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ECONOMICS 3150C

Fall 2010

Professor Lazar

Office: N205J

flazar@yorku.ca

736-5068

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Lecture 2: September 23

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Exchange Rates

• Is the Canadian $ a petro currency?

E Light crude

Jan. 1/01 0.6683 $26.80

Jan. 1/02 0.6258 $19.84

Jan. 1/03 0.6350 $31.20

Jan. 1/04 0.7752 $32.52

Jan. 1/05 0.8162 $43.45

Jan. 1/06 0.8642 $61.04

Jan. 1/07 0.8584 $61.05

Jan. 1/08 1.0074 $95.98

Jan. 1/09 0.8260 $44.60

Jan. 1/10 0.9555 $79.50

Sept. 7/10 0.9544 $73.82

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Exchange Rates

• C$ peaked at 1.0905 on Nov. 7/07

• Crude oil prices peaked in July/08

• Between Nov/07 and July/08, C$ depreciated 11%, crude oil prices increased 55%

%∆E % ∆Light crude

Jan. 1/01 -0.8% -17.5%

Jan. 1/02 -6.4 -26.0

Jan. 1/03 1.5 57.3

Jan. 1/04 22.1 4.2

Jan. 1/05 5.3 33.6

Jan. 1/06 5.9 40.5

Jan. 1/07 -0.7 0.0

Jan. 1/08 17.4 57.2

Jan. 1/09 -18.0 -53.5

Jan. 1/10 15.7 78.3

Sept. 7/10 -0.0 -7.1

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Foreign Exchange Markets

• Participants:– Commercial banks

– Corporations

– Non-bank financial institutions

– Hedge funds

– Foreign exchange dealers

– Central banks

• Exchange rates – spot, forward– Rates move together

• Futures, options (call and put)

• Foreign exchange swaps – spot sale of a currency combined with forward repurchase of same currency

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Foreign Exchange Markets

• Key financial centers: London, New York, Zurich, Tokyo– Frankfurt, Hong Kong, Singapore, Dubai, Mumbai and Shanghai

• Daily volume of transactions: US$4 T/day– 2006/7: US$3.3T/day

– 2000: US$1 T/day

– 60%+ in London and NYC

– Currency trading in Canadian $: C$95 B/day

• US stock markets: about $150B/day

• US Treasury market: about $500B/day

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Foreign Exchange Markets

• Each transaction involves two currencies, so market shares calculated out of 200%– US$: 86%

• Euro-$ trades: 27%

• Yen-$ trades: 13%

• Pound-$: 12%

• Emerging market currencies-$: 19%

• Emerging market currencies-Euro: 4%

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Foreign Exchange Markets

• Forward exchange rate: – Over-the-counter transactions between bank and customers whereby bank

agrees to buy or sell specified amount of currency at an agreed rate (forward rate) for delivery at specified future date (as of September 7/10)

– 1 month: 0.9539– 1 year: 0.9475– 5 years: 0.9327– Spot rate: 0.9543

• Futures: Transactions on an exchange– Closing dates for contracts, usually end of each quarter– Fixed value for each contract

• Options: Transactions on an exchange– Rights to buy/sell currencies at pre-specified exchange rate at future point

in time (usually available with monthly closing dates)

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Revaluations of Exchange Rates and Impacts on Relative Prices

• Prices of comparable Canadian and US goods expressed in same currency– P[C]*E; P[US] = P[C]*E/P[US]– Depreciation (appreciation): ( )

• Example: Bombardier selling Q400 to Horizon Air• Price set in $C or $US?• Set in $US (US$ 40 M) – no foreign exchange risk for Horizon Air• Delivery in 6 months

– @ current E: Bombardier will receive C$ 41.9 M– If C$ depreciates by 5% (E = 0.907), Bombardier will receive C$ 44.1M– If C$ appreciates by 5% (E = 1.002), Bombardier will receive C$ 39.9M– Implications for profit margins, pricing?

