8/7/2022

International Finance

Chapter 3
Exchange Rates and the
Foreign Exchange Market:
An Asset Approach

Learning Objectives
3.1 Relate exchange rate changes to changes in the
relative prices of countries’ exports.
3.2 Describe the structure and functions of the foreign
exchange market.
3.3 Use exchange rates to calculate and compare returns
on assets denominated in different currencies.
3.4 Apply the interest parity condition to find equilibrium
exchange rates.
3.5 Find the effects of interest rates and expectation shifts
on exchange rates.

Preview
• The basics of exchange rates
• Exchange rates and international relative prices
• Demand and equilibrium in the foreign exchange market
• The demand of currency and other assets
• A model of foreign exchange markets
– role of interest rates on currency deposits/bonds
– role of expectations of exchange rates
– forward exchange rates and covered interest parity

1
 8/7/2022

Definitions of Exchange Rates

• Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency.
– How much can be exchanged for one dollar?
$0.01027
– How much can be exchanged for one yen?
¥
• Exchange rates allow us to denominate the cost or price of a
good or service in a common currency.
– How much does a Nissan cost? ¥2,500,000

– Or, ¥2,500,000  $0.01027

 $25,672.50
¥

Table 3.1 Exchange Rate Quotations (1 of 5)

Currencies

DOLLAR POUND
DOLLAR Day’s EURO EURO POUND Day’s
Jun 3 Currency Closing Mid Change Closing Mid Day’s Change Closing Mid Change
Argentina Argentine Peso 68.8026 0.0953 77.1927 0.3569 86.6673 0.3917
Australia Australian Dollar 1.4423  0.0088 1.6181  0.0046
Ne g a ti v e 0.008 8
1.8168 Ne g a ti v e 0.004 6
 0.0053 Ne g a ti v e 0.005 3

Bahrain Bahraini Dinar 0.3772 0.0000 0.4231 0.0013 0.4751 0.0014

Bolivia Bolivian Boliviano 6.9100 7.7526 0.0251
Bl a n k

8.7042 0.0273
Brazil Brazilian Real 5.0281  0.1935 5.6412  0.1981
Ne g a ti v e 0.193 5
6.3336 Ne g a ti v e 0.198 1
 0.2231 Ne g a ti v e 0.223 1

Canada Canadian Dollar 1.3489 0.0001 1.5133 0.0050 1.6991 0.0055

Chile Chilean Peso 764.9900  15.2950 858.2761  14.3210
Ne g a ti v e 15.29 50
963.6213 Ne g a ti v e 14.32 10
 16.1809 Ne g a ti v e 16.18 09

China Chinese Yuan 7.1099  0.0006 7.9769 0.0252

Ne g a ti v e 0.000 6
8.9560 0.0274
Colombia Colombian Peso 3579.3300  46.9050 4015.8094  39.4294 4508.7106
Ne g a ti v e 46.90 50 Ne g a ti v e 39.42 94
 44.7456 Ne g a ti v e 44.74 56

Costa Rican
Costa Rica Colon 577.1050 1.7850 647.4796 4.0960 726.9515 4.5235
Czech
Republic Czech Koruna 23.7213 0.0004 26.6139 0.0868 29.8805 0.0943
Denmark Danish Krone 6.6449  0.0199 7.4552 0.0019 8.3702 0.0012
Neg ativ e 0 .0 19 9

Egypt Egyptian Pound 16.0836 0.1097 18.0449 0.1812 20.2598 0.2014

Hong Kong Hong Kong Dollar 7.7503  0.0002 Ne g a ti v e 0.000 2
8.6953 0.0279 9.7626 0.0303

Table 3.1 Exchange Rate Quotations (2 of 5)

DOLLAR POUND
DOLLAR Day’s EURO EURO POUND Day’s
Jun 3 Currency Closing Mid Change Closing Mid Day’s Change Closing Mid Change
Hungary Hungarian Forint 306.7205  2.1010 344.1232  1.2335
Ne g a ti v e 2.101 0

