Download Chapter 2: Introduction to Exchange Rates and Foreign

Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
International Macroeconommics
Chapter 2: Introduction to Exchange Rates and Foreign
Exchange Market
Instructor: Yuan Liu
Department of Economics, UCDavis
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Outline
1
Exchange Rate Essentials
2
Foreign Exchange Market
3
Arbitrage and Spot Exchange Rate
4
No Arbitrage Conditions
CIP
UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Outline
1
Exchange Rate Essentials
2
Foreign Exchange Market
3
Arbitrage and Spot Exchange Rate
4
No Arbitrage Conditions
CIP
UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Defining the Exchange Rate
An Exchange Rate (E) is the Price of one currency in terms of
another.
Conventional Way
Units of home currency per foreign currency
US is the home country, E: $/€(American Term)
Europe is the home country, E: €/$ (European Term)
1
E$/euro = Eeuro/$
E$/euro = 1.33
Eeuro/$ = 0.75
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Defining the Exchange Rate
Compare goods price across country:
Price of a tux
Exchange-rate
Price in £
NewYork
$4000
E$/£ = 1.53
£2614
Instructor: Yuan Liu
Hongkong
London
HK$ 30,000 £2,500
E$/HK $ = 0.1
£3000
£2500
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Defining the Exchange Rate
Compare goods price across country:
Price of a tux
Exchange-rate
Price in £
NewYork
Hongkong
London
$4000
HK$30, 000 £2, 500
E$/£ = 1.63 E$/HK $ = 0.1
£2454
£3000
$2500
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Appreciation and Depreciation
E$/£ :1.53→ 1.63
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Appreciation and Depreciation
E$/£ :1.53→ 1.63
It takes more $ to buy one unit £.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Appreciation and Depreciation
E$/£ :1.53→ 1.63
It takes more $ to buy one unit £.
£appreciates relative to $, $ depreciates relative to £.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Appreciation and Depreciation
E$/£ :1.53→ 1.63
It takes more $ to buy one unit £.
£appreciates relative to $, $ depreciates relative to £.
Price of Tux in N.Y: $4000.
£2614 → £2454.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Appreciation and Depreciation
Appreciation: increase in the value of a currency relative
to another.
Depreciation: decrease in the value of a currency relative
to another.
Given exchange rtae is expressed as units of Home
currency per foreign currency.
Exchange rate increases: home currency depreciation
Exchange rate decreases: home currency appreciation
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Multilateral Exchange Rates
According to bilateral exchange rate, dollar can be
appreciating against one currency at the same time
depreciating against another currency.
1
1
Aug 3rd, 2013, The Economist
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Multilateral Exchange Rates
Nominal Effective Exchange Rate: a weighted average of
several bilateral exchange rates, usually using trade shares
as weights to reflect the relative importance of each of
the bilateral pairs involved.
Example: Suppose US only trade with Britian and EU.
∆E$/£ = −10%,trade share of UK in US trade is 40%.
∆E$/euro = 30%, trade share of EU in US trade is 60%.
−10% × 40% + 30% × 60% = +0.14
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Outline
1
Exchange Rate Essentials
2
Foreign Exchange Market
3
Arbitrage and Spot Exchange Rate
4
No Arbitrage Conditions
CIP
UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Features
Foreign Exchange Market (FOREX) is a collection of private
individuals, corporations, and some public institutions that buy
and sell currencies.
Volume is enormous:
2010 $4 trilion per day. US GDP?
Highly integrated internationally:
there is not a moment in the day when foreign exchange
is not being traded somewhere in the world.
Concentrated in major FOREX centers:
London, New York, Tokyo: half of the trade
Other important centers?
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Actors
Private Actors
Commercial Banks
interbank trading is 3/4 of all FOREX transactions
globally.
Highly concentrated in a few international banks:
Deutsche Bank, Citigroup, Barclay.
Corporations
Non-bank Financial Institutions
Government
Capital Contral
Intervention
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
Forward: fix the price today, but deliver currency in the
future.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
US#
Bestbuy#
Forward#contract#
FOREX#
TV#(1#month#later)#
Yen#(1#month#later)#
Japan#
Sony#
If#$depreciaFon/#¥appreciaFon#1#month#later,#
bestbuy#pay#more.#
To#avoid#the#risk,#buy#forward,#fix#the#exchange#rate#today##
actually#delivery#of#¥#and#payment#happens#1#month#later##
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
Swap: combination of a spot contract and a forward
contract.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
US#
Bestbuy#
swap#contract#
##Receive#Yen#now##
Japan#
Yen#(1#month#later)#
Don’t#want#hang#on#to#Yen,#need#use#$#
A#swap#contract#include#a#spot#sell#of#¥#for#$,##
And#a#forward#buy#of#¥#using#$#
FOREX#
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
Futures: standardized forward contract, can be traded
on an organized futures exchange and thus delivery of
currency is not necessary.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Spot exchange rate: the exchange rate for currency
transactions that takes place immediately.
Derivatives
Options: An option provides the buyer with the right to
buy (call) or sell (put) a currency in exchange for
another at a prespecitiedexchange rate at a future date.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Outline
1
Exchange Rate Essentials
2
Foreign Exchange Market
3
Arbitrage and Spot Exchange Rate
4
No Arbitrage Conditions
CIP
UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
Arbitrage: buy low and sell high.
If arbitrage opportunity exists, market is out of
equilibrium.
If arbitrage opportunity not exists, market is in
equilibrium because it satisfies no-arbitrage condistion.
highly integrated market, arbitrage opportunity will be
immediately spotted and exploited by traders. market
goes back to equilibrium immediately.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
N.Y .
