EC3343 International Finance

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

1
Recap

• Two-period model for current account (CA) determination

1. Two-period model setup
2. CA sustainability and No-Ponzi-game condition
3. Determination of optimal CA balance
• Pros and cons of CA deficit

2
Learning Objectives

1. Introduction to the exchange rates and the foreign

exchange market (Forex)

2. Determine the equilibrium exchange rate

3
Part 1

Introduction to exchange rate and foreign exchange market

• Definition of exchange rate
• Appreciation and depreciation
• Foreign exchange market (Forex)

4
In the news:

Sources:
• https://www.reuters.com/article/uk-
global-forex/dollar-pressured-again-as-
economic-fears-linger-amid-declines-in-
u-s-yields-idUSKCN1VI03Z
• https://www.reuters.com/article/uk-
britain-sterling-open/pound-gains-as-
uk-opposition-parties-agree-front-to-
stop-no-deal-brexit-idUSKCN1VH0RD
• https://www.reuters.com/article/uk-
japan-economy-aso/japan-closely-
watching-yen-moves-with-urgency-
finance-minister-aso-idUSKCN1VH082

5
Definition of Exchange Rates
Exchange rates are quoted as:
1. units of domestic currency per unit of foreign currency (E),
or
2. units of foreign currency per unit of domestic currency (1/E).
Notation (in textbook)
𝐸𝑆$/$ = 1.40
• Today’s Singapore dollar/US dollar exchange rate
• (number of S$ per $)
• 1.40 SGD per unit of USD
𝐸$/€ = 1.18
• Today’s US dollar/Euro exchange rate
• (number of $ per €)
• 1.18 USD per unit of EUR 6
Definition of Exchange Rates

Exchange rates allow us to denominate the relative price of

goods and services in a common currency.

Price of iPhone Xs in an Apple Store, USA: USD 999

Or, 999 x 1.3893 = SGD 1387.91
(using the spot rate closing on 27-Aug-19: 𝐸𝑆$/$ = 1.3893 )

Price of iPhone Xs in an Apple Store, Singapore: SGD 1649

Data source: https://www.apple.com/shop/buy-iphone/iphone-xs,

https://www.apple.com/sg/shop/buy-iphone/iphone-xs &
https://www.bloomberg.com/quote/USDSGD:CUR

7
Depreciation and Appreciation

Depreciation is a decrease in the value of a currency relative

to another currency.
A depreciated currency is less valuable and can be exchanged
for a smaller amount of foreign currency.
• Example: SGD per unit of USD 1.35 → 1.40
• iPhone (USD 999): SGD 1349 → SGD 1399
A depreciated currency means that imports are more
expensive and exports are cheaper.

8
Depreciation and Appreciation

Appreciation is an increase in the value of a currency relative

to another currency.
An appreciated currency is more valuable and can be
exchanged for a larger amount of foreign currency.
• Example: SGD per unit of USD: 1.35 → 1.3
• iPhone (USD 999): SGD 1349 → SGD 1299
An appreciated currency means that imports are cheaper and
exports are more expensive.

9
Active Learning: Depreciation and Appreciation

Suppose you want to exchange SGD to USD for a holiday in New

York.
a. If SGD appreciates, S$1 can exchange for more / less US$?
b. If SGD depreciates, S$1 can exchange for more / less US$?

After the holiday, you want to exchange the remaining USD back
to SGD:
c. If SGD appreciates, US$1 can exchange for more / less S$?
d. If SGD depreciates, US$1 can exchange for more / less S$?

10
Active Learning: Depreciation and Appreciation

https://www.bloomberg.com/quote/SGDUSD:CUR https://www.bloomberg.com/quote/USDSGD:CUR

𝐸𝑈𝑆𝐷/𝑆𝐺𝐷 = 0.7200 or 𝐸𝑆𝐺𝐷/𝑈𝑆𝐷 =1.3888 on 28 Aug 2019.

𝐸𝑈𝑆𝐷/𝑆𝐺𝐷 = 0.8008 or 𝐸𝑆𝐺𝐷/𝑈𝑆𝐷 =1.2987 on 29 Aug 2014.
Compared to 5 years ago, SGD has appreciated / depreciated against the USD.
Compared to 5 years ago, USD has appreciated / depreciated against the SGD.
11
In the news:

Source:
https://www.bloomberg.com/news/articles/2019-
05-28/singapore-added-to-u-s-monitoring-list-on-
currencies &
https://www.straitstimes.com/business/economy/m
as-says-it-does-not-engage-in-currency-
manipulation-in-response-to-us-treasury
12
S$ Nominal Effective Exchange Rate (S$NEER)

Source: https://www.mas.gov.sg/news/monetary-policy-statements/2019/mas-
monetary-policy-statement-12apr19
13
S$ Nominal Effective Exchange Rate (S$NEER)

Source: http://info.maybank2u.com.sg/pdf/investment-
insurance/insight/fx-insight-03-07-19.pdf
14
Foreign Exchange Market

Foreign exchange market (Forex) is where currencies of

different countries are exchanged for one another.
• Daily transactions of FX products was over $5.0 trillion in
April 2016, up from $500 billion in 1989.
• Most transactions (88% in April 2016) are denominated in
U.S. dollars.
• Singapore is the largest Forex market in Asia-Pacific, and the
third largest in the world since 2013 (after London and New
York).

Source: https://www.bis.org/publ/rpfx16fx.pdf

15
Forex Market Participants
Commercial banks
buy/sell deposits in different currencies

Non-bank financial institutions

e.g. mutual funds, hedge funds, securities firms, insurance
companies, pension funds
make financial investment overseas

Non-financial firms
conduct regular export and import business

Central banks
conduct foreign exchange interventions
16
Forex Market Participants

https://www.bis.org/publ/rpfx16fx.pdf

17
Forex Market Participants:
Commercial Banks
Commercial banks are at the centre of the forex market:
• Foreign currency trading among banks—called
interbank trading—accounts for much of the activity in
the forex market.
• The rates available to corporate customers, called “retail”
rates, are usually less favourable than the “wholesale”
interbank rates.
• A multinational corporation wishing to convert $100,000
into Euro might find it costly to search for other players.
• By serving many corporations simultaneously,
commercial banks can economize on these search costs.

18
Forex Market Participants:
Central Bank
Central bank is the other key player in forex market:
• While the volume of CB transactions is typically not as
large as commercial banks, the impact of CB
transactions may be far greater.
• The reason is that participants in the forex market
closely watch CB actions for clues about future
macroeconomic policies that may affect exchange rates.
• In fixed exchange rate regimes, CB actively intervene in
forex market to maintain stable exchange rate. (Topic for
lectures 8 & 9.)

19
Forex Market Transactions:
Major Currencies
Even though a forex transaction can potentially happen
between any two currencies, most transactions are between a
foreign currency against the U.S. dollars.
• For example, a bank wishing to sell Swiss francs and buy
Israeli shekels will find it much easier to exchange first to
dollar, then from dollar to shekels.
• Due to this pivotal role, the U.S. dollar is regarded as a
vehicle currency.
• Other important vehicle currencies include the Euro,
Japanese yen, and British pound.

20
Forex Market Transactions:
Major Currencies

Data source: https://www.bis.org/publ/rpfx16fx.pdf

21
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.
• They can be used for hedging exchange rate risk or
seeking for speculative gains.
22
Spot Rates and Forward Rates
Dollar/Pound Spot and Forward Exchange Rates, 1983–2016.
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.
Chart: Figure 3.1 of adopted text, International Finance: Theory and Policy, Global Edition, 11th Edition, Krugman et al. (2018).
23
Case Study: Singapore Airlines

According to the annual report of SIA, the company is exposed

to the exchange rate risk due to its foreign-denominated
operating revenues.
• Account for 63.5% of total revenues and 64% of
expenses in 2011.

SIA uses forward foreign currency contracts to hedge a

portion of its future foreign exchange exposure.
• Such contracts allow SIA to sell currencies at pre-
determined rates, buying either USD or SGD with
settlement dates ranging from one month up to one
year.
24
Part 2

Determination of equilibrium exchange rate

• Supply and demand in Forex market

• Equilibrium in Forex market
• Interest parity condition

25
Determination of Exchange Rate
Like other prices in the economy, exchange rates are
determined by supply and demand:

Supply of currency is largely controlled by the central bank:

• Monetary Authority of Singapore
• Federal Reserve
• People's Bank of China

Demand of currency is dominated by the demand for its

deposits：
• Rate of return, or interest rate
• Expected future exchange rate

26
Rate of Return

Nominal rate of return: the percentage change in value that an

asset offers during a time period.

• If $100 deposit offers an annual interest of $2, the nominal rate

of return is 2%.

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

• If the inflation is 1.5%, the price rises by 1.5%, the real rate of
return is then (1+2%)/(1+1.5%) − 1 ≈ 2% – 1.5% = 0.5%.

• If inflation rate is zero, nominal rate of return equals the real rate
of return.

27
Which Deposit to Buy?
Interest Rates on Dollar and Yen Deposits, 1978–2016
Since dollar and yen interest rates are not measured in
comparable terms, they can move quite differently over time.

Source: Datastream. Three-month interest rates are shown.

Chart: Figure 3.2 of adopted text, International Finance: Theory and Policy, Global Edition, 11th Edition, Krugman et al. (2018).
28
Which Deposit to Buy?

Suppose you have 100 SGD, and you are free to deposit in
terms of SGD, USD, or JPY.
• Suppose the interest rate is:
• 3% on a SGD deposit ; 4% on USD deposit, and 2% on
JPY deposit.
• Suppose the current exchange rate is:
• 1 SGD = 1 USD = 1 JPY;
• Suppose the expected exchange rate in one year is:
• 1 SGD = 1.02 USD = 0.98 JPY.

29
Which Deposit to Buy?

Exchange and Total return Exchange back Expected

Deposit As in 1 year to SGD Rate of Return

100*(1+0.03)=
100 SGD 103 SGD 3%
103 SGD

100*(1+0.04)= 104/1.02=
100 USD 1.96%
104 USD 101.96 SGD

100*(1+0.02)= 102/0.98=
100 JPY 4.08%
102 JPY 104.08 SGD

30
Interest Parity Condition (IPC)
Interest Parity Condition: in equilibrium, expected rates of
return of home and foreign currency deposits are equal.

𝟏 + 𝑹′ 𝑬𝒆
𝟏+𝑹=
𝑬
where
𝑹 = interest rates on domestic deposits
𝑹′ = interest rates on foreign deposits;
𝑬 is the current exchange rate, defined as units of
domestic currency per unit of foreign currency;
𝑬𝒆 is the expected exchange rate.
31
Interest Parity Condition (IPC)
Interest Parity Condition: in equilibrium, expected rates of
return of home and foreign currency deposits are equal.

Exchange to foreign Interest on 1 unit

currency now of foreign deposits

𝟏
𝟏+𝑹= 𝟏 + 𝑹′ 𝑬𝒆
𝑬

Interest on 1 unit of
Exchange back to home
home currency deposits
currency in the future

32
Interest Parity Condition (IPC)

𝐸𝑒 𝐸 𝑒 −𝐸 1+𝑅′ 𝐸 𝑒
Since =1 + , rewrite 1 + 𝑅 = as:
𝐸 𝐸 𝐸

𝐸𝑒 − 𝐸
1 + 𝑅 = 1 + 𝑅′ 1+
𝐸

𝐸𝑒 − 𝐸
log 1 + 𝑅 = log 1 + 𝑅′ + log 1 +
𝐸

𝑬𝒆 − 𝑬
𝑹 ≈ 𝑹′ +
𝑬
33
Model of Forex Market

How do changes in the current exchange rate affect the

expected rate of return of foreign currency deposits?

Consequently, how do changes in current exchange rate affect

the choice of currency deposits to invest in?

34
Model of Forex Market
𝟏
𝑬 ↑, 𝟏 + 𝑹′ 𝑬𝒆 − 𝟏 ↓
𝑬
• Depreciation of the domestic currency today lowers the
expected return of deposits on foreign currency deposits.
Why?

• When the domestic currency depreciates, each unit of

domestic currency now buy less foreign currency;

• The initial cost of investing in foreign currency deposits

increases, thereby lowering the expected rate of return
of foreign currency deposits.

35
Model of Forex Market
𝟏
𝑬 ↓, 𝟏 + 𝑹′ 𝑬𝒆 − 𝟏 ↑
𝑬
• Appreciation of the domestic currency today raises the
expected return of deposits on foreign currency deposits.
Why?

• When the domestic currency appreciates, each unit of

domestic currency now buy more foreign currency;

• The initial cost of investing in foreign currency deposits

decreases, thereby raising the expected rate of return of
foreign currency deposits.

36
Model of Forex Market

Rate of return on home

𝑬
deposit, 𝑹

Expected rate of return (ROR) on

𝟏 1+𝑅 ′ 𝐸 𝑒
𝑬𝟏 foreign deposit, −1
𝐸

𝑹
𝑹𝟏

37
Determination of the
Equilibrium Exchange Rate
𝟏+𝑹′ 𝑬𝒆
Rearrange 𝟏 + 𝑹 = into
𝑬
𝟏 + 𝑹′ 𝑬𝒆
𝑬=
𝟏+𝑹

Factors that changes the equilibrium exchange rate:

• Interest rate on domestic currency deposit, 𝑅;
• Interest rate on foreign currency deposit, 𝑅′;
• Expected future exchange rate, 𝐸 𝑒 .
38
Determination of the
Equilibrium Exchange Rate

The effects of changing interest rates:

1. Higher interest rate on domestic currency will raise the

demand for domestic currency → domestic currency
appreciates.

2. Lower interest rate on domestic currency will reduce the

demand for domestic currency → domestic currency
depreciates.

39
 Rise in Domestic Interest Rate
Rise in domestic interest rate, 𝑹 ↑
𝑬

𝑬𝟏 𝟏
𝑬𝟐 < 𝑬𝟏 𝟐
𝑬𝟐
𝑹𝑶𝑹

𝑹
𝑹𝟏 𝑹𝟐
Domestic currency appreciates.
40
 Rise in Foreign Interest Rate

Rise in foreign interest rate, 𝑹′ ↑

𝑬

𝟐
𝑬𝟐
𝑬𝟐 > 𝑬𝟏 𝑹𝑶𝑹𝟐
𝑬𝟏
𝟏 𝑹𝑶𝑹𝟏

𝑹
𝑹𝟏
Domestic currency depreciates.

41
Case Study: Credit Cycle for EMEs

• Since 2015, the U.S. economy has seen a steady and robust
recovery – the unemployment rate declined to 5%, and
growth and inflation picked up.
• In Dec. 2015, the Fed raised the interest rate for the first
time since the 2008 GFC to 0.25%–0.5%.
• In Dec. 2016, the Fed raised the interest rate again and
announced the possibility of future rate raise.
• The interest rate hike had huge impact on currencies of
emerging market economies (EMEs).

42
Case Study: Credit Cycle for EMEs
Credit cycle for EMEs:
Phase 1: Low Fed rate → capital flows into EME → EME currency
appreciation and buildup of foreign debt
Phase 2: Fed rate hike → capital flows out of EME → EME currency
depreciation and liquidity shock

43
Rise in Expected Exchange Rate
If people expect the home currency to depreciate in the future:
• Same amount of foreign deposits can be exchange back to
more domestic currency in the future
• The expected rate of return on foreign deposits increases;
• Demand for foreign deposits increases now;
• Foreign currency appreciates / home currency depreciates.
• Self-fulfilling prophecy:
• Expected depreciation of dollar leads to an actual
depreciation.

44
 Rise in Expected Exchange Rate

Rise in expected exchange rate 𝑬𝒆 ↑

𝑬

𝟐
𝑬𝟐
𝑬𝟐 > 𝑬𝟏 𝑹𝑶𝑹𝟐
𝑬𝟏
𝟏 𝑹𝑶𝑹𝟏

𝑹
𝑹𝟏
An expected depreciation of a currency leads to an actual
depreciation.
45
Limitations of Interest Parity Condition

The Interest Parity Condition assumes that investors only

consider rate of return when making investment.
• But realistic investors also consider other factors such as risk
and liquidity
• The interest parity condition assumes free capital mobility.
• But mobilizing capital across borders may incur a substantial
cost (e.g. capital control).

46
Arbitrage in Forex Market

• Assuming the interest parity condition holds, will investors

receive the same actual return from domestic and foreign
deposits?
• No. Expected return is different from actual return.
• Gain and loss from trading currency is still possible
under the interest parity condition.
• If currency trading is systemically profitable (arbitrage
opportunity), investors will rush in to take advantage. This
would eliminate the arbitrage.
• Quantitative finance

47
Case Study: The Japanese Yen Carry Trade
• During 2000s, the Japanese yen interest rates were close to
zero while Australia’s interest rates were rising over 7% by
2008.
• Interest parity condition suggests investing in yen deposits and
Australian dollar deposits should yield the same return.
• Nonetheless, households in Japan invested billions in
Australian bonds, betting that Yen would further depreciate in
the future.
• Japanese Yen carry trade.
• Carry trade: investors frequently borrow low-interest rate
currencies (called “funding” currencies) and buy high-
interest currencies (called “investment” currencies),
resulting in profits over long periods.
48
Case Study: The Japanese Yen Carry Trade
Cumulative Total Investment Return in Australian Dollar
Compared to Japanese Yen, 2003-2013
The Australian dollar-yen carry trade has been profitable on
average but is subject to sudden large reversals, as in 2008.

Source: Exchange rates and 3-month Treasury yields from Global Financial Data.
Chart: Figure 3.7 of adopted text, International Finance: Theory and Policy, Global Edition, 11th Edition, Krugman et al. (2018).
49
Covered Interest Parity

To eliminate the exchange rate risk, investors use forward

contract to lock in their return:

𝟏 + 𝑹′ 𝑭
locked−in return = −𝟏
𝑬
where 𝑭 is the forward exchange rate.
Covered interest parity says rates of return on dollar deposits
and “covered” foreign currency deposits using the forward
exchange rate are the same.

𝟏 + 𝑹′ 𝑭
𝑹= −𝟏
𝑬
50
Summary

Introduction to exchange rate

• Definition of exchange rate
• Appreciation and depreciation
• Foreign exchange market

Determination of equilibrium exchange rate

• Supply and demand in foreign exchange market
• Equilibrium of foreign exchange market
• Interest parity condition

51