386.3611 1

 1.4253 Ne g a ti v e 1.425 3

India Indian Rupee 75.4700 0.1075 84.6731 0.3948 95.0659 0.4334

Indonesian  322.5000 15830.6500  349.1678
14110.0000 Neg ativ e 3 2 2 .5 000

 309.3157 17773.7017
Ne g a ti v e 309 .3 157 Ne g a ti v e 349 .1 678

Indonesia Rupiah
Israel Israeli Shekel 3.4763 0.0030 3.9002 0.0161 4.3789 0.0176
Japan Japanese Yen 108.8250 0.2400 122.0956 0.6644 137.0816 0.7317
..One Month 108.8249
Bl a n k
0.2399 122.0956 0.6644 137.0816 0.7316
..Three Month 108.8248
Bl a n k
0.2397 122.0956 0.6645 137.0815 0.7314
..One Year 108.8242
Bl a n k
0.2384 122.0957 0.6647 137.0816 0.7309
Kenya Kenyan Shilling 106.1000  0.3500
Ne g a ti v e 0.350 0

119.0383  0.0054 Ne g a ti v e 0.005 4

133.6491  0.0199
Ne g a ti v e 0.019 9

Kuwait Kuwaiti Dinar 0.3081  0.0002 Ne g a ti v e 0.000 2

0.3457 0.0010 0.3881 0.0010

Malaysia Malaysian Ringgit 4.2625  0.0150 Ne g a ti v e 0.015 0

4.7823  0.0013 Ne g a ti v e 0.001 3

5.3693  0.0020 Ne g a ti v e 0.002 0

Mexico Mexican Peso 21.5950  0.0380 Ne g a ti v e 0.038 0

24.2284 0.0361 27.2022 0.0377

New Zealand New Zealand 1.5570  0.0139 Ne g a ti v e 0.013 9

1.7469  0.0099
Neg ativ e 0 .0 09 9

1.9613  0.0113 Ne g a ti v e 0.011 3

Nigeria Nigerian Naira 388.1800 1.4300 435.5163 3.0116 488.9718 3.3307

Norway Norwegian Krone 9.4775  0.0501 Ne g a ti v e 0.050 1

10.6332  0.0215 Ne g a ti v e 0.021 5

11.9384  0.0254 Ne g a ti v e 0.025 4

2
 8/7/2022

Table 3.1 Exchange Rate Quotations (3 of 5)

DOLLAR POUND
DOLLAR Day’s EURO EURO POUND Day’s
Jun 3 Currency Closing Mid Change Closing Mid Day’s Change Closing Mid Change
Pakistan Pakistani Rupee 164.2000  0.8500 n e g a ti ve 0.85 00

184.2232  0.3531 206.8349 Ne g a ti v e 0.353 1

 0.4180
Ne g a ti v e 0.418 0

Peruvian Nuevo
3.3860  0.0145 Ne g a ti v e 0.014 5

3.7989  0.0039 Ne g a ti v e 0.003 9

4.2652  0.0048
Ne g a ti v e 0.004 8

Peru Sol
Philippines Philippine Peso 50.1200  0.2250 Ne g a ti v e 0.225 0

56.2318  0.0693 Ne g a ti v e 0.069 3

63.1338  0.0843
Ne g a ti v e 0.084 3

Poland Polish Zloty 3.9347 0.0150 4.4145 0.0311 4.9564 0.0345

Romania Romanian Leu 4.3079  0.0185 Ne g a ti v e 0.018 5

4.8333  0.0050 Ne g a ti v e 0.005 0

5.4265  0.0062
Ne g a ti v e 0.006 2

Russia Russian Ruble 68.6488  0.1112 Ne g a ti v e 0.111 2

77.0201 0.1254 86.4735 0.1318

Saudi Arabia Saudi Riyal 3.7550 0.0015 4.2128 0.0153 4.7299 0.0167
Singapore Singapore Dollar 1.3970  0.0026 Ne g a ti v e 0.002 6

