1 the foreign exchange market and exchange rates lecture 18
TRANSCRIPT
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The foreign Exchange market and exchange rates
Lecture 18
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Introduction
In September 1997, global financial system trembled
Currency crisis rocked Asian financial markets capital flight to US fell and so did US Exports
How investors, and individuals, make transactions when people and organizations are in different countries
Determination of exchange rates and what causes them to change overtime
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Exchange Rates and Trade
1990’s markets for goods and services and financial assets were global because of imports and exports
When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!
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How is buying a domestic good different from buying a foreign good?
Buy Pakistani good, pay in Re Buy a US good, buy $ and then pay in $ Buy too many US goods, buying too many $
that raises $ value against Re1. An increase in currency’s value as compared
to that of another is Appreciation2. A fall in value is depreciation3. Change in currency’s value can affect
domestic manufacturers and workers… How?
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Example
1DM = $0.5 1DM = $0.6
Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!
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Nominal Vs. Real Exchange Rate
Nominal ER doesn’t measure real purchasing power of the currency
Nominal: Re 1 = $1/84 = $0.0012
RER = NER x P/Pf
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REAL ER
Big Mac Example Domestic Price: Rs 300 Foreign Price: $2.56 NER = $0.0012/Re
EXr = 0.0012 x 300/2.56 =
0.14 US BM/Pak BM
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EXr is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another
CPI or Inflation Rates as the ratio of P/Pf
REAL ER
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Real ER
If EXr increases, more units of foreign goods could be traded per unit of domestic goods
Relationship between EX and EXr depends on the Rates of Inflation
%Δ ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf
ΔEX/EX = ΔEXr/EXr + (πf – π)
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Foreign Exchange Market
Market forces determine exchange rates that prevail for consumers and investors
International currencies traded in forEx markets
ForEx markets are over-the-counter markets
Currencies transactions in ForEx Markets: Spot Market and Forward Market
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Determine LR Exchange rates
Forces of Demand and Supply 1$ = Rs 60 1$ = Rs 50 Rs appreciated and $ depreciate; Qd of $
increases and Qs of Rs increased!
Price level differences P > Pf
Productivity differences Prod > Prodf
Preferences (For foreign goods) Trade Barriers
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Example
DM/$
PUS > PGER
Long Run ER
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Purchasing Power Parity Theory
Law of one price: PPP Comparison of international price of identical
good, PPP holds When extend the concept to a group of
goods, it becomes PPP theory of ER determination
Assume: EXr are constant
EX = EXr x Pf / P
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Does the Theory match Reality?
Actual ER movements are just not a reflection of changing price levels
The assumption that EXr are constant is not realistic
All goods can’t be traded because of different barriers
However, PPP is a good measure for LR determination of exchange rates
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Model for SR Exchange Rate Determination
Pakistan: Domestic, US: Foreign Rs 10000 @ 5% Year End 10000(1+0.05) = Rs 10500
Suppose Re 1 = $0.0125 Rs10000 = $125 $125 @ 5%, Year End 125(1+0.05) = $ 131.25 Convert them to Rs: $0.0125*1.05 = $0.013125 / Re $131.25/0.013125 = Rs 10000
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Cont’d
Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i) Rs (1+0.05) = Rs 1.05 Re 1 invested abroad, Rs [EX (1+if)] / EXe
0.0125(1.05)/0.013125 = Re 1
Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets
1+i = EX(1+if)/EXe
Assume: Identical risks, liquidity and info characteristics
1+i = 1+ if – ΔEXe / EX
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Model: Comparing Exp Returns on domestic and foreign assets
If EX = 97 Yen/$ R > Rf
Investors should buy local assets
If EX = 105 Yen/$ R < Rf
Investors should buy foreign assets
Exp Return in DC
Yen/$ R = i
5%
100
Rf = if – ΔEXe / EX
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ER Fluctuations
Increase in domestic ‘i’
EX appreciates
As return falls, EX depreciates
Exp Return in DC
Yen/$ R0
5%
100
Rf
R1
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ER Fluctuations
Increase in Pe
i = ier + Pe
EXe appreciation falls
Rf increases and EX depreciates
Exp Return in DC
Yen/$ R0
5%
100
Rf
R1
Rf 1
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ER Fluctuations
Rf increased
EX depreciates
Rf falls, EX appreciates
Exp Return in DC
Yen/$ R0
5%
100
Rf Rf 1
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ER Fluctuations
EXe increases Rf falls
EX appreciates
Exp Return in DC
Yen/$ R0
5%
100
Rf
Rf 1
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Currency Premiums in ForEx Markets
It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency
i = if – ΔEXe / EX – hf,d