lecture2 - ECO365 Topic 2 Exchange Rate and Foreign...

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Unformatted text preview: ECO365 Topic 2 Exchange Rate and Foreign Exchange Market Overview 1. Exchange Rate Essentials Defining the Exchange Rate Appreciations and Depreciations Multilateral Exchange Rates 2. Exchange Rates in Practice Exchange Rate Regimes: Fixed Versus Floating Recent Exchange Rate Experiences 2 ECO365 Overview 3. The Market for Foreign Exchange The Spot Contract Transaction Costs Derivatives Private Actors Government Actions 4. Arbitrage and spot exchange rates Arbitrage with Currencies Cross Rates and Vehicle Currencies 5. Arbitrage and interest rates Riskless Arbitrage: Covered Interest Parity (CIP) Risky Arbitrage: Uncovered Interest Parity (UIP) 3 ECO365 Exchange Rate : Definition Definition : Exchange rate is the price of one (Foreign) currency expressed in terms of another (Home) currency. E1/2 will denote the exchange rate in units of country 1 currency per units of country 2 currency. Example : If the U.S. dollar price of one U.K. pound sterling (£1) is $1.85, then E$/£ = 1.85. 4 ECO365 Exchange Rate : Depreciation Definition : When the Home currency depreciates, the price of the Foreign currency in terms of the Home currency goes up. A more valuable Foreign currency. Exports are cheaper, imports are dearer. Example : Exchange rate changes from 1.5 CAD per EUR to 2 CAD per EUR => CAD depreciates against EUR. 5 ECO365 Exchange Rate : Appreciation Definition : When the Home currency appreciates, the price of the Foreign currency in terms of the Home currency goes down. A more valuable Home currency. Exports are dearer, imports are cheaper. Example : Exchange rate changes from 1.5 CAD per EUR to 1 CAD per EUR => CAD appreciates against EUR. 6 ECO365 Exchange Rate : Example 7 ECO365 Exchange Rate : Multilateral rates The bilateral exchange rate, as seen above, shows the price at which one currency is exchanged for another. In practice, it is possible for a currency to appreciate relative to one currency, while depreciating relative to another. In order to understand the “average” change in the value of a currency, we need to use a multilateral exchange rate. 8 ECO365 Exchange Rate : Multilateral rates Changes in the Effective Exchange Rate (EER) tell us how the value of a currency has changed “on average” against a basket of currencies. If the home country trades with countries 1,…,N then the fractional (%) change in EER relative to the base year is given by the trade-weighted average change in each bilateral exchange rate: 9 ECO365 Exchange Rate : Multilateral rates 10 ECO365 Exchange Rate : Regimes Definition : An exchange rate regime refers to a government’s policy regarding the exchange rate. There are two broad categories : Fixed exchange rate (or pegged exchange rate) 2. Floating exchange rate (or flexible exchange rate) 1. 11 ECO365 Exchange Rate : Regimes Definition : An exchange rate regime refers to a government’s policy regarding the exchange rate. There are two broad categories : Fixed exchange rate (or pegged exchange rate) 2. Floating exchange rate (or flexible exchange rate) 1. A country’s exchange rate does not fluctuate at all (or only narrowly) against some base currency over a sustained period, usually a year or longer. Government intervention in the market for foreign exchange is needed to maintain the fixed exchange rate. 12 ECO365 Exchange Rate : Regimes Definition : An exchange rate regime refers to a government’s policy regarding the exchange rate. There are two broad categories : Fixed exchange rate (or pegged exchange rate) 2. Floating exchange rate (or flexible exchange rate) 1. A country’s exchange rate typically fluctuates over time in a wider range. The government makes no attempt to peg the exchange rate against a base currency. 13 ECO365 Exchange Rate : Experience Evidence from Developed Countries 14 ECO365 Exchange Rate : Experience Evidence from Developing Countries 15 ECO365 Exchange Rate : Experience In reality, instead of only fixed and floating exchange rate regimes, there is a continuum of regimes. Managed floating involves some intervention. Crawling pegs and Bands allow some movement. Currency board is a hard peg with special rules. Some countries have no currency of their own. 16 ECO365 Exchange Rate : Experience A currency may be used in more than one country in two cases: 1. Currency union A group of countries agree to use a common currency. Currency unions, such as the Eurozone, often involve joint monetary policy across countries. 2. Dollarization A country adopts an existing currency. Countries that dollarize often do so unilaterally without any influence over monetary policy. 17 ECO365 Forex Market : Definition Definition : The market in which trade in foreign currency takes place is the Foreign Exchange (or Forex) Market. Since the exchange rate is a price, it is determined in the Forex market by the interaction of demand and supply of foreign currency. 18 ECO365 Forex Market : Definition Characteristics : Huge volumes are traded everyday. In April 2007, $1.36 trillion was being traded daily in Britain. Most transactions involve exchange of foreign currency for U.S. dollars. No central organized market. Trade is over-the-counter (OTC) between two parties. Highly integrated through telephone, fax, high-speed internet links. 