Feenstra 3e Macro Ch2 Econ Ch13

7/25/2019 Feenstra 3e Macro Ch2 Econ Ch13

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Introduction to Exchange Rates

and the Foreign Exchange Market2

1. Exchange Rate Essentials2. Exchange Rates in Practice

3. The Market for Foreign Exchange

4. Aritrage and !"ot Exchange Rates

#. Aritrage and Interest Rates

$. %onclusions

© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor

1



•Exchange rates aect lar!e lo"s o international tra#e by inluencin! the $rices in #ierent currencies%

• Forei!n e&chan!e also acilitates massi'e lo"s o

international in'estment, "hich inclu#e #irect in'estments

as "ell as stoc( an# bon# tra#es%

• In the foreign exchange market, trillions o #ollars are

tra#e# each #ay an# the economic im$lications o shits in

the mar(et can be #ramatic%


2

Introduction



In this cha$ter, "e be!in to stu#y the nature an# im$act o

acti'ity in the orei!n e&chan!e mar(et% The to$ics "e co'er

inclu#e)

• e&chan!e rate basics,

• basic acts about e&chan!e rate beha'ior,

• the orei!n e&chan!e mar(et, an#

• t"o (ey mar(et mechanisms) arbitrage an# expectations.


3

Introduction




4

1 Exchange Rate Essentials

• *n e&chan!e rate + E is the $rice o some orei!n currency

e&$resse# in terms o a home +or #omestic currency%

• -ecause an e&chan!e rate is the relati'e $rice o t"o

currencies, it may be .uote# in either o t"o "ays)

o The number o home currency units that can bee&chan!e# or one unit o orei!n currency%

o The number o orei!n currency units that can be

e&chan!e# or one unit o home currency%



• To a'oi# conusion, "e must s$eciy "hich country is the

home country an# "hich is orei!n%

• When "e reer to a $articular countrys e&chan!e rate, "e

"ill .uote it in terms o units o home currency $er units oorei!n currency%

• For e&am$le, enmar(s e&chan!e rate "ith the Euroone is

.uote# as anish (rone $er euro +or (r/%

&efining the Exchange Rate





TABLE 2-1

E&chan!e ate 5uotations This table sho"s ma6or e&chan!e rates as they mi!ht a$$ear in the

inancial me#ia% 7olumns +1 to +3 sho" rates on ecember 31, 2012% For com$arison,columns +4 to +8 sho" rates on ecember 31, 2011% For e&am$le, column +1 sho"s that at

the en# o 2012, one 9%:% #ollar "as "orth 0%;;8 7ana#ian #ollars, %8; anish (rone, 0%<;

euros, an# so on% The euro=#ollar rates a$$ear in bol# ty$e%

E >/ ? 1%31@ ? 9%:% e&chan!e rate +*merican terms

E /> ? 0%<; ? Euroone e&chan!e rate +Euro$ean terms

© 2014 Worth Publishers

International Economics, 3e | Feenstra/Taylor 8


1

? 2/>

>/2 E

E <;%0

1 ?%31@1



• I one currency buys more o another currency, "e say it has

e&$erience# an appreciation Aits 'alue has risen,

appreciated, or strengthened %

• I a currency buys less o another currency, "e say it hase&$erience# a depreciation Aits 'alue has fallen,

depreciated , or weakened.

A""reciations and &e"reciations


<




In 9%:% terms, the ollo"in! hol#s true)

• When the 9%:% e&chan!e rate E >/ rises, more #ollars are

nee#e# to buy one euro% The $rice o one euro !oes u$ in

#ollar terms, an# the 9%:% #ollar e&$eriences a #e$reciation%

• When the 9%:% e&chan!e rate E >/ falls, e"er #ollars are

nee#e# to buy one euro% The $rice o one euro !oes #o"n in

#ollar terms, an# the 9%:% #ollar e&$eriences an

a$$reciation%



@




To #etermine the sie o an a$$reciation or #e$reciation, "ecom$ute the $ro$ortional chan!e, as ollo"s)

• In 2011, at time t, the #ollar 'alue o the euro "as

E >/,t ? >1%2;@%

• In 2012, at time t B 1, the #ollar 'alue o the euro "as

E >/,tB1 ? >1%31@%

• The chan!e in the #ollar 'alue o the euro "as

C E >/,t

? 1%31@ D 1%2;@ ? B >0%020%

• The $ercenta!e chan!e "as

C E >/,t/ E >/,t ? B0%020/1%2;@ ? B1%4%

• Thus, the euro appreciated a!ainst the #ollar by 1%4%



;