London
E$/£
= 2, E$/£
= 1.8.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
N.Y .
London
E$/£
= 2, E$/£
= 1.8.
buy £ in London, sell them in N.Y.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
N.Y .
London
E$/£
= 2, E$/£
= 1.8.
buy £ in London, sell them in N.Y.
in the FOREX market, this transaction:
London
increases demand of £ in London, E$/£
↑
N.Y .
increases supply of £ in N.Y., E$/£ ↓
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
N.Y .
London
E$/£
= 2, E$/£
= 1.8.
buy £ in London, sell them in N.Y.
in the FOREX market, this transaction:
London
increases demand of £ in London, E$/£
↑
N.Y .
increases supply of £ in N.Y., E$/£ ↓
N.Y .
London
until E$/£
= E$/£
no arbitrage opportunity, market
back to equilibrium.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Outline
1
Exchange Rate Essentials
2
Foreign Exchange Market
3
Arbitrage and Spot Exchange Rate
4
No Arbitrage Conditions
CIP
UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
example
has $100 can deposit in US (i$ = 2%) or UK (i£ = 8%).
option1: deposit in US, earn 2% interests.
option2: convert $100 to £, and deposit £in UK, earn 8%
interests. 1 year later, convert £back to $.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
example
has $100 can deposit in US (i$ = 2%) or UK (i£ = 8%).
option1: deposit in US, earn 2% interests.
option2: convert $100 to £, and deposit £in UK, earn 8%
interests. 1 year later, convert £back to $.
E$/£ = 1.8 and F$/£ = 1.7
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
No Arbitrage Condition: CIP
E$/£ = 1.8
$100
$100
= £55.556
E$/£
i$ = 2%
i£ = 8%
$100(1 + i$ ) = $102
£60F$/£ = $102
F$/£ = 1.7
Instructor: Yuan Liu
CH2
£55.556(1 + i£ ) = £60
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
No Arbitrage Condition: CIP
Gross rate of return of $ deposite: 1 + i$ .
Gross rate of return of £deposite:
F$/£
(1
E$/£
Covered Interest Parity: 1 + i$ =
+ i£ ).
F$/£
(1
E$/£
+ i£ )
In equilibrium:
Total Gross Return on $ Deposit=Total Gross Return on
£Deposit
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
What Determines the Forward Rate?
CIP: 1 + i$ =
F$/£
(1
E$/£
+ i£ )
1+i$
Rearrange CIP: F$/£ = E$/£ 1+i
£
i$ , i£ , E$/£ →F$/£
In practice, this is exactly how the price of a forward contract
is set.
? →i$ , i£ , E$/£
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Equilibrating Process
E$/£ = 1.8
$100
$100
= £55.556
E$/£
i$ = 2%
i£ = 8%
$100(1 + i$ ) = $102
£60F$/£ = $108
F$/£ = 1.8
£55.556(1 + i£ ) = £60
F
Arbitrage opportunity: 1 + i$ < E$/£
(1 + i£ )
$/£
Demand of £increases in spot market, E$/£ ↑
Supply of £increases in forward market, F$/£ ↓
F
Until 1 + i$ = E$/£
(1 + i£ ). Back to equilibrium.
$/£
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Test of CIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Example
has $100 can deposit in US (i$ = 2%) or UK (i£ = 8%).
option1: deposit in US, earn 2% interests.
option2: convert $100 to £, and deposit £in UK, earn 8%
interests. 1 year later, convert £back to $.
e
E$/£ = 1.8 and E$/£
= 1.7
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
No Arbitrage Condition: UIP
E$/£ = 1.8
$100
$100
= £55.556
E$/£
i$ = 2%
i£ = 8%
$100(1 + i$ ) = $102
£60F$/£ = $102
e
E$/£
= 1.7
Instructor: Yuan Liu
CH2
£55.556(1 + i£ ) = £60
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
No Arbitrage Condition: UIP
Gross rate of return of $ deposite: 1 + i$ .
Expected gross rate of return of £deposite:
Uncovered Interest Parity: 1 + i$ =
e
E$/£
E$/£
e
E$/£
E$/£
(1 + i£ ).
(1 + i£ )
In equilibrium:
Total Gross Return on $ Deposit=Expected Total Gross
Return on £Deposit
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
What Determines the Spot Rate?
UIP: 1 + i$ =
e
E$/£
E$/£
(1 + i£ )
e 1+i£
Rearrange CIP: E$/£ = E$/£
1+i$
e
i$ , i£ , E$/£
→E$/£
e
? →i$ , i£ , E$/£
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
UIP: A Useful Approximation
∆E e
$/£
i$ = i£ + E$/£
Net rate of return on $ deposit=Net Rate of return on
£deposit.
Return on £deposit include the £interest rate and the
expected appreciation of £against $.
∆E e
$/£
i$ − i£ = E$/£
Interest Rate Differential = Expected percentage change
of exchange rate.
How much higher $ interest rate is than £interest rate =
Expected depreciation of $ against £.
How much lower $ interest rate is than £interest rate =
Expected appreciation of $ against £.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Test of UIP
i$ = i£ +
e
∆E$/£
?
E$/£
Hard to measure expectations.
Maybe errors with the measure of expectations.
Risk premium.
Expected return is risky. Investors ask for a premium
associate with the risk that they undertake.
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Test of UIP
Instructor: Yuan Liu
CH2
Exchange Rate Essentials
Foreign Exchange Market
Arbitrage and Spot Exchange Rate
No Arbitrage Conditions
CIP
UIP
Short-run Exchange Rate Determination
Instructor: Yuan Liu
CH2