1.5674 0.0022 1.7597 0.0023

South African
16.9163  0.1885 Ne g a ti v e 0.188 5

18.9791  0.1492 Ne g a ti v e 0.149 2

21.3086  0.1698
Ne g a ti v e 0.169 8

South Africa Rand

South Korean  8.7500  5.3583
1216.6500 Ne g a ti v e 8.750 0

1365.0135 Ne g a ti v e 5.358 3

1532.5558  6.1763
Ne g a ti v e 6.176 3

South Korea Won

Sweden Swedish Krona 9.2891  0.0357 Ne g a ti v e 0.035 7

10.4219  0.0062 Ne g a ti v e 0.006 2

11.7011  0.0082
Ne g a ti v e 0.008 2

Switzerland Swiss Franc 0.9621 0.0015 1.0794 0.0051 1.2118 0.0056

New Taiwan
29.8745  0.0800
Ne g a ti v e 0.080 0

33.5175 0.0192 37.6315 0.0177

Taiwan Dollar
Thailand Thai Baht 31.5525 Bl a n k

35.4001 0.1148 39.7452 0.1248

Tunisia Tunisian Dinar 2.8531  0.0050 3.2010 0.0048 3.5939 0.0051

Table 3.1 Exchange Rate Quotations (4 of 5)

POUND
DOLLAR DOLLAR EURO EURO POUND Day’s
Jun 3 Currency Closing Mid Closing Mid Closing Mid Day’s Change Closing Mid Change
Turkey Turkish Lira 6.7298  0.0028 7.5504 0.0214 8.4771Ne g a ti v e 0.002 8

0.0232
United Arab
3.6732 Bl a n k

4.1211 0.0134 4.6269 0.0145

Emirates UAE Dirham
United
0.7939  0.0025
Ne g a ti v e 0.002 5

0.8907 0.0001 Bl a n k Bl a n k

Kingdom Pound Sterling

..One Month 0.7939  0.0025 Ne g a ti v e 0.002 5

0.8906 0.0001 Bl a n k Bl a n k

..Three Month 0.7939  0.0025

Ne g a ti v e 0.002 5

0.8905 0.0001 Bl a n k Bl a n k

..One Year 0.7941  0.0025 Ne g a ti v e 0.002 5

0.8901 0.0001 Bl a n k Bl a n k

United States Bl a n k

1.1219
Ne g a ti v e 1.121 9 Bl a n k

0.0036 1.2597 0.0040

United States Dollar
..One Month Bl a n k

1.1219 Ne g a ti v e 1.121 9 Bl a n k
 0.1338 Ne g a ti v e 0.133 8

1.2597 0.0040
..Three Month Bl a n k

1.1217 Ne g a ti v e 1.121 7 Bl a n k

 0.1338 Ne g a ti v e 0.133 8

1.2597 0.0040
..One Year Bl a n k Bl a n k

1.1210  0.1338 Ne g a ti v e 0.133 8

1.2599 0.0040
Venezuelan Bl a n k Bl a n k Bl a n k Bl a n k Bl a n k Bl a n k

Venezuela Bolivar Fuerte

Vietnamese
23262.0000 5.5000 26098.6896 90.7520 29302.0544 98.8350
Vietnam Dong

Table 3.1 Exchange Rate Quotations (5 of 5)

DOLLAR EURO POUND
DOLLAR Day’s EURO Day’s POUND Day’s
Jun 3 Currency Closing Mid Change Closing Mid Change Closing Mid Change
European
0.8913  0.0029
Ne g a ti v e 0.002 9 Bl a n k Bl a n k

1.1227  0.0001
Ne g a ti v e 0.000 1

Union Euro

..One Month Bl a n k
0.8912  0.0029
Ne g a ti v e 0.002 9 Bl a n k Bl a n k

1.1227  0.0001
Ne g a ti v e 0.000 1

..Three
0.8911  0.0029
Ne g a ti v e 0.002 9 Bl a n k Bl a n k

1.1226  0.0001
Ne g a ti v e 0.000 1

Month Bl a n k

..One Year Bl a n k
0.8903  0.0029
Ne g a ti v e 0.002 9 Bl a n k Bl a n k

1.1221  0.0001 Ne g a ti v e 0.000 1

Rates are derived from WM Reuters Spot Rates and MorningStar (latest rates at time of
production). Some values are rounded. Currency redenominated by 1000. The exchange
rates printed in this table are also available at www.FT.com/marketsdata.

3
 8/7/2022

Depreciation and Appreciation (1 of 5)

• Depreciation is a decrease in the value of a currency
relative to another currency.
– A depreciated currency is less valuable (less
expensive) and therefore can be exchanged for (can
buy) a smaller amount of foreign currency.
– $1  €  $1.20  € means that the dollar has depreciated
relative to the euro. It now takes $1.20 to buy one euro,
so that the dollar is less valuable.
– The euro has appreciated relative to the dollar:
it is now more valuable.