:imilarly, o'er the same year)

• In 2011, at time t, the euro 'alue o the #ollar "as

E />,t ? 0%<<0%

• In 2012, at time t B 1, the euro 'alue o the #ollar "as

E />,tB1 ? 0%<;%

• The chan!e in the #ollar 'alue o the euro "as

C E />,t ? 0%<; D 0%<<0 ? D0%011%

• The $ercenta!e chan!e "asC E />,t / E />,t ? D0%011/0%<<0 ? D1%43%

• Thus, the #ollar depreciated a!ainst the euro by 1%43%



10




Economists calculate multilateral e&chan!e rate chan!es bya!!re!atin! bilateral e&chan!e rates usin! tra#e "ei!hts to construct

an a'era!e o'er each currency in the bas(et% The resultin! measure

is calle# the chan!e in the effective exchange rate% For e&am$le)

• :u$$ose 40 o ome tra#e is "ith country 1 an# 80 is "ith

country 2% omes currency a$$reciates 10 a!ainst 1 but

#e$reciates 30 a!ainst 2%

• To in# the chan!e in omes eecti'e e&chan!e rate by multi$ly

each e&chan!e rate chan!e by the tra#e share an# sum)

+D10 G 40 B +30 G 80 ? +D0%1 G 0%4 B +0%3 G 0%8 ?

D0%04 B 0%1@ ? 0%14 ? B14%

• omes eecti'e e&chan!e rate has #e$reciate# by 14%

Multilateral Exchange Rates


11




In !eneral, su$$ose there are N currencies in the bas(et, an#omes tra#e "ith all N $artners is)

Tra#e ? Tra#e1 B Tra#e2 B % % % B Tra#e N %

*$$lyin! tra#e "ei!hts to each bilateral e&chan!e rate chan!e,the home countrys eecti'e e&chan!e rate + E eecti'e "ill chan!e

accor#in! to the ollo"in! "ei!hte# a'era!e)



12


chan!esratee&chan!enominal bilateralo a'era!e"ei!hte#=Tra#e

2

2

21

1

1

eecti'e

eecti'e

Tra#e

Tra#e

Tra#e

Tra#e

Tra#e

Tra#e N

N

N

E

E

E

E

E

E

E

E ∆

++

∆

+

∆

=

∆




FIGURE 2-1

Eecti'e E&chan!e ates) 7han!e in

the Halue o the 9%:% ollar, 2002=

2012 The chart sho"s the 'alue o

the #ollar usin! t"o #ierent bas(ets

o orei!n currencies% *!ainst a

bas(et o < ma6or currencies, the#ollar ha# #e$reciate# by 3 by

early 200@% *!ainst a broa# bas(et o

28 currencies, the #ollar ha# lost only

2 by 200@% This is because the

#ollar "as loatin! a!ainst the ma6or

currencies, but the broa# bas(et

inclu#e# im$ortant 9%:% tra#in!

$artners +such as 7hina that

maintaine# i&e# or ti!htly mana!e#

e&chan!e rates a!ainst the #ollar%


13




Exa'"le( )sing Exchange Rates to %o'"are Prices

in a %o''on %urrenc*

TABLE 2-2

9sin! the E&chan!e ate to 7om$are Prices in a 7ommon 7urrency o" $ay

attention, 00<J This table sho"s ho" the hy$othetical cost o Kames -on#s ne&t

tu&e#o in #ierent locations #e$en#s on the e&chan!e rates that $re'ail%


14





1

2 Exchange Rates in Practice

Exchange Rate Regi'es( Fixed +ersus Floating

There are t"o ma6or ty$es o exchange rate regimes A i&e# an# loatin!)

