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LECTURE 2: Exchange Rates

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The (nominal) exchange rate is the price of 1 unit of foreign exchange ... Credit risk (for bonds) = default downgrade legal. UCEAP Int Pol Econ. Dr DN Tambakis ... – PowerPoint PPT presentation

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Title: LECTURE 2: Exchange Rates


1
LECTURE 2 Exchange Rates Currency Markets
(Krugman Obstfeld International Macro Theory
and Policy, ch. 13)
  • The (nominal) exchange rate is the price of 1
    unit of foreign exchange
  • Example on June 30, 2002 1.53/1 (USD/GBP)
  • Exchange rates and relative prices
  • appreciation US PM down, PX up
  • depreciation US PM up, PX down
  • A stronger dollar makes exports less competitive
    and imports cheaper
  • A weaker USD brings imported inflation (How?)

2
The Foreign Exchange (FX) Market
  • By far the biggest of all financial markets
  • Average daily turnover gt 1.5 trillion
  • The players commercial banks, corporations,
    non-banks (pension funds, investment banks) and
    central banks
  • FX trading centres Tokyo, HK/Singapore,
    Frankfurt, London, NY
  • The market that never sleeps
  • Spot versus forward exchange rates
  • Derivatives markets futures and options

3
Asset Returns, Interest Rates and Risk
  • Nominal rates of return nominal interest rates
    i performance in money terms
  • definition P(t)-P(t-1)/P(t-1) x 100
  • Real rates of return performance in real terms
    r
  • Ex ante (expected inflation) versus ex post
    (realized inflation)
  • Risk Expected ?? Realized (actual) return
  • Price risk the risk that prices move over time
  • Liquidity risk the risk that you cannot sell
  • Political risk
  • Credit risk (for bonds) defaultdowngradelegal

4
Managing (hedging) risk using financial
derivatives markets
  • Impact of Hedging on the Expected Cash Flows of
    the Firm

5
Exchange rate equilibrium using INTEREST RATE
PARITY
  • Assume that international investors care only
    about expected rates of return they are
    risk-neutral
  • Expected rates of return, in , of investing in
    and over the same time period are equal when
  • R R (Ee/- E/)/E/
  • For example R10, R5 and (Ee/- E/)/E/
    5, the expected depreciation of the dollar
  • Now, fixing Ee/ at, say, 1.05 /, and R at,
    say, 5 we get an inverse relationship between
    todays exchange rate E/ and R (Ee/-
    E/)/E/
  • If we then also know the fixed US dollar interest
    rate R we can find the equilibrium exchange rate
    when is true. This mechanism is known as
    interest rate parity.

6
Example The equilibrium / exchange rate
E/
2
1
Expected return on euro deposits
3
R
Rates of return in dollars
7
How does equilibrium change over time?
  • Remember the expected future Ee/ exchange rate
    level is fixed for now (so expected depreciation
    also)
  • Changing stance of US monetary policy
  • R rises vertical shifts right -gt appreciates
    now ( depreciates)
  • R falls vertical shifts left -gt depreciates
    now ( appreciates)
  • Changing stance of the euro-zones monetary
    policy
  • R rises sloping line shifts out -gt
    appreciates now ( depreciates)
  • R falls sloping line shifts in -gt depreciates
    now ( appreciates)
  • Now suppose that currency market sentiment
    changes Ee/ can vary
  • Ee/ rises sloping line shifts out -gt
    depreciates now
  • Ee/ falls sloping line shifts in -gt
    appreciates now

8
Interest Rate Differential between Dollar- and
Peso-Denominated Deposits in Argentina (basis
points 1/100 of a percent)
  • Interest Differential on Dollar- and
    Peso-Denominated Deposits in Argentina (basis
    points 1/100 of a percent)

9
Summary (and caveat)
  • Interest rates and exchange rates can be closely
    linked in the short term (lt1 year)
  • Exchange rates are very difficult to forecast
  • Random walks may perform better than
    macroeconomic models
  • Risk was not included. In reality investors are
    risk-averse prefer less risk w/same Ereturn
  • We need risk premia (p), especially for emerging
    markets, to capture political risk etc
  • R - R (Ee/- E/)/E/ p
  • Be careful about interpreting the sign of p !
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