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The foreign Exchange market and exchange rates

The foreign Exchange market and exchange rates. Lecture 18. Introduction. In September 1997, global financial system trembled Currency crisis rocked Asian financial markets  capital flight to US fell and so did US Exports

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The foreign Exchange market and exchange rates

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  1. The foreign Exchange market and exchange rates Lecture 18

  2. Introduction • In September 1997, global financial system trembled • Currency crisis rocked Asian financial markets  capital flight to US fell and so did US Exports • How investors, and individuals, make transactions when people and organizations are in different countries • Determination of exchange rates and what causes them to change overtime

  3. Exchange Rates and Trade • 1990’s markets for goods and services and financial assets were global because of imports and exports • When an individual, business, or G in one country trades, lends or borrows in another, they must use a nominal exchange rate!

  4. How is buying a domestic good different from buying a foreign good? • Buy Pakistani good, pay in Re • Buy a US good, buy $ and then pay in $ • Buy too many US goods, buying too many $ that raises $ value against Re • An increase in currency’s value as compared to that of another is Appreciation • A fall in value is depreciation • Change in currency’s value can affect domestic manufacturers and workers… How?

  5. Example • 1DM = $0.5 • 1DM = $0.6 • Since DM value in terms of $ has increased, DM has appreciated or became more expensive while $ depreciated!

  6. Nominal Vs. Real Exchange Rate • Nominal ER doesn’t measure real purchasing power of the currency • Nominal: Re 1 = $1/84 = $0.0012 • RER = NER x P/Pf

  7. REAL ER • Big Mac Example • Domestic Price: Rs 300 • Foreign Price: $2.56 • NER = $0.0012/Re • EXr = 0.0012 x 300/2.56 = 0.14 US BM/Pak BM

  8. REAL ER • EXr is computed from price indices which compares the price of a group of goods in one country with the price of similar group of goods in another • CPI or Inflation Rates as the ratio of P/Pf

  9. Real ER • If EXr increases,more units of foreign goods could be traded per unit of domestic goods • Relationship between EX and EXr depends on the Rates of Inflation • %Δ ΔEXr/EXr = ΔEX/EX + ΔP/P – ΔPf/Pf • ΔEX/EX = ΔEXr/EXr + (πf – π)

  10. Foreign Exchange Market • Market forces determine exchange rates that prevail for consumers and investors • International currencies traded in forEx markets • ForEx markets are over-the-counter markets • Currencies transactions in ForEx Markets: Spot Market and Forward Market

  11. Determine LR Exchange rates • Forces of Demand and Supply • 1$ = Rs 60  1$ = Rs 50 • Rs appreciated and $ depreciate; Qd of $ increases and Qs of Rs increased! • Price level differences  P > Pf • Productivity differences  Prod > Prodf • Preferences (For foreign goods) • Trade Barriers

  12. Example DM/$ PUS > PGER Long Run ER

  13. Purchasing Power Parity Theory • Law of one price: PPP • Comparison of international price of identical good, PPP holds • When extend the concept to a group of goods, it becomes PPP theory of ER determination • Assume: EXr are constant • EX = EXr x Pf / P

  14. Does the Theory match Reality? • Actual ER movements are just not a reflection of changing price levels • The assumption that EXr are constant is not realistic • All goods can’t be traded because of different barriers • However, PPP is a good measure for LR determination of exchange rates

  15. Model for SR Exchange Rate Determination • Pakistan: Domestic, US: Foreign • Rs 10000 @ 5% • Year End  10000(1+0.05) = Rs 10500 • Suppose Re 1 = $0.0125  Rs10000 = $125 • $125 @ 5%, Year End  125(1+0.05) = $ 131.25 • Convert them to Rs: $0.0125*1.05 = $0.013125 / Re • $131.25/0.013125 = Rs 10000

  16. Cont’d • Re 1 is invested in Pakistan, Rs (1 + i)*1 = Rs (1+i) • Rs (1+0.05) = Rs 1.05 • Re 1 invested abroad, Rs [EX (1+if)] / EXe • 0.0125(1.05)/0.013125 = Re 1 • Under Interest Rate Parity: expected return on domestic assets should equate expected return on foreign assets • 1+i = EX(1+if)/EXe • Assume: • Identical risks, liquidity and info characteristics • 1+i = 1+ if – ΔEXe / EX

  17. Model: Comparing Exp Returns on domestic and foreign assets Yen/$ R = i • If EX = 97 Yen/$ • R > Rf • Investors should buy local assets • If EX = 105 Yen/$ • R < Rf • Investors should buy foreign assets Rf = if – ΔEXe / EX 100 5% Exp Return in DC

  18. ER Fluctuations Yen/$ R0 R1 • Increase in domestic ‘i’ • EX appreciates • As return falls, EX depreciates Rf 100 5% Exp Return in DC

  19. ER Fluctuations Yen/$ R0 R1 • Increase in Pe • i = ier + Pe • EXe appreciation falls • Rf increases and EX depreciates Rf Rf1 100 5% Exp Return in DC

  20. ER Fluctuations Yen/$ R0 • Rf increased • EX depreciates • Rf falls, EX appreciates Rf Rf1 100 5% Exp Return in DC

  21. ER Fluctuations Yen/$ R0 • EXe increases  Rf falls • EX appreciates Rf1 Rf 100 5% Exp Return in DC

  22. Currency Premiums in ForEx Markets • It’s a number that indicates investors collective preference for financial instruments denominated in one currency relative to those denominated in the other currency • i = if – ΔEXe / EX – hf,d

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