chapter twelve the foreign exchange market copyright © 2004 pearson education canada inc. slide...

Chapter Twelve

The Foreign Exchange Market

Copyright © 2004 Pearson Education Canada Inc. Slide 12–3

Exchange Rates, 1974–2002



• Definitions

1. Spot exchange rate

2. Forward exchange rate

3. Appreciation

4. Depreciation



• Currency appreciates, country's goods prices abroad and foreign goods prices in that country

1. Makes domestic businesses less competitive

2. Benefits domestic consumers

• FX traded in over-the-counter market1. Trade is in bank deposits denominated in different

currencies


Law of One Price

• Example: Canadian steel $100 per ton, Japanese steel, 10 000 yen per ton


If E = 50 yen/$ then price are:

Canadian Steel Japanese Steel

In Canada $100 $200

In Japan 5000 yen 10,000 yen

Law of One Price

• Law of one price E = 100 yen/$

If E = 100 yen/$ then price are:

Canadian Steel Japanese Steel

In Canada $100 $100

In Japan 10 000 yen 10 000 yen


Purchasing Power Parity (PPP)

• PPP Domestic price level 10%, domestic currency 10%

1. Application of law of one price to price levels

2. Works in long run not short run

• Problems with PPP1. All goods not identical in both countries

(i.e., Toyota versus Chevy)

2. Many goods and services are not traded (e.g., haircuts)


PPP: Canada and U.S.


Factors Affecting E in Long Run

• Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E


Expected Returns and Interest Parity

Re for Francois Re for Al

$ Deposits iD Et1

e Et Et

iD

F Deposits iF iD Et1

e Et Et

Relative Re iD iF Et 1

e Et Et

iD iF Et 1

e Et Et


iD iF Et1

e Et

Et

Et1e Et

Et

5% i F 15%

– Example: if iD = 10% and expected appreciation of $,

Expected Returns and Interest Parity

• Interest Parity Condition– $ and F deposits perfect substitutes

(2)


Deriving RF Curve

• RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF

A s s u m e i F = 1 0 % , E et + 1 = 1 e u r o / $

P o i n t

A : E t = 0 . 9 5 0 . 1 0 1 . 0 0 . 9 5 . 9 5 0 . 0 4 8 4 . 8 %FR

B : E t = 1 . 0 0 . 1 0 1 . 0 1 . 0 1 . 0 0 . 1 0 0 1 0 . 0 %FR

C : E t + 1 = 1 . 0 5 0 . 1 0 1 . 0 1 . 5 1 . 0 5 0 . 5 8 5 . 8 %FR


Deriving RD Curve

• Deriving RD Curve– Points B, D, E, RD = 10%, so curve is vertical

• Equilibrium– RD = RF at E*

– If Et > E*, RF > RD, sell $, Et

– If Et < E*, RF < RD, buy $, Et


Equilibrium in the Foreign Exchange Market


Shifts in RF

1. RF curve shifts right when– iF : because RF at

each Et

– Eet+1 : because expected

appreciation of F at each Et and RF

2. Occurs: 1. Domestic P ; 2. Restrictions on trade ; 3. Imports ; 4. Exports ; 5. Productivity

Figure 4: Shifts in the Schedule for the Expected Return on Foreign Deposits RF


Shifts in RD

1. RD shifts right when

– iD , because RD at each Et

– Assumes that domestic πe unchanged, so domestic real rate

Factors that Shift RF and RD



Response to i Because πe

1. πe , Eet+1 , expected

appreciation of F , RF shifts out to right

2. iD , RD shifts to right

3. However because πe > iD , real rate , Ee

t+1 more than iD RF shifts out > RD shifts out and Et


Response to Ms

1. Ms , P , Eet+1 ,

expected appreciation of F , RF shifts right

2. Ms , i D , RD shifts leftGo to point 2 and Et

3. In long run, i D returns to old level, RD shifts back, go to point 3 and get exchange rate overshooting


Why Exchange Rate Volatility?

• Expectations of Eet+1 fluctuate

• Exchange rate overshooting


Profiting from FX Forecasts

• Forecasters look at factors discussed here

• FX forecasts affect financial institutions managers' decisions

• If forecast yen appreciate, yen depreciate, – Sell franc assets, buy euro assets

– Make more euros loans, less yen loans

– FX traders sell yen, buy euros

chapter twelve the foreign exchange market copyright © 2004 pearson education canada inc. slide...

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