Introduction to Exchange Rates

13
and the Foreign Exchange Market
1. Exchange Rate Essentials
2. Exchange Rates in Practice
3. The Market for Foreign Exchange
4. Arbitrage and Interest Rates
5. Conclusions

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Introduction

• Exchange rates affect large flows of international trade

by influencing the prices in different currencies.

• Foreign exchange also facilitates massive flows of

international investment, which include direct investments
as well as stock and bond trades.

• In the foreign exchange market, trillions of dollars are

traded each day and the economic implications of shifts in
the market can be dramatic.

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Introduction

In this chapter, we begin to study the nature and impact of

activity in the foreign exchange market. The topics we cover
include:

• exchange rate basics,

• basic facts about exchange rate behavior,

• the foreign exchange market, and

• two key market mechanisms: arbitrage and expectations.

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1 Exchange Rate Essentials

• An exchange rate (E) is the price of a foreign currency

expressed in terms of a home (or domestic) currency.
• Because an exchange rate is the relative price of two
currencies, it may be quoted in either of two ways:
o The number of home currency units that can be
exchanged for one unit of foreign currency.
o The number of foreign currency units that can be
exchanged for one unit of home currency.

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1 Exchange Rate Essentials

Defining the Exchange Rate

• To avoid confusion, we must specify which country is the

home country and which is foreign.
• When we refer to a particular country’s exchange rate, we
will quote it in terms of units of home currency per units of
foreign currency.
• For example, the UAE exchange rate with the UK is quoted
as AED per £ (or AED/£)

• E$/€ = 1.318 = U.S. exchange rate (American terms)

• E€/$ = 0.759 = Eurozone exchange rate (European terms)

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 1 1
E$/€ = 1.318 =
E €/$ 0.759

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1 Exchange Rate Essentials

Appreciations and Depreciations

• If one currency buys more of another currency, we say it has
experienced an appreciation—its value has risen,
appreciated, or strengthened.

• If a currency buys less of another currency, we say it has

experienced a depreciation—its value has fallen, depreciated,
or weakened.

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1 Exchange Rate Essentials

Appreciations and Depreciations

In U.S. terms, the following holds true:

• When the U.S. exchange rate E$/€ rises, more dollars are
needed to buy one euro. The price of one euro goes up in
dollar terms, and the U.S. dollar experiences a depreciation.

• When the U.S. exchange rate E$/€ falls, fewer dollars are
needed to buy one euro. The price of one euro goes down in
dollar terms, and the U.S. dollar experiences