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Chapter Twelve

Chapter Twelve. THE FOREIGN EXCHANGE MARKET. Foreign Exchange Rates: 1980-98. 美金/外幣 以1973年3月為 index=100. The Foreign Exchange Market. Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Depreciation 4.Appreciation.

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Chapter Twelve

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  1. Chapter Twelve THE FOREIGN EXCHANGE MARKET

  2. Foreign Exchange Rates: 1980-98 美金/外幣 以1973年3月為index=100

  3. The Foreign Exchange Market • Definitions: • 1. Spot exchange rate • 2. Forward exchange rate • 3. Depreciation • 4.Appreciation Immediate (2-day) exchange of bank deposits denominated in different currencies 注意A貨幣升值x%，則B貨幣會貶值，但不會剛好貶值x%

  4. The Foreign Exchange Market • Currency appreciates, country's goods prices  abroad and foreign goods prices  in that country • 1. Makes domestic businesses less competitive 對出口不利 • 2. Benefits domestic consumers 對進口有利 • FX traded in over-the-counter market • 1. Trade is in bank deposits denominated in different currencies

  5. In the long run 假設兩國鋼鐵品質相同 Law of One Price • Example: American steel $100 per ton, Japanese steel, 10,000 yen per ton • If E = 50 yen/$ then prices are: • American Steel Japanese Steel • In U.S. $100 $200 • In Japan 5000 yen 10,000 yen • If E = 100 yen/$ then prices are: • American Steel Japanese Steel • In U.S. $100 $100 • In Japan 10,000 yen 10,000 yen • Law of one price E = 100 yen/$ ∴日本人會買美國鋼鐵，不買日本鋼鐵，而美國人也會買美國鋼鐵，不買日本鋼鐵 ∴美金日圓 或者日本人或美國人都會買美國鋼鐵運到日本來賣以賺取套利，∴美鋼價格到$150，日鋼價格會下跌到7,500 yen

  6. Purchasing Power Parity (PPP) 當日鋼價格10%，變成11000yen，則美金必須升值10%，變成110yens/1美金 ，因為要使得日本鋼鐵在美國能賣$100 (11,000yen/110yen)，也就是說美金升值 要剛好抵銷掉日本鋼鐵價格的上升 • PPP  Domestic price level  10%, domestic currency大約  10%，foreign currency  10% • 1. Application of law of one price to price levels • 2. Works in long run not short run • Problems with PPP • 1. All goods not identical in both countries: Toyota vs Chevy • 2. Many goods and services are not traded: e.g. haircuts

  7. PPP: U.S. and U.K

  8. Factors Affecting E in Long Run • Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E

  9. Expected Returns and Interest Parity • RETe for • Francois Al • --------------------------------------------------------------------------------------------------- • $ Deposits iD + (Eet+1 - Et)/Et (註一)\ iD • F Deposits iFiF - (Eet+1 - Et)/Et (註二) • -------------------------------------------------------------------------------------------------- • Relative RETeiD - iF + (Eet+1 - Et)/Et iD - iF + (Eet+1 - Et)/Et • Interest Parity Condition: • $ and F deposits perfect substitutes • iD = iF - (Eet+1 - Et)/Et Example: if iD = 10% and expected appreciation of $, (Eet+1 - Et)/Et, = 5% iF = 15% Relative expected return on dollar deposit in terms of francs or dollars =interest rate on foreign deposit – expected appreciation of the dollar =expected return on foreign deposit in terms of dollars RETF=5%-4%=1% 因為同樣的risk與liquidity以及充分的capital mobility 假設市場處在均衡狀態，當本土利率低於國外利率時，則預期本土貨幣升值，以彌補本土利率之不足。 若relative RETe>0，則大家(美國人與法國人)只想hold美金存款，而不要法國存款

  10. 註一(假設法國人將一塊法郎換成美金後存到美國銀行，一年後再換成法郎，其報酬率為)： • 1/Et*(1+iD)*Eet+1-1 • = iD*(Eet+1/Et)+(Eet+1-Et)/Et • ≈ iD+(Eet+1-Et)/Et • 註二(假設美國人將一塊美金換成法郎後存到法國銀行，一年後再換成美金，其報酬率為)： • [1*Et*(1+iF)/Eet+i]-1 • = (Et/Eet+1)*(1+iF)-1 • = (iF)*(Et/Eet+1)+(Et-Eet+1)/Eet+1 • ≈ iF-(Eet+1-Et)/Et

  11. Deriving RETF Curve • Assume iF = 10%, Eet+1 = 10 francs/$ • Point • A: Et = 9.5 RETF = .10 - (10-9.5)/9.5 = .048 = 4.8% • B: Et = 10.0 RETF = .10 - (10-10)/10 = .100 =10.0% • C: Et = 10.5 RETF = .10 - (10-10.5)/10.5 = 14.8% • RETF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RETF

  12. Deriving RETD Curve • Deriving RETD Curve • Points B, D, E, RETD = 10%: so is vertical • Equilibrium • RETD = RETF at E* • If Et > E*, RETF > RETD, sell $, Et • If Et < E*, RETF < RETD, buy $, Et =iD

  13. Equilibrium in the Foreign Exchange Market

  14. Shifts in RETF • RETF curve shifts right when • 1. iF: because RETF at each Et • 2. Eet+1: because expected appreciation of F at each Et and RETF • Occurs: 1) Domestic P, 2) Tariffs and quotas 3) Imports , 4) Exports , 5) Productivity 

  15. Shifts in RETD • RETD shifts right when • 1. iD; because RETD at each Et • Assumes that domestic πe unchanged, so domestic real rate 

  16. Factors that Shift RETF and RETD

  17. Response to i Because πe 本國利率上升 • 1. πe, Eet+1, expected appreciation of F, RETF shifts out to right • 2. iD, RETD shifts to right • However because πe > iD, real rate , Eet+1 more than iD • RETF shifts out > RETD shifts out and Et

  18. 長期 Response to Ms • 1. Ms, P, Eet+1, expected appreciation of F, RETF shifts right • 2. Ms, i D, RETD shifts left • Go to point 2 and Et • 3. In long run, i D returns to old level, RETD shifts back, go to point 3 and get Exchange Rate Overshooting 短期

  19. Why Exchange Rate Volatility? • 1. Expectations of Eet+1 fluctuate • 2. Exchange rate overshooting

  20. The Dollar and Interest Rates • 1. Value of $ and real rates rise and fall together, as theory predicts • 2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises

  21. Profiting from FX Forecasts • Forecasters look at factors discussed here • FX forecasts affect financial institutions managers' decisions • If forecast DM appreciate, franc depreciate, • 1. Sell franc assets, buy DM assets • 2. Make more DM loans, less franc loans • 3. FX traders sell francs, buy DMs

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