Lecture 2: Exchange Rates and

the Foreign Exchange Market

Topics:
 Exchange Rates
 Foreign exchange market
 Asset approach to exchange rates

Interest Rate Parity Conditions

1 Definitions
 a) Define Exchange Rates:
 Def of exchange rate: price of one currency in terms
of another.
 The conventional way of reporting this in economics i
s home currency per foreign. In the U.S. this is $ per f
oreign currency.(direct or American terms)
 For example, currently it would take about $1.50 to b
uy one European euro (E$/euro) This is the conventio
n in economics and will be used in this class.
 Sometimes you will hear quoted the other way aroun
d, often called European terms. ie: 0.9 euro/$.
 b) Exchange rates are important for trade
because they allow you to compare the cost of
imports to that of domestic goods in common
terms. There was a period when Americans
were going to Germany to buy Mercedes and
bring them home, rather than buying them in
the U.S.
 Example: Consider the Mercedes: suppose the
going price is 50 thousand euros in Germany
and 80 thousand dollars in the US. Would
people flock to Germany? Depends on the
exchange rate - comparing $ and euro is like
comparing apples and oranges.
 Suppose the $/euro exchange rate is 1.5.
 So the 50 thousand euros equals:
 50 thousand euros * (1.50$/euro) = 75 thous
and $
 At this exchange rate, looks like its cheaper
to buy the car in Germany.
 How know using the rate not upside
down? Look at units: have euro, want
dollars, so multiply by $/euro and euro
cancels out, and you left with units in
dollars.
 c) Note: the way we conventionally define
the exchange rate can also make it
confusing to talk about changes in the
exchange rate, which we call appreciations
and depreciations.
 Appreciation: increase in value of the given
currency relative to another.
 Say the $/euro rate changed from 1.5 to 1.4,
we say the dollar appreciated relative to the
euro. Or we could say the euro depreciated
relative to the dollar.
 Note that
 Notethat this can be confusing. Given how
we define the exchange rate as home
currency per foreign, if this gets lower, it
means that it takes less home currency units
to buy a foreign currency unit, and this means
the home currency is worth more. Hence a
appreciation of the home currency.
2 Features of foreign exchange market.
 a) Actors
 1) commercial banks: Commercial
banks are at the center of the foreign
exchange market because almost every
sizable international transaction
involves the debiting and crediting of
accounts at commercial banks in
various financial centers.
 Interbank trading
 Banks routinely enter the foreign exchange mar
ket to meet the needs of their customers—prim
arily corporations. In addition, a bank will also q
uote to other banks exchange rates at which it i
s willing to buy currencies from them and sell cu
rrencies to them. Foreign currency trading amo
ng banks—called interbank trading—accounts
for most of the activity in the foreign exchange
market.
 The rates available to corporate customers,
called "retail" rates, are usually less favorabl
e than the "wholesale“ interbank rates. The
difference between the retail and wholesale
rates is the bank's compensation for doing t
he business.
 2)Corporations: Corporations with operation
s in several countries frequently make or rec
eive payments in currencies other than that
of the country in which they are headquarter
ed.
 3)Nonbank financial institutions: Over the y
ears, deregulation of financial markets in the
United States, Japan, and other countries h
as encouraged nonbank financial institutions
to offer their customers a broader range of s
ervices, many of them indistinguishable from
those offered by banks. Among these have
been services involving foreign exchange tra
nsactions. Institutional investors, such as pe
nsion funds, often trade foreign currencies.
 4)Central banks. Learned in BOP accounts
that central banks sometimes intervene in th
e foreign exchange market. While the volum
e of central bank transactions is typically not
large, the impact of these transactions may
be great. （ Why ）
b) Characteristics