• Fixed +or pegged exchange rates luctuate in a narro"

ran!e +or not at all a!ainst some base currency o'er a

sustaine# $erio#% * countrys e&chan!e rate can remainri!i#ly i&e# or lon! $erio#s only i the !o'ernment

inter'enes in the orei!n e&chan!e mar(et in one or both

countries%

• Floating +or flexible exchange rates luctuate in a "i#erran!e, an# the !o'ernment ma(es no attem$t to i& it a!ainst

any base currency% *$$reciations an# #e$reciations may

occur rom year to year, each month, by the #ay, or e'ery

minute%




18

FIGURE 2-2 (1 of 2)

This i!ure sho"s the e&chan!e rates o three currencies a!ainst the 9%:% #ollar% The 9%:%#ollar is in a loatin! relationshi$ "ith the yen, the $oun#, an# the 7ana#ian #ollar +or

loonie% The 9%:% #ollar is sub6ect to a !reat #eal o 'olatility because it is in a loatin!

re!ime, or free float%

APP,I%ATI-

Exchange Rate Behavior: e!ecte" #eve!o$e" %o&ntrie' 1*-2+12




1<

FIGURE 2-2 (2 of 2)

This i!ure sho"s e&chan!e rates o three currencies a!ainst the euro, intro#uce# in 1;;;%The $oun# an# the yen loat a!ainst the euro% The anish (rone $ro'i#es an e&am$le o a

i&e# e&chan!e rate% There is only a tiny 'ariation aroun# this rate, no more than $lus or

minus 2% This ty$e o i&e# re!ime is (no"n as a band%

APP,I%ATI-

Exchange Rate Behavior: e!ecte" #eve!o$e" %o&ntrie' 1*-2+12 (contin&e")




1@

FIGURE 2-, (1 of 2)

:electe# e'elo$in! 7ountries, 1;;8=2012 E&chan!e rates in #e'elo$in! countries sho"a "i#e 'ariety o e&$eriences an# !reater 'olatility% Pe!!in! is common but is $unctuate#

by $erio#ic crises +you can see the eects o these crises in !ra$hs or Thailan#, :outh

Lorea, an# In#ia%

APP,I%ATI-

e!ecte" #eve!o$ing %o&ntrie' 1*-2+12




1;

FIGURE 2-, (2 of 2)

In#ia is an e&am$le o a mi##le !roun#, some"here bet"een a i&e# rate an# a ree loat,calle# a managed float% 7olombia is an e&am$le o a crawling peg . The 7olombian $eso

is allo"e# to cra"l !ra#ually, it stea#ily #e$reciates at an almost constant rate or se'eral

years rom 1;;8 to 2002% Dollarization occurre# in Ecua#or in 2000, "hich is "hen a

country unilaterally a#o$ts the currency o another country%

APP,I%ATI-

e!ecte" #eve!o$ing %o&ntrie' 1*-2+12 (contin&e")




20

Exchange Rate Regi'es of the /orld

• Fi!ure 2=4 sho"s an IMF classiication o e&chan!e rate

re!imes aroun# the "orl#, "hich allo"s us to see the

$re'alence o #ierent re!ime ty$es across the "hole

s$ectrum rom i&e# to loatin!%

• The classiication co'ers 1;2 economies or the year 200@,

an# re!imes are or#ere# rom the most ri!i#ly i&e# to the

most reely loatin!%

• :e'en countries use an ultrahar# $e! calle# a currency

board, a ty$e o i&e# re!ime that has s$ecial le!al an# $roce#ural rules #esi!ne# to ma(e the $e! Nhar#erOAthat

is, more #urable%

Recent Exchange Rate Ex"eriences

APP,I%ATI-




21

FIGURE 2-

This i!ure sho"s IMF classiication o e&chan!e rate re!imes aroun# the "orl# or co'ers 1;2

economies in 2010% e!imes are or#ere# rom the most ri!i#ly i&e# to the most reely loatin!%

:e'en countries use an ultrahar# $e! calle# a currency boar#, "hile 3 others ha'e a har# $e!%

APP,I%ATI-

A $ectr&. of Exchange Rate Regi.e'




22

FIGURE 2-)

*n a##itional 43 counties ha'e ban#s, cra"lin! $e!s or ban#s, "hile 48 countries ha'e

e&chan!e rates that either loat reely, are mana!e# loats are allo"e# to loat "ithin "i#e

ban#s%

APP,I%ATI-

A $ectr&. of Exchange Rate Regi.e' (contin&e")




23

3 The Market for Foreign Exchange

E&chan!e rates the "orl# o'er are set in the foreign exchange

market +or forex or FX market%• The ore& mar(et is not an or!anie# e&chan!e) tra#e is

con#ucte# No'er the counter%O

• In *$ril 2010, the !lobal ore& mar(et tra#e#, >4 trillion $er

#ay in currency%

• The three ma6or orei!n e&chan!e centers are locate# in the

9nite# Lin!#om, the 9nite# :tates, an# Ka$an%

• ther im$ortant centers or ore& tra#e inclu#e on! Lon!,Paris, :in!a$ore, :y#ney, an# Qurich%




