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Chapter 10
Exchange
Rates and
Exchange
Rate Systems
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
Introduction:
Fixed, Flexible, or In-Between?
• Disagreements related to exchange rates and
exchange rate systems
• Countries have numerous choices
• Exchange rate systems require different policies
and respond differently to the pressures of the world
economy
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10-2
Exchange Rates and
Currency Trading
• Exchange rate: The price of domestic
currency stated in terms of another
currency
• For US it is dollars per pound, or dollars
per yen
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Exchange Rates and
Currency Trading
• Frequently traded currencies are:
- European Union’s euro
- Japanese yen
- British pound
• All three are flexible exchange rates
• It doesn’t matter how many of one
currency is required to buy another
• Can’t use “strong” and “weak”
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Figure 10.1 Dollar Exchange Rates for Commonly
Traded Currencies, 1999–2008
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Exchange Rates and
Currency Trading
• Appreciation: Less domestic
currency is required to buy 1 unit of
foreign currency
• Depreciation: More domestic
currency is required to buy 1 unit of
foreign currency
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Reasons for
Holding Foreign Currencies
1. Trade and investment
2. Interest rate arbitrage
•
Borrow money where interest rates are low
and sell it where interest rates are high
•
Capital inflow in high interest countries
decreases interest rates
•
Outflow of capital from low interest rate
countries increases interest rates
•
Powerful force in global economy
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Reasons for
Holding Foreign Currencies
3. Speculation
•
speculators sell overvalued currencies and
buy undervalued currencies
•
Help restore equilibrium after currency has
become under- or overvalued
•
Some argue it can be destabilizing by
leading to under- or overvalued currency
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Institutions
• Four main groups involved in foreign currency
markets:
– Retail customers: firms and individuals that
hold foreign currency
– Commercial banks: hold inventories of foreign
currencies as part the services to customer;
most important of four participants
– Foreign exchange brokers: middlemen between
buyers (banks) and sellers of foreign currency
– Central banks: a country’s bank of banks
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10-9
Exchange Rate Risk
• Exchange rate risks: currencies are constantly
changing in value
– Actual payment in a foreign currency will likely
be a different domestic currency amount from
when the contract was signed
– Created mechanisms to deal with problem.
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10-10
Exchange Rate Risk
• Forward exchange rate: The price of currency that
will be delivered in the future
• Forward market: A market in which the buying and
selling of currencies for future delivery takes place
– Eliminates risk from future payments
– Contract is signed the day they agree to
ship/receive goods that guarantees price for 30,
90, or 180 days
• Spot market: Buying and selling of foreign
currencies in the present
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Exchange Rate Risk
• Hedging: Use forward market to protect themselves
against foreign exchange risk while holding foreign
assets
– Done by buying forward contract to sell foreign
currency at the same time the interest earning
asset matures
– Covered interest arbitrage: Use of forward
market by an interest rate arbitrageur against
exchange rate risk
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10-12
The Supply and Demand for
Foreign Exchange
• Currency’s value is determined by its supply and
demand
– Under a flexible exchange rate system currency
appreciates/depreciates based on changes in
supply/demand
– Under a fixed exchange rate system, the central bank
counteracts changes in the market to hold currency’s
value constant
• Biggest disadvantage: trade-off between supporting the
exchange rate and maintaining economic growth.
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TABLE 10.1
A Hypothetical Example of the
Exchange Rate in the Long Run
• Purchasing power parity (PPP): the equilibrium
value of an exchange rate is at the level that allows a
given amount of money to buy the same quantity of
goods abroad as it will buy at home
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Exchange Rates in the Long Run
• PPP is underlying tendency of exchange rates in long
run, not short or medium run
• If currency is over- or undervalued, automatic
changes in buying/selling currency and flow of goods
will restore PPP
• Usually equalization is through exchange rates, not
prices
• PPP is based on goods arbitrage which fails to
acknowledge other costs
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Exchange Rates in the
Medium Run and Short Run
• Medium run forces:
– The country’s economic growth: increases
incomes, increases demand for imports
and an outward shift in the demand for
foreign currency, domestic currency
depreciates
– Growth abroad: results in an increase of
exports from the home country and an
increase in the supply of foreign currency,
domestic currency appreciates
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Exchange Rates in the
Medium Run and Short Run
• Short run (a year or less) effects on the
exchange rate stem from financial capital
flows
• These flows are determined by (1) interest
rates and (2) expectations of future
exchange rates
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Exchange Rates in the
Medium Run and Short Run
• Interest parity: the difference between any
two countries’ interest rates is equal to the
expected change in the exchange rate
– If i = i*, investors are indifferent
– If i > i*, investors prefer home to foreign
investment
• Best choice is also determined by exchange
rate movements during the period
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Exchange Rates in the
Medium Run and Short Run
• Difference between the forward exchange rate (F)
and the spot rate (R) is expected appreciation or
depreciation
– F > R: home currency expected to depreciate and is selling
at a discount
– F<R: home currency expected to appreciate and is selling
at a premium
– However, say, i < i* and F = R: no changes are expected in
the exchange rate, and investors should invest in foreign
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Exchange Rates in the
Medium Run and Short Run
• Processes in economy continue until interest parity
condition is reached
– i – i* = (F-R)/R
– Interest rate differentials are approximately equal
to expected changes in the exchange rate
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Exchange Rates in the
Medium Run and Short Run
• Capital flight can be self-fulfilling
– If investors expect depreciation, they converts their
assets to another currency
– Demand for foreign exchange increases
– Supply is depressed and currency depreciates
• Sudden shift in expectations occurs when
government policies are inconsistent and
unsustainable
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Table 10.2 Composition of Currency Trades,
April 2007
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Table 10.3 Currency Trading Centers
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TABLE 10.4
Major Determinants of an
Appreciation or Depreciation
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The Real Exchange Rate
• Foreign prices ultimately determine the purchasing
power of the domestic currency in terms of the
foreign currency
– Real exchange rate: the market exchange rate
(nominal exchange rate) adjusted for price
differences between countries
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Alternatives to Flexible
Exchange Rates
• Fixed exchange rate system: The value of a
nation’s money is defined in terms of a fixed amount
of a commodity (e.g., gold) or of another currency
(e.g., U.S. dollar); the Gold standard exchange rate
system
• Flexible (floating) exchange rate system: The
value of the currency is allowed to float up and down
with market forces
• Purely fixed or floating systems today are rare
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