Download Chapter 8

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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
8.1
Explain the difference between nominal and real exchange rates.
8.2
Explain how markets for foreign exchange operate.
8.3
Explain how exchange rates are determined in the long run.
8.4
Use a demand and supply model to explain how exchange rates
are determined in the short run.
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Is Ben Bernanke Responsible for Japanese Firms Moving to the
United States?
•The increase in the value of the Japanese yen following the financial
crisis made it more expensive for Japanese firms to export products to
the United States.
•Some Japanese firms like Toyota shifted production to the U.S. so that
both revenue and costs would be in dollars, thus insulating them from the
effects of changes in exchange rates.
•What led to the rising value of the yen? This was due in part to U.S.
monetary policy, which pushed interest rates to record low levels, and
therefore declines in the value of the dollar against other currencies.
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Key Issue and Question
Issue: Volatility in exchange rates during recent years has led some
Japanese firms to relocate production to the United States and other
countries.
Question: Why has the value of the dollar declined against other
major currencies during the past 10 years?
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8.1 Learning Objective
Explain the difference between nominal and real exchange rates.
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Exchange Rates and Trade
• When individuals or firms in the United States import or export goods or
invest in other countries, they need to convert dollars into foreign currencies.
A nominal exchange rate is the price of one currency in terms of another
currency.
• Changes in the exchange rate between the dollar and foreign currencies
affect the prices that U.S. consumers pay for foreign imports.
Appreciation is an increase in the value of a currency in exchange for
another currency.
Depreciation is a decrease in the value of a currency in exchange for
another currency.
Exchange Rates and Trade
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Making the Connection
What’s the Most Important Factor in Determining Sony’s Profits?
• In the long run, Sony’s profits depend on its ability to innovate, to produce at
a low cost, and to market its products to consumers.
• In the short run, Sony’s profits depend on the prices it charges relative to its
competitors.
• Since Sony sells most of its goods outside of Japan, changes in exchange
rates will affect its foreign currency prices.
• An increase in the value of the yen from ¥105 to ¥100 per euro (€) would
reduce Sony’s profits by about ¥30 billion.
• So, top managers of Sony and other Japanese firms continue to find ways to
cushion the impacts of the changing value of the yen.
Exchange Rates and Trade
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Is It Dollars per Yen or Yen per Dollar?
• Direct quotations are exchange rates quoted as units of domestic currency
per unit of foreign currency.
• Indirect quotations are exchange rates as units of foreign currency per unit
of domestic currency.
• In financial news, the conventions in reporting exchange rates are a mixture
of direct and indirect quotations.
Figure 8.1
Exchange Rates and Trade
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Figure 8.1
Foreign-Exchange Cross Rates
The second entry in the U.S. row shows that the exchange rate on this day was $1.3034 per
euro (€). The last entry in the U.S. Dollar column shows that the exchange rate can be
expressed as €0.7672 per dollar.
Exchange Rates and Trade
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Figure 8.2
The panels show the exchange rates between the United States dollar and the yen, the
Canadian dollar, and the euro. An increase in the exchange rate represents a depreciation of
the dollar.
Exchange Rates and Trade
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Nominal Exchange Rates versus Real Exchange Rates
The real exchange rate is the rate at which goods and services in one country
can be exchanged for goods and services in another country.
• Example: The real exchange rate between the dollar and the pound in terms
of Big Macs =
Dollar price of Big Macs in New York
Pound price of Big Macs in London  Dollars per pound exchange rate (nominal exchange rate)
• Using the price indexes of both countries, the real exchange rate =
U.S. consumer price index
British price index  Dollars per pound exchange rate (nominal exchange rate)
Exchange Rates and Trade
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Nominal Exchange Rates versus Real Exchange Rates
Rearranging the terms of the real exchange rate equation, the relationship
between the nominal and real exchange rates:
where
E = nominal exchange rate (units of foreign currency per unit of
domestic currency)
e = real exchange rate
PDomestic = domestic price level
PForeign = foreign price level
Exchange Rates and Trade
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8.2 Learning Objective
Explain how markets for foreign exchange operate.
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Foreign-Exchange Market
The foreign-exchange market is an over-the-counter market where
international currencies are traded.
• Large commercial banks are market makers because they are willing to buy
and sell major currencies at any time.
• Most foreign-exchange trading takes place among commercial banks
located in London, New York, and Tokyo, with secondary centers in Hong
Kong, Singapore, and Zurich.
• With daily trading in the trillions of dollars, the foreign-exchange market is
one of the largest financial markets in the world.
• Participants include investment portfolio managers and central banks.