24

• The sim$lest ore& transaction is a contract or the imme#iatee&chan!e o one currency or another bet"een t"o $arties%

This is (no"n as a spot contract%

• The e&chan!e rate or this transaction is oten calle# the spot

exchange rate%

• The use o the term Ne&chan!e rateO al"ays reers to the s$ot

rate or our $ur$oses%

• The s$ot contract is the most common ty$e o tra#e an#a$$ears in almost ;0 o all ore& transactions%

The !"ot %ontract





2

&eri0ati0es

FIGURE 2-/ • In a##ition to the s$ot contractsother ore& contracts inclu#e

forwards, swaps, futures, an#

options%

• 7ollecti'ely, all these relate#ore& contracts are terme#

derivatives%

• The s$ot an# or"ar# rates

closely trac( each other%





28

Foreign Exchange &eri0ati0es

Forards

* or"ar# contract #iers rom a s$ot contract in that the t"o

$arties ma(e the contract to#ay, but the settlement date or the

#eli'ery o the currencies is in the uture, or or"ar#% The time to

#eli'ery, or maturity, 'aries% o"e'er, because the $rice is i&e#

as o to#ay, the contract carries no risk %

!a"s

* s"a$ contract combines a s$ot sale o orei!n currency "ith a

or"ar# re$urchase o the same currency% This is a common

contract or counter$arties #ealin! in the same currency $air o'eran# o'er a!ain% 7ombinin! t"o transactions re#uces

transactions costs%

APP,I%ATI-




2<


Futures

* utures contract is a $romise that the t"o $arties hol#in! thecontract "ill #eli'er currencies to each other at some uture #ate

at a $res$eciie# e&chan!e rate, 6ust li(e a or"ar# contract%

9nli(e the or"ar# contract, utures contracts are stan#ar#ie#,

mature at certain re!ular #ates, an# can be tra#e# on anor!anie# utures e&chan!e%

-"tions

*n o$tion $ro'i#es one $arty, the buyer, "ith the ri!ht to buy

+call or sell + put a currency in e&chan!e or another at a $res$eciie# e&chan!e rate at a uture #ate% The buyer is un#er no

obli!ation to tra#e an# "ill not e&ercise the o$tion i the s$ot

$rice on the e&$iration #ate turns out to be more a'orable%

APP,I%ATI-




2@


eri'ati'es allo" in'estors to en!a!e in hedging +ris(

a'oi#ance an# speculation +ris( ta(in!%

• Example 1: e#!in!% *s chie inancial oicer o a 9%:% irm,

you e&$ect to recei'e $ayment o 1 million in ;0 #ays or

e&$orts to France% The current s$ot rate is >1%20 $er euro%Rour irm "ill incur losses on the #eal i the #ollar "ea(ens to

less than >1%10 $er euro% Rou a#'ise that the irm buy 1

million in call o$tions on #ollars at a rate o >1%1 $er euro,

ensurin! that the irms euro recei$ts "ill sell or at least thisrate% This loc(s in a minimal $roit e'en i the s$ot rate alls

belo" >1%1% This is he#!in!%

APP,I%ATI-




2;


eri'ati'es allo" in'estors to en!a!e in hedging +ris(a'oi#ance an# speculation +ris( ta(in!%

• Example 2: :$eculation% The mar(et currently $rices one=year

euro utures at >1%30, but you thin( the #ollar "ill "ea(en to

>1%43 in the ne&t 12 months% I you "ish to ma(e a bet, you

"oul# buy these utures, an# i you are $ro'e# ri!ht, you "ill

realie a 10 $roit% *ny le'el abo'e >1%30 "ill !enerate a

$roit% I the #ollar is at or belo" >1%30 a year rom no",

ho"e'er, your in'estment in utures "ill be a total loss% Thisis s$eculation%

APP,I%ATI-




30

• Most ore& tra#ers "or( or commercial banks% *bout 3/4th o

all ore& transactions !lobally are han#le# by 6ust 10 ban(s%

• The e&chan!e rates or these tra#es un#erlie .uote# mar(et

e&chan!e rates%

• :ome cor$orations may tra#e in the mar(et i they are en!a!e#in e&tensi'e transactions in orei!n mar(ets%