Depreciation and Appreciation (2 of 5)

• Appreciation is an increase in the value of a currency
relative to another currency.
– An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for (can
buy) a larger amount of foreign currency.
– $1  €  $0.90  € means that the dollar has appreciated
relative to the euro. It now takes only $0.90 to buy one
euro, so that the dollar is more valuable.
– The euro has depreciated relative to the dollar:
it is now less valuable.

Depreciation and Appreciation (3 of 5)

• A depreciated currency is less valuable, and therefore it can buy
fewer foreign produced goods that are denominated in foreign
currency.
¥2,500,000  $0.01027
– A Nissan costs  $25,672.50
¥
$0.011185
– Less expensive than $27,962.50 at
¥
• A depreciated currency means that imports are more expensive
and domestically produced goods and exports are less
expensive.
• A depreciated currency lowers the price of exports relative to
the price of imports.

4
 8/7/2022

Depreciation and Appreciation (4 of 5)

• An appreciated currency is more valuable, and therefore it can buy more
foreign produced goods that are denominated in foreign currency.

$0.011185
– A Nissan costs ¥2,500,000  $27,962.50 at
¥

– becomes less expensive $0.010

$25,000 at
¥

• An appreciated currency means that imports are less expensive and

domestically produced goods and exports are more expensive.
• An appreciated currency raises the price of exports relative to the price
of imports.

Depreciation and Appreciation (5 of 5)

• Table 3.2 shows the relative prices implied by exchange
rates of $1.25 per pound, $1.50 per pound, and $1.75 per
pound.
• If the good’s money prices do not change, an
appreciation of the dollar against the pound makes
sweaters more expensive in terms of jeans (each pair of
jeans buys fewer sweaters).
• All else equal, an appreciation of a country’s
currency raises the relative price of its exports to its
imports, while a depreciation lowers the relative price
of its exports to its imports.

Table 3.2 $ / £ Exchange Rates and the Relative Price of

Dollars per pound

American Designer Jeans and British Sweaters

Exchange rate $ / £ Do l l a rs p er pou nd 1.25 1.50 1.75

Relative price (pairs of jeans/sweater) 1.39 1.67 1.94

Note: The above calculations assume unchanged money

prices of $45 per pair of jeans and £50 per sweater.

5
 8/7/2022

Foreign Exchange Markets (1 of 4)

• The set of markets where foreign currencies and other
assets are exchanged for domestic ones
– Institutions buy and sell deposits of currencies or
other assets for investment purposes.
• The daily volume of foreign exchange transactions was
$6.6 trillion in April 2019
– up substantially from $500 billion in 1989.
• Most transactions exchange foreign currencies for U.S.
dollars.

Foreign Exchange Markets (2 of 4)

The participants:
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in different
currencies for investment purposes.
2. Corporations (non-financial businesses) conduct foreign
currency transactions to buy/sell goods, services and assets.
3. Non-bank financial institutions (mutual funds, hedge funds,
securities firms, insurance companies, pension funds) may
buy/sell foreign assets for investment.
4. Central banks: conduct official international
reserves transactions.

Foreign Exchange Markets (3 of 4)

• Buying and selling in the foreign exchange market are
dominated by commercial and investment banks.
– Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more
per transaction.
– Central banks sometimes intervene, but the direct
effects of their transactions are small and transitory in
many countries.

6
 8/7/2022

Foreign Exchange Markets (4 of 4)

• Computer and telecommunications technology transmit
information rapidly and have integrated markets.
• The integration of financial markets implies that there can
be no significant differences in exchange rates across
locations.
– Arbitrage: buy at low price and sell at higher price for
a profit.
– If the euro were to sell for $1.1 in New York and $1.2
in London, could buy euros in New York (where
cheaper) and sell them in London at a profit.

Spot Rates and Forward Rates

• Spot rates are exchange rates for currency exchanges
“on the spot,” or when trading is executed in the present.
• Forward rates are exchange rates for currency
exchanges that will occur at a future (“forward”) date.
– Forward dates are typically 30, 90, 180, or 360 days
in the future.
– Rates are negotiated between two parties in the
present, but the exchange occurs in the future.

Figure 3.1 Dollar/Pound Spot and

Forward Exchange Rates, 1983–2020

Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spot
exchange rates, at end of month.

