Currency Basics

7/30/2019 Currency Basics

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Exchange Rates Basics


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Exchange rate is a price

the number of units of onecurrency that can be exchanged for one unit ofanother currency

Direct quote: dollars per foreign currency; e.g. 1.50$/

Indirect quote: foreign currency per dollar; e.g. 82/$

Here we are assuming dollar as the home currency

Forex market : OTC market, 24 hr market, Largestfinancial market with a daily turnover of $4 trillion

Participants: Corporate(Trade/Investment),Commercial Banks(large volumes, on behalf ofcorporations/retail), Exchange Brokers(matching

Introduction


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Real Exchange rate R = e * P /P

R is the relative price of foreign goods, as can be seen from the fact that

R = ($/foreign currency) * foreign currency price of foreign goods

$ price of domestic goods

= $ price of foreign goods / $ price of domestic goods

An increase in R is known as a depreciation of the real exchange rate

(foreign goods become more expensive) and a decrease in R is anappreciation of the real exchange rate (foreign goods become cheaper)

Note that nominal exchange rate appreciation can cause real exchangerate appreciation, all else equal, i.e. if relative prices in the two economies

do not change. However, changes in prices can cause the real exchangerate to fluctuate without an underlying change in the nominal exchangerate.

An increase in domestic prices, all else equal, will cause the realexchange rate to appreciate; A decrease in foreign prices, all else equal,

will also cause a real exchange rate appreciation


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International Exchange rate systems Gold Standard : 1876 1913

Participating countries commit to fix the prices of their domestic

currencies in terms of a specified amount of gold Important for countries to hold gold reserves Money supply growth is limited Interrupted by WWI with interrupted trade flows and free

movement of gold

Advantages: Objective system Maintain purchasing power for long periods Maintains exchange rates within narrow limits

Disadvantages: Gold value not absolutely stable over long periods Currency cannot be expanded because of requirements of trade Cannot follow independent monetary policy


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International Exchange Rate systems Bretton woods: 1944

Each country pledged to maintain a fixed or pegged exchangerate for its currency within a fixed value (+/- 1%) in terms of Gold.

IMF and world bank were created to aid countries with BOP andexchange rate problems

Only USD was convertible to gold ($35/ounce)

Devaluation was not be used as competitive trade policy If worst cases devaluation up to 10% was allowed

Triffins Criticism: With dollars piling outside USD not enough gold in US coffers

Special Drawing Rights (SDR): Reserve asset is created by IMF Initially Gold, Revised to be weighted average of 5 IMF members SDRs can be exchanged with any currency


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International Exchange Rate systems

An Eclectic Currency Arrangement, 1973 Present

Floating Rate Systems: Market forces determine exchange rates

Changes with macroeconomic variables

Insulation from shocks emanating from other

countries Helps to maintain independent monetary policy

Managed float Monetary authority intervenesactively

Independent float no monetary intervention


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International Exchange Rate systems Currency Pegging:

Developing country pegging its currency with strongcurrency or of its major trade partner

Not advised if trading is diversified; use basket ofcurrencies

Can peg to SDRs as well E.g Bulgrian Lev, Danish Krone

Crawling Peg:

Allow the peg to change over time to catch up withchanges in market determined rates

Hybrid of fixed and floating rate systems

E.g. Mexican Peso


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International Exchange Rate systems Target Zone Arrangement:

Intra-zone exchange rates are fixed

European Monetary Union before Euro

Same currency is an extension of this Euro

Currency Board: Implicit commitment to exchange domestic currency for

a specified foreign currency at a fixed exchange rate

Restrictions on issuing authority to fulfill its legal

obligation

Dollarization: Use USD as official currency of the country


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Fixed Vs Floating ExchangeRates Fixed rates provide stability in international prices

and lessen risks of all businesses

Fixed rates - Anti-inflationary requiring countryto follow restrictive monetary and fiscal policies(such policies not helpful in high unemploymentand slow economic growth)

Fixed rates central banks need to maintainlarge reserves to defend rates occasionally

Flexible rates consistency with economicfundamentals

Changes are slow and smooth


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Some Basic Determinants Differentials in Inflation

Higher inflation depreciation

Differentials in Interest Rates

High interest rates Capital inflow Currency appreciation

Current-Account Deficits High deficit more foreign currency required depreciation

Public Debt

High Debt SpendingInflationary

Debt servicing eventual default

Perceived riskiness

All above leading to depreciation


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Some Basic Determinants Terms of Trade - A ratio comparing export prices to import prices

Related to BOP and Current Account deficits

Favorable improvement - appreciation

Political Stability and Economic Performance

Capital flows are affected


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Theories behind exchange rates

International ParityConditions: Relative PPP

Interest Rate Parity

Fischer effect Balance of Payments:

Current AccountBalances

Portfolio investment FDI

Exchange rateregimes

Official monetary

reserves

Asset Approach:

Relative interest rates

Prospects ofeconomic growth

Supply and demandfor assets

Outlook for politicalstability

Speculation andLiquidity

Political risks andcontrols


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Purchasing Power Parity (PPP) Every equal product available in two countries should have the same

price

However, this strict application of the rule cannot be expected to apply,since between two countries there is only a single exchange rate linkingtheir respective currencies. This suggests that PPP only makes sensewhen applied to a bundle of goods and services, implying that weshould be looking at a price index for each country.

Then PPP tells us that there ought to be an exact connection betweeninflation rates in two countries, and changes in the exchange ratebetween them.

So why might PPP not fit the facts as well as theory suggests it should?

First, exchange rates are determined by demand and supply of

foreign exchange, which in turn depends on trade flows andinternational capital movements

Second, the usual measures of inflation are based on indexes of finalgoods prices in the domestic and foreign economies. Such indexesrarely include asset prices and rarely focus on the goods andservices that participate in trade - for instance, the consumer price

index (CPI) is often used. Third man transactions in most economies involve non-traded


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International Fisher Relation Let the nominal interest rate be r, the real rate be

R. Let the expected rate of inflation be E(I). Thenfor a given economy, Fisher claimed that:

(1 + r) = (1 + R)*(1 + E(I))

According to Fisher, R is likely to be stable overtime, hence variations in nominal interest ratesare likely to be correlated with movements ininflationary expectation

Fisher went beyond this to suggest that the realreturns available in different economies should beessentially equal

In that case, differences in nominal returnsdepend only on differences in inflationaryexpectations.


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Foreign Exchange Expectations

Relation

F = E(S1), which means that the current value of theforward exchange rate for one period ahead mustequal the current expectation of the spot rate that willprevail then

In other words, the forward exchange rate is anunbiased predictor of the future spot rate

However, sometimes it is argued that the relationship,under conditions of risk, needs to be amended by arisk premium


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Uncovered Interest Rate Parity The following equation represents uncovered

interest rate parity

Where E(St+ k) is the expected future spot exchange rate at

time t + k

kis the number of periods into the future from time

t St is the current spot exchange rate at time t

i$ is the interest rate in the US

ic is the interest rate in a foreign country orcurrency area

Approximation:


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Covered Interest Parity Summarized by equation

Where Ft is the forward exchange rate at time t


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