Pri0ate Actors

• :ome !o'ernments en!a!e in $olicies that restrict tra#in!,

mo'ement o ore&, or restrict cross=bor#er inancialtransactions are calle# a orm o capital control%

• In lieu o ca$ital controls, the central ban( must stan# rea#y to

buy or sell its o"n currency to maintain a i&e# e&chan!e rate%

o0ern'ent Actions





31

4 Aritrage and !"ot Exchange Rates

FIGURE 2-*

*rbitra!e an# :$ot ates *rbitra!e ensures that the tra#e o currencies in e" Ror(

alon! the $ath *- occurs at the same e&chan!e rate as 'ia Son#on alon! $ath *7-%

*t - the $oun#s recei'e# must be the same% e!ar#less o the route ta(en to !et to -% London

!"

N.#.

!" E E =




32

In !eneral, three outcomes are a!ain $ossible%

1% The #irect tra#e rom #ollars to $oun#s has a better rate) E /

> U E / E />

2% The in#irect tra#e has a better rate) E /> V E / E />

3% The t"o tra#es ha'e the same rate an# yiel# the same result) E /> ? E /

E />% nly in the last case are there no $roit o$$ortunities% This no-

arbitrage condition)

Aritrage ith Three %urrencies

The ri!ht=han# e&$ression, a ratio o t"o e&chan!e rates, is calle# a

cross rate%


rate7ross

2/>

2/T

>/ 2 2/T

ratee&chan!eirect

>/T E

E

E E E ==




33

FIGURE 2-0

*rbitra!e an# 7ross ates Trian!ular arbitra!e ensures that the #irect tra#e o currencies

alon! the $ath *- occurs at the same e&chan!e rate as 'ia a thir# currency alon! $ath

*7-% The $oun#s recei'e# at - must be the same on both $aths, an#


>/ 2 2/T>/T E E E =




34

• The ma6ority o the "orl#s currencies tra#e #irectly "ith only

one or t"o o the ma6or currencies, such as the #ollar, euro,

yen, or $oun#%

• Many countries #o a lot o business in ma6or currencies such as

the 9%:% #ollar, so in#i'i#uals al"ays ha'e the o$tion to en!a!ein a trian!ular tra#e at the cross rate%

• When a thir# currency, such as the 9%:% #ollar, is use# in these

transactions, it is calle# a vehicle currency because it is not

the home currency o either o the $arties in'ol'e# in the tra#ean# is 6ust use# or interme#iation%

%ross Rates and +ehicle %urrencies





3

# Aritrage and Interest Rates

*n im$ortant .uestion or in'estors is in "hich currency they

shoul# hol# their li.ui# cash balances%

• Woul# sellin! euro #e$osits an# buyin! #ollar #e$osits ma(e a $roit or a ban(er

• These #ecisions #ri'e #eman# or #ollars 'ersus euros an# the

e&chan!e rate bet"een the t"o currencies%

The Prole' of Risk

* tra#er in e" Ror( cares about returns in 9%:% #ollars% * #ollar

#e$osit $ays a (no"n return, in #ollars% -ut a euro #e$osit $ays a

return in euros, an# one year rom no" "e cannot (no" or sure

"hat the #ollar=euro e&chan!e rate "ill be%

• $iskless arbitrage an# risky arbitrage lea# to t"o im$ortant

im$lications, calle# parity conditions%




38

7ontracts to e&chan!e euros or #ollars in one years time carry

an e&chan!e rate o % >/ #ollars $er euro% This is (no"n as the

forward exchange rate%

• I you in'est in a #ollar #e$osit, your >1 $lace# in a 9%:% ban(

account "ill be "orth +1 B i> #ollars in one years time% The#ollar 'alue o $rinci$al an# interest or the 9%:% #ollar ban(

#e$osit is calle# the dollar return.

• I you in'est in a euro #e$osit, you irst nee# to con'ert the

#ollar to euros% 9sin! the s$ot e&chan!e rate, >1 buys 1/ E >/ euros to#ay%

• These 1/ E >/ euros "oul# be $lace# in a euro account earnin!

i , so in a years time they "oul# be "orth +1 B i / E >/ euros%

Riskless Aritrage( %o0ered Interest Parit*





3<

To a'oi# that ris(, you en!a!e in a or"ar# contract to#ay toma(e the uture transaction at a or"ar# rate % >/%

