Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 10

Exchange Rates and Exchange Rate Systems

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-2

Introduction: Fixed, Flexible, or In-Between?

• Disagreements related to exchange rates and exchange rate systems

• Countries have numerous choices

• Exchange rate systems require different policies and respond differently to the pressures of the world economy


Exchange Rates and Currency Trading

• Exchange rate: The price of domestic currency stated in terms of another currency

• For US it is dollars per pound, or dollars per yen


• Frequently traded currencies are:

- European Union’s euro

- Japanese yen

- British pound• All three are flexible exchange rates• It doesn’t matter how many of one

currency is required to buy another• Can’t use “strong” and “weak”



Figure 10.1 Dollar Exchange Rates for Commonly Traded Currencies, 1999–2008



• Appreciation: Less domestic currency is required to buy 1 unit of foreign currency

• Depreciation: More domestic currency is required to buy 1 unit of foreign currency


Reasons for Holding Foreign Currencies

1. Trade and investment

2. Interest rate arbitrage

• Borrow money where interest rates are low and sell it where interest rates are high

• Capital inflow in high interest countries decreases interest rates

• Outflow of capital from low interest rate countries increases interest rates

• Powerful force in global economy


Reasons for Holding Foreign Currencies

3. Speculation

• speculators sell overvalued currencies and buy undervalued currencies

• Help restore equilibrium after currency has become under- or overvalued

• Some argue it can be destabilizing by leading to under- or overvalued currency


Institutions

• Four main groups involved in foreign currency markets:

– Retail customers: firms and individuals that hold foreign currency

– Commercial banks: hold inventories of foreign currencies as part the services to customer; most important of four participants

– Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency

– Central banks: a country’s bank of banks


Exchange Rate Risk

• Exchange rate risks: currencies are constantly changing in value

– Actual payment in a foreign currency will likely be a different domestic currency amount from when the contract was signed

– Created mechanisms to deal with problem.


Exchange Rate Risk

• Forward exchange rate: The price of currency that will be delivered in the future

• Forward market: A market in which the buying and selling of currencies for future delivery takes place

– Eliminates risk from future payments

– Contract is signed the day they agree to ship/receive goods that guarantees price for 30, 90, or 180 days

• Spot market: Buying and selling of foreign currencies in the present


Exchange Rate Risk

• Hedging: Use forward market to protect themselves against foreign exchange risk while holding foreign assets– Done by buying forward contract to sell foreign

currency at the same time the interest earning asset matures

– Covered interest arbitrage: Use of forward market by an interest rate arbitrageur against exchange rate risk


The Supply and Demand for Foreign Exchange

• Currency’s value is determined by its supply and demand

– Under a flexible exchange rate system currency appreciates/depreciates based on changes in supply/demand

– Under a fixed exchange rate system, the central bank counteracts changes in the market to hold currency’s value constant

• Biggest disadvantage: trade-off between supporting the exchange rate and maintaining economic growth.


TABLE 10.1 A Hypothetical Example of the Exchange Rate in the Long Run

• Purchasing power parity (PPP): the equilibrium value of an exchange rate is at the level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home


Exchange Rates in the Long Run

• PPP is underlying tendency of exchange rates in long run, not short or medium run

• If currency is over- or undervalued, automatic changes in buying/selling currency and flow of goods will restore PPP

• Usually equalization is through exchange rates, not prices

• PPP is based on goods arbitrage which fails to acknowledge other costs

Exchange Rates in the Medium Run and Short Run

• Medium run forces:

– The country’s economic growth: increases incomes, increases demand for imports and an outward shift in the demand for foreign currency, domestic currency depreciates

– Growth abroad: results in an increase of exports from the home country and an increase in the supply of foreign currency, domestic currency appreciates




• Short run (a year or less) effects on the exchange rate stem from financial capital flows

• These flows are determined by (1) interest rates and (2) expectations of future exchange rates



• Interest parity: the difference between any two countries’ interest rates is equal to the expected change in the exchange rate

– If i = i*, investors are indifferent

– If i > i*, investors prefer home to foreign investment

• Best choice is also determined by exchange rate movements during the period



• Difference between the forward exchange rate (F) and the spot rate (R) is expected appreciation or depreciation

– F > R: home currency expected to depreciate and is selling at a discount

– F<R: home currency expected to appreciate and is selling at a premium

– However, say, i < i* and F = R: no changes are expected in the exchange rate, and investors should invest in foreign



• Processes in economy continue until interest parity condition is reached

– i – i* = (F-R)/R

– Interest rate differentials are approximately equal to expected changes in the exchange rate



• Capital flight can be self-fulfilling

– If investors expect depreciation, they converts their assets to another currency

– Demand for foreign exchange increases

– Supply is depressed and currency depreciates

• Sudden shift in expectations occurs when government policies are inconsistent and unsustainable

Table 10.2 Composition of Currency Trades, April 2007


Table 10.3 Currency Trading Centers



TABLE 10.4 Major Determinants of an

Appreciation or Depreciation


The Real Exchange Rate

• Foreign prices ultimately determine the purchasing power of the domestic currency in terms of the foreign currency

– Real exchange rate: the market exchange rate (nominal exchange rate) adjusted for price differences between countries


Alternatives to Flexible Exchange Rates

• Fixed exchange rate system: The value of a nation’s money is defined in terms of a fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar); the Gold standard exchange rate system

• Flexible (floating) exchange rate system: The value of the currency is allowed to float up and down with market forces

• Purely fixed or floating systems today are rare

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

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