Download Week 8: Lecture 7

International Finance
Lecture 7
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Learning Outcomes
1. What is the foreign exchange market
and its characteristics.
2. What determines the exchange rates
in the long run.
3. What determines the exchange rates
in the short run.
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What is the Foreign Exchange Market (FX)?
The Foreign Exchange Market is the financial market in which currencies
are bought and sold: is a transaction where a given amount of currency is
exchanged for an amount of another currency. The need for the Foreign
Exchange Market is to facilitate International trade and the currency
conversion:
• currencies were required to be settled from the country of both the
importer and the exporter. It therefore plays an extremely important role
in facilitating cross-border trade, financial transactions and investment.
Companies investing spare cash for short terms in money market
accounts
• More recently, it allows borrowers to have access to the International
capital markets in order to meet their financing needs in the currency
which is most helpful to their requirements.
An exchange rate is the price of one money in terms of another.
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Characteristics of the Foreign Exchange Market
• The Forex Market does not exist physically – there is no location. It
is a framework in which participants banks, brokers and foreign
exchange dealers (mostly banks) are connected by computers,
telephones and telex (SWIFT) and operates in most financial
centers globally. Because the Forex Market is so highly integrated
globally, it can operate 24 hours a day – when one major market is
closed, another major market is open to facilitate trade occurring 24
hours a day moving from one major market to another. Most
exchanges of currency are made through bank deposits that is
transferred electronically from one account to another.
• The Forex Market is an over-the-counter market (no location no
building) that is trading in financial instruments that are not listed or
available on an officially recognized exchange (such as the NYSE –
New York Stock Exchange), but traded in direct negotiation
between buyers and sellers. Trading takes place telephonically or
electronically.
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•Example: When we say that a bank is buying
dollars in the foreign exchange market what we
actually mean is that the bank is buying deposits
denominated in dollars. And the individual citizens
are buying currency in the retail market from
dealers such as American Express or from banks.
Because retail prices are higher than wholesale
when we buy foreign exchange we are getting
fewer units of foreign currency per dollar than
exchange rates in the box indicate.
American Express Corporation in Manhattan also
known as the Three World Financial Centre.
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The examination of foreign exchange market is an important
subject in International Finance
• The exchange rate affects the economy and our daily lives because for
example when the U.S dollar becomes more valuable relative to
foreign currencies , foreign goods become cheaper for Americans and
American goods become more expensive for foreigners. When the U.S
dollar falls in value foreign goods become more expensive for
Americans and American goods become cheaper for foreigners.
• Fluctuation in the exchange rate also affect both inflation and output
and are an important concern to monetary policymakers. When the US
dollar falls in value the higher prices of imported goods feed directly
into a higher price level and inflation. A declining US dollar which
makes US goods cheaper for foreigners increases the demand for US
goods and leads to higher production and output.
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Economic theories of exchange
rate determination
• Exchange rates, like the price of any good or asset in a
free market, are determined by the demand and supply of
one currency relative to the demand and supply of
another.
• The analysis of the factors that determine Exchange rates
is divided into two parts: the long-run and the short-run
determinants.
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Exchange Rates in the Long-run
• The long-run analysis is based on the scheme that there is
predictable relationship between product price levels and exchange
rates. The relationship is based on the fact that people choose to
buy goods and services from one country or another according to
the prices they must pay.
• Therefore we use the following two versions of this relationship for
better understanding of the factors that determine exchange rates in
the long run. (The relationship between Price and exchange rates
can be explained by)
– Law of One Price
– Purchasing Power Parity (PPP)
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Law of one price
If two countries produce an identical good, and
transportation costs and trade barriers are very low or
free, the price of the good should be the same
throughout the world no matter which country produce it.
Example: A jacket selling for $50 in New York is identical to a
French jacket retail for 39.24Eur in Paris. For the law of one price to
hold the exchange rate between the $ and the € must be $1 =
0.78Eur (39.24/50). If not this mean that the jacket will be expensive
in one of the two cities either in N.Y or in Paris (the city of which its
currency has been appreciated) and the demand in the expensive
country will go to zero and only if the exch.rate falls will start selling
again.
In reality the law of one price does not hold closely for
most products traded internationally because transport
costs are not low and governments do not practice free
trade. Also firms apply discrimination on price in different
national markets.
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Purchasing power parity (PPP)
 A basket of tradable products will have the same cost in
different countries if the cost is stated in the same
currency. The theory of PPP is simply an application of the
law of one price to national price levels rather than to
individual prices.
 Based on the evidence the theory of PPP does not hold as
well and thus can not fully explained exchange rates. The
reason is that the basket many times does not include the
same products and sometimes nontraded goods are
incorporated. But there is evidence that large differences
from PPP tend to shrink over time for traded products.