• The +1 B i / E >/ euros you "ill ha'e in one years time can

then be e&chan!e# or +1 B i % >// E >/ #ollars, or the #ollar

return on the euro ban( #e$osit%

Riskless Aritrage( %o0ered Interest Parit*

• This is calle# covered interest parity +C! because all

e&chan!e rate ris( on the euro si#e has been Nco'ere#O by use

o the or"ar# contract%


( ) ( )

#e$ositseuroonreturn0ollar

2/>

2/> 2

#e$osits#ollaronreturn0ollar

> 11 E

% ii +=+



FIGURE 2-

*rbitra!e an# 7o'ere# Interest Parity 9n#er 7IP, returns to hol#in! #ollar #e$osits

accruin! interest !oin! alon! the $ath *- must e.ual the returns rom in'estin! in euros!oin! alon! the $ath *7- "ith ris( remo'e# by use o a or"ar# contract% ence, at -,

the ris(less $ayo must be the same on both $aths, an#)


3@


( ) ( ) 2

2/>

2/>> 11 i

E

% i +=+




International Economics, 3e | Feenstra/Taylor

3;

E0idence on %o0ered Interests Parit*

FIGURE 2- (1 of 2)

Financial Siberaliation an# 7o'ere# Interest Parity) *rbitra!e -et"een the 9nite# Lin!#om

an# Xermany The chart sho"s the #ierence in monthly $oun# returns on #e$osits in -ritish

$oun#s an# Xerman mar(s usin! or"ar# co'er rom 1;<0 to 1;;% In the 1;<0s, the #ierence

"as $ositi'e an# oten lar!e) tra#ers "oul# ha'e $roite# rom arbitra!e by mo'in! money rom

$oun# #e$osits to mar( #e$osits, but ca$ital controls $re'ente# them rom reely #oin! so%

APP,I%ATI-

Financia! Li3era!i4ation an" %overe" Intere't 5arit6




40

E0idence on %o0ered Interest Parit*

FIGURE 2- (2 of 2)

Financial Siberaliation an# 7o'ere# Interest Parity) *rbitra!e -et"een the 9nite# Lin!#om

an# Xermany +continue# *ter inancial liberaliation, these $roits essentially 'anishe#, an#

no arbitra!e o$$ortunities remaine#% The 7IP con#ition hel#, asi#e rom small #e'iations

resultin! rom transactions costs an# measurement errors%

APP,I%ATI-

Financia! Li3era!i4ation an" %overe" Intere't 5arit6 (contin&e")

# A it d I t t R t




41

•In this case, tra#ers ace e&chan!e rate ris( an# must ma(e a forecast o the uture s$ot rate% We reer to the orecast as

, "hich "e call the expected exchange rate%

• -ase# on the orecast, you e&$ect that the euros you

"ill ha'e in one years time "ill be "orth"hen con'erte# into #ollarsY this is the expected dollar return

on euro #e$osits%

• The e&$ression or uncovered interest parity "#!$ is)

Riskless Aritrage( )nco0ered Interest Parit*


e E >/2

>/2 2 /,1+ E i+

>/2>/2 2 //,1+ E E i e

+

( ) ( )

#e$ositseuroonreturn#ollarE&$ecte#

/>

/>

#e$osits#ollaronreturnollar

> 11 E

E ii

e

+=+

# A it d I t t R t



FIGURE 2-1+

*rbitra!e an# 9nco'ere# Interest Parity 9n#er 7IP, returns to hol#in! #ollar #e$ositsaccruin! interest !oin! alon! the $ath *- must e.ual returns rom in'estin! in euros

!oin! alon! the ris(y $ath *7-% ence, at -, the e&$ecte# $ayo must be the same on

both $aths, an#

%


42


( ) ( ) 2

2/>

2/>> 11 i

E

E i

e

+=+

# A it d I t t R t




43

/hat &eter'ines the !"ot Rate

• 9nco'ere# interest $arity is a no=arbitra!e con#ition that

#escribes an e.uilibrium in "hich in'estors are in#ierent

bet"een the returns on unhe#!e# interest=bearin! ban(

#e$osits in t"o currencies%

• We can rearran!e the terms in the unco'ere# interest $arity

e&$ression to sol'e or the s$ot rate)