19 ECO365 Forex Market : Quotations 20 ECO365 Forex Market : Spot contract Definition : Spot contract refers to a transaction involving immediate exchange of one currency for another. The price at which trade takes place is the spot exchange rate. Default risk very low; settlement is now nearly instantaneous. Most common type of trade, accounting for nearly 90% of all foreign exchange market transactions. Personal transactions account for a very small share of total transactions. 21 ECO365 Forex Market : Transaction Costs Definition : Transaction costs reflect market frictions that drive a wedge between the price paid by the buyer and the price received by the seller. Spread between “buy at” and “sell for” price of foreign currency bought/sold through retail exchange. Reflects fees and commissions that go to intermediaries standing between the individual seeking to exchange currency and the centralized Forex market. 22 ECO365 Forex Market : Transaction Costs 23 ECO365 Forex Market : Derivatives Definition : Derivatives are contracts with pricing derived from the spot rate. Derivatives allow investors to trade foreign exchange for delivery at different times and under different contingencies. In general, derivatives allow investors to alter payoffs, affecting the risk associated with his/her investment portfolio. Hedging: risk reduction Speculation: risk taking. 24 ECO365 Forex Market : Derivatives 1. Forwards A and B agree to trade currencies at set price on the settlement date, which is in the future. Contract cannot be traded with third parties. 2. Swaps A and B agree to trade at set price today and do reverse trade at a set price in the future. Swaps combine two contracts (a spot and a forward) into one, thereby lowering transactions costs. 25 ECO365 Forex Market : Derivatives 3. Futures A and B agree to trade currencies at set price in the future. Either side of the contract can be traded to third parties (through exchanges). Parties left holding contract must deliver. 4. Options A grants to B the option to buy (call) or sell (put) currencies from/to A, at set price in the future. B may or may not execute the option, but if B opts to execute the contract then A must deliver. 26 ECO365 Forex Market : Actors 1. 2. 3. 4. 5. 27 Commercial Banks Corporations Non-bank financial institutions Speculators Government ECO365 Forex Market : Govt. actions The government may participate in the Forex market in a number of ways: Impose capital controls to limit trading. Establish an official market for foreign exchange and pass a law requiring agents to buy and sell at rates set by the government. Take less drastic measures, like relying on intervention to control foreign exchange prices. This is usually the responsibility of the central bank. 28 ECO365 Arbitrage Definition : Arbitrage is the act of buying low and selling high. Arbitrage exploits any profit opportunities arising from price differences. A market is in equilibrium if it satisfies a noarbitrage condition. If the market were out of equilibrium, arbitrage would drive up price in the low-price market and drive down price in the high-price market. 29 ECO365 Arbitrage : Two Currencies Two Currencies : US dollar and UK pound. Take advantage of differences in price of dollars quoted in New York and London: E£/$NY = £0.50 per dollar E£/$London = £0.55 per dollar A NY trader can make a riskless profit by selling $1 in London for 55p, using the proceeds to buy 55/50=$1.10 dollars in NY. An instant 10% riskless profit! As times go on, E in london will go down and E in NY will go up 30 ECO365 Arbitrage : Multiple Currencies Definition : The cross rate allows us to compare exchange rates defined in terms of different currencies. With 3 currencies, the no-arbitrage condition is : The vast majority of currency pairs are exchanged 31 through a third currency, the vehicle currency. As of April 2007, the most common vehicle currency was the U.S. dollar – used in 86% of all foreign exchange transactions. ECO365 As long as I have exchange rate for one currency in relative to all other currency, I can solve for all direct exchange rate for all currencies Arbitrage : Exchange Rate Risk Definition : Exchange rate risk refers to changes in the value of an asset due to a change in the exchange rate. Two ways to deal with the risk : these two refer to all kinds of asset 1. Riskless arbitrage Investor covers the risk of the exchange rate changing in the future by using a forward contract. forward contract: contract states that u will buy the currency 3 months later at a specific exchange rate that is marked today 2. Risky arbitrage Investor does not cover the risk and invests according to the current and expected future exchange rate. Investors questions: which currency should I keep? he need to consider the how much interest rate for each currency and the exchange rate 32 ECO365 Riskless Arbitrage : Definition Dollar return on dollar deposits : 1+i$ Riskless dollar return on Euro deposits : (1+i€)F$/€/E$/€ F$/€ is the forward exchange rate which is known today. Definition : The condition that the riskless returns on deposits of any two currencies are equal when measured in the same currency is the covered interest parity (CIP) condition. The CIP holds when 1+i$ = (1+i€)F$/€/E$/€ 33 ECO365 Riskless Arbitrage : Evidence Does the CIP hold in reality? Considers the German deutschmark (GER) relative to the British pound (UK), 1970-1994. Hypothetical profit from riskless arbitrage : Even if the hypothetical profit is non-zero, arbitrage may not be possible. 