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INTERNATIOANAL FINANCE

INTERNATIOANAL FINANCE. INTERNATIOANAL FINANCE. CHAPTER 2. Exchange Rates and the Foreign Exchange Market :. An Asset Approach. the price of one unit foreign currency. in terms of domestic currency. the price of one unit domestic currency. in terms of foreign currency.

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INTERNATIOANAL FINANCE

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  1. INTERNATIOANAL FINANCE INTERNATIOANAL FINANCE

  2. CHAPTER 2 Exchange Rates and the Foreign Exchange Market : An Asset Approach

  3. the price of one unit foreign currency in terms of domestic currency the price of one unit domestic currency in terms of foreign currency Relative Concepts Exchange rate: 汇率 the price of one currency in terms of another Quotations Unit currency Pricing currency 直接标价法 Direct quote foreign currency domestic currency 间接标价法 Indirect quote domestic currency foreign currency Direct quote: Indirect quote:

  4. 美元 人民币 Examples Direct Quotation In Shanghai USD100=CHY810.565 In Frankfort USD1=EUR0.8245 欧元 Indirect Quotation 英镑 In London GBP1=USD1.7575 USD1=EUR0.8245 In New York

  5. Depreciation and Appreciation 贬值 与 升值 All else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners. ___________ All else equal, a appreciation of a country’s currency makes its goods dearer for foreigners. ___________

  6. Foreign Exchange Market 外 汇 市 场 Defination: the market in which international currencies are traded. Major actors of the FX market: • Corporations • Commercial bank • Central banks • Nonbank financial institutions

  7. ---- ------- Commercial banks A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N ------- ------- ------- ---- Corporations (importors & exporters) Nonbank financial institutions Other users (eg.international tourists ) Framework of the Market (I) Central bank Buying foreign currency with domestic currency Buying domestic currency with foreign currency selling foreign currency buying foreign currency

  8. ---- ---- ---- ---- ---- ---- Framework of the Market (II) Central bank Interbank market Intervenient trading or Wholesale market 银行间市场 Commercial banks A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N Over-the-counter market commercial trading or Retail market Corporations(importors & exporters) 柜台交易市场 Nonbank financial institutions Other users (eg.international tourists )

  9. New York London Paris Frankfort Shanghai Tokyo What’s you spot USD JPY, pls ? Buy USD1( million ) 140.20/30 OK, done. Framework of FX market (III) Hongkong Singapore Sydney

  10. Characteristics of the Market • Foreign exchange trading takes place in many financial centres. • These major forex trading centres forms a round-o’clock market as they are linked by direct phones, fax and internet. arbitrage • Most FX deals between banks involve exchanges of nondollar currencies for U.S. dollars. examples a vehical currency

  11. Spot Rates & Forward Rates 即期汇率与远期汇率 • Spot Exchange Rates: • Exchange rates governing such “on-the-spot” trading. (two days after a deal is struck) • Forward Exchange Rates: • Exchange rates deals sometimes specify a value date farther away than 2days-- 30days , 90days,180days,or even several years.

  12. Foreign Exchange Swaps • Foreign Exchange Swaps: • a spot sale of a currency combined with a forward repurchase of the currency

  13. Currency Futures • Futures: • a future contract means a promise that a specified amount of foreign currency will be delivered on a specified date in the future

  14. Currency Options • Options: • gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at a specified expiration date

  15. Demand for Foreign Currency Assets • Asset & Asset Returns • Interest Rates • Exchange Rates & Asset Returns • A Simple Rule • Return, Risk, and Liquidity in the Foreign Exchange Market

  16. Exchange Rate & Asset Returns • Rate of return: The percentage increase in value it offers over some period. • Invest 100$ to buy a share of stock and the dividend is 1$. • If the price rise to 109 $ or drop to 89 $. • (109 +1)/100 –1 = 10% • (89 + 1)/100 –1 = – 10% • Expected rate of return (P.334)

  17. Equilibrium in the FX Market : The basic equilibrium condition Interest Parity 利息平价 The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.

  18. (1+R$ ) $ $f Ee$/€ E$/€ (1+R€ ) €f € Asset Market Linkages $ • (1+R$ ) = $f dollar money market Future spot FX market Spot FX market $f /Ee$/€ = €f € • E$/€ =$ Euro money market € • (1+R€ ) = €f e.g. E$/€ = 1.2, €1000000= $ ? e.g.R$ =10%, $1200000=$f ? €• E$/€ •(1+ R$)/ Ee$/€ = € • (1+ R€) e.g.R€ = 6%, € 1000000= €f? e.g. Ee$/€ =1.245, $f 132000= €f? €1000000×1.2= $ 1200000 1000000×1.2×(1+10%)/1.245=1000000×(1+ 6%) € 1000000×(1+ 6%)= €f10 60000 $1200000×(1+10%)=$f1320000 $f 132000/1.245= €f10 6000