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Long-run: 4 factors affecting
exchange rates
GENERAL RULE:
 If the demand
reason)
 If the demand
reason)
for domestic goods increases (for any
Appreciation of the currency
for domestic goods falls (for any
Depreciation of the currency
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1.Money Supply, Prices and Inflation
In line with PPP theory when prices of American goods
Increases (holding prices of foreign goods stable) the
demand for American goods falls and the dollar tends to
depreciate so that American goods can be sold and vice versa.
So in the long run a rise in a country’s price level causes its
currency to depreciate and a fall in the country’s price level causes
its currency to appreciate.
A country with high inflation should expect its currency to depreciate
against the currency of a country with a lower inflation rate.
Inflation occurs when the money supply increases faster than output
increases.
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2. Trade Barriers
Barriers to free trade such as tariffs (taxes on imported goods)
and quotas (restrictions on the quantity of foreign goods that
can be imported) can affect the exchange rate. This is because
when a country increases trade barriers the imported goods are
becoming more expensive and thus the demand for domestic
products increases. Consequently the currency of the country is
appreciating and vice versa.
So in the long run a rise in trade barriers cause a country’s currency
to appreciate and a fall cause its currency to depreciate.
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3. Preferences for domestic versus foreign goods
Supposed that the home country is US.
If the Japanese develop an appetite for American goods (e.g.
Florida oranges, American movies) the increased demand for
American goods (exports) tends to appreciate the dollar,
because the American products will continue to sell well even
at a higher value of dollar. Likewise if there is a high demand
for the imports in US instead for the domestic goods the dollar
will depreciate.
Increased demand for a country’s exports causes its currency to
appreciate in the long run, and conversely increased demand for
imports causes the domestic currency to deprecate in the long run.
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4. Productivity
If productivity in domestic sectors that produce traded goods
rises in a country the prices are declining, relative to imported
goods, and therefore the demand for domestic products
increases and thus currency is appreciating finally in the long
run.
In the long run as a country becomes more productive relative to
other countries its currency appreciates and vice versa.
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Exchange Rates in the Short-run
• How current exchange rates (spot exchange rates) are
determined in the short run?
Economists believe that pressures on exchange rates in the
short run can be best understood in terms of the demands
and supplies of assets such as government bonds
denominated in different currencies.
The investors determine the expected return in an investment in a bond
expressed in a foreign currency by using:
1.The basic return on the bond: the interest rate or yield. There is an
important relationship between the return on home currency bonds and the
return on foreign currency bonds. Investors will change their portfolios if
there are differences between these two returns.
2.The expected gain or loss on currency exchanges: the expected
appreciation or depreciation of the foreign currency.
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Sort-run: 2 factors affecting exchange rates
1.
Interest rates and exchange rates
•
Foreign exchange markets do seem sensitive to movements in interest rates and
jumps of exchange rates often follow changes in interest rates. If our interest rate
(i) increases ,while the foreign interest rate (if) and the spot exchange rate
expected in the future (eex) remain constant, the return comparison is in favor of
investments in bonds denominated in our currency. If international financial
investors want to shift toward domestic-currency assets , they first need to buy
our domestic currency before they can buy the domestic currency bonds. This
increase in demand for domestic currency increases the current value of
domestic currency (so e decreases).
Domestic currency appreciates
The change in the spot exchange rate can happen very quickly even within a few
minutes.
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If our interest instead decreases, while the foreign interest rate (if) and the spot
exchange rate expected in the future (eex) remain unchanged, the value of our
currency is decreased (so e increases).
Domestic currency depreciates
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•
If the foreign interest rate (if) increases, the story is similar. Assuming
that the domestic interest rate and the expected future spot exchange
rate are constant, the return comparison is in favor of investments in
bonds denominated in foreign currency. A shift by international financial
investors toward foreign currency bonds would require them first to buy
foreign currency in the foreign exchange market. This increase in
demand for the foreign currency increases the current value of the
foreign currency (foreign currency appreciates) and the domestic
currency depreciates. (so e increases).
•
If instead the foreign interest decreases, the spot rate e decreases: the
foreign currency depreciates and the domestic currency appreciates.
(so e decreases).
Investment funds follow the higher rates. As they change countries, they
bid up currency values.
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1. Assume an initial
exchange rate of £1 =
$1.85. (home country
is
US)
There
are
rumours that the UK is
going
to
increase
interest rates.