 Volume is enormous: over a trillion

dollars a day.
 Banks dealing in e market tend to be
concentrated in certain key financial
cities: know which biggest? London
largest, but also NY, Tokyo, Frankfurt
and Singapore.
 Highly integrated globally: when one major
market is closed usually another is open, so
people can trade around the clock, moving fr
om one center to another.
 Integration means exchange rate quotes in
different centers must be the same. Is guara
nteed by arbitrage, defined as making a riskl
ess profit on a financial trade ？
 IfNY offer more euros for a $ (lower price of
euros, higher price of $, E$/euro is low) than
Frankfurt, then people will take their $, sell
in NY for bunch of euros, then sell these in
Frankfurt for dollars again and end up with
more dollars than they started.
 Possibilityfor you to make riskless profit? N
o ， because of short-lived.
 The increased demand for euros in NY woul
d drive up the price of euros in terms of $ - t
his is an exchange rate depreciation for the
$.
 There are computers monitoring such openi
ngs and ready to take advantage of them.
 So gaps close up very quickly.
Vehicle currency.
 Most foreign exchange transactions are betwee
n banks and take place in $, even if want to cha
nge Swedish Kroner for Polish zloty, not dollars
.
 Easier to change Kroner first to $ and then $ to
zlotys. Since US is so important in world econo
my, there are many people willing to trade dolla
rs for Kroner and zloty for dollars, to take the op
posite sides of your trade, rather than the oppo
site side of a direct Kroner for zloty trade.
 Euro and Yen are also used as vehicles, but les
s so at current time.
c) Spot and forward rates
 The exchange transactions talked about so
far take place on the spot.
 Spot rates are exchange rates for currency
exchanges “on the spot”, or when trading is
executed in the present.
In practice it can’t be right away because it
typically takes two days for the checks to
clear used to make the payments.
 Forward rates are exchange rates for
currency exchanges that will occur at a
future (“forward”) date.
forward dates are typically 30, 90, 180 or 360
days in the future.
rates are negotiated between individual
institutions in the present, but the exchange
occurs in the future.
 Suppose Best Buy electronics is expecting a
shipment of Sony TVs in a month, for which it
needs to pay yen.
 Could wait until the shipment to buy the yen to pay
Sony, but not know what will happen to value of
that yen in meantime.
 If yen appreciates a lot, the $ price that the store
has to pay to get the TVs could change a lot.
 To avoid this risk, the store can arrange for
currency trade ahead of time to be executed later
at a set exchange rate. This rate is the forward
rate.
Spot and Forward Rates
D ） Other methods of currency exch
ange
 Foreign exchange swaps: a combination
of a spot sale with a forward repurchase,
both negotiated between individual
institutions.
swaps often result in lower fees or
transactions costs because they combine
two transactions.
 Why do this? Say our electronics store
sold some computers in Japan and got
yen, know will need them again in a
month to buy Sony TVs, but not want to
hang on the money in yen over the
month, want to hold it in dollars for
domestic expenses.
 Might be lower brokers fees if arrange
both transactions at one time.
 Futures contracts: a contract designed by
a third party for a standard amount of foreig
n currency delivered/received on a standard
date.
contracts can be bought and sold in markets, an
d only the current owner is obliged to fulfill the c
ontract.
 Some people just trade these contracts to
make a profit, because expect the value of
the contract to change as expectations for
exchange rate movements change. This is
an example of currency speculation.
 i.e. if suddenly looks like $ will appreciate, a
contract specifying dollars be delivered for a
given amount of yen looks more profitable,
and price of contact will go up.
 Options contracts: a contract designed by a third
party for a standard amount of foreign currency
delivered/received on or before a standard date.
 contracts can be bought and sold in markets.

