goethe business school chapter ix: exchange rates a.what is an exchange rate? b.purchasing power...
TRANSCRIPT
Goethe Business SchoolGoethe Business School
Chapter IX: Exchange ratesA. What is an exchange rate?
B. Purchasing power parity (long run)
C. Exchange rates in the short run
D. The organization of foreign exchange markets
E. Exchange rate crises
F. Interventions in foreign exchange markets
Goethe Business SchoolGoethe Business School
2
What is an “exchange rate”? The price of one currency in terms
of another (say dollars per euro) is called the exchange rate
Foreign exchange (forex) transactions are effected on specific markets for: spot transactions; forward transactions; futures transactions; options
Goethe Business SchoolGoethe Business School
3
Appreciation and depreciation
If you pay more € for forex, your currency € is said to “depreciate”; if you pay less, your currency “appreciates”
w=€/$Depreciation
w=€/$Appreciation
Goethe Business SchoolGoethe Business School
4
Why are exchange rates important? They affect the relative price of domestic
and foreign goods When a country’s currency appreciates,
the country’s goods become more expensive abroad, and foreign goods become cheaper
Will the exchange rate equate foreign and domestic prices?
Goethe Business SchoolGoethe Business School
5
The law of one price
Under market conditions, arbitrage will indeed equate prices in the different regions of the domestic economy
If there are no barriers to trade, this also applies to international trade
If the price level in country A is higher than in country B, the exchange rate should correct for this difference
Goethe Business SchoolGoethe Business School
6
The law of one price Identical goods should sell for the same price in
two separate markets when there are no transportation costs and no differential taxes applied in the two markets
Consider the following information about movie video tapes sold in the US and Mexican markets: Price of videos in US market (Pv) = $20
Price of videos in Mexican market (Pv) = p150
Spot exchange rate (p/$) = 10 p/$
Goethe Business SchoolGoethe Business School
7
The law of one price The dollar price of videos sold in Mexico can be
calculated by dividing the video price in pesos by the spot exchange rate
If the law of one price held, then the dollar price would have to be p150/10p/$ = $15 in Mexico to match the price in the US
Since the dollar price of the video is less than the dollar price in the US, the law of one price does not hold in this circumstance
If the law holds, we speak of “purchasing-power parity” (PPP)
Goethe Business SchoolGoethe Business School
10
PPP and short-term exchange rate
PPP, et
Time t
Short-term exchange rate (e)
PPP
Goethe Business SchoolGoethe Business School
11
The purchasing power parity (PPP) theory
The PPP theory makes sense only in the long run
In the short run there are significant deviations from PPP due to short-term movements of capital
Goethe Business SchoolGoethe Business School
12
Readings
Reading 9-1: “Purchasing Power Parity”, OECD, Main Economic Indicators, May 2005
Reading 9-2: “Big Mac Index”, The Economist, December 16, 2004
Goethe Business SchoolGoethe Business School
13
Factors that affect exchange rates: long run Factors that affect the exchange rates are
(w = depreciation, w = appreciation): Relative price levels: if P/P*, then w Tariffs and quota: if import duty , then w A shift in preferences for domestic
versus foreign goods: if export demand , then w if import demand , then w
Productivity: If productivity , then w
Goethe Business SchoolGoethe Business School
14
Exchange rates in the short run The theory of the long-run behavior of
exchange rates cannot explain the large changes of current (spot) exchange rates
In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $)
Goethe Business SchoolGoethe Business School
15
Comparing expected returns across nations We consider Euroland the “home country”, and
the domestic currency €. The USA are the “foreign country” with the
foreign currency $.Euro deposits bearan interest rate i€.
Dollar deposits bearan interest rate i$.
How does Hans, the European, compare the return on dollar deposits abroad
with the return on domesticinvestments in € ?