Foreign-Exchange Markets
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Forward and Futures Contracts in Foreign Exchange
• Spot market transactions involve an exchange of currencies immediately at
the current exchange rate.
• In forward transactions, traders agree today to a forward contract to
exchange currencies on a specific future date at an exchange rate known as
the forward rate.
• Futures contracts are traded on exchanges (e.g., CBOT), and they reduce
counterparty risk, and thus default risk.
• The amount of trading in forward contracts is at least 10 times greater than
the amount of trading in futures contracts.
• Call and put options contracts are also available on foreign exchange.
Foreign-Exchange Markets
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Exchange-Rate Risk, Hedging, and Speculating
Exchange-rate risk is the risk that a firm will suffer losses because of
fluctuations in exchange rates.
• The forward rate reflects what traders in the forward market expect the spot
exchange rate to be in the future, so it may not equal the current spot rate.
• To hedge against a fall (rise) in the value of a currency, a firm sells (buys)
that currency in the forward market.
• A hedger uses derivatives markets to reduce risk, while a speculator uses
derivatives markets to place a bet on the future value of a currency.
• Firms and investors can also use options contracts to hedge or to speculate.
• The disadvantage of speculating with options contracts is that their prices
are higher than are the prices of forward contracts.
Foreign-Exchange Markets
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Making the Connection
Can Speculators Drive Down the Value of a Currency?
• In February 2010, the managers of four hedge funds met in New York City to
discuss whether it would be profitable to use derivatives to bet that the value
of the euro would fall.
• In response to criticisms from U.S. and European government officials, those
fund managers claimed that they were just exchanging ideas on an
investment opportunity.
• Over the following years, the euro-dollar exchange rate never dropped
significantly
• Exchange rates among major currencies are determined by factors that a
few hedge fund managers probably can’t affect, however large those funds
are.
Foreign-Exchange Markets
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8.3 Learning Objective
Explain how exchange rates are determined in the long run.
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Exchange Rates in the Long Run
The Law of One Price and the Theory of Purchasing Power Parity
The law of one price is the idea that identical products should sell for the
same price everywhere.
• The law of one price is the basis for the theory of purchasing power parity
(PPP).
Theory of purchasing power parity (PPP) states that exchange rates move
to equalize the purchasing power of different currencies.
• In the long run, an exchange rate should be at a level that the equivalent
amount of any country’s currency can buy the same amount of goods and
services.
Exchange Rates in the Long Run
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The Law of One Price and the Theory of Purchasing Power Parity
• In the long run, arbitrage activity in the foreign exchange market causes PPP
to hold.
• PPP makes an important prediction: If one country has a higher inflation rate
than another country, its currency will depreciate relative to the currency of
the other country.
• Recall the real exchange rate equation:
If Domestic is the domestic inflation rate and Foreign is the foreign inflation
rate, then
% change in e = % change in E + Domestic – Foreign.
If PPP holds, e =1, so that
% change in E = Foreign – Domestic
Exchange Rates in the Long Run
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Is PPP a Complete Theory of Exchange Rates?
• Real-world complications keep PPP from being a complete explanation
of exchange rates:
1. Not all products can be traded internationally
2. Products are differentiated
3. Governments impose barriers to trade, e.g., tariffs and quotas
A tariff is a tax a government imposes on imports.
A quota is a limit a government imposes on the quantity of a good that can
be imported.
Exchange Rates in the Long Run
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Solved Problem 8.3
Should Big Macs Have the Same Price Everywhere?
The Economist magazine tracks the
prices of the McDonald’s Big Mac
around the world.
The table shows the Big Mac’s prices
in the different countries, along with the
exchange rate with the U.S. dollar.
a. Explain whether the statistics in the table are consistent with the theory
of purchasing power parity.
b. Explain whether your results in part (a) mean that arbitrage profits exist
in the market for Big Macs.
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Solved Problem 8.3
Should Big Macs Have the Same Price Everywhere?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by determining whether the theory of purchasing power
parity applies to Big Macs.
We can convert the price of a Big Mac in a given country to its price in dollars. For
example, in the case of Japan: ¥320/(¥78.22/$) = $4.09, which is close to the U.S.
price.
However, this is not the case for the majority of other countries, so that PPP does not
hold in general for Big Macs.
Step 3 Answer part (b) by explaining whether arbitrage profits exist in the
market for Big Macs.
It is not possible to make arbitrage profits by buying low-price Big Macs in one country
and selling them in another.
Exchange Rates in the Long Run
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8.4 Learning Objective
Use a demand and supply model to explain how exchange rates are
determined in the short run.
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A Demand and Supply Model of Short-Run Movements
in Exchange Rates
A Demand and Supply Model of Exchange Rates
• The model determines both the equilibrium nominal exchange rate and the
equilibrium real exchange rate, holding price levels constant.
• The demand for U.S. dollars represents the demand by foreign households
and firms for U.S. goods and U.S. financial assets.
• The supply of dollars in exchange for a foreign currency is determined by the
willingness of households and firms that own dollars to exchange them for
the foreign currency.
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A Demand and Supply Model of Exchange Rates
Figure 8.3
The Demand and Supply of
Foreign Exchange
The demand curve for dollars in
exchange for yen is downward
sloping because the lower the
dollar exchange rate, the more
dollars demanded.
The supply curve of dollars in
exchange for yen is upward
sloping because the quantity of
dollars supplied will increase as
the dollar exchange rate increases.
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Shifts in the Demand and Supply for Foreign Exchange
Figure 8.4 (1 of 2)
The Effect of Changes
in the Demand and
Supply for Dollars
Panel (a) illustrates the
effect of an increase in
the demand for dollars in
exchange for yen.
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Shifts in the Demand and Supply for Foreign Exchange
Figure 8.4 (2 of 2)
The Effect of Changes
in the Demand and
Supply for Dollars
Panel (b) illustrates the
effect of an increase in the
supply of dollars in
exchange for yen.
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The “Flight to Quality” during the Financial Crisis
Figure 8.5
Movements in the Trade-Weighted Exchange Rate of the U.S. Dollar
During the financial crisis of 2007–2009, many foreign investors sought a safe haven in
U.S. Treasury securities. As a result, the demand for dollars and thus the dollar exchange
rate increased.
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The Interest-Rate Parity Condition
• Investors account for more than 95% of demand for foreign
exchange, reflecting the importance of international capital mobility.
• To purchase Japanese bonds, you assume some exchange-rate
risk: While your funds are invested in Japanese bonds, the value of
the yen might decline relative to the dollar.
• To eliminate any arbitrage profits, the difference between the
interest rates on a Japanese bond and a U.S. bond must equal the
expected change in the exchange rate between the yen and the
dollar.
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The Interest-Rate Parity Condition
The interest-rate parity condition holds that differences in interest rates
on similar bonds in different countries reflect expectations of future changes in
exchange rates.
This condition also means:
Interest rate on domestic bond = Interest rate on foreign bond
– Expected appreciation of the domestic currency.
• If the expected returns (including expected changes in the exchange rate)
from the domestic and foreign bonds are not the same, then investors can
make arbitrage profits.
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The Interest-Rate Parity Condition
Differences in interest rates in different countries do not always reflect
expectations of future changes in exchange rates for several reasons:
1. Differences in default risk and liquidity.
2. Transactions costs.
3. Exchange-rate risk.
To account for the additional risk of investing in a foreign asset we can include
a currency premium in the interest-rate parity equation:
Interest rate on the domestic bond = Interest rate on the foreign bond
– Expected appreciation of the domestic currency – Currency premium
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Solved Problem 8.4
Can You Make Money Investing in Japanese Bonds?
Suppose you read the following investment advice:
“One strategy for earning an above-average return is to borrow money in the
United States at 3% and invest it in Japan in a comparable investment at 6%.”
Would you follow this strategy?
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Solved Problem 8.4
Can You Make Money Investing in Japanese Bonds?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Use the interest-rate parity condition to answer the question by
explaining the relationship between expected changes in exchange rates
and differences in interest rates across countries.
If the interest-rate parity condition holds, then a 3-percentage-point gap between
the U.S. bond and Japanese bond rates means that investors must be expecting
that the value of the dollar will appreciate against the yen by 3%.
A U.S. investor who borrows money at 3% in the U.S. and invests it at 6% in
Japan will not gain anything if the dollar appreciates by 3%.
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Making the Connection
In Your Interest
Should You Invest in Emerging Markets?
• Emerging markets refer to developing countries with rapid economic growth
rates (e.g., China and India).
• Many investors have responded to low U.S. interest rates by diversifying
their portfolios with stocks and bonds of emerging-market companies.
• But high economic growth does not necessarily mean high long-term
investment returns.
• Also, economic growth typically results in a larger number of stocks, which in
turn creates a “dilution effect” in financial investments.
• Still, investors can minimize risk by (1) buying an index fund that includes
stocks from both developed and emerging markets, and (2) combine
emerging market investments with conventional investments.
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“Why has the value of the dollar declined against other major currencies
during the past 10 years?”
Relatively higher inflation rates in the United States and lower interest
rates have caused the value of the dollar to decline against other major
currencies.
Lower real interest rates in the United States reduced foreign investors’
demand for U.S. bonds and thus their demand for dollars.
The dollar exchange rate declined as a result.
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