INTERNATIONAL FINANCE LESSON 3

real exchange rate  Asset market approach  Uncovered interest rate parity...  Price of foreign currency in terms of national currency  How many units of national currency do we need

Exchange Rates

Antu Panini Murshid

Today’s Agenda

 Nominal vs real exchange rate

 Asset market approach

 Uncovered interest rate parity

Currencies and Exchange

Rates

 Each country has a currency in which

the prices of goods and services are quoted

 An exchange rate is the price of one

currency in terms of another This is sometimes called the nominal

exchange rate

 An exchange rate can be quoted in

two ways

 Direct (American) terms and indirect

(European) terms

 In this course we will always (unless

otherwise stated) quote the exchange rate in direct terms

Exchange Rate Quoting

 Price of foreign currency in terms of

national currency

 How many units of national currency

do we need to buy a unit of foreign currency

 Example $/€, $/¥

 Today’s dollar-euro exchange rate is

$1.07384 per euro

Direct Terms

 Price of national currency in terms of

foreign currency

 How many units of foreign currency do

we need to buy a unit of national

 A depreciation of the dollar against the

euro means that the price of a euro in terms of dollars has gone up

 An appreciation of the dollar against

the euro means that the price of a euro

in terms of dollars has gone down

Appreciation and Depreciation

of a Currency

 If the dollar depreciates against the

euro this must mean that the euro has appreciated against the dollar

 If the dollar appreciates against the

euro this must mean that the euro has depreciated against the dollar

Appreciation and Depreciation

of a Currency

 An exchange rate depreciation means the

domestic currency has depreciated and an exchange rate appreciation means the

domestic currency has appreciated

 If the exchange rate depreciates then e↑

 If the exchange rate appreciates then e↓

Appreciation and Depreciation

of the Exchange Rate

 If the $/€ exchange rate moves from e=1.00

to e=.95….

 exchange rate has appreciated by 5%

 Dollar has appreciated against the euro by

5% (it now cost $0.95 as opposed to $1 to buy €1) and the euro has depreciated

against the dollar by approximately 5% (it now costs €1.05 to buy $1)

Example

 Suppose a car in UK costs ₤30,000, if

e=1.50, then dollar price is $45,000,

i.e the price of foreign goods in terms

of domestic currency is eP f

 Suppose the same car in the US costs

$36,000, then the price of the foreign car in terms of the price of domestic

cars is eP f /P=1.25

Real Exchange Rate

 The real exchange rate (θ) gives the

price of a unit of a foreign goods, in terms of the price of domestic goods

 That is θ = eP f / P, where P is the

domestic price level and P f is foreign

price level

Real Exchange Rate

 If θ↑ we say that the real exchange

rate has depreciated

 θ↑ if either e↑ P↓ or P f ↑

 If θ↓ we say that the real exchange

rate has appreciated

 θ↓ if either e↓ P↑ or P f ↓

Real Exchange Rate

Appreciation/Depreciation

 If the real exchange rate depreciates, the

price of foreign goods relative to the price of domestic goods increases and exports

become more competitive while imports

become more expensive

 If the real exchange rate appreciates, the

price of foreign goods relative to the price of domestic goods decreases and exports

become less competitive while imports

become cheaper

Foreign Exchange Market

 Players in the foreign exchange market

 Commercial banks, large corporations, non-bank

financial institutions, central banks

 Commercial banks are by far the largest

players in the foreign exchange market

However large corporations like IBM and GE also engage in significant transactions

Another groups of important players are

central banks

Foreign Exchange Market

 Characteristics of the market

 The main markets are London, New York,

Tokyo

 Daily global value of forex trading $1.7

trillion

 $ vehicle currency

Determination of the Spot

Exchange Rate

 What determines the exchange rate?

 Demand and supply

 What factors might affect demand and

Expected Returns

 Expected rate of return

 Risk and liquidity

 We will abstract from risk and liquidity

for now and assume that these

characteristics are the same across

different assets If this is the case, we will prefer to hold assets offering the highest expected rate of return

How Do We Compare Returns on

Various International Assets?

 $-assets pay returns in dollars

 €-assets pay returns in euros

 In order to compare these returns, we

need to measure all returns in terms of one currency

How Do We Compare Returns on

Various International Assets?

 But why does it matter, isn’t 5%

interest in the US just the same as 5%

in Germany?

 No…because the exchange rate

between dollar and the euro may

change

 Suppose the $/€ exchange rate is 1.00

 The interest rate in the US is 10%

 The interest rate in Germany is 5%

 Expect $/€ exchange rate to be 1.10

 Which asset offers the highest rate of

return?

 Gross return on $1 deposited at a US

bank is $1.10

 What is the gross return on $1

deposited in a German bank?

Equilibrium Exchange Rate

 If the rate of return on dollar assets is

greater than the dollar rate of return on euro assets there will be an excess demand for dollar assets

 If the rate of return on dollar assets is less

than the dollar rate of return on euro assets there will be an excess demand for euro

assets

 Only when the rate of return on dollar assets

is equal to the rate of return on euro assets will the exchange rate be in equilibrium

Uncovered Interest Rate Parity Condition

 The UCIP condition states that the

return to investing in domestic assets must equal the expected return on

investing in foreign assets (when the returns are measured in the same

currency)

 i ≈ i f + %E(∆e)

Example: UCIP Holds

 i = 10% (US rate), i f = 5% (German

rate), e t = 1.00 ($/€) and E(e t+1 ) = 1.05

 Expected return to a $100 investment in

€-denominated German asset is:

Example: UCIP Doesn’t Hold

asset is 8%+5%=13% > 10% ($-return on

US asset)

 $ depreciates immediately (e↑) e = 1.03.

 Since E(e t+1 ) = 1.05, %E(∆e)=2%

 Hence %E(∆e)+i f =8%+2%=10%=i

Example: UCIP Doesn’t Hold

 Suppose now instead that the domestic

interest rate increases such that i = 12% (US rate) If i f = 5% (German rate), e t =

demand for US assets increases and the

dollar appreciates to e t = 0.98 Thus

%E(∆e)=7%, so UCIP is again restored

$-Return on Foreign Assets

and the Exchange Rate

1.10

1.00 0.95 1.05

Equilibrium Exchange Rate— Graphical Representation

Rate of return on dollar assets

Expected return on

€ assets

UIPC holds—

equilibrium exchange rate

Domestic interest rate increases

New equilibrium—the exchange rate

appreciates today and UCIP is restored

e 2

Foreign interest rate increases

e 2

Rise in expected future price of euros