 a contract gives the owner the option, but not obligation,

of buying or selling currency if the need arises.
 Call option: have the right to buy an amount
of currency at a specified e rate any time
before a specified date.
 Put option: right to sell.
 Like futures, options can themselves be
bought and sold.
3 Asset approach to exchange
rates:
 Preview: Theories of exchange
rate determination
 Now we come to the question of how
does the foreign exchange market
determine what the exchange rate will
be. There two main theories we will
study here:
 The asset approach – which is based
upon “interest rate parity”
 The monetary approach – which is
based upon “purchasing power parity”
 Each of these tells a logical but
somewhat different story of how the e
rate is determined.
A general theme in the next couple
lectures will be to discuss these
stories, the empirical evidence on
how well each explains e rate
movements, and how the two
theories perhaps could be
integrated together.
 AssetApproach: First we discuss the a
sset approach. Recall that most foreign
exchange holdings are in form of bank
deposits, which is a type of asset, and t
hese can be analyzed as any other ass
et.
 The Demand for Currency
Deposits
 What influences the demand for (willingness to
buy) deposits denominated in domestic or foreign
currency?

 Factors that influence the return on assets

determine the demand for those assets.
The Demand for Currency Deposits
(cont.)
 Rate of return: the percentage change in value that an
asset offers during a time period.
 The annual return for $100 savings account with an interest rate of
2% is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/
$100 = 2%
 Real rate of return: inflation-adjusted rate of return.
 stated in terms of real purchasing power: the amount of real goods
& services that can be purchased with the asset.
 the real rate of return for the above savings account when inflation
is 1.5%: 2% – 1.5% = 0.5%. The asset can purchase 0.5% more
goods and services after 1 year.
The Demand for Currency Deposits
(cont.)
 If prices are given at some level, inflation is
0% and (nominal) rates of return = real rates of
return.
 For bank deposits in different currencies, we often
assume that prices are given at some level. (A
good short run assumption.)
The Demand for Currency Deposits
(cont.)
 Risk of holding assets also influences decisions about
whether to buy them.
 Liquidity of an asset, or ease of using the asset to buy goods
and services, also influences the willingness to buy assets.
 But we assume that risk and liquidity of bank
deposits in the foreign exchange market are the same,
regardless of their currency denomination.
 risk and liquidity are only of secondary importance when deciding to
buy or sell currency.
 importers and exporters may be concerned about risk and liquidity, but
they make up a small fraction of the market.
The Demand for Currency Deposits
(cont.)
 We assume that investors are primarily concerned
about the rates of return on bank deposits. Rates
of return are determined by
 interest rates that the assets earn

 expectations about appreciation or depreciation

The Demand for Currency Deposits
(cont.)
 A currency’s interest rate is the amount of a currency an
individual can earn by lending a unit of the currency for a
year.
 The rate of return for a deposit in domestic currency
is the interest rate that the bank deposit earns.
 To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider
 the interest rate for the foreign currency deposit
 the expected rate of appreciation or depreciation of the foreign
currency relative to the domestic currency.
The Demand for Currency Deposits
(cont.)
 Suppose the interest rate on a dollar deposit is 2%.
 Suppose the interest rate on a euro deposit is 4%.
 Does a euro deposit yield a higher expected rate
of return?
 Suppose today the exchange rate is $1/€1, and the expected rate 1
year in the future is $0.97/€1.
 $100 can be exchanged today for €100.

 These €100 will yield €104 after 1 year.

 These €104 are expected to be worth $0.97/€1 x €104 = $100.88.
The Demand for Currency Deposits
(cont.)
 The rate of return in terms of dollars from investing in euro
deposits is ($100.88-$100)/$100 = 0.88%.
 Let’s compare this rate of return with the rate of return from
a dollar deposit.
 rate of return is simply the interest rate
 After 1 year the $100 is expected to yield $102:
($102-$100)/$100 = 2%
 The euro deposit has a lower expected rate of return: all
investors will prefer dollar deposits and none are willing to
hold euro deposits.
The Demand for Currency Deposits
(cont.)
 Note that the expected rate of appreciation of the eu
ro is ($0.97- $1)/$1 = -0.03 = -3%.
 We simplify the analysis by saying that the dollar rat
e of return on euro deposits approximately equals
 the interest rate on euro deposits
 plus the expected rate of appreciation on
euro deposits
 4% + -3% = 1% ≈ 0.88%