Riskless Aritrage( )nco0ered Interest Parit*


>

2 2/> 2/>11

i

i E E e

+

+=




44

Assets and Their Attriutes

• *n in'estors entire $ortolio o assets may inclu#e stoc(s, bon#s,

real estate, art, ban( #e$osits in 'arious currencies, an# so on% *ll

assets ha'e three (ey attributes that inluence #eman#) return,

ris(, an# li%uidity%

• *n assets rate of return is the total net increase in "ealth

resultin! rom hol#in! the asset or a s$eciie# $erio# o time,ty$ically one year%

• The ris( o an asset reers to the 'olatility o its rate o return%

• The li.ui#ity o an asset reers to the ease an# s$ee# "ith "hich it

can be li.ui#ate#, or sol#%• We reer to the orecast o the rate o return as the expected rate

of return%




4

E0idence on )nco0ered Interest Parit*

• i'i#in! the 9IP by the 7IP, "e obtain , or %

• *lthou!h the expected future spot rate an# the forward rate

are use# in t"o #ierent orms o arbitra!eAris(y an#

ris(less, in e.uilibrium they shoul# be e&actly the sameJ

• I both co'ere# interest $arity an# unco'ere# interest $arity

hol#, the or"ar# must e.ual the e&$ecte# uture s$ot rate%

• In'estors ha'e no reason to $reer to a'oi# ris( by usin! theor"ar# rate, or to embrace ris( by a"aitin! the uture s$ot

rate%

APP,I%ATI-

2/> 2/> /1 % E e

=

2/> 2/> % E e

=

% -



© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor 48


• I the or"ar# rate e.uals the e&$ecte# s$ot rate, the expected

rate of depreciation e.uals the forward premium +the

$ro$ortional #ierence bet"een the or"ar# an# s$ot rates)

• While the let=han# si#e is easily obser'e#, the e&$ectations

on the ri!ht=han# si#e are ty$ically unobser'e#%

APP,I%ATI-

on#e$reciatio rateE&$ecte#

2/>

2/>

$remiumFor"ar#

2/>

2/> 11 −=− E

E

E

% e

APP,I%ATI-




4<


FIGURE 2-11

E'i#ence on Interest Parity

When 9IP an# 7IP hol#, the

12=month or"ar# $remium

shoul# e.ual the 12=month

e&$ecte# rate o #e$reciation%

* scatter$lot sho"in! theset"o 'ariables shoul# be close

to the #ia!onal 4=#e!ree

line%

9sin! e'i#ence rom sur'eys

o in#i'i#ual ore& tra#ers

e&$ectations o'er the $erio#1;@@ to 1;;3, 9IP in#s some

su$$ort, as the line o best it

is close to the #ia!onal%

APP,I%ATI-




© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor 4@

• The 9IP a$$ro&imation e.uation says that the home interest rate

e.uals the orei!n interest rate $lus the e&$ecte# rate o

#e$reciation o the home currency%

• :u$$ose the #ollar interest rate is 4 $er year an# the euro 3%I 9IP is to hol#, the e&$ecte# rate o #ollar #e$reciation o'er a

year must be 1% The total #ollar return on the euro #e$osit is

a$$ro&imately e.ual to the 4 that is oere# by #ollar #e$osits%

)nco0ered Interest Parit*( A )seful A""roxi'ation


#e$ositseuroonreturno rate#ollarE&$ecte#

#ollar theo on#e$reciatio rateE&$ecte#

/>

/>

#e$ositseuroonrateInterest

#e$osits#ollaronreturno rateollar

?#e$osits#ollaron

rateInterest

> E

E ii

e∆

+=




© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor 4;

!u''ar*

FIGURE 2-12 (1 of 2)

o" Interest Parity elationshi$s E&$lain :$ot an# For"ar# ates In the s$ot mar(et,

9IP $ro'i#es a mo#el o ho" the s$ot e&chan!e rate is #etermine#% To use 9IP to in# the

s$ot rate, "e nee# to (no" the e&$ecte# uture s$ot rate an# the $re'ailin! interest rates

or the t"o currencies%






0

!u''ar*

FIGURE 2-12 (2 of 2)

o" Interest Parity elationshi$s E&$lain :$ot an# For"ar# ates In the or"ar# mar(et,

7IP $ro'i#es a mo#el o ho" the or"ar# e&chan!e rate is #etermine#% When "e use 7IP,

"e #eri'e the or"ar# rate rom the current s$ot rate +rom 9IP an# the interest rates or

the t"o currencies%




1% The e&chan!e rate in a country is the $rice o a unit oorei!n currency e&$resse# in terms o the home currency%

This $rice is #etermine# in the s$ot mar(et or orei!n

e&chan!e%

L e y T e r mE5 P-IT!