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Revaluations of Exchange Rates and Impacts on Relative Prices

• Depreciation of spot rate of C$ increases C$ price of foreign goods and services, unless foreign prices reduced– US$ price of US good/service: US$100 (PUS), with

E=0.9544, C$ price of this good/service = PUS / E = C$104.78

– Depreciation of C$: i.e. E decreases to 0.9067 (5% depreciation in the value of the C$ relative to the US$), C$ price of this US good/service (US$ price unchanged at US$100) at new exchange rate is C$110.29

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Revaluations of Exchange Rates and Impacts on Relative Prices

• Depreciation of the spot rate for the C$ also reduces foreign currency price of Canadian goods and services, unless C$ price increased– C$ price of Canadian good/service: C$100 (PC), with

E=0.9544, US$ price of this good/service = PC * E = US$95.44

– Depreciation of C$: E decreases to 0.9067, US$ price of this Canadian good/service (C$ price unchanged at C$100) at new exchange rate is US$90.67

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Revaluations of Exchange Rates and Impacts on Relative Prices

• Ceteris paribus, competitive position of Canadian-based companies improves vis a vis foreign competitors when C$ depreciates and deteriorates when C$ appreciates as long as Canadian companies do not use many US or foreign produced/priced parts, components, services– Depreciation may lead to higher rate of inflation (prices of

imported goods and services), and increase in wage demands– Foreign suppliers may improve quality, productivity to maintain

competitive position– Foreign suppliers may reduce profit margins to maintain prices in

C$– Canadian suppliers may become lax (X-inefficient) and less

innovative

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Aggregate Demand

• EX (exports of goods and services)– Determinants of D: real income, relative prices – Income of major trading partners – US in particular– Relative prices – prices of Canadian produced goods

and services relative to price of competing foreign produced goods and services

• PC E/PUS

– Non-price competitiveness of Canadian companies– Trade barriers – tariffs, transportation costs, Buy

America

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Aggregate Demand

• IM (imports of goods and services)– GDP in Canada

– Relative prices – prices of Canadian produced goods and services relative to price of competing foreign produced goods and services

– Non-price competitiveness of Canadian companies

– Trade barriers

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Links between Spot and Forward Rates

• Covered interest rate parity:– Invest C$1 for one year in Government of Canada bond at interest rate of

R(1,C): $1 [1+R(1,C)] C$

– Invest C$1 for one year in US Government bond at interest rate of R(1, US): $1*E[1+R(1,US)] US$ convert into C$ at end of year at spot exchange rate at that time (speculate) or enter into forward contract at beginning of year at forward rate of F

– For investor to be indifferent between two investments and not speculate: [1+R(1,C)] = E[1+R(1,US)] /F

– F = E{[1+R(1,US)]/[1+R(1,C)]}

– R(1,C) = {E[1+R(1,US)] – F}/F R(1,US) + (E-F)/F R(1,US) + (F*-E*)/E*

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Hedging

• Derivatives: financial instruments whose value depends upon other financial instruments or assets (commodities)– Forward contracts (provided by banks)

– Futures contracts (traded on exchanges)

– Options on futures – examples for interest rates, currencies, commodities

– Securitized financial instruments; e.g. mortgage-backed bonds

– Swaps: interest rates, currency, credit default

• Derivatives offer insurance against various forms of financial risks (interest rates, currencies, commodity prices, etc.)– Also enable gambling: e.g. credit default swaps

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Hedging

• Eliminate foreign exchange risks resulting from possible revaluation of exchange rate

• Consider case of Air Canada buying B787s from Boeing: 5 per year for six years starting (?)

• Consider exchange rate risk in first year of deliveries – assume that all planes are delivered at end of year and fully paid for at that time; cost per plane US$225 M– AC to pay US$1,125M for first year of deliveries

– Foreign exchange rate risk: How many C$ will it cost AC – Depends on value of spot rate at that time

– At current spot rate (E=0.9544), AC will pay C$1,179M

– If C$ appreciates by the time of deliveries, AC will pay less in C$

– If C$ depreciates, AC will pay more in C$

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Hedging

• Options for Air Canada– Speculate – maximum exposure depends upon degree

of appreciation

– Hedge – avoid exposure

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Hedging

• Hedging options:– Forward contract – lock in forward rate F AC pays

with certainty at end of year $1,125 M/F• AC foregoes possibility of gaining from appreciation

– One-year futures contract

– One-year call option to buy US$1,125 M at a pre-specified exchange rate (e.g. E = 0.94) and pay C$1,197M if option is exercised most costly form of hedging but allows AC to gain from appreciation of C$

