appreciation - good or bad?
1. To business: Makes domestic businesses less competitive.
Difficult for domestic manufacturer to sell their goods
abroad and increase competition at home as foreign goods
become cheaper
2. To consumer: Benefits as foreign goods become cheaper.
3. Others: Government, students, tourists/tourism industry
7/34
How is Forex Traded?

No physical place but a network of telephones, emails and other
telecommunication facilities connecting all large banks in the
world

In organized OTC market in which many dealers stand ready to
buy and sell deposits denominated in specific currencies.

Market very competitive since dealers are in constant telephone
and computer contact

Operates 24-hours a day

Trades involve buying and selling bank deposits denominated in
different currencies, no buying of notes

Trades in the foreign exchange market involve transactions in
excess of $1 million
8/34
How is Forex Traded?


Participants:

Commercial banks (interbank market, retail)

Corporates with international operations (current
transactions and hedging)

Non-bank financial institutions

Central banks (forex intervention)
Typical consumers buy foreign currencies from
retail dealers such as American Express
9/34
2. Exchange Rate
Determination
Determination of Exchange Rates

ERs are determined by interaction of supply and demand of
currency in forex market.

Behavior of ER is different in long run compared to short run

In long run, behavior of ER can be explained by theory of
Purchasing Power Parity (PPP)

ER between two currencies will adjust to reflect changes in
price levels

ER is determined by changes in relative price because PPP is
based on Law of One Price
1.
2.
Price level in an important concept that drives the forces
of supply and demand
Price of an identical good should be the same throughout
the world, regardless of which country produces it
11/34
Exchange Rates in the Long Run:
Law of One Price
 Law of One Price: If 2 countries produce an identical
good, price of the good should be the same throughout
the world no matter which country produces it
 Suppose: US steel costs $100 per ton & Jap steel costs
10,000 yen per ton

According to Law of One Price, the ER has to be:
$100/ton=10,000 yen/ton
= 100 yen/$ or $0.01/yen
12/34
Exchange Rates in the Long Run:
Law of One Price
 At this ER 100 yen/$:


US steel costs 10,000 yen per ton in Japan ($100/ton x 100
yen/$)
Jap steel costs $100 per ton in US (10,000 yen/ton x $0.01/yen)
 If price in US increase as reflected by yen/USD ER goes
to 200 yen/$:


US steel costs 20,000 yen per ton in Japan ($100/ton x 200
yen/$)
Jap steel costs $50 per ton in US (10,000 yen/ton x $0.005/yen)
 DD for US steel goes to zero resulting in excess supply
of US steel. US price has to decline to increase demand
for US steel

13/34
US ER must depreciate so that the yen-$ ER will go to 100 yen/$ (from
200 yen/$)
Exchange Rates in the Long Run:
Theory of Purchasing Power Parity (PPP)

Theory of PPP states:

Application of law of one price to price levels

Inflation rate differences cause changes in the nominal
exchange rate.

Domestic price level increases by 10%, domestic currency
would depreciate by 10%
 Works in long run, not short run

Complications with PPP
1.
2.
All goods are not identical in both countries (i.e., Toyota
versus Chevy)
Many goods and services are not tradable across borders
14/34
(e.g., haircuts, land, etc.)
Factors Affecting Exchange Rates
in Long Run
Basic Principle: Any factor contributing to increased demand for
domestic goods relative to foreign goods, domestic currency
will appreciate
1.
2.
Relative price levels:

When price of dom goods, the dd for domestic goods decrease

Dom curr must depreciate so that the domestic goods can still
sell

In LR, a rise in relative price levels cause a country’s currency to
depreciate
Tariffs and quotas:

Impact: reduces the availability of foreign goods in dom market

 the dd for domestic goods and the dom curr will appreciate

In the LR,  trade barriers causes a country’s currency to
appreciate
15/34
Factors Affecting Exchange Rates
in Long Run
3.
4.
Preferences for domestic vs foreign goods

Increased demand for a country’s good causes its currency to
appreciate

Increased demand for imports causes the domestic currency to
depreciate
Productivity

 productivity, dom business can lower the prices of dom
goods,  the dd for dom goods, dom curr appreciates