 R€ + (Ee$/€ - E$/€)/E$/€
 The Demand for Currency Deposits
(cont.)
 The difference in the rate of return on dollar deposi
ts and euro deposits is
 R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) =

R$ - R€ - (Ee$/€ - E$/€)/E$/€
expected current
interest rate exchange rate exchange rate
expected rate
of return = on euro
interest rate deposits expected rate of appreciation
on dollar of the euro
deposits
expected rate of return on euro deposits
The Demand for Currency Assets
The Market for Foreign Exchange
 We use the
 demand for (rate of return on) dollar denominated
deposits
 and the demand for (rate of return on) foreign currency
denominated deposits to construct a model of the foreign
exchange market.
 The foreign exchange market is in equilibrium when
deposits of all currencies offer the same expected
rate of return: interest parity.
 interest parity implies that deposits in all currencies are
deemed equally desirable assets.
 The Market for Foreign Exchange
(cont.)
 Interest parity says:
R$ = R€ + (Ee$/€ - E$/€)/E$/€
 Why should this condition hold? Suppose it didn’t.
 Suppose R$ > R€ + (Ee$/€ - E$/€)/E$/€ .
 Then no investor would want to hold euro deposits, driving down th
e demand and price of euros.
 Then all investors would want to hold dollar deposits, driving up the
demand and price of dollars.
 The dollar would appreciate and the euro would depreciate, increasi
ng the right side until equality was achieved.
 The Market for Foreign Exchange
(cont.)
 How do changes in the current exchange rate
affect expected returns in foreign currency?
 The Market for Foreign Exchange
(cont.)
 Depreciation of the domestic currency today lowers the
expected return on deposits in foreign currency.
 A current depreciation of domestic currency will raise the initial cost
of investing in foreign currency, thereby lowering the expected
return in foreign currency.
 Appreciation of the domestic currency today raises the
expected return of deposits in foreign currency.
 A current appreciation of the domestic currency will lower the initial
cost of investing in foreign currency, thereby raising the expected
return in foreign currency.
Expected Returns on Euro Deposits
when Ee$/€ = $1.05 Per Euro
Expected rate of
Current Interest rate on dollar Expected dollar return
exchange rate euro deposits depreciation on euro deposits
E$/€ R€ (1.05 - E$/€)/E$/€ R€ + (1.05 - E$/€)/E$/€
1.07 0.05 -0.019 0.031
1.05 0.05 0.000 0.050
1.03 0.05 0.019 0.069
1.02 0.05 0.029 0.079
1.00 0.05 0.050 0.100
The Current
Exchange
Rate and
the Expected
Return on
Dollar
Deposits
The Current Exchange Rate and the
Expected Return on Dollar Deposits
Current exchange
rate, E$/€

1.07

1.05

1.03
1.02

1.00
0.031 0.050 0.069 0.079 0.100
R$ Expected dollar return
on dollar deposits, R$
Determination of the Equilibrium
Exchange Rate
No one is willing to
hold euro deposits

No one is willing to
hold dollar deposits
The Market for Foreign Exchange
 The effects of changing interest rates:
 an increase in the interest rate paid on deposits
denominated in a particular currency will increase the
rate of return on those deposits.
 This leads to an appreciation of the currency.

 A rise in dollar interest rates causes the dollar

to appreciate.
 A rise in euro interest rates causes the dollar
to depreciate.
The Effect of a Rise in the
Dollar Interest Rate

A depreciation
of the euro is
an appreciation
of the dollar.
The Effect of a Rise in the
Euro Interest Rate
The Effect of an Expected
Appreciation
of the Euro

People now
expect the
euro to
appreciate
The Effect of an Expected
Appreciation of the Euro (cont.)
 If people expect the euro to appreciate in the future,
then investment will pay off in a valuable (“strong”)
euro, so that these future euros will be able to buy
many dollars and many dollar denominated goods.
 the expected return on euros therefore increases.
 an expected appreciation of a currency leads to an actual
appreciation (a self-fulfilling prophecy)
 an expected depreciation of a currency leads to an actual
depreciation (a self-fulfilling prophecy)
Empirical tests on interest parity.

