Foreign Exchange Markets

The Foreign-
Exchange
Market and
Exchange Rates
Why do we care about exchange rate
markets?

Countries have different currencies and

exchange is denoted in these different
currencies
For trade to occur, you need to be able
to buy and sell in the currency of your
trading partner.
Why not just one currency?
Appreciation and Depreciation

Appreciation: when your currency becomes

more expensive in terms of other currencies.
(For example If 1 USD cost 1 Euro and then
went up to 1.2 Euros you have an
appreciation
Depreciation: when your currency becomes
less expensive in terms of other currencies.
(For example if the USD cost 1 Euro and then
went down to .8 Euros you have a
depreciation)
Exchange Rates

The nominal exchange rate is the price of one

countrys exchange rate in terms of anothers.
Example: In India, if you want to buy a dollar,
it costs 50 Rupees on the market- so, the
nominal exchange for dollars is 1/50=.02
dollars per rupee in India. In the U.S, the
nominal exchange rate for a rupee is 50
rupees to the dollar.
Real Exchange Rate

The real exchange rate is the purchasing

power of a currency relative to the purchasing
power of other currencies.
Things cost different amounts in each country.
For example, to take the Indian case with 50
rupees to the dollar. A shirt in India may cost
250 rupees, while in the U.S it costs 10
dollars. Are you better off buying in India or in
the U.S? To check, we have to calculate the
real exchange rate
Real E.R

Formula: EXr=[EX X P]/Pf

Real E.R= (Nominal ER X Domestic Price)/Foreign
Price
= (Rs.50/$1 )*($10)/Rs.250=2 Indian Shirts/1 U.S
Shirt
So shirts are in real terms, twice as expensive in the
U.S as they are in India
Price indices

In reality, we compare not prices of any

particular good, but general prices
(price indices) (basket of goods
containing lots of common items)
So we compare general price levels
Relationship between Nominal and
Real Exchange Rates over time

Formula: EXr=[EX * P]/Pf

So, in percentages
EXr/EXr= EX/EX+P/P-Pf/Pf
%change in RE=% change in nominal+
percentage change in price level
domestically- percentage change in
price level in the foreign country
Example

EXr/EXr= EX/EX+P/P-Pf/Pf
Let us take our previous example and say that
that shirts cost more in the US- (now they are
$15). The RER is now
(Rs.50/$1 )*($15)/Rs.250=3 Indian Shirts/1
U.S Shirt
The change in EX=0, in P=50% in Pf=0
Change in EXr=50%
Foreign-Exchange Markets

Spot market transactions involve immediate

exchanges of currency or bank deposits.
Example: I exchange one dollar for 45 rupees
today
Forward transactions involve future
exchanges of currencies or bank deposits.
Example: I buy a contract today to exchange
$1 for 45 rupees 3 months from now? Why?
Zero sum game.
Causes of Higher Long-run Exchange Rates

A decrease in a countrys relative price level (If U.S goods

are cheaper than in India, more people will buy U.S
goods, and bid up the price of the dollar)
An increase in a countrys relative productivity
(If U.S goods are made more productively, they will be
cheaper than in India, more people will buy U.S goods,
and bid up the price of the dollar)
A decrease in a countrys demand for foreign goods or a
rise in foreign demand for a countrys exports (If people
think that Indian goods are not of the same quality, they
will buy more U.S goodsetc)
An increase in a countrys tariffs (foreign goods become
costlier)
Rearranging our Equation

EX/EX = EXr/EXr + f-
refers to inflation
Nominal E.R change = Real E.R change+
difference in foreign and domestic
inflation rates
Purchasing Power Parity/Law of One
Price
Law of One Price: LOOP-if two countries produce an
identical good, if the good is tradable, if there is free trade
and there are no transactions /transportation costs, then the
price should be the same in both countries. In the shirt
example, U.S consumers would buy Indian shirts, buy more
rupees, causing an appreciation of the Indian rupee and
making it relatively more costly to buy the shirt. This would
go on till the RER= 1 shirt India/1 shirt US
Purchasing power parity (PPP) theory applies the law of
one price to a group of goods. Under LOOP, RER is always
constant, (percentage change is zero) so according to PPP,
changes in N.E.R reflect inflation rate differences cause
changes in the nominal exchange rate.
EX/EX = EXr/EXr + f-underPPP EX/EX = f-
Another Determinant of Exchange Rates

The flow of goods and services (called trade) is not

the only thing that moves between countries
Capital flows too (financial flows between countries).
Just like with trade, borrowers need finance in their
local currency and sellers need repayment in their
own currency, so they need foreign exchange
markets.
How does this explain the fact that while the U.S has
a constant and huge trade deficit, its currency isnt
depreciating fast?
Determining Short-run
Exchange Rates

Investors compare the return on a

domestic asset with the return on a
foreign asset evaluated in terms of
domestic currency.
 Example in the Book
Two assets with equal risk- Japanese Bonds and U.S
Bonds each offering 5% return.
Basic point- overall return (R) depends on both
interest rate and exchange rate
The return on a domestic asset (1 + i) should be
compared with the return on a foreign asset evaluated
in terms of domestic currency (1+ if EXe/EX). Note
Exe= expected change
If Japanese yen depreciates by 5% over the year the
return to the U.S bond is 1+.05=1.05=5% return, while
to the Japanese bond=1+.05-.05=1= 0% return
The graph shows the expected rate of return on a Japanese bond.
Let the expected exchange rate one year from now be 100. If
current ER is 105, then actual R=.05+5/105=.098=9.8%
If current ER is 97, then actual R=.05+ (-3/97)=1.9%
Rules
Nominal interest rate parity: ceteris paribus, the
nominal returns of domestic and foreign assets must
be equal.
International capital mobility results in an exchange
rate market equilibrium reflecting the nominal
interest rate parity condition: When domestic and
foreign assets have identical risk, liquidity, and
information characteristics, their nominal returns
(measured in the same currency) also must be
identical (i = if EXe/EX).
Real interest rate parity: expected real rates of
interest are equal. (1 + r) = (1 + rf)(EXrr/EXre ).
Other comparative statics:
1. Effect of a Change in the Domestic Real Interest Rate
Effect of an Increase in Domestic
Expected Inflation
Effect of a Change in the Foreign
Interest Rate
Effect of Changes in
Exchange Rate Expectations
Play ball!

You are a currency speculator. Choose

(as soon as you can) what currency,
Yen or the Dollar, you would under the
following bits of news
Choices
Japanese productivity continues to increase
U.S announces unilateral tariffs on all
Japanese products
U.S products seen to be of better quality
Japanese raise interest rates
Higher expected inflation in the U.S
Moodys downgrades Japanese bonds
U.S trade deficit continues to rise