Goethe Business SchoolGoethe Business School
16
Comparing expected returns across nations If Hans invests in the USA, he must realize that
his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €
If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%
Goethe Business SchoolGoethe Business School
17
Comparing expected returns across nations More formally
€
RET$(€) = i$ −w e t+1 −wtwt
€
Differential RET (€) = i€ − (i$ −w e t+1 −wtwt
)
= i€ − i$ +w e t+1 −wtwt
Goethe Business SchoolGoethe Business School
18
Comparing expected returns across nations If Bill invests in Euroland, he must realize
that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $
If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€ ), then the expected return is 3%+10%=13%
Goethe Business SchoolGoethe Business School
19
Comparing expected returns across nations More formally
€
RET€($) = i€ +w e t+1 −wtwt
€
Differential RET ($) = i$ − (i€ +w e t+1 −wtwt
)
= i$ − i€ −w e t+1 −wtwt
Goethe Business SchoolGoethe Business School
20
The key point:RET$ and RET€ are symmetrical (with opposite sign)
As the relative expected return on €-deposits increases, both domestic and foreign residentsrespond in the same way: they want to holdmore €-deposits and fewer deposits in $€
- Differential RET ($){ } = − i$ − i€ −
w e t+1 −wtwt
⎧ ⎨ ⎩
⎫ ⎬ ⎭
= i€ − i$ +w e t+1 −wtwt
€
Differential RET (€) = i€ − i$ +w e t+1 −wtwt
Goethe Business SchoolGoethe Business School
21
Interest parity condition
At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk
When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:
€
i€ = i$ −w e t+1 −wtwt
Goethe Business SchoolGoethe Business School
22
Why? Arbitrage and liquidity trading
Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition
Goethe Business SchoolGoethe Business School
23
The organization of globalforex markets
Paul Bernd SpahnPaul Bernd SpahnPaul Bernd Spahn
EuroEuroEuro
Goethe Business SchoolGoethe Business School
24
Fx transactions by currency pairs, 2004 (in %)
¥
$ € Other
€ 28
17 3
£ 14 2
SFr 4 1
Other 26 2 2
Goethe Business SchoolGoethe Business School
25
Volume of fx transactions in bill. US $, daily (April)
Goethe Business SchoolGoethe Business School
26
Fx transactions by market place (April 2001)
Geographical distribution of fx turnover, 2004
United Kingdom32%
United States20%Japan
8%
Singapore5%
Germany5%
Hong Kong4%
Australia3%
Switzerland3%
France3%
Canada2%
Other15%
Goethe Business SchoolGoethe Business School
28
Which type of activities must be distinguished ?
Financing of real economic activity Exports and imports Foreign direct investment
Portfolio management Life insurers Investment funds Hedge funds
Liquidity trading (arbitraging) Speculative „noise trading“
Goethe Business SchoolGoethe Business School
30
Actors in forex markets
Reported fx market turnover by counterparty, 2004
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1995 1998 2001 2004
With non-financial customers
With other financial institutions
With reporting dealers
Goethe Business SchoolGoethe Business School
31
And will be concentrated even more …
Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology
Goethe Business SchoolGoethe Business School
34
Interventions in forex markets
Our analysis of foreign exchange markets assumed completely free markets so far
In practice, there are also monetary policy interventions in these markets
Under the present system („managed floating” or „dirty floating“), exchange rates might fluctuate daily, but central banks attempt to „smooth“ price behavior in the very short run, and even over some extended period of time
Goethe Business SchoolGoethe Business School
35
Forex interventions By statute, Treasuries (governments) possess
typically the lead role in setting forex policy, but in practice it is usually based on a consensus between the government and the central bank
However stabilizing forex interventions for longer periods have become extremely rare in the US (‘benign neglect’) and in the EU
In carrying out stabilizing interventions, the central bank sells/buys international reserves
Goethe Business SchoolGoethe Business School
36
Balance sheet of a central bank
Assets Liabilities
Base moneyGold
International reserves
Securities
Goethe Business SchoolGoethe Business School
37
Sterilized intervention in forex markets If a central bank buys/sells international
reserves, this has the same effect on the monetary base as OMOs
If the central bank allows this effect to happen, this is called an “unsterilized foreign exchange intervention”
If the expansionary (or contractionary) effect on base money is offset by a counteracting OMO, this is called “sterilization”
Goethe Business SchoolGoethe Business School
38
“Sterilized” forex intervention
Central BankAssets Liabilities
Foreign assets(International reserves)
-€1 billion
Government bonds
+€1 billion
Monetary base(reserves)
Remains unchanged
Goethe Business SchoolGoethe Business School
39
Unsterilized forex intervention
As this type of policy is equivalent to an OMO, it also produces the same results
An increase in the money supply leads to a higher price level in the long run, and hence to a devaluation of the currency
This increases the expected return on foreign deposits, and shifts the RETF-schedule to the right
Goethe Business SchoolGoethe Business School
40
Effect of a purchase of $ against €
Exchange rate($/€)
Expected return in €
1
RETF1RETD
1
iD1
E1
2
RETF2
E2
Goethe Business SchoolGoethe Business School
41
The long-run adjustment process In the short run, not only the return on
foreign asset increases, but also the return on domestic assets declines
The short-run outcome is a fall in the exchange rate from E1 to E3
In the long run, however, the domestic interest rate returns to the former level.
The exchange rate moves back to its new longer term position at point E2
Goethe Business SchoolGoethe Business School
42
Effect of a purchase of $ against €
Exchange rate($/€)
Expected return in €
1
2
RETF2
RETF1RETD
1
iD1iD2
E1
E2
3
RETD2
E3
In the long run the RETD-curvemoves back to theoriginal position.
In the short run the RETD-curvemoves to the left
Goethe Business SchoolGoethe Business School
43
Consequences An unsterilized intervention in which domestic
currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency
An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency
Goethe Business SchoolGoethe Business School
Reading 9-3: “The domino effect”, The Economist, July 3rd, 2008
44
Goethe Business SchoolGoethe Business School
45
Discussion 9: Dealing with exchange rates Why is understanding exchange rates so
important for businesses, even for non-financial firms?
What could decision makers do to hedge against exchange rate risks?
Should governments or central banks try to intervene in the exchange markets?