1、2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-1Chapter 13EXCHANGE RATES AND THE FOREIGNEXCHANGE MARKET:AN ASSET APPROACH(汇率与外汇市场:资产分析法)汇率与外汇市场:资产分析法)2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-2Outline of this chapterExchange RatesForeign exchange marketAsset approach t
2、o exchange ratesInterest parity conditionEmpirical testsCovered interest parity2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-3Chapter 13 - IntroductionExchange rates are important because they enable us to translate different countries prices into comparable terms.Exchange rates are de
3、termined in the same way as other asset prices.The general goal of this chapter is to show: How exchange rates are determinedThe role of exchange rates in international trade2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-4Exchange RatesThe (spot) exchange rate (E) is price of one curren
4、cy in terms of another for immediate trade (on the spot).The conventional way of reporting this in economics (but not in the news) is home currency per unit of foreign. In the U.S. this is $ per unit foreign currency.Example, yesterday E$/ = 1.04 $/Sometimes you will hear quoted the other way around
5、, often called European terms. E.g., 0.96 /$.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-5Exchange RatesAn exchange rate can be quoted in two ways:Direct The price of the foreign currency (外币)(外币)in terms of home currency(本币)(本币)Indirect The price of domestic currency in terms of the
6、 foreign currency2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-6Exchange RatesExchange rates are important for trade because they allow you to compare the cost of imports to that of domestic goods in common terms.Example: You visit New York and see an portable computer for $1000. What
7、is that in RMB? Consider units: you want to convert $ to RMB so you need to multiply by an exchange rate expressed in RMB/$ (check: multiply units and cancel).2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-7EUR/USD: Euro exchange rate (20002002)The euro was officially introduced 1/1/200
8、0 and floats against the dollar. Founding members had been in a fixed exchange rate agreement with each other for several years.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-8ARS/USD: Argentine exchange rate (19952002)The peso was pegged 1:1 to the dollar since stabilization in 1991. T
9、he peg was officially abandoned in a crisis in Dec. 2001Jan. 2002.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-9JPY/USD: Japanese exchange rate (19932002)The dollar floats against the yen. Occasional attempts are made to “manage” this rate. In 1995 the rate was 100 /$. From 1949 until
10、 1970 it had been 360 /$!2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-10GBP/USD: British exchange rate (since 1776)Usually quoted as $/. Floating now, but fixed under the gold standard for most of 18001931 at 4.86 $/. Under the Bretton Woods regime (1950s1960s) the fixed rate was 2.80
11、 $/. The dollar lost much (over 90%) of its value in the War of Independence, then recovered. Fared better during the Civil War. In the long run the pound has weakened considerably.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-11RMB/USD: Exchange Rate of P. R. China(1981-2003)02468101/
12、02/819/02/885/03/96USD2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-12Appreciations and depreciations(升值和贬值升值和贬值)Our definition of E = home per unit foreign currencyDefinition can make it confusing to talk about changes in E, called appreciations and depreciations.Depreciation of home
13、countrys currency A rise in the home price of a foreign currency Appreciation of home countrys currency A fall in the home price of a foreign currency 2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-13Appreciations and depreciationsSay the $/ rate changed from 1.04 to 1.05. Now how much
14、would the suit would cost in $ terms?Dollars are not buying as many euros now, so the dollar has depreciated or weakened (against the euro).If E$/ rises we say that the dollar has depreciated.If E$/ falls we say that the dollar has appreciated.This may seem counterintuitive. Sad, but true.2022-5-17
15、Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-14The Foreign Exchange MarketExchange rates are determined in the foreign exchange market.The major participants in the foreign exchange market are: Commercial banks International corporations Non-bank financial institutions Central banks2022-5-17 Le
16、ctured by Dr Jin HongfeiDr Jin Hongfei Slide 13-15The foreign exchange market: actorsCommercial banks: a company has bank debit its account, change into foreign currency, and make payment by depositing in its foreign bank.Interbank trading: bank enters foreign exchange market to execute multiple tra