  19. (1+R$ ) $ $f Ee$/€ E$/€ €f (1+R€ ) € Derivation of Interest Parity Condition •(1+R$ ) 利息平价条件 /Ee$/€ = € • (1+R€ ) € • E$/€ (1+R€ ) Ee$/€ E$/€(1+R$ ) = / Interest Parity Condition (Ee$/€-E$/€ )/ E$/€= R$ -R€ or R$ = R€+(Ee$/€-E$/€)/E$/€ E$/€=Ee$/€ (1+R€)/(1+R$) E$/€+E$/€•R$ = Ee$/€ +Ee$/€•R€ (Ee$/€-E$/€)/E$/€=R$-R€-(Ee$/€-E$/€ )/E$/€•R€ (Ee$/€-E$/€)/E$/€=R$ -Ee$/€•R€ / E$/€ Ee$/€-E$/€=E$/€•R$ -Ee$/€•R€ ________________ ∵(Ee$/€-E$/€ )/ E$/€•R€ is a small number ∴ (Ee$/€-E$/€)/E$/€=R$ -R€or • The change in the expected future exchange rate is roughly equal to the difference between the two interest rates. R$ = R€+(Ee$/€-E$/€)/E$/€ ( interest parity condition ) • The expected rate of return on one asset must equal that of the other asset when measured in the same currency.

  20. (1+R$ ) $f $ E$/€ Ee$/€ €f (1+R€ ) € Forward Exchange Rates & Covered Interest Parity 远期汇率与抵补的利息平价 Let Ee$/€ =Ef$/€ , expected future FX market is seen as forward FX market. Covered Interest Parity (Ef$/€-E$/€ )/ E$/€= R$ -R€ or R$ = R€+(Ef$/€-E$/€)/E$/€ (Ef$/€-E$/€ )/ E$/€= R$- R€ •(1+R$ ) € • E$/€ /Ef$/€ = € • (1+R€ ) (1+R€ ) E$/€(1+R$ ) Ef$/€ = / Ef$/€ =E$/€• (1+R$ )/(1+R€ ) E$/€+E$/€•R$ = Ef$/€ +Ef$/€•R€ Ef$/€ Ef$/€-E$/€=E$/€•R$ -Ef$/€•R€ (Ef$/€-E$/€)/E$/€=R$ -Ef$/€•R€ / E$/€ If R$ > R € , then Ef $/€ > E $/€ ; (Ef$/€-E$/€)/E$/€=R$-R€-(Ef$/€-E$/€ )/E$/€•R€ ________________ If R$ = R € , then Ef$/€ = E $/€ ; ∵(Ef$/€-E$/€ )/ E$/€•R€ is a small number If R$ < R € , then Ef$/€ < E $/€ . ∴ (Ef$/€-E$/€)/E$/€=R$ -R€or • The currency with a lowerer interest rate sells at a premium in the forward exchange market. , then P = R$– R€. Let P stand for premium R$ = R€+(Ef$/€-E$/€)/E$/€ ( covered interest parity ) 升水 ● The currency with a higher interest rate sells at a discount in the forward exchange market. , then D = – P= R€ – R$ . discount Let D stand for 贴水

  21. Expected dollar return on euro deposits E$/€ How changes in E affect expected returns (I) R$= R€ + (Ee$/€- E$/€)/ E$/€ R€ + (Ee$/€/ E$/€ -1) current depreciation R$> R€ + (Ee$/€- E$/€)/ E$/€ capital inflow Dollar appreciates. R$= R€ + (Ee$/€- E$/€)/ E$/€ Expected dollar return Interest parity condition holds again.

  22. How changes in E affect expected returns (II) = R€ + (Ee$/€/ E$/€ - 1) R$ > Other things equal , depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits. = R€ + (Ee$/€/ E$/€ - 1) R$ < Other things equal , appreciation of a country’s currency today raises the expected domestic currency return on foreign currency deposits.

  23. How changes in E affect expected returns (III) With fixed Ee$/€ and R€, the relation between today’s E$/€ and the expected dollar return on euro deposits defines a download-sloping schedule.

  24. How changes in E affect expected returns (IV) Given Ee$/€ and R€ , an appreciation of the dollar against the euro deposits, measured in terms of dollars, and vice versa.

  25. The Equilibrium Exchange Rate R$= R€ + (Ee$/€- E$/€)/ E$/€ Equilibrium in the FX market is at point 1, where the expected dollar return on dollar and euro deposits are equal.

  26. Interest Rates, Expectations & Equilibrium (I) The Effect of Changing Interest Rates on the Current Exchange Rate Conclusion: All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa.

  27. The Effect of Changing Interest Rates on the Current Exchange Rate Interest Rates, Expectations & Equilibrium (II) All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign currency, and vice versa. Rise in R€ Conclusion:

  28. Interest Rates, Expectations & Equilibrium (III) The Effect of Changing expectations on the Current Exchange Rate Conclusion: All else equal ,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

  29. Interest Rates, Expectations & Equilibrium (IV) All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa. All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign currency, and vice versa. All else equal ,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

  30. Question

  31. Thanks

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