University:
California State University, Northridge
Course:
ECON 405 | International Trade
Academic year:

2024
Views:

345

Pages:

24
Author:

Rory Rhodes

Topic 7 Exchange Rates and the Foreign Exchange Market: An Asset Approach Part 1 Preview • The basics of exchange rates • Exchange rates and the prices of goods • The foreign exchange market • The demand for foreign currency deposits • Equilibrium in the foreign exchange market ♦ role of interest rates ♦ role of expectations of future exchange rates 13-2 Introduction • The price of one currency in terms of another is called an exchange rate. • Because of their strong influence on the current account and other macroeconomic variables, exchange rates are among the most important prices in an open economy. • An exchange rate is also an asset price, so the principles governing the behavior of other asset prices also govern the behavior of exchange rates. 13-3 Definitions of Exchange Rates • Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. ♦ How much can be exchanged for one dollar? ¥102/$1 ♦ How much can be exchanged for one yen? $0.0098/¥1 • Exchange rates allow us to denominate the cost or price of a good or service in a common currency. ♦ How much does a Honda cost? ¥3,000,000 ♦ Or, ¥3,000,000 x $0.0098/¥1 = $29,400 13-4 Table 1: Exchange Rate Quotations Exchange rates are reported daily in newspapers’ financial sections. This shows the dollar exchange rates for currencies traded in NY at 4:00 p.m. on July 23, 2007. Rates listed here are interbank rates: the rates banks charge to each other. No amount less than $1 million is traded at these “wholesale” rates. 13-5 Depreciation and Appreciation • Depreciation is a decrease in the value of a currency relative to another currency. ♦ A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. ♦ $1/€1 → $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable. ♦ The euro has appreciated relative to the dollar: it is now more valuable. 13-6 Depreciation and Appreciation (cont.) • Appreciation is an increase in the value of a currency relative to another currency. ♦ An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. ♦ $1/€1 → $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable. ♦ The euro has depreciated relative to the dollar: it is now less valuable. 13-7 Depreciation and Appreciation (cont.) • A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency. ♦ How much does a Honda cost? ¥3,000,000 ♦ ¥3,000,000 x $0.0098/¥1 = $29,400 ♦ ¥3,000,000 x $0.0106/¥1 = $31,800 • A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive. • A depreciated currency lowers the price of exports relative to the price of imports. 13-8 Depreciation and Appreciation (cont.) • An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency. ♦ How much does a Honda cost? ¥3,000,000 ♦ ¥3,000,000 x $0.0098/¥1 = $29,400 ♦ ¥3,000,000 x $0.0090/¥1 = $27,000 • An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive. • An appreciated currency raises the price of exports relative to the price of imports. 13-9 Foreign Exchange Markets • Exchange rates are determined by the interaction of individuals, firms, and financial institutions that buy and sell foreign currencies to make international payments. • The market in which international currency trades take place is called the foreign exchange market. 13-10 Foreign Exchange Markets (cont.) Major participants: 1. Commercial banks and other depository institutions • Vast majority of foreign exchange transactions involve the exchange of bank deposits denominated in different currencies. • Banks routinely enter the foreign exchange market to meet the needs of their customers –primarily corporations. 13-11 Foreign Exchange Markets (cont.) 2. Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) • Buy and sell foreign currencies for investment. 3. Corporations • Conduct foreign currency transactions to buy/sell goods, services, and assets. 13-12 Foreign Exchange Markets (cont.) 4. Central banks • Conduct official international reserves transactions. • Volume of these transactions are not typically large but may have strong impacts on exchange rates. • Market participants watch central bank actions for clues about future macroeconomic policies that may impact exchange rates. 13-13 Foreign Exchange Markets (cont.) • Foreign exchange trading takes place in many financial centers, with the largest volume of trade occurring in: ♦ London, New York, Tokyo, Frankfurt, and Singapore • The daily volume of foreign exchange transactions was $3.2 trillion in April 2007.  