Chapter 13

Exchange Rates
and the Foreign
Exchange
Market: An Asset
Approach

Slides prepared by Thomas Bishop

Preview
The basics of exchange rates
Exchange rates and the prices of goods
The foreign exchange markets
The demand for currency and other assets
A model of foreign exchange markets

role of interest rates on currency deposits

role of expectations about the exchange rates

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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? 102/$1

How much can be exchanged for one yen? $0.0098/1

Exchange rate allow us to denominate the cost or

price of a good or service in a common currency.

How much does a Honda cost? 3,000,000

Or, 3,000,000 x $0.0098/1 = $29,400

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Depreciation and Appreciation

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 ! $1.20/1 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.

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Depreciation and Appreciation (cont.)

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.

$1/1 ! $0.90/1 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.

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Depreciation and Appreciation (cont.)

A depreciated currency is less valuable, and therefore
it can buy fewer foreign produced goods that are
denominated in foreign currency.

How much does a Honda cost? 3,000,000

3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0100/1 = $30,000

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.
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Depreciation and Appreciation (cont.)

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

How much does a Honda cost? 3,000,000

3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0090/1 = $27,000

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.
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The Foreign Exchange Market

The participants:
1. Commercial banks and other depository institutions:
transactions involve buying/selling of bank deposits
in different currencies for investment.
2. Non bank financial institutions (pension funds,
insurance funds) may buy/sell foreign assets.
3. Private firms: conduct foreign currency transactions
to buy/sell goods, assets or services.
4. Central banks: conduct official international
reserves transactions.
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The Foreign Exchange Market (cont.)

Buying and selling in the foreign exchange
market are dominated by commercial 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 usually small
and transitory.

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The Foreign Exchange Market (cont.)

Characteristics of the market:
Trading occurs mostly in major financial
cities: London, New York, Tokyo, Frankfurt,
Singapore.
The volume of foreign exchange has grown:

in 1989 the daily volume of trading was $600 billion,

in 2001 the daily volume of trading was $1.2 trillion.

About 90% of transactions in 2001 involved US

dollars.
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The Foreign Exchange Market (cont.)

Computers transmit information rapidly and
have integrated markets.
The integration of markets implies that there is
no significant arbitrage between markets.

if dollars are cheaper in New York than in London,

people will buy them in New York and stop buying
them in London. The price of dollars in New York
rises and the price of dollars in London falls, until
the prices in the two markets are equal.

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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 individual institutions

in the present, but the exchange occurs in the future.

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Spot and Forward Rates

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Other methods of currency exchange

Foreign exchange swaps: a combination of a spot
sale with a forward repurchase, both negotiated
between individual institutions.

swaps often result in lower fees or transactions costs

because they combine two transactions.

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.

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Other Methods of Currency Exchange

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.

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The Demand for Currency Deposits

What influences the demand for (willingness
to buy) deposits denominated in domestic or
foreign currency?
Factors that influence the return on assets
determine the demand for those assets.

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The Demand for Currency Deposits

(cont.)
Rate of return: the percentage change in value that
an asset offers during a time period.

The annual return for $100 savings account with an interest

rate of 2% is $100 x 1.02 = $102, so that the rate of return =
($102 - $100)/$100 = 2%

Real rate of return: inflation-adjusted rate of return.

stated in terms of real purchasing power: the amount of real

goods & services that can be purchased with the asset.

the real rate of return for the above savings account when
inflation is 1.5%: 2% 1.5% = 0.5%. The asset can
purchase 0.5% more goods and services after 1 year.

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The Demand for Currency Deposits

(cont.)
If prices are given at some level, inflation is
0% and (nominal) rates of return = real rates
of return.
For bank deposits in different currencies, we
often assume that prices are given at some
level. (A good short run assumption.)

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The Demand for Currency Deposits

(cont.)
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.
But we assume that risk and liquidity of bank
deposits in the foreign exchange market are the same,
regardless of their currency denomination.

risk and liquidity are only of secondary importance when

deciding to buy or sell currency.

importers and exporters may be concerned about risk and

liquidity, but they make up a small fraction of the market.

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The Demand for Currency Deposits

(cont.)
We assume that investors are primarily
concerned about the rates of return on bank
deposits. Rates of return are determined by

interest rates that the assets earn

expectations about appreciation or depreciation

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The Demand for Currency Deposits

(cont.)
A currencys interest rate is the amount of a currency
an individual 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 bank 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.

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The Demand for Currency Deposits

(cont.)
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 1 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 x 104 =

$100.88.