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Demand for Financial Assets

• Relative expected rates of return – returns on financial assets denominated in different currencies must be compared in the same currency– Forward-looking decisions

• Risk – variability of expected return, default risk and expected losses in case of default, confidence in predicting future returns– Comparison of expected return for same degree of risk

– Diversification of portfolio to reduce overall risk for portfolio

– Measurement of risk

– Risk preference

• Liquidity: cost/speed of converting asset into cash– Precautionary motive for holding liquid assets

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Demand for Financial Assets

• Two financial assets: Government of Canada bond with one year to maturity; US Government Bond with one year to maturity

• C$ bonds have higher degree of risk and are more illiquid than US$ bonds represents value of risk and illiquidity

• Covered interest rate parity condition must hold (with expected E – E(e) – in place of F) adjusted for greater risk and less liquidity of C$ government bonds: – R(1,C) = R(1,US) + (E*(e)-E*)/E* + – (E*(e)-E*)/E* : expected change in value of C$

– (E*(e)-E*)/E* > 0 C$ expected to depreciate

– (E*(e)-E*)/E* < 0 C$ expected to appreciate

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Demand for Financial Assets

• Following graph– Horizontal axis: expected rate of return in C$– E*(e) is assumed to be independent of E*, so

the higher is E*, the smaller is the expected change in the value of the C$, and the smaller is the expected C$ return on US Government bond

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E*

R(1,C)

[R(1,US)0, 0, E*(e)0]

R0

E*01

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Impact on Exchange Rate

• Impact on E*: R(1,US) R(1,C) E*(e)

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R(1,C)

[R(1,US)0, 0, E*(e)0]

R0

1

E*

E*0

R(1,US), , or E*(e)

2E*1

R1

3E*2

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Problems with Model

• Speed of adjustments – stability, herd effect • Variety of assets – different terms to maturity, risks, degree of

liquidity, expected returns• Transactions costs; differential tax treatment• Formulation of expectations

– Momentum – Surprises

• Ignores current account transactions and direct intervention by central bank

• Determinants of E* -- consider case of financial assets with more than 10 years to maturity

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Problems with Model

• Fundamental Problem:– When asset markets in equilibrium, flows = 0 no D/S for

currencies– Flows do not = 0: asset markets not in equilibrium uni-

directional capital flows during adjustment period; speed of adjustment to restore equilibrium

– To salvage model, need to consider growth in wealth and stock of assets

Flight to Safety

2001 09/10 09/11 09/12 09/13 09/14 09/17

A$ 1.948 1.918 1.939 1.940 1.943 1.995

Real 2.597 2.666 2.654 2.723 2.702 2.667

C$ 1.565 1.566 1.559 1.569 1.564 1.569

Euro 1.112 1.096 1.103 1.099 1.086 1.086

Rupee 47.34 47.41 47.44 47.53 47.79 47.85

Peso 9.37 9.50 9.43 9.47 9.49 9.43

Rouble 29.46 29.47 29.47 29.47 29.48 29.46

Won 1285 1291 1284 1290 1297 1299

Swiss franc 1.687 1.642 1.661 1.652 1.623 1.614

Baht 44.64 44.64 44.41 44.20 44.10 43.96

Indonesia rupiah

9101 9105 9065 9120 9095 9339

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Flight to Safety

2008 09/12 09/15 09/16 09/17 09/18 09/19

A$ 1.224 1.237 1.260 1.277 1.252 1.207

Real 1.782 1.807 1.829 1.882 1.914 1.825

C$ 1.061 1.068 1.073 1.078 1.070 1.047

Euro 0.706 0.705 0.707 0.708 0.695 0.695

Rupee 45.63 45.94 46.83 46.18 46.36 45.72

Peso 10.58 10.71 10.74 10.89 10.85 10.61

Rouble 25.57 25.57 25.59 25.62 25.38 25.36

Won 1106 1106 1159 1116 1154 1140

Swiss franc 1.134 1.119 1.120 1.121 1.099 1.111

Baht 34.67 34.58 34.25 34.33 34.12 34.12

Indonesia rupiah

9388 9449 9416 9376 9387 9348

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