 Itis difficult to test the interest rate

parity condition, because it is difficult to
get a measure of people’s expectations.
 Some economists have used the actual
future exchange rate as a proxy for
expectations in the past, assuming that
people correctly predict the future rate.
 Some economists have used survey data on
expectations – they call people who take
part in the foreign exchange market and ask
them what rates they expect.
 Both sets of tests tend to find the interest
parity condition does not hold well. But this
may simply reflect the fact that the expected
future exchange rate component of the
equation was measured with error, not that
the theory was wrong.
Another reason why the tests
may reject the interest parity
condition is the role of risk.
 There is some risk involved because you do not kn
ow ahead of time what the future exchange rate wi
ll be; if your expectations turn out to be wrong, the
payoff from your investment scheme may be differ
ent from what you expected. This may make peopl
e require an extra expected return on EURO depo
sits as compensation for uncertainty. In this case t
here would be an extra term in the interest parity e
quation: RP representing the risk premium:
 R$ = REURO + (Ee $/EURO - E$/EURO)/ E$/EURO - RP
 (Note: RP can in principle be either positive or neg
ative, depending on how the risk is perceived both
by people trading EURO for $ and those trading $ f
or EURO, since both groups are exposed to risks
of different types).
 Covered Interest Parity
 Covered interest parity relates interest rates across
countries and the rate of change between forward exchange
rates and the spot exchange rate:
R$ = R€ + (F$/€ - E$/€)/E$/€
where F$/€ is the forward exchange rate.
 It says that rates of return on dollar deposits and “covered”
foreign currency deposits are the same.
 How could you make easy, risk-free money in the foreign exchange
markets if covered interest parity did not hold?
 Covered positions using the forward rate involve little risk.
 Summary
1. Exchange rates are prices of foreign currencies
in terms of domestic currencies, or vice versa.
2. Depreciation of a country’s currency means that it
is less expensive (valuable) and
goods denominated in it are less expensive:
exports are cheaper and imports more
expensive.
 A depreciation will hurt consumers of imports but help
producers of exports.
 Summary (cont.)
3. Appreciation of a country’s currency means that it is more
expensive (valuable) and goods denominated in it are
more expensive: exports are more expensive and imports
cheaper.
 An appreciation will help consumers of imports but hurt producers
of exports.

