Introduction to Exchange Rates and the Foreign Exchange Market Today une 25, 2010 country Pers ere ‘usta ase Liat Canada 1037 1380 Denmark 6.036 ous fro oan 1215 Hong Kong 19 1150 India 46.360 ute Japan 99.350 a60u8 Mexico 12597 18.993 Sweden 770 11622 United Kingdom oss 1000 United states 1.000 196 Soe US fsa ane rdf oem 0 ion hang att © Sn? eases asdaneas a ‘ee eee Pere Lar aaa ae 1.000 9.583 sra79 110.308 15.631 osm owze 122 One Year Ago tune 25, 2009 Pers 125 Re 528 0.703 1750 48.160 96.860 n220 7460 0.500 1.000Using the information in the table for June 25, 2010, compute the Danish Krone-Canadian dollar exchange 1302, Exarcs Answer: Exuics = (6.036 kr/$)/(1.037 C$/8) = 5.8206 ke/CS, 4d. Visit the Web site of the Board of governors of the Federal Reserve System at utp: //wwwafederalreserve.gov/. Click on “Economic Research and Data” and then “Statistics: Releases and Historical Data.” Download the H.10 release For- eign Exchange Rates (weekly data available). What has happened to the value of the USS. dollar relative to the Canadian dollar, Japanese yen, and Danish krone since June 25, 20107 Answer: Answers will vary ‘e. Using the information from (d), what has happened to the value of the U.S. dol- lar relative to the British pound and the euro? Note: the H.10 release quotes, ‘hese exchange rates as U.S. dollars per unit of foreign currency in line with long- standing market conventions. Answer: Answers will vary. 2. Consider the United States and the countries it trades with the most (measured in trade volume); Canada, Mexico, China, and Japan. For simplicity assume these are the ‘only four countries with which the United States trades. Trade shares and exchange nites for these four countries are as follows: Courtay (curency) share of wade 5 per Fein 2008 Dollar per Fx in 2010 Canada (collar 36% 0.9225 0.9643 Mexico (p2s0) 2% 0.0756 0.0788, Chia (yuan) 2% 0.1466 oars Sepan Ge) 16% 0.005 ont a, Compute the percentage change from 2009 to 2010 in the four USS. bilateral ex- change rates (defined as US. dollars per units of foreign exchange, or FX) in the table provided Answer: Y%AB vcs = (0.9643 ~ 0.9225) / 0.9225 = 4.53% 5 (0.0788 ~ 0.0756) / 0.0756 = 4.23% (0.1473 — 0.1464) / 0.1464 = 0.61% %AF,w = (0.0112 — 0.0108 / 0.0108 = 6.67% 1b. Use the trade shares as weights to compute the percentage change in the nomi- nal effective exchange rate for the United States between 2009 and 2010 (in US. dollars per foreign currency basket). Answer: The trade-weighted percentage change in the exchange rate is AE = 0.360%AE.cx) + 0.280% jos) + 0.2006AE ua) #016 Q6AE) AE = 0.36(4.53%) + 0.28(4.23%) + 0.20(0.61%) + 0.16(6.67%) = 4.01% ‘¢. Based on your answer to (b), what happened to the value of the US. dollar against this basket between 2009 and 2010? How does this compare with the change in the value of the USS. dollar relative to the Mexican peso? Explain your Answer: The dollar depreciated by 4.01% against the basket of currencies. Vise 4-vis the peso, the dollar depreciated by 4.23%. 3, Go-ro-the Wek site tor bederal Hesesve_beonomie Date HEB ie btepeecrereanel: a1b. What is the (riskless) euro-denominated return on British deposits for this in- vestor using forward cover? Answer: The euro-denominated return on British deposits using forward cover is equal to €1,071 (= €1,000 X (1.575 / 1.5) X (1 + 0.02). cc. Is there an arbitrage opportunity here? Explain why or why not. Is this an equi- librium in the forward exchange rate market? Answer: Yes, there is an arbitrage opportunity: The euro-denominated return on. British deposits i higher than that on Dutch deposits. The net return on each ccuro deposit in a Dutch bank is equal to 4.04% versus 7.1% (= (1.575 / 1.5) X (1 + 0.02)) on a British deposit (using forward cover). This is not an equilibri in the forward exchange market. The actions of traders seeking to exploit the ar~ bitrage opportunity will cause the spot and forward rates to change. 4. If the spot rate is 1.5 euros per pound, and interest rates are as stated previously, what is the equilibrium forward rate, according to CIP? Answer: CIP implies: Fy, = Berg (I+ §) / (I + ig) = 1.5 X 1.0404 7 1.02, €1.53 per £ ‘©. Suppose the forward rate takes the value given by your answer to (@), Calculate the forward premium on the British pound for the Dutch investor (here ex- change rates are in euros per pound). Is it positive or negative? Why do investors requite this premium/discount in equilibrium? Answer: Forwand premium = (Feie/ Fey ~ 1) = (1.53 / 1.50) ~ 1 = 0.03 39%, The existence of a positive forward premium would imply that investors ex- pect the euro to depreciate relative to the British pound, Therefore, when estab- lishing forward contracts, the forward rate is higher than the current spot rate £. IF UIP holds, what is the expected depreciation of the euro against the pound over one year? Answer: Acconling to the UIP approximation, MIE i¢ / Eye = ip ~ fe = 2.04% ‘Therefore, the euro i& expected to depreciate by 2.04%. Using the exact UIP condition, we first need to convert the exchange rates into pound-curo terms to calculate the depreciation in the euro. From UIP: AP ye = Eye X (+ 1))/ (1+) = (1/18) x (1 + 0.02) / (1 + 0.0404) = £0.654 per € Therefore, the depreciation in the euro i equal to 1.959% (0.654 — 0.667)/01667. {g. Based on your answer to (f), what isthe expected euro-pound exchange rate one year ahead? Answer: Using the exact UIP (not the approximation), we know that the fol- lowing is true: Pig = Eye X (1-4 i) /(I + i) = 1.5 X 10404 / 1.02 = (E153 per £. Using the approximation, Egg deren by 209% fo 0657 to O59, Thi implies the new spot rate, Ea,c= 1 7. You are a financial adviser to a USS. corporation that expects to receive a payment of 40 million Japanese yen in 180 days for goods exported to Japan.’The current spot rate is 100 yen per USS. dollar (Ey = 0.0100). You are concerned that the US. dol lar is going to appreciate against the yen over the next six months. ‘a. Assuming that the exchange rate remains unchanged, how much does your firm expect t0 receive in U.S. dollars? Answer: The firm expects to receive $400,000 (= 940,000,000 / 100), 1b. How much would your firm receive (in US. dollar) ifthe dollar appreciated to 110 yen per US. dollar (Eyy = 0.00909)? Answer: The firm would receive $363,636 (= ¥49,000,000 / 110).Exchange Rates I: The Monetary Approach in the Long Run 0 ee Eee = PPE/Evxnxor = 5,000/30 = 166.7 ‘ eee Answer: The relative price of coffee in these two markets is: | = G0 X 160)/5000 = 0.96 <1 2 Consider each-of the following goodsand services For each, identify whether the aw ‘of one price-will held and state-whether the relative prices Jesethen-or equal to} Explain pouranaierin-termeotthe atmptione ve tiake whenr-tsing the law-oFene price fe Rive tendet- tively in the United Stator ane Cana Amsowert-yf =ri a tbat ie His faa! weiigi weiiei Gea tells = bea relate llPPP, the Home country will experience aHel Et o|FE B g i i z fae é lees RH j ¥ R000 ee seas 28 20%, 32925. You are given the following information. The current dollarpound exchange rate is, $2 per British pound. A U.S. basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to keep US. inflation at 2% and the Bank of England is predicted to keep UK. inflation at 3%. The speed of convergence to absolute PPP is 15% per year. a, What is the expected US. minus UK. inflation differential for the coming year? Answer: The inflation differential is equal to ~1% (= 2% ~ 3%). bb. What is the current US. real exchange rate, cis With the United Kingdom? Answer: The current real exchange rate is: Aunvvs = Ex cPin)/ Pos = $120/8100 = 1.2. ¢. How much is the dollar overvalued undervalued? Answer: The British pound is undervalued by 20% and the US. dollar is over~ valued by 20% (= 1.2 -1/ 1) d. What do you predict the U.S. real exchange rate with the United Kingdom will be in one year’ time? Answer: We can use the information on convergence to compute the implied ‘change in the US. real exchange rate. We know the speed of convergence to ab- solute PPP is 15%; that is, each year the exchange rate will adjust by 15% of what is needed to achieve the real exchange rate equal to 1 (assuming prices in each ‘country remain unchanged). Today, the real exchange rate is equal to 1.2, imply- ing a 0.2 decrease is needed to satisfy absolute PPP. Over the next year, 15% of this adjustment will occur, so the real exchange rate will decrease by 0.03.There- fore, after one year, the US. real exchange rate, quxaass Will equal 1.17. fe. What is the expected rate of real depreciation for the United States (versus the United Kingdom)? Answer: From (d), the real exchange rate will decrease by 0.03. Therefore, the rate of real depreciation is equal to —2.5% (=—0.08 / 1.20). This implies a teal appreciation in the United States relative to the United Kingdom, £. What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)? Answer: The expected rate of nominal depreciation can be calculated based ‘on the inflation differential plus the expected real depreciation from (e). In this ‘ase, the inflation differential is ~1% and the expected real appreciation is, 2.5%, so the expected nominal depreciation is —3.5%. That is, we expect a 3.5% appreciation in the US. dollar relative to the British pound. What do you predict will be the dollar price of one pound a year from now? Answer: The current nominal exchange rate is $2 per pound and we expect a 3.5% appreciation in the dollar (from [f])."Therefore, the expected exchange rate in one year is equal to $1.93 (= $2 X (1—0.035). 6. Describe how each of the following factors might explain why PPP isa better guide for exchange rate movements in the long run versus the short run: (1) transactions costs, (2) nontraded goods, (3) imperfect competition, and (4) price stickiness. As mar- kets become increasingly integrated, do you suspect PPP will become a more usefil guide in the fature? Why or why not?Answer: Each of these fictors hinders trade more in the short run than in the long run, Specifically, each is a reason to expect that the condition of frictionless trade is not satisfied. For this reason, PPP is more likely to hold in the long run than in the short run, (1) Transactions costs. Over longer periods of time, producers generally face decreas- ing average costs (as fixed costs become variable costs in the long run). Therefore, the average cost associated with a given transaction should decrease. Q) Nontraded goods. Goods that are not traded among countries cannot be arbi- traged. Since intercountry arbitrage is required for PPP, nontraded goods will prevent ‘exchange rates from completely adjusting to PPP, Examples of nontracted goods i clude many services that require a physical presence on site to complete the work. ‘There are many of these, ringing, from plumbers to hairdressers (3) Imperfect competition, Imperfect competition implies that producers of differen- tiated products have the ability to influence prices. In the short run, these firms may either collude to prevent price adjustment, or they may engage in dramatic changes in price (e., price wars) designed to capture market share. These collusion agree ments and price wars generally are not long-lasting. (4) Price stickiness In the short rum, prices may be inflexible for several reasons. Firms ‘may face menu costs, or fear that price adjustments will adversely affect market share. Firms also may have wage contracts that are set in nominal terms. However, in the long run, these costs associated with changing prices dissipate, either because menu ccoxts decrease over time or because firms and workers renegotiate wage contracts in the long run, [As markets become more integrated, PPP should become a better predictor of ex change rate movements. For PPP to hold, we have to assume frictionless trade. The more integrated markets are, the closer they are to achieving frictionless trade. 7. Consider two countries, Japan and Korea. In 1996, Japan experienced relatively slow ‘output growth (194), whereas Korea had relatively robust output growth (696). Sup~ pose the Bank of Japan allowed the money supply to grow by 2% each year, whereas the Bank of Korea chose to maintain relatively high money growth of 12% per year. For the following questions, use the simple monetary model (where L is constant) You will find it easiest to treat Korea as the home country and Japan as the foreign country. ‘a, What is che inflation rate in Korea? In Japan? Answer: Ba ~ ee > = 12% — 6% = 656 2% — 1% = 1% b. Whar is the expected rate of depreciation in the Korean won relative to the B= yg, AE uy = (Wy — 7) = 6% — 1% = 5Y.You can check this by using the following expresion fiom the monetary mode: %XE ney = (jt — ge) — ~ a) «Suppor the Bank of Kors inter the money growth rt fom 12% 20 15% If nothing in Japan changes, what i the new inflation rate in Korea? Answer: 3 = de — ge = 159% — 6% = 99%@ Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative to the yen? Answer: To keep the exchange rate constant, the Bank of Korea must lower its money growth rate. We can figure out exactly which money growth rate will keep the exchange rate fixed by using the fundamental equation for the simple ‘monetary model (used above in [b)) YAP ary = (Hx — Bx) — (by — 8) The objective is to Set %AP an = 0 (U8 — 95) = (hh) — gy) Plug in the values given in the question and solve for yt: (ut — 6%) = Qi — 199) wha 7% ‘Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange sate with Japan will remain unchanged. £. Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appreciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective? Angwer: Using the same reasoning as previously, the objective is for the won to appreciate: %MF yay <0 ‘This can be achieved if the Bank of Korea allows the money supply to grow by Jess than 7% each year. The diagrams on the following page show how this would affect the variables in the model over time. 8, This question uses the general monetary model, in which L is no longer assumed constant and money demand is inversely related to the nominal interest rate. Con- sider the same scenario described in the beginning of the previous question. In ad tion, the bank deposits in Japan pay 3% interest iy = 3% ‘a. Compute the interest rate paid on Korean deposit. Answer: Fisher effect: (ig, ~ &) = (re — 2) Solve f0F ig = (6% — 194) + 39% = 8% 1b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show chat the rel interest rate in Korea is equal to the real interest rate in Japan, (Note that the inflation rates you calculated in the previous question will apply here.) Answer: 2% — 1% = 1% Tis = faoy ~ Te = 82 — 616 = 2% ‘c. Suppose the Bank of Korea increases the money growth rate from 12% to 15% and the inflation rate rises proportionately (one for one) with this increase. Ifthe nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean deposits? Answor: We know that the inflation rate in Korea will increase to 9%, We also know that the real interest rate will remain unchanged. Therefore: at te = 1% + 9% = 10%,Bank of Korea increases ‘money growth rate