2. Investing in the
UK would now be
more
attractive
and demand for £
would rise
Exchange Rates
$ per £
S£
3. The rise in
demand
for £
creates
a
shortage in the
relationship
between demand
for £ and supply
–
the
price
(exchange rate)
would rise
1.90
1.85
D£1
Shortage
D£
Q1
Q3
Q2
Quantity of £ currency
in ForEx Markets
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• What happens if both interest rates change at the same
time?
• The answer is strait forward. What matters is the interest
rate differential : i - if . If the interest rate differential
increases, the return differential shifts in favor of domestic
currency bonds : e tends to decrease and domestic
currency appreciates. In the opposite situation the
domestic currency depreciates and the e increases.
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2. Investor psychology and the bandwagon effect
Lacking other information the role of expectations is extremely important
in forecasting the future. The price of foreign exchange also rises when
the expected future spot exchange rate rises. How come?
If you expect you will have to pay more for the Euros that you will
need later because you expect the Euro/Dollar rate to rise, why not
buy now before it does? Thus, the increased demand for Euros will
bid the price up now.
•
When financial investors decide that they now expect the future spot
exchange rate to be higher than they previously expected relative to the
current spot rate, this means that they expect the foreign currency to
appreciate more or to depreciate less, or to appreciate rather than
depreciate. For example if we assume that the interest rate differential is
is unchanged, and the home country is US, and if we expect that the
future spot exch.rate will increase from $5.05 per Sfr to about $5.15 per
Sfr then the return differential is in favor of the foreign currency
denominated bonds.
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• Result: International financial investors will want to buy
foreign currency assets and their first step will be to buy
foreign currency in the foreign exchange marker. This
increase in demand for foreign currency increases the
current spot exchange rate e : the foreign currency
appreciates and the domestic currency depreciates. So
what is happening at the end is exactly what the investors
were expecting.
• If instead the investors are expecting that the future spot
exchange rate will decrease, with the interest rate
differential unchanged, the return differential changes in
favor of domestic-currency investments and the value of
our currency increases (e decreases).
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What factors can influence the direction of the
expectations of the investors?
• Many things can influence investors some of them are:
1. The bandwagon effect: some investors predict/foresee
that the recent trend of the exchange rate will continue in the
future as well. Especially regarding the near future: the next
minutes, hours, days, weeks.
For instance currencies that have been appreciating are
expected to continue to do so. The recent actual increase in
the exchange rate value of a country’s currency leads some
investors to expect further increases.
2.
Unexpected information-news: about government
policies, about national and international economic data or
performance and about political leaders and situations both
domestic politics and international tensions.
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• For instance the foreign exchange market often react to
news regarding the figures of trade of a country or the
current account balances, that is measures which reflect
the balance or imbalance between a country’s exports
and imports of goods and service. For example an
increase in a country’s trade deficit or its current account
deficit especially shows that the country is in need for
foreign financing. If the foreign financing that will cover
the deficit is not assured to be forthcoming then the
country’s currency will tend to fall in the foreign exchange
market. The increasing demand for foreign currency as
part of the process of paying for the excess of imports
over exports tends to appreciate the foreign currency and
depreciate the domestic currency.
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Determinants of e in the Short run
Change in Variable
Effects for the current
Direction of International spot exchange rate
Financial Investors
e= Domestic Currency /
foreign currency
Domestic Interest rate (i)
Increases
Toward domestic-currency e decreases - domestic
assets
currency appreciates
Decreases
Toward foreign-currency
assets
e increases - domestic
Toward foreign-currency
assets
e increases - domestic
currency depreciates
Foreign Interest rate (if)
Increases
Decreases
currency depreciates
Toward domestic-currency e decreases - domestic
assets
currency appreciates
Expected future Spot
Exchange Rate (eex)
Increases
Decreases
Toward foreign-currency
assets
e increases - domestic
currency depreciates
Toward domestic-currency e decreases - domestic
assets
currency appreciates
APPENDIX
Managerial implications
• Exchange rates influence the profitability
of trade and investment deals
• International businesses must understand
the forces that determine exchange rate:
– Forward exchange rate is not a fair predictor
– Inflation affects foreign exchange markets
– International businesses need to take the
proper safety measures before trading or
investing in a country
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Exchange rate forecasting
• Efficient market school: ‘Prices reflect all
available public information’
• Inefficient market school: ‘Prices do not reflect
all available information’
– Use fundamental (economic theory) or technical
(price/volume data) analysis to predict the
exchange rate
– Analysis suggest that professional forecasters are
no better than forward exchange rates in predicting
future spot rates
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Approaches to forecasting
• Fundamental analysis
– Draws on economic theory to build
sophisticated econometric models for
predicting exchange rate movements
• Technical analysis
– Uses price and volume /quantity data to
determine trends
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