2% When the home e&chan!e rate rises, less orei!n currency is bou!ht/sol# $er unit o home currencyY the home currency

has #e$reciate#% I home currency buys x less orei!n

currency, the home currency is sai# to ha'e #e$reciate# by x

%





3% When the home e&chan!e rate alls, more orei!n currency is bou!ht/sol# $er unit o home currencyY the home currency

has a$$reciate#% I home currency buys x more orei!n

currency, the home currency is sai# to ha'e a$$reciate# by x

%





4% The e&chan!e rate is use# to con'ert the $rices o !oo#s an#assets into a common currency to allo" meanin!ul $rice

com$arisons%





% E&chan!e rates may be stable o'er time or they mayluctuate% istory su$$lies e&am$les o the ormer +i&e#

e&chan!e rate re!imes an# the latter +loatin! e&chan!e rate

re!imes as "ell as a number o interme#iate re!ime ty$es%





8% *n exchange rate crisis occurs "hen the e&chan!e ratee&$eriences a su##en an# lar!e #e$reciation% These e'ents

are oten associate# "ith broa#er economic an# $olitical

turmoil, es$ecially in #e'elo$in! countries%





<% :ome countries may or!o a national currency to orm acurrency union "ith other nations +e%!%, the Euroone, or

they may unilaterally a#o$t the currency o another country

+N#ollariationO%


© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor <



@% Soo(in! across all countries to#ay, numerous i&e# an#loatin! rate re!imes are obser'e#, so "e must un#erstan#

both ty$es o re!ime%


© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor @



;% The ore& mar(et is #ominate# by s$ot transactions, butmany #eri'ati'e contracts e&ist, such as or"ar#s, s"a$s,

utures, an# o$tions%


© 2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor ;



10% The main actors in the mar(et are $ri'ate in'estors an#+re.uently the !o'ernment authorities, re$resente# usually

by the central ban(%





11% *rbitra!e on currencies means that s$ot e&chan!e rates area$$ro&imately e.ual in #ierent ore& mar(ets% 7ross rates

+or in#irect tra#es an# s$ot rates +or #irect tra#es are also

a$$ro&imately e.ual%





12% is(less interest arbitra!e lea#s to the co'ere# interest $arity+7IP con#ition% 7IP says that the #ollar return on #ollar

#e$osits must e.ual the #ollar return on euro #e$osits, "here

or"ar# contracts are use# to co'er e&chan!e rate ris(%






13% 7o'ere# interest $arity says that the or"ar# rate is#etermine# by home an# orei!n interest rates an# the s$ot

e&chan!e rate%




L T



14% is(y interest arbitra!e lea#s to the unco'ere# interest $arity+9IP con#ition% 9IP says that "hen s$ot contracts are use#

an# e&chan!e rate ris( is not co'ere#, the #ollar return on

#ollar #e$osits must e.ual the e&$ecte# #ollar returns on

euro #e$osits%




L T



1% 9nco'ere# interest $arity e&$lains ho" the s$ot rate is#etermine# by the home an# orei!n interest rates an# the

e&$ecte# uture s$ot e&chan!e rate%




L T



e&chan!e rate

a$$reciation

#e$reciation

eecti'e e&chan!e rate

e&chan!e rate re!imes

i&e# +or $e!!e# e&chan!e

rates

loatin! +or le&ible e&chan!e

rates

ree loat e&chan!e rate re!ime ban#

mana!e# loat

e&chan!e rate crises

cra"lin! $e!

currency +or monetary union

#ollariationcurrency boar#

orei!n e&chan!e +ore& or FZ

mar(et

L e y T e r mE5 TERM!s$ot contract

s$ot e&chan!e rate

s$rea#

mar(et rictiontransaction costs

#eri'ati'es

or"ar#

s"a$

utures

o$tioncommercial ban(s

interban( tra#in!

cor$orations

nonban( inancial

institutions

ca$ital controloicial mar(et

blac( mar(et

inter'ention

arbitra!e

e.uilibrium

no=arbitra!e con#ition

cross rate'ehicle currency

or"ar# e&chan!e rate

co'ere# interest $arity +7IP

rate o return

ris(

li.ui#itye&$ecte# rate o return

e&$ecte# e&chan!e rate

unco'ere# interest $arity

+9IP

e&$ecte# rate o

#e$reciationor"ar# $remium

Documents

Feenstra 3e Macro Ch2 Econ Ch13