34 ECO365 Riskless Arbitrage : Evidence difference is very small, if it is big, there will be an arbitrage 35 ECO365 * Digression : Demand for Asset The demand for a currency is determined by the same considerations that influence the demand for any other asset : 1. Return 2. Risk 3. Liquidity 36 ECO365 * Digression : Demand for Asset The demand for a currency is determined by the same considerations that influence the demand for any other asset : 1. Return 2. Risk 3. Liquidity 37 The percentage increase in value that this asset offers over some time period. All else equal, prefer assets with a higher return. ECO365 * Digression : Demand for Asset The demand for a currency is determined by the same considerations that influence the demand for any other asset : 1. Return 2. Risk 3. Liquidity 38 Captures the variability in return of an asset. If savers dislike uncertainty, they may refuse to hold a risky asset, even if it offers high returns sometimes. ECO365 * Digression : Demand for Asset The demand for a currency is determined by the same considerations that influence the demand for any other asset : 1. Return 2. Risk 3. Liquidity 39 Captures the cost and speed at which savers can dispose of an asset. Matters if the savers need to prepare for emergencies. ECO365 * Digression : Demand for Asset Return of an asset depends on : 1. Interest rate 2. Expected change in the asset’s value 40 To compare two assets, they need to be denominated in the same currency. The real return to an asset is the return after controlling for inflation. When comparingrate relative desirability of two the interest assets, the return suffices, provided prices of both the assets change in the same way. ECO365 Risky Arbitrage : Definition Dollar return on dollar deposits : 1+i$ Expected dollar return on Euro deposits : (1+i€)Ee$/€/E$/€ Ee$/€ is the expected exchange rate which is not known today. Definition : The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is the uncovered interest parity (UIP) condition. The UIP holds when 41 ECO365 1+i$ = (1+i€) Ee$/€ /E$/€ Risky Arbitrage : Spot rate The UIP can be re-arranged to obtain If we know the expected future exchange rate and the interest rates, the spot rate can be calculated. spot rate is the today exchange rate 42 ECO365 Risky Arbitrage : Equivalence Interest parity conditions CIP : UIP : Thus CIP plus UIP imply Intuition: If F did not equal Ee , one party to the forward contract would be better off waiting for the more favorable Ee to materialize (provided the investors are risk neutral). 43 ECO365 Risky Arbitrage : Evidence An important testable equation : If this is negative, it is an appreciation The left-hand side is easily observed. Difficulty is with the right-hand side. Observations are based on surveys of traders. spot rate and forward rate are known now. Forward rate is shown in newspaper Different traders have different expected exchange rates. We take the average of their expected exchange rates 44 ECO365 Risky Arbitrage : Evidence If CIP = UIP, all the green points will lie on the black line Green points are exchange rate in terms of US dollar e.g. Exchange rate of CAN in terms of US, Exchange rate of pound in terms of US 45 ECO365 Forward rate is similar to expected exchange rate in some extend because red line and black line are similar Risky Arbitrage : Approximation An useful approximation of the UIP is This is not in the textbook but maybe in test and exam 46 ECO365 Case study : CAD-$ exchange rate Canadian in terms of US dollar Increasing mean Canadian dollar depreciation in terms of US dollar 47 ECO365 Case study : CAD-$ exchange rate There seems to be two main factors responsible for the continued depreciation of the CAD against the $ between 1990 and 2000: 1. Commodity prices 2. Interest rates 48 ECO365 Case study : CAD-$ exchange rate There seems to be two main factors responsible for the continued depreciation of the CAD against the $ between 1990 and 2000: 1. Commodity prices 2. Interest rates The East Asian crisis of 97-98 severely affected Canada. The prices of commodities (energy, food, metals, minerals, forest products) fell significantly. Since commodities consist of almost 40% of Canada’s exports, the demand for CAD went down. 49 US importers pay less for Canadian commodities so demand for CAN dollar ECO365 goes down, so price of CAN dollar goes down, this affect expected exchange rate in the future Case study : CAD-$ exchange rate There seems to be two main factors responsible for the continued depreciation of the CAD against the $ between 1990 and 2000: 1. Commodity prices 2. Interest rates In the early 1990s, the Bank of Canada embarked on a policy to lower the interest rates on Canadian bonds. The demand for Canadian bonds went down, thereby reducing the demand for CAD. People buy bonds because it can earn high interest. Low interest rate, less demand for Canadian bond 50 ECO365 Summary 51 ECO365 ...
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