7
 8/7/2022

Other Methods of Currency Exchange (1 of 3)

• Foreign exchange swaps: a combination of a spot sale

with a forward repurchase.
• Swaps allow parties to meet each other’s needs for a
temporary amount of time and often cost less in fees than
separate transactions.
– For example, suppose Toyota receives $1 million
from American sales, plans to use it to pay its
California suppliers in three months, but wants to
invest the money in euro bonds in the meantime.

Other Methods of Currency Exchange (2 of 3)

• Futures contracts: a contract designed by a third party

for a standard amount of foreign currency
delivered/received on a standard date.
– Contracts can be bought and sold in markets, and
only the current owner is obliged to fulfill the contract.

Other Methods of Currency Exchange (3 of 3)

• Options contracts: a contract designed by a third party

for a standard amount of foreign currency
delivered/received on or before a standard date.
– Contracts can be bought and sold in markets.
– A contract gives the owner the option, but not
obligation, of buying or selling currency if the need
arises.
– A call option gives the owner the right to buy, while a
put option gives the right to sell, a specified amount
of foreign currency at a specified price at any time
prior to the specified expiration date.

8
 8/7/2022

The Demand of Currency Deposits (1 of 12)

• What influences the demand of (willingness to buy)

deposits denominated in domestic or foreign currency?
• Factors that influence the return on assets determine the
demand of those assets.

The Demand of Currency Deposits (2 of 12)

• Rate of return: the percentage change in value that an

asset offers during a time period.

– The annual return for $100 savings deposit with an

interest rate of 2% is $100  1.02  $102, so that the

($102  $100)
rate of return   2%
$100

The Demand of Currency Deposits (3 of 12)

• Real rate of return: inflation-adjusted rate of return, which

represents the additional amount of goods and services
that can be purchased with earnings from the asset.
– The real rate of return for the above savings deposit
when inflation is 1.5% is 2%  1.5%  0.5%. After
accounting for the rise in the prices of goods and
services, the asset can purchase 0.5% more goods
and services after 1 year.

9
 8/7/2022

The Demand of Currency Deposits (4 of 12)

• If prices are fixed, the inflation rate is 0% and (nominal)

rates of return = real rates of return.
• Because trading of deposits in different currencies occurs
on a daily basis, we often assume that prices do not
change from day to day.
– A good assumption to make for the short run.

The Demand of Currency Deposits (5 of 12)

• Risk of holding assets also influences decisions about

whether to buy them.
• Liquidity of an asset, or ease of using the asset to buy
goods and services, also influences the willingness to
buy assets.

The Demand of Currency Deposits (6 of 12)

• But we assume that risk and liquidity of currency

deposits in foreign exchange markets are essentially the
same, regardless of their currency denomination.
– Risk and liquidity are only of secondary importance
when deciding to buy or sell currency deposits.
– Importers and exporters may be concerned about risk
and liquidity, but they make up a small fraction of the
market.

10
 8/7/2022

The Demand of Currency Deposits (7 of 12)

• We therefore say that investors are primarily concerned

about the rates of return on currency deposits.
• Rates of return that investors expect to earn are
determined by
– interest rates that the assets will earn
– expectations about appreciation or depreciation

The Demand of Currency Deposits (8 of 12)

• A currency deposit’s interest rate is the amount of a

currency that an individual or institution can earn by
lending a unit of the currency for a year.
• The rate of return for a deposit in domestic currency is
the interest rate that the deposit earns.
• To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider
– the interest rate for the foreign currency deposit
– the expected rate of appreciation or depreciation of
the foreign currency relative to the domestic currency.

Figure 3.2 Interest Rates on Dollar and

Yen Deposits, 1978–2020

Since dollar and yen interest rates are not measured in comparable terms, they can
move quite differently over time.
Source: Datastream. The figure shows three-month interest rates.

11
 8/7/2022

The Demand of Currency Deposits (9 of 12)

• Suppose the interest rate on a dollar deposit is 2%.
• Suppose the interest rate on a euro deposit is 4%.
• Does a euro deposit yield a higher expected rate of return?
– Suppose today the exchange rate is $1 €1, and the
expected rate one year in the future is $0.97  €1.
– $100 can be exchanged today for €100.
– These €100 will yield €104 after 1 year.
– These €104 are expected to be worth $0.97  €1 €104
= $100.88 in 1 year.