About 86% of transactions involved US dollars.  About 37% of transactions involved euros. 13-14 Foreign Exchange Markets (cont.) • Computer and telecommunications technology transmit information rapidly so the foreign exchange market is highly integrated. • The integration of financial centers implies that there is no significant arbitrage between markets. ♦ Arbitrage: buying at a low price and selling at a high price for a profit. • What will happen if dollars are cheaper in New York than in Hong Kong? • People will buy dollars in New York and sell them in Hong Kong, so that their price rises in New York and falls in Hong Kong, until the price of dollars is equal in both markets. 13-15 Foreign Exchange Markets (cont.) • Most transactions between banks (86% in 2007) are exchanges of foreign currencies for U.S. dollars. • U.S. dollar is sometimes called a vehicle currency because of its pivotal role in so many foreign exchange deals. ♦ A 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. • Why is the U.S. dollar so prominent? ♦ U.S. is the largest economy in the world with 30% of total output. ♦ Easy to find buyers and sellers for U.S. dollars. 13-16 Spot Rates and Forward Rates • Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is executed in the present. • Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date. ♦ Forward dates are typically 30, 90, 180, or 360 days in the future. ♦ Rates are negotiated between two parties in the present, but the exchange occurs in the future. 13-17 Fig. 1: Dollar/Pound Spot and Forward Exchange Rates, 1981–2007 Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month. Spot and forward exchange rates tend to move in a highly correlated fashion. Spot Rates and Forward Rates (cont.) • Forward rates are used to eliminate short-run exchange rate risk. • E.g., Radio Shack must pay ¥9,000 for each Japanese radio in 30 days. • Each radio can sell for $100, so profits depend on the dollar cost of the radios. ♦ Current spot rate: $0.0105/¥ → cost per radio = $0.0105/¥ x ¥9,000 = $94.50 → profit = $100 - $94.50 = $5.50. ♦ If $ depreciates: $0.0115/¥ → cost per radio = $0.0115/¥ x ¥9,000 = $103.50 → loss = $100 - $103.50 = -$3.50. 13-19 Spot Rates and Forward Rates (cont.) • To avoid this risk, Radio Shack can make a 30-day forward exchange deal with B of A. ♦ B of A sells yen to Radio Shack in 30 days at a rate of $0.0107/¥. • Thus, Radio Shack is guaranteed the cost per radio = $0.0107/¥ x ¥9,000 = $96.30 and profit = $3.70. 13-20 Other Methods of Currency Exchange • Foreign exchange swaps: a combination of a spot sale with a forward repurchase. ♦ Swaps often result in lower fees or transactions costs because they combine two transactions. • E.g., Toyota has just received $1 million from U.S. sales and knows it must pay those dollars to a MI supplier in 3 months. Toyota would also like to invest the $1 million in euro bonds. • A 3 month swap of dollars into euros avoids the fees from two separate transactions: (1) selling dollars for spot euros and (2) selling the euros for dollars on the forward market. 13-21 Other Methods of Currency Exchange (cont.) • Futures contracts: a contract that a specified amount of foreign currency will be delivered on a specified date in the future. ♦ Contracts can be bought and sold in organized futures market, and only the current owner is obliged to fulfill the contract. 13-22 Other Methods of Currency Exchange (cont.) • Options contracts: 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. ♦ Option’s seller is required to sell or buy the foreign currency at the discretion of the option’s owner, who is under no obligation to exercise his right. ♦ Such contracts are helpful if you are uncertain about the timing of foreign currency payments. 13-23 Other Methods of Currency Exchange (cont.) • Forwards, swaps, futures, and options are all examples of financial derivatives –which are recorded in a country’s financial account. ♦ Financial derivatives are a class of assets that are more complicated than stocks and bonds, but with values that can depend on stock or bond values. ♦ In 2006, the net cross-border derivative flow into the U.S. was $28.8 billion. 13-24

Exchange Rates and the Foreign Exchange, Part 1

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