17、desvery large transactions.Corporations: some corporations enter market directly. Nonbank financial institutions: Deregulation allows them to compete in the market. E.g. pension funds.Central banks: sometimes intervene to increase or decrease the supply of their currency or purposefully affect E. Of
18、ficial interventions are relatively small, because there is so much private money involved. Is central bank a big enough player to affect E?2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-16Inter-bank trading Foreign currency trading among banks It accounts for most of the activity in th
19、e foreign exchange market.Exchange Rates and International Transactions2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-17The foreign exchange market: characterVolume is enormous: over a trillion dollars a day.US GDP is about $10 trillion in the whole year.Concentrated in certain key fina
20、ncial cities: where?London largest, also NY, Tokyo, Frankfurt and Singapore.Highly integrated globally: one major market is usually open, so people can trade around the clock.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-18The foreign exchange market: characterQuotes in different cente
21、rs are same, by arbitrage(套利):If NY offers more /$, than Frankfurt, people take $, sell in NY for , sell these in Frankfurt for $ and end up with profit.Computers monitoring such openings and ready to take advantage of them. So gaps close up very quickly.Vehicle currency. Most transactions in $Even
22、if want to change for , US is large in world economy; many people willing to trade dollars for and , rather than the opposite sides of a direct - trade. and Yen also used as vehicles, but less so.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-19Vehicle currency A currency that is widely
23、 used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide
24、 13-20Spot exchange rates (E) Apply to exchange currencies “on the spot” Transactions that take place basically immediately. In practice not right away because it typically takes two days for settlements, i.e. for the checks to clear.Forward exchange rates (F) is the price for a currency trade for s
25、ome date in future.Forward and spot exchange rates, while not necessarily equal, do move closely together.Spot Rates and Forward Rates(现汇汇率和期汇汇率现汇汇率和期汇汇率)2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-21 Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981-2001Spot Rates and
26、Forward Rates2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-22 Forward RatesA way of hedging (套期保值) against the risk of E changes.Example. Electronics wholesaler orders Sony TVs from Japan, will be billed and have to pay in in 90 days.Could wait for the bill, then buy the to pay Sony, b
27、ut who knows what will happen to yen-dollar E in meantime.Risk: If appreciates against the $, the store will have to pay a higher $ price for the TVs.To avoid risk, can contract now for currency to be delivered 90 days hence at set price, the forward exchange rate F/$.2022-5-17 Lectured by Dr Jin Ho
28、ngfeiDr Jin Hongfei Slide 13-23Spot sales of a currency combined with a forward repurchase of the currency.Example. Do a spot sale, then arrange a repurchase in the future at a set rate. Why do this?Suppose electronics firm also sells U.S. computers in Japan and gets paid in . May need in a month to
29、 buy more Sony TVs, but does not want to hang on to the the money in over the month, e.g., wants to use it for ongoing $ expenses. Lower brokers fees to do both transactions at one time.Foreign Exchange Swaps2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-24Futures contract期货合约期货合约Future
30、s contract: The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.Unlike a forward contract, you can trade itCurrency exchange occurs when contract comes due, and is delivered to whomever is holding the contract in the end.Some peopl
31、e trade these contracts to make a profit: expect value of contract to change as expectations about E change.Tool of currency speculation. E.g., if it suddenly looks like $ will appreciate (expected rise in spot E), existing $/ futures contract (at a preset E) looks more profitable, and its price wil
32、l go up.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-25The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.Call option: right to buy a specified amount of currency at a specified E any time be
33、fore a specified date.Put option: the similar right to sell.Like futures, options can themselves be bought and sold.Foreign exchange option外汇期权外汇期权2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-26Exchange RatesWhat determines the Exchange Rate?Supply versus Demand2022-5-17 Lectured by D
34、r Jin HongfeiDr Jin Hongfei Slide 13-27Determinants of demand for assetsWhat are the determinants of the demand for a financial asset? The expected rate of return.bank savings account: the interest rate (certain).stocks & bonds: dividends, capital gain (uncertain)2022-5-17 Lectured by Dr Jin Hongfei
35、Dr Jin Hongfei Slide 13-28Determinants of demand for assetsIn addition to return, some savers care about two other features: risk and liquidity.Risk: Even if a stock has a higher expected payoff than a saving account, uncertain payoff means it may be less desirable.Liquidity: how easy it is to conve
36、rt the asset to cash if you want to buy a different one or use your savings for consumption.In the theory, we do not emphasize risk and liquidity for now. We start by assuming that main issue in deciding which asset to buy is the expected return.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Sli
37、de 13-29The demand for a foreign currency bank deposit is influenced by the same considerations that influence the demand for any other asset.Assets and Asset ReturnsDefining Asset Returns The percentage increase in value an asset offers over some time period.The Real Rate of Return The rate of retu
38、rn computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase.The Demand for Foreign Currency Assets2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-30 Figure 13-2: Interest Rates on Dollar and Deutschmark Deposits, 1975-1998
39、The Demand for Foreign Currency Assets2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-31Foreign currency assets and returnsWhat is the expected return for the large bank accounts typically used in foreign exchange market transactions?Example. You invest in a account in Europe. It pays an
40、 interest rate. Is that rate your expected return?For foreign currency accounts, changes in E affect the value of the asset in domestic currency terms.When deciding whether to hold your assets in $ accounts or accounts, you need to consider the interest rates on each deposit option and the expected
41、change in the exchange rate in the meantime.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-32Foreign currency assets and returns: exampleIn words: $100 to invest in $ or (risk-free) account. R$ = annual interest on $ account = 2.9%. R = annual interest on a account = 5%. Spot E$/ = 1.0.
42、 Expected E in 1 year, Ee$/ = 0.98.In pictures:In this example, interest parity holds. The investor is indifferent between holding each risk-free deposit.Theory: this will be our arbitrage condition for market equilibrium.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-33Interest parity
43、conditionExpresses in mathematics what we saw in words and pictures: interest parity holds when risk-free deposits earn same expected return in each location.Expected net return on the euro deposit = ( interest rate) + (expected appreciation of euro)*= R + (Ee$/ E$/ ) / E$/Expected net return on the
44、 dollar deposit= ($ interest rate) = R$2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-34Interest parity conditionBy equating the two returns we derive the (uncovered) interest parity condition (UIP):R$ = R + (Ee$/ E$/ ) / E$/NB: equation * is an approximation. Chapter 13, Footnote 7.An
45、equivalent UIP for European investors, expected appreciation of $ = expected appreciation of (approx).UIP is one theory of exchange market equilibrium.2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-35A Simple RuleThe dollar rate of return on euro deposits is approximately the euro inter
46、est rate plus the rate of depreciation of the dollar against the euro. The rate of depreciation of the dollar against the euro is the percentage increase in the dollar/euro exchange rate over a year.The Demand for Foreign Currency Assets2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-36F
47、oreign exchange market equilibrium: intuitionRecall that expected return on euro deposit= R + (Ee$/ E$/ ) / E$/This shows that all else held constant a change in todays spot exchange rate E$/ will affect the expected euro return.In particular, a stronger euro today means a lower expected return in t
48、he future, given the expected level of the exchange rate in the future Ee$/ .Why? Example where Ee$/ = 1.05 and R = 0.05.If E$/ = 1.05 expected return on deposit = 0.05If E$/ = 1.03 expected return on deposit 0.07If E$/ =1.00 expected return on deposit 0.10Locally, this appears approximately linear.
49、2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-37 Table 13-4: Todays Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/ = $1.05 per EuroEquilibrium in the Foreign Exchange Market2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-38Figure 13-3: T
50、he Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits2022-5-17 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 13-39Foreign exchange market equilibrium:some theory and a figureUIP says, dollar return = expected euro return, orR$ = R + (Ee$/ E$/ ) /