The Demand of Currency Deposits (10 of 12)

• The rate of return in terms of dollars from investing in euro deposits is

 $100.88  $100   0.88%.

$100
• Let’s compare this rate of return with the rate of return from a dollar deposit.
– The rate of return is simply the interest rate.
– After 1 year the $100 is expected to yield $102:

 $102  $100   2%
$100

• The euro deposit has a lower expected rate of return: thus, all investors
should be willing to dollar deposits and none should be willing to hold euro
deposits.

The Demand of Currency Deposits (11 of 12)

• Note that the expected rate of appreciation of the euro was
$0.97  $1
 0.03  3%.
$1

• We simplify the analysis by saying that the dollar rate of return

on euro deposits approximately equals
– the interest rate on euro deposits
– plus the expected rate of appreciation of euro deposits

– 4%  3%  1%  088%
– E e$/ €  E$/ €
R€ +
E$/ €

12
 8/7/2022

The Demand of Currency Deposits (12 of 12)

• The difference in the rate of return on dollar deposits and

euro deposits is

Model of Foreign Exchange Markets (1 of 6)

• Construct model of foreign exchange markets using:

– the demand of (rate of return on) dollar-denominated
deposits
– and the demand of (rate of return on) foreign
currency– denominated deposits

Table 3.3 Comparing Dollar Rates of

Return on Dollar and Euro Deposits
Rate of Return
Expected Rate of Difference between
Dollar Euro Dollar Depreciation Dollar and Euro
Bla nk
Interest Rate Interest Rate Against Euro Deposits
e
E$/€  E$/€ E$/e €  E $/ €
Case R$
R s ub $

R€
R s u b e uro s ta rt fra ctio n upp er Eto th e lo wer e po wer, s ub $ pe re uro mi nu s upp er Esu b $ per eu ro ov er upp er Esu b $ per eu ro end frac ti on

R$  R€ 
R s u b $ m in us R sub e uro m in us start fra ctio n upp er Eto th e lo wer e powe r, su b $ per e uro mi nu s upp er Esu b $ per eu ro ove ru ppe rE sub $ p er eu ro end frac ti on

E$/€ E$/ €

1 0.10 0.06 0.00 0.04

2 0.10 0.06 0.04 0.00

3 0.10 0.06 0.08 0.04 Ne g a ti v e 0.04

4 0.10 0.12 0.04 Ne g a ti v e 0.04

0.02

13
 8/7/2022

Model of Foreign Exchange Markets (2 of 6)

• Model in equilibrium when deposits of all currencies offer

the same expected rate of return: interest parity.
– Interest parity implies that deposits in all currencies
are equally desirable assets.
– Interest parity implies that arbitrage in the foreign
exchange market is not possible.
• Interest parity says:

E e$/ €  E$/ €
R$  R€ 
E$/ €

Model of Foreign Exchange Markets (3 of 6)

• Why should the interest parity condition hold?
– Suppose it did not. Suppose
E e $/ €  E$/ €
R$ > R€ 
E$/ €

– Then no investor would want to hold euro deposits, driving

down the demand and price of euros.
– Then all investors would want to hold dollar deposits,
driving up the demand and price of dollars.
– The dollar would appreciate and the euro would
depreciate, increasing the right side until equality was
achieved.

Model of Foreign Exchange Markets (4 of 6)

• How do changes in the current exchange rate affect the

expected rate of return of foreign currency deposits?
• Depreciation of the domestic currency today lowers the
expected rate of return on foreign currency deposits.
– When the domestic currency depreciates, the initial
cost of investing in foreign currency deposits
increases, thereby lowering the expected rate of
return of foreign currency deposits.

14
 8/7/2022

Model of Foreign Exchange Markets (5 of 6)

• Appreciation of the domestic currency today raises the

expected return of deposits on foreign currency deposits.
– When the domestic currency appreciates, the initial
cost of investing in foreign currency deposits
decreases, thereby lowering the expected rate of
return of foreign currency deposits.