In the LR, if a country is more productive relative to another,
its currency appreciates
16/34
Factors Affecting Exchange Rates in Long Run
17/34
ER in the Short Run
 ER shows larger fluctuations in the SR than in
the LR
 In the SR, an ER is the price of domestic bank
deposits in terms of foreign bank deposits
 Thus, ER can be determined by analyzing the
dd for domestic asset holding and foreign asset
holdings (the determinants of asset demand)
 The most important factor affecting this
demand is the expected return on these assets
relative to each other
18/34
Exchange Rates in the Short Run:
Expected Returns and Interest Parity
 According to the interest parity condition:
e
E
D
F
t 1  Et
i i 
Et
 The interest parity condition states that the domestic interest
rate is equal to foreign interest rate minus the expected
appreciation of the domestic currency.
Example: if i D = 10% and expected appreciation of $ is 5%,
Ete1  Et
F
 5%  i  15%
Et
19/34
Exchange Rates
in the Short Run
 The usual approach to supply-demand
analysis focused on import/export demand
 Here, we emphasize stocks rather than flows,
because flows are small relative to the
domestic and foreign asset stocks.
Exchange Rates in the Short Run:
Supply Curve Analysis
 We will use the US as the “home country,” so
domestic assets are denominated in US
dollars. We will use “euros” the generically
represent any foreign country's currency.
 Dollar assets supplied is primarily the quantity
of bank deposits, bonds, and equities in the
United States. This is fairly fixed in the shortrun.
 The quantity supplied at any exchange rate
does not change, so the supply curve, S, is
vertical.
Exchange Rates in the Short Run:
Demand Curve Analysis
 The demand curve traces out the quantity
demanded at each current exchange rate
 The current exchange rate and the expected
future exchange rate are held constant in this
analysis.
 Let’s see a specific example that illustrates
this point.
Exchange Rates in the Short Run:
Supply and Demand Curves
Deriving the Demand Curve
Assume iF = 5%, Eet+1 = 1 euro/$
Point
A: Et = 1.05
(1.00 – 1.05)/1.05 = 4.8%
B: Et = 1.00
(1.00 – 1.00)/1.00 = 0.0%
C: Et+1 = 0.95
(1.00 – 0.95)/0.95 = 5.2%
 The demand curve connects these points and is
downward sloping because when Et is higher,
expected appreciation of the dollar is higher.
Exchange Rates in the Short Run:
Equilibrium
 Equilibrium



Supply = Demand at E*
If Et > E*, Demand < Supply, buy $, Et 
If Et < E*, Demand > Supply, sell $, Et 
3. Explaining Changes
in Exchange Rates
Explaining Changes
in Exchange Rates
 To understand how exchange rates shift in
time, we need to understand the factors that
shift expected returns for domestic and
foreign deposits.
 We will examine these separately, as well as
changes in the money supply and exchange
rate overshooting.
Explaining Changes in Exchange
Rates: Increase in iD
 Demand curve
shifts right
when iD :
because
people want to
hold more
dollars
 This causes
domestic
currency to
appreciate.
Explaining Changes in Exchange
Rates: Increase in iF
 Demand
curve shifts
left when iF:
because
people want
to hold fewer
dollars
 This causes
domestic
currency to
depreciate.
Explaining Changes in Exchange Rates: Increase
in Expected Future FX Rates
 Demand curve
shifts left
whe:
because
people want to
hold more
dollars
 This causes
domestic
currency to
appreciate.
Explaining Changes in Exchanges
Rates
 Similar to determinants of exchange rates in
the long-run, the following changes increase
the demand for foreign goods (shifting the
demand curve to the right), increasing





Expected fall in relative U.S. price levels
Expected increase in relative U.S. trade barriers
Expected lower U.S. import demand
Expected higher foreign demand for U.S. exports
Expected higher relative U.S. productivity
 These are summarized in the following slides.
Explaining Changes in Exchanges
Rates (a)
Explaining Changes in Exchanges
Rates (b)