4. Commercial banks that invest in deposits of different

currencies dominate the foreign exchange market.
 Expected rates of return are most important in determining the
willingness to hold these deposits.
 Summary (cont.)
5. Returns on bank deposits in the foreign
exchange market are influenced by interest
rates and expected exchange rates.
6. Equilibrium in the foreign exchange market
occurs when returns on deposits in domestic
currency and in foreign currency are equal:
interest rate parity.
7. An increase in the interest rate on a
currency’s deposit leads to an increase in
the rate of return and to an appreciation of
the currency.
 Summary (cont.)
8. An expected appreciation of a currency leads to
an increase in the expected rate of return for that
currency, and leads to an actual appreciation.
9. Covered interest parity says that rates of return
on domestic currency deposits and “covered”
foreign currency deposits using the forward
exchange rate are the same.
 Case 1
 In Munich a bratwurst costs 2 euros; a hot d
og costs $1 at Boston’s Fenway Park. At an
exchange rate of $1.5/per euro, what is the
price of a bratwurst in terms of hot dogs? All
else equal, how dose this relative price chan
ge if the dollar appreciates to $1.25 per euro
? Compared with the initial situation, has a h
ot dog become more or less expensive relati
ve to a bratwurst?
 Answer 1
 At an exchange rate of $1.50 per euro, the
price of a bratwurst in terms of hot dogs is 3
hot dogs per bratwurst.
 After a dollar appreciation to $1.25 per euro,
the relative price of a bratwurst falls to 2.5
hot dogs per bratwurst.
 Case 2
A U.S. dollar costs 7.5 Norwegian kroner, bu
t the same dollar can be purchased for 1.25
Swiss Francs. What is the Norwegian krone/
Swiss francs exchange rate?
Case 3 Calculate the dollar rates of
return on the following assets:
 a. A painting whose price rises from
$200,000 to $250,000 in a year.
 b. A bottle of rare Burgundy, whose price
rises from $180 to $216 between 2006 and
2007.
 Case 3
 c.
A 10,000 pounds deposit in a Londo
n bank in a year when the interest rate
on pounds is 10%,and $/pound exchan
ge rate moves from $1.50 per pound to
$1.38 per pound.
 Case 4
 What would be the real rates of return
on the assets in the case 3 if the price
changes described were accompanied
by a simultaneous 10 percent increase
in all dollar prices?
 Case 5
 Suppose the dollar interest rate and the
pound sterling interest rate are the same,5
percent per year. What is the relation
between the current equilibrium $/£
exchange rate and its expected future level?
Suppose the expected future $/£ exchange
rate, $1.52 per pound, Britain’s interest rate
rises to 10 percent per year. If the U.S.
interest rate also remains constant, what is
the new equilibrium $/£ exchange rate?
 Question 1
 Suppose you have $50,000 you wish to invest.
For each of the following scenarios explain
whether you would be better off putting your
money in the foreign or domestic alternative
presented. Assume that the level of risk is same
for the two alternatives in each case.
 a. You don’t anticipate needing your money for
10 years. Historically the US stock market has a
long run return of about 15% per year. You
expect that trend to continue. The stock market in
Taiwan has historically yielded a return of 22%
per year, though you expect only half that return
over the next ten years due to the financial
turmoil in Asia. A US dollar is currently worth 33
Taiwanese dollars. You expect the exchange rate
to hold steady over the next ten years.
 Answer
a. Since there is no anticipated change in the
exchange rate, all that you need to do is
compare the expected return of 15% in the
US to the expected return of 11% in Taiwan.
Since the US return is higher, you do better
by keeping your money in the US. The
historical return of 22% in Taiwan is
irrelevant here.
 b. You know you will need your money in 2
years. The interest rate on corporate bonds
in the US is 5% while corporate bonds in
Peru carry an interest rate of 14%. The
current exchange rate is 3.34 New Sol per
dollar. You expect that in two years the
exchange rate will be 4.8 New Sol per
dollar.
 b. Keeping your money in the US for the two
years yields a gross return of
$50,000 x (1.05)2 = $55,125.
Putting your money in the Peruvian bond
yields a gross return of
$50,000 x (1.14)2 x 3.34 x (1/4.8) = $45,215.
Thus you should keep your money in the US
because the expected depreciation of the
New Sol more than cancels out the higher
interest rate in Peru.
 c. You only want to invest for four months.
The interest rate on bank deposits on Euros
is 4.5% while that on dollar deposits is 3.5%.
The current exchange rate is 0.92 Euros per
dollar. You expect the exchange rate to be
0.93 Euros per dollar four months from now.
 c.Again you should keep your money in the
US. Using a similar method to that in part b,
we see that in the US, the gross bank
account return is approximately $50,580,
while the return on the Euro account is only
about $50,200.
 Question 2
 a. Suppose that the South African interest rate is 4% and the
US interest rate is 6%. If the expected future spot exchange
rate one year from now is 6.05 Rand per dollar, what must
the current spot exchange rate be in order to clear the
foreign exchange market?
 b. Suppose that the expected future spot rate is 6.25 rather
than 6.05. How does that alter the equilibrium exchange rate
you calculated in part a?
 c. Using the expected exchange rate from part b, explain
what would happen if the South African interest rate
happened to be 6.7%. Can your answer to part b also be the
answer to this question? Explain.
 d. Ignoring your expectations about the future spot rate,
what would be the equilibrium forward exchange rate using
the information given in part c if there is no risk premium and
if covered interest rate parity holds?