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The Demand for Currency Deposits

(cont.)
The rate of return in terms of dollars from investing in
euro deposits is ($100.88-$100)/$100 = 0.88%.
Lets compare this rate of return with the rate of return
from a dollar deposit.

rate of return is simply the interest rate

After 1 year the $100 is expected to yield $102:

($102-$100)/$100 = 2%

The euro deposit has a lower expected rate of return:

all investors will prefer dollar deposits and none are
willing to hold euro deposits.
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The Demand for Currency Deposits

(cont.)
Note that the expected rate of appreciation of
the euro is ($0.97- $1)/$1 = -0.03 = -3%.
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 on
euro deposits
4% + -3% = 1% 0.88%

R + (Ee$/ - E$/)/E$/
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The Demand for Currency Deposits

(cont.)
The difference in the rate of return on dollar
deposits and euro deposits is
R$ - (R + (Ee$/ - E$/)/E$/ ) =
R$
expected rate
of return =
interest rate
on dollar
deposits

- R
interest rate
on euro
deposits

- (Ee$/ - E$/)/E$/
expected
exchange rate

current
exchange rate

expected rate of appreciation

of the euro

expected rate of return on euro deposits

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The Demand for Currency Assets

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The Market for Foreign Exchange

We use the

demand for (rate of return on) dollar denominated

deposits
and the demand for (rate of return on) foreign
currency denominated deposits to construct a
model of the foreign exchange market.

The foreign exchange market is 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 deemed equally desirable assets.

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The Market for Foreign Exchange (cont.)

Interest parity says:
R$ = R + (Ee$/ - E$/)/E$/
Why should this condition hold? Suppose it didnt.

Suppose R$ > R + (Ee$/ - E$/)/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.

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The Market for Foreign Exchange (cont.)

How do changes in the current exchange rate
affect expected returns in foreign currency?

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The Market for Foreign Exchange (cont.)

Depreciation of the domestic currency today lowers
the expected return on deposits in foreign currency.

A current depreciation of domestic currency will raise the

initial cost of investing in foreign currency, thereby lowering
the expected return in foreign currency.

Appreciation of the domestic currency today raises

the expected return of deposits in foreign currency.

A current appreciation of the domestic currency will lower the

initial cost of investing in foreign currency, thereby raising the
expected return in foreign currency.

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Expected Returns on Euro Deposits when

Ee$/ = $1.05 Per Euro
Expected rate of
Current
Interest rate on
dollar
exchange rate euro deposits
depreciation
E$/

(1.05 - E$/)/E$/

Expected dollar return

on euro deposits
R + (1.05 - E$/)/E$/

1.07

0.05

-0.019

0.031

1.05

0.05

0.000

0.050

1.03

0.05

0.019

0.069

1.02

0.05

0.029

0.079

1.00

0.05

0.050

0.100

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The Current
Exchange
Rate and
the Expected
Return on
Dollar
Deposits

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The Current Exchange Rate and the

Expected Return on Dollar Deposits
Current exchange
rate, E$/
1.07
1.05
1.03
1.02
1.00
0.031

0.050
R$

0.069

0.079 0.100
Expected dollar return
on dollar deposits, R$

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Determination of the Equilibrium

Exchange Rate
No one is willing to
hold euro deposits
No one is willing to
hold dollar deposits

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The Market for Foreign Exchange

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.

A rise in dollar interest rates causes the dollar

to appreciate.

A rise in euro interest rates causes the dollar

to depreciate.

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The Effect of a Rise in the

Dollar Interest Rate

A depreciation
of the euro is
an appreciation
of the dollar.

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The Effect of a Rise in the

Euro Interest Rate

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The Effect of an Expected Appreciation

of the Euro

People now
expect the
euro to
appreciate

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The Effect of an Expected Appreciation

of the Euro (cont.)
If people expect the euro to appreciate in the
future, then investment will pay off in a
valuable (strong) euro, so that these future
euros will be able to buy many dollars and
many dollar denominated goods.

the expected 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)

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Covered Interest Parity

Covered interest parity relates interest rates across
countries and the rate of change between forward
exchange rates and the spot exchange rate:
R$ = R + (F$/ - E$/)/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 make easy, risk-free money in the foreign

exchange markets if covered interest parity did not hold?

Covered positions using the forward rate involve little risk.

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Summary
1. Exchange rates are prices of foreign
currencies in terms of domestic currencies,
or vice versa.
2. Depreciation of a countrys currency means
that it is less expensive (valuable) and
goods denominated in it are less expensive:
exports are cheaper and imports more
expensive.

A depreciation will hurt consumers of imports but

help producers of exports.

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Summary (cont.)
3. Appreciation of a countrys currency means that it is
more expensive (valuable) and goods denominated
in it are more expensive: exports are more
expensive and imports cheaper.

An appreciation will help consumers of imports but hurt

producers of exports.

4. Commercial 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.

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Summary (cont.)
5. Returns on bank deposits in the foreign
exchange market are influenced by interest
rates and expected exchange rates.
6. Equilibrium in the foreign exchange market
occurs when returns on deposits in domestic
currency and in foreign currency are equal:
interest rate parity.
7. An increase in the interest rate on a
currencys deposit leads to an increase in the
rate of return and to an appreciation of the
currency.
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Summary (cont.)
8. An expected appreciation of a currency
leads to an increase in the expected rate of
return for that currency, and 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.

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