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Chapter 14 (3)
Exchange Rates and the Foreign Exchange
Market:
An Asset Approach
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Chapter
Organization
Exchange Rates and
International Transactions
Domestic and Foreign Prices
Exchange Rates and Relative
Prices
The Foreign Exchange Market
The Actors
Box: Exchange Rates, Auto
Prices, and Currency Wars
Characteristics of the Market
Spot Rates and
Forward Rates
Foreign Exchange Swaps
Futures and Options
The Demand for Foreign Currency Assets
Assets and
Asset Returns
Box: Nondeliverable Forward Exchange
Trading in Asia
Risk and Liquidity
Interest Rates
Exchange Rates and Asset
Returns
A
Simple Rule
Return, Risk, and Liquidity in the
Foreign Exchange Market
Equilibrium in
the Foreign Exchange Market
Interest Parity: The Basic
Equilibrium Condition
How Changes in the Current Exchange
Rate Affect Expected Returns
The Equilibrium Exchange
Rate
Interest Rates, Expectations, and
Equilibrium
The
Effect of Changing Interest Rates on the Current
Exchange Rate
The Effect of Changing Expectations on
the Current Exchange Rate
Case Study: What Explains the Carry
Trade?
Summary
APPENDIX TO CHAPTER 14 (3): Forward
Exchange Rates and Covered Interest Parity
? 2015 Pearson Education Limited
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Chapter Overview
The purpose
of this chapter is to show the importance of the
exchange rate in translating foreign prices
into domestic values as well as to
begin the presentation of exchange rate
determination. Central to the
treatment
of exchange rate determination is the insight that
exchange rates are determined in the same way
a
s other asset prices. The
chapter begins by describing how the relative
prices of different countries’ goods
are affected by exchange rate changes.
This discussion illustrates the central importance
of exchange rates
for cross-border
economic linkages. The determination of the level
of the exchange rate is modeled in
the
context of the exchange rate’s role as the
relative price of foreign and domestic currencies,
using the
uncovered interest parity
relationship.
The euro is used often in
examples. Some students may not be familiar with
the currency or aware of
which
countries use it; a brief discussion may be
warranted. A full treatment of EMU and the
theories
surrounding currency
unification appears in Chapter 20(9).
The description of the foreign exchange
market stresses the involvement of large
organizations (commercial
banks,
corporations, nonbank financial institutions, and
central banks) and the highly integrated nature
of the market. The nature of the
foreign exchange market ensures that arbitrage
occurs quickly so that
common rates are
offered worldwide. A comparison of the trading
volume in foreign exchange markets to
that in other markets is useful to
underscore how quickly price arbitrage occurs and
equilibrium is restored.
Forward
foreign exchange trading, foreign exchange futures
contracts, and foreign exchange options play
an important part in currency market
activity. The use of these financial instruments
to eliminate short-run
exchange rate
risk is described.
The explanation of
exchange rate determination in this chapter
emphasizes the modern view that exchange
rates move to equilibrate asset
markets. The foreign exchange demand and supply
curves that introduce
exchange rate
determination in most undergraduate texts are not
found here. Instead, there is a discussion
of asset pricing and the determination
of expected rates of return on assets denominated
in different
currencies.
Students may already be familiar with
the distinction between real and nominal returns.
The text demonstrates
that nominal
returns are sufficient for comparing the
attractiveness of different assets. There is a
brief
description of the role played by
risk and liquidity in asset demand, but these
considerations are not
pursued in this
chapter. (The role of risk is taken up again in
Chapter 18[7].)
Substantial space is
devoted to the topic of comparing expected returns
on assets denominated in domestic
and
foreign currency. The text identifies two parts of
the expected return on a foreign currency asset
(measured in domestic currency terms):
the interest payment and the change in the value
of the foreign
currency relative to the
domestic currency over the period in which the
asset is held. The expected return
on a
foreign asset is calculated as a function of the
current exchange rate for given expected values of
the
future exchange rate and the
foreign interest rate.
The absence of
risk and liquidity considerations implies that the
expected returns on all assets traded in the
foreign exchange market must be equal.
It is thus a short step from calculations of
expected returns on foreign
assets to
the interest parity condition. The foreign
exchange market is shown to be in equilibrium only
when
the interest parity condition
holds. Thus, for given interest rates and given
expectations about future exchange
rates, interest parity determines the
current equilibrium exchange rate. The interest
parity diagram introduced
here is
instrumental in later chapters in which a more
general model is presented. Because a command of
this interest parity diagram is an
important building block for future work, we
recommend drills that
employ this
diagram.
The result that a dollar
appreciation makes foreign currency assets more
attractive may appear counterintuitive
to students
—
why
does a stronger dollar reduce the expected return
on dollar assets? The key to explaining
this point is that, under the static
expectations and constant interest rates
assumptions, a dollar appreciation
today implies a greater future dollar
depreciation; so, an American investor can expect
to gain not only the
Chapter 14
Exchange Rates and the Foreign Exchange
Market: An Asset Approach
77
foreign interest payment
but also the extra return due to the dollar’s
additional future depreciation. The
following diagram illustrates this
point. In this diagram, the exchange rate at time
t
?
1
is expected to be
equal to
E
. If the exchange rate at
time
t
is also
E
,
then expected depreciation is 0. If,
however, the exchange
rate depreciates
at time
t
to
E
??
then it must
appreciate to reach
E
at
time
t
??
1. If the exchange rate
appreciates
today to
E
??
then it must
depreciate to reach
E
at
time
t
??