Table 3.4 Today’s Dollar/Euro Exchange Rate and the

Expected Dollar Return on Euro Deposits When E e $/€  $1.05 uppe r E to the lowe re power, s ub $ per euro minus uppe rE sub $ per euro = $ 1.05

per Euro

Today’s Dollar/Euro Interest Rate on Euro Expected Dollar Expected Dollar

Exchange Rate Depreciation Rate Return on Euro
against Euro Deposits
1.05  E$/ € 1.05  E$/€
E s u b $ pe re uro R s u b e uro R s u b e uro + s ta rt fracti on 1.0 5 mi nus u ppe rE sub $ p er euro o ver up per Es ub $ pe re uro e nd fracti on

E$/ € R€ R€ 
E$/€
s ta rt fra ctio n upp er 1.05 mi nu s up per Es ub $ pe re uro ov er upp er Esu b $ per eu ro end fra ctio n

E$ /€

1.07 0.05 0.019 Ne g a ti v e 0.019

0.031

1.05 0.05 0.00 0.05

1.03 0.05 0.019 0.069

1.02 0.05 0.029 0.079

1.00 0.05 0.05 0.10

Figure 3.3
The Relation
Between the
Current
Dollar/Euro
Exchange
Rate and the
Expected
Dollar Return
on Euro
Deposits

Given that E$e/ €  1.05 and R €  0.05 an appreciation of the dollar against

the euro raises the expected return on euro deposits, measured in terms of dollars.

15
 8/7/2022

Figure 3.4
Determinati
on of the
Equilibrium
Dollar/Euro
Exchange
Rate

Equilibrium in the foreign exchange market is at point 1, where the

expected dollar returns on dollar and euro deposits are equal.

Model of Foreign Exchange Markets (6 of 6)

• The effects of changing interest rates:

– An increase in the interest rate paid on deposits
denominated in a particular currency will increase the
rate of return on those deposits.
– This leads to an appreciation of the currency.
– Higher interest rates on dollar-denominated assets
cause the dollar to appreciate.
– Higher interest rates on euro-denominated assets
cause the dollar to depreciate.

Figure 3.5
Effect of a
Rise in the
Dollar
Interest
Rate

A rise in the interest rate offered by dollar deposits from R$1 to R$2

causes the dollar to appreciate from E$1/ € (point 1) to E$2/ € (point 2).

16
 8/7/2022

Figure 3.6
Effect of a
Rise in the
Euro
Interest
Rate

A rise in the interest rate paid by euro deposits causes the dollar to depreciate from

E$1/ € (point 1) to E$2/ € (point 2). (This figure also describes the effect of a rise in the

expected future $  € exchange rate.)

The Effect of Changing Expectations on

the Current Exchange Rate

• If people expect the euro to appreciate in the future, then

euro-denominated assets will pay in valuable euros, so
that these future euros will be able to buy many dollars
and many dollar-denominated goods.
– The expected rate of return on euros therefore
increases.
– An expected appreciation of a currency leads to an
actual appreciation (a self-fulfilling prophecy).
– An expected depreciation of a currency leads to an
actual depreciation (a self-fulfilling prophecy).

What Explains Carry Trade?

• International investors frequently borrow low-interest currencies and
buy high-interest currencies, with results that can be profitable over
long periods—this activity is called carry trade.
• The extent of carry trade positions can become very large when
sizable international interest differentials open up. Is the prevalence
of the carry trade evidence that interest parity is wrong?
• While interest parity does not hold exactly in practice, in part because
of the risk and liquidity factors mentioned earlier, economists are still
trying to understand if the carry trade requires additional explanation.
– The high-interest currencies that carry traders target may
experience abrupt crashes.

17
 8/7/2022

Figure 3.7 Cumulative Total Investment Return in

Australian Dollars Compared with Japanese Yen, 2006–
2020

The Australian dollar-yen carry trade has been profitable on average but is subject to
sudden large reversals, as in 2008.
Source: Quarterly Japanese yen/Australian dollar exchange rate, 90-day Australia bank bill rate, and 90-day
Japan certificate of deposit rate from FRED database. The chart compares the cumulative value over time of a ¥100
investment in Japanese interest-bearing 90-day bonds, rolled over every quarter, with the same yen investment
converted into Australian dollars, invested in 90-day Australian bonds and rolled over every quarter, and then
converted back into yen at the end of the investment period.

Forward Exchange Rates and Covered

Interest Parity (1 of 5)
• Covered interest parity (CIP) relates interest rates across countries
and the rate of change between forward exchange rates and the spot
exchange rate:
F$/ €  E$/ €
R$  R€ 
E$/ €

where F$/ € is the forward exchange rate.

