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ECON 332 (1)

Course Notes - Chapter 12-17 Includes all textbook notes.

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ECON 332
Usman Hannan

ECON 332 Notes Exchange Rates and the Foreign Exchange Market: An Asset Approach (Ch 13) Exchange Rates and International Transactions Exchange Rate: The price of one currency in terms of another Can be quoted either as the price of the foreign currency in terms of dollars (direct/American exchange) or as the price of dollars in terms of the foreign currency (indirect/European terms) Also an asset price; Thus, the principles governing the behaviour of other asset prices also govern the behaviour of exchange rates Allow us to compare prices of goods and services produced in other countries Assets are a form of wealth; A way of transferring purchasing power from the present into the future All else equal, a depreciation of a countrys currency makes its goods cheaper for foreigners; Exports are cheaper for foreigners and imports from abroad are more expensive for domestic residents All else equal, an appreciation of a countrys currency makes its goods more expensive for foreigners; Exports are more expensive for foreigners and imports from abroad are cheaper for domestic residents Relative Prices influence import and export demands All else equal, a depreciation of a countrys currency lowers the relative price of its exports and raises the relative price of its imports All else equal, an appreciation of a countrys currency raises the relative price of its exports and lowers the relative price of its imports Foreign Exchange Market The market in which international currency trades is called the Foreign Exchange Market The major participants in the foreign exchange market are: 1. Commercial Banks: At the center of foreign exchange market b/c almost every sizable international transaction involves debiting/crediting of accounts at commercial banks in various financial centers (i.e. the exchange of bank deposits denominated in different currencies) 2. Corporations that engage in international trade: Frequently make or receive payments in currencies other than that of the country in which they are headquartered 3. Nonbank Financial Institutions: Institutional investors (ex. pension funds) often trade foreign currencies; Hedge funds, which cater to very wealthy individuals and are not bound by government regulations that limit mutual funds trading strategies, trade actively in the foreign exchange market (ex. hedge funds) 4. Central Banks: Sometimes intervene in foreign exchange markets; the volume of the transactions is typically not large but may have a great impact since participants in the foreign exchange markets watch central bank actions for clues about future macroeconomic policies (ex. the interest rate) that may affect exchange rates (ex. appreciation and depreciation) 5. Individuals: May participate in the market (ex. tourist buying foreign currency at a hotel), but such cash transactions are an significant fraction of foreign exchange trading Interbank Trading is the trading of foreign currency among banks and accounts for most of the activity in the foreign exchange market using wholesale/interbank exchange rates Corporations trade foreign currency with commercial banks (debit/credit) using retail exchange rates; They have the incentive to work with banks because it reduces search costs as well as the interest rate issue Commercial banks profit at the retail market = wholesale exchange rate retail exchange rate Arbitrage is the process of buying a currency cheap in one country and selling it for a higher price (dear) in another; risk-free, rare, and short-lived since the increase in demand will drive the exchange rate back Vehicle Currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency (ex. USD, Euro, Pound) Mechanisms of Foreign Exchange Markets: Spot Exchange Rates govern on-the-spot trades (called spot transactions) Forward Exchange Rates are involved in forward transactions (deals that specify a future transaction date called the value date) 1 A Foreign Exchange Swap is a spot sale of a currency combined with a forward repurchase of the currency (ex. receive $1M in sales; owe a US supplier in 3 months; invest in $1M in euro bonds for 3 months the 3 month swap of dollars into euros may result in lower brokers fees than the 2 separate transactions of selling dollars for spot euros and selling the euros for dollars on the forward market) A Futures Contract promises that a specified amount of foreign currency will be delivered on a specific date in the future; buy = long; sell = short A Forward Contract (private transaction OTC market) is an alternative way to ensure that you receive the same amount of foreign currency on the date in question A Foreign Exchange Option gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date; the seller has no obligation to exercise the right Put Options give the right to sell the foreign currency at a known exchange rate at any time during the period Ex. You expect foreign currency to arrive 1 year from now. Hedge it using a put. Call Options give the right to buy the foreign currency at a known price Ex. You expect to make payments to a foreign country. Hedge it using a call. Options may be written on many underlying assets (including foreign exchange futures) Demand for Foreign Currency Assets Asset Returns: Desirability of an asset is judged largely on the basis of its rate of return, the percentage increase in value it offers over some time period Ex. Invest $100, stock price rises $10; ROR = 10% Decisions must be based on an expected rate of return Asset demand is driven by real rate of return, risk and liquidity Real Rate of Return: The expected rate of return that savers consider in deciding which assets to hold (i.e. the asset demand) is the expected real rate of return Is computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase Only the real return measures the goods and services a saver can buy in the future in return for giving up some consumption today Ex. Suppose the dollar value of an investment increases by 10% but the dollar prices of all goods and services also increase by 10%. In real terms, the real rate of return is 0. Rates of return expressed in currency (dollar returns) can still be used to compare real returns on different assets (ex. value of bottles of wine) All else equal, individuals prefer to hold those assets offering the highest expected real rate of return Risk is the variability an asset contributes to savers wealth An assets real return is usually unpredictable and may turn out to be quite different from what savers expect when they purchase the asset Savers dislike uncertainty and are reluctant to hold assets that make their wealth highly variable An asset with a high expected ROR may appear undesirable to savers if the realized ROR fluctuates widely Liquidity is the ease/speed with which the asset can be sold for exchanged goods Assets differ according to the cost and speed at which savers can dispose of them Savers prefer to hold some liquid assets as a precaution against unexpected pressing expense that might force them to sell less liquid assets at a loss Participants in the foreign exchange market base their demands for deposits of different currencies on a comparison of these assets expected rates of return To compare returns on different deposits, market participants need to know: (1) How the money values of the deposits will change and (2) How exchange rates will change so that they can translate RORs of other currencies A currencys interest rate is the amount of the currency that an individual can earn by lending a unit of the currency for a year Example: Suppose that todays exchange rate is $1.100/, but you expect the rate to be $1.165/ in 1 year. Suppose also that the dollar interest rate is 10%/year while the euro interest rate is 5%/year. This means that 2 a deposit of $1.00 pays $1.10 after a year while a deposit of 1 pays 1.05 after a year. Which of these deposits offer the higher return? Solution: American Deposit: The expected dollar rate of return is ($1.10 - $1.00)/$1.00 = 10% Euro Deposit: Todays exchange rate ($1.100/) shows that a deposit of 1 will be $1.10 (= 1 x $1.100/) If you deposit 1 today, you will earn 5%/year. Thus, after a year, the deposit will be worth 1.05 You expect that this will be worth (1.05 x $1.165/ =) $1.223 The expected dollar rate of return is thus ($1.223 - $1.10)/$1.10 = 0.11 = 11% Therefore, you expect to do better by holding your wealth in the form of euro deposits The Rate of Depreciation is the percentage increase in the domestic-foreign (i.e. dollar/euro) exchange rate over a year (in the above example, the dollars expected depreciation rate is *1.165-1.10]/1.10 = 5.9% 6%) The dollar rate of return on foreign deposits is approximately the foreign interest rate plus the rate of deprec
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