1. Thus, under static
expectations, a depreciation
today
implies an expected appreciation and vice versa.
Figure 14(3)-1
This pedagogical tool can be employed
to provide some further intuition behind the
interest parity
relationship. Suppose
that the domestic and foreign interest rates are
equal. Interest parity then requires
that the expected depreciation is equal
to zero and that the exchange rate today and next
period is equal
to
E
. If the domestic interest
rate rises, people will want to hold more domestic
currency deposits. The
resulting
increased demand for domestic currency drives up
the price of domestic currency, causing the
exchange rate to appreciate. How long
will this continue? The answer is that the
appreciation of the
domestic currency
continues until the expected depreciation that is
a consequence of the domestic
currency’s appreciation today just
offsets the interest differential.
The text presents exercises on the
effects of changes in interest rates and of
changes in expectations of
the future
exchange rate. These exercises can help develop
students’ intuition. For example, the initial
result of a rise in U.S. interest rates
is a higher demand for dollar-denominated assets
and thus an increase
in the price of
the dollar. This dollar appreciation is large
enough that the subsequent expected dollar
depreciation just equalizes the
expected return on foreign currency assets
(measured in dollar terms) and
the
higher dollar interest rate.
The
chapter concludes with a case study looking at a
situation in which interest rate parity may not
hold:
the carry trade. In a carry
trade, investors borrow money in low-interest
currencies and buy high-interest-
rate
currencies, often earning profits over long
periods of time. However, this transaction carries
an element
of risk as the high-
interest-rate currency may experience an abrupt
crash in value. The case study discusses
a popular carry trade in which
investors borrowed low-interest-rate Japanese yen
to purchase high-interest-
rate
Australian dollars. Investors earned high returns
until 2008, when the Australian dollar abruptly
crashed,
losing 40 percent of its
value. This was an especially large loss as the
crash occurred amidst a financial
crisis in which liquidity was highly
valued. Thus, when we factor in this additional
risk of the carry trade,
interest rate
parity may still hold.
The Appendix
describes the covered interest parity relationship
and applies it to explain the determination
of forward rates under risk neutrality
as well as the high correlation between movements
in spot and
forward rates.
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2015 Pearson Education Limited
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Answers to
Textbook Problems
1.
At an exchange rate of 1.05 $$ per euro,
a 5 euro bratwurst costs 1.05$$/euro
?
5 euros
?
$$5.25. Thus,
the bratwurst in Munich is $$1.25 more
expensive than the hot dog in Boston. The relative
price is
$$5.25/$$4
?
1.31. A bratwurst costs
1.31 hot dogs. If the dollar depreciates to
1.25$$/euro, the bratwurst
now costs
1.25$$/euro
?
5 euros
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$$6.25, for a relative
price of $$6.25/$$4
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1.56.
You have to give up
1.56 hot dogs to
buy a bratwurst. Hot dogs have become relatively
cheaper than bratwurst after the
depreciation of the dollar.
2.
If it were cheaper to buy
Israeli shekels with Swiss francs that were
purchased with dollars than to
directly
buy shekels with dollars, then people would act
upon this arbitrage opportunity. The demand
for Swiss francs from people who hold
dollars would rise, causing the Swiss franc to
rise in value
against the dollar. The
Swiss franc would appreciate against the dollar
until the price of a shekel
would be
exactly the same whether it was purchased directly
with dollars or indirectly through Swiss
francs.
3.
Take for example the exchange rate
between the Argentine peso, the US dollar, the
euro, and the
British pound. One dollar
is worth 5.3015 pesos, while a euro is worth
7.0089 pesos. To rule out
triangular
arbitrage, we need to see how many pesos you would
get if you first bought euros with
your
dollars (at an exchange rate of 0.7564 euros per
dollar), then used these euros to buy pesos. In
other words, we need to compute
E
= E
EUR/USD
×
E
ARG/EUR
=
0.7564×
7.0089 = 5.3015 pesos
per dollar. This is almost exactly
(with rounding) equal to the direct rate of pesos
per dollar.
Following the same
procedure for the British pound yields a similar
result.
We need
to say that triangular arbitrage is
“approximately” ruled out for several reasons.
First,
rounding error means that there
may be some small discrepancies between the direct
and indirect
exchange rates we
calculate. Second, transactions costs on trading
currencies will prevent complete
arbitrage from occurring. That said,
the massive volume of currencies traded make these
transactions
costs relatively small,
leading to “near” perfect arbitrage.
4.
A
depreciation of Chinese yuan makes the import more
expensive. Since the demand for oil is
inelastic, China needs to import oil
from the oil exporting countries. This leads to
spending more on
oil when the exchange
rate falls in value. This can cause the balance of
payment to worsen in the
short run.
Hence, a depreciation of domestic currency may or
may not have a favourable impact on
the
balance of payment in the short run.
5.
The dollar rates of
return are as follows:
a.
($$250,000
?
$$200,000)/$$200,000
?
0.25.
b.
($$275
?
$$255)/$$255
?
0.08.
c.
There are two parts to this return. One
is the loss involved due to the appreciation of
the dollar;
the dollar appreciation is
($$1.38
?
$$1.50)/$$1.50
?
?
0.08. The other part of the
return is the interest
paid by the
London bank on the deposit, 10 percent. (The size
of the deposit is immaterial to the
calculation of the rate of return.) In
terms of dollars, the realized return on the
London deposit
is thus 2 percent per
year.
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