• It says that rates of return on dollar deposits and “covered” foreign

currency deposits are the same.
– How could you earn a risk-free return in the foreign exchange
markets if covered interest parity did not hold?
– Covered positions using the forward rate involve little risk.

Forward Exchange Rates and Covered

Interest Parity (2 of 5)
• For example, suppose the 1-year forward price of euros in terms of dollars
is F$ / €  $1.113 and the spot exchange rate is E$/€ = $1.05 per euro.
• If R€  0.04, compare the rate of return on a covered euro deposit to a 10%
rate of return on a dollar deposit (R$  0.10).
– A €1 deposit costs $1.05 today and is worth €1.04 after 1 year.
– Selling €1.04 forward today at the forward exchange rate $1.113 per

euro yield a dollar value after 1 year of  $1.113 per euro    €1.04   $1.158.
– The rate of return on the covered purchase of a euro deposit is
1.158  1.05   1.05  0.103. or 10.3%, is greater than a 10% rate
of return on a dollar deposit and covered interest parity fails.

18
 8/7/2022

Forward Exchange Rates and Covered

Interest Parity (3 of 5)

• The forward premium on euros against dollars (also

called the forward discount on dollars against euros) is

F$/ €  E$/ €
E$/ €

• Using this terminology, the covered interest parity

condition becomes:
– The interest rate on dollar deposits equals the interest
rate on euro deposits plus the forward premium on
euros against dollars.

Forward Exchange Rates and Covered

Interest Parity (4 of 5)
• Figure 3-8 graphs the difference between dollar interbank
interest rates and the covered return to investing in three
foreign interbank markets.
– Big deviations from CIP emerged around the time of the
worldwide banking crisis in 2007–2008. CIP did not
reestablish itself after the crisis passed.
– The deviations from CIP tend to be negative, implying that
it would be profitable to arbitrage by borrowing dollars,
selling them for foreign currencies, and then investing the
proceeds in foreign money markets while selling the
proceeds forward to complete the round trip out of dollars
and back

Figure 3.8
U.S. Dollar
Three-
Month
Interest
Rate Less
Covered
Rate on
Three-
Month
Foreign
Bank
Deposits

Covered interest parity held well up until the financial crisis that started in 2008, but it has
not held closely since then. The three non-U.S. investment currencies shown are the
euro, pound, and yen.

19
 8/7/2022

Forward Exchange Rates and Covered

Interest Parity (5 of 5)
• By comparing the uncovered interest parity (UIP) condition,
E e $/ €  E$/ €
R$  R€ 
E$/ €

with the covered interest parity condition, you will find that both
conditions can be true at the same time only if the 1-year
forward rate quoted today equals the spot exchange rate
people expect to materialize a year from today: F$/ €  E$/e €
• Covered transactions do not involve exchange rate risk,
whereas uncovered transactions do.

Summary (1 of 4)
1. An exchange rate is the price of one country’s currency in
terms of another country’s currency.

– It enables us to translate different countries’ prices into

comparable terms.

2. Depreciation of a currency means that it becomes less

valuable and goods denominated in it are less expensive:
exports are cheaper and imports more expensive.
3. Appreciation of a currency means that it becomes more
valuable and goods denominated in it are more
expensive: exports are more expensive and imports
cheaper.

Summary (2 of 4)
4. Commercial and investment banks that invest in
deposits of different currencies dominate the foreign
exchange market.

– Expected rates of return are most important in

determining the willingness to hold these deposits.

5. Rates of return on currency deposits in the foreign

exchange market are influenced by interest rates and
expected exchange rates.

20
 8/7/2022

Summary (3 of 4)
6. Equilibrium in the foreign exchange market occurs when
rates of returns on deposits in domestic currency and in
foreign currency are equal: interest rate parity.
7. An increase in the interest rate on a currency’s deposit
leads to an increase in its expected rate of return and to
an appreciation of the currency.

Summary (4 of 4)
8. An expected appreciation of a currency leads to an
increase in the expected rate of return for that currency,
and thus leads to an actual appreciation.
9. Covered interest parity says that rates of return on
domestic currency deposits and “covered” foreign
currency deposits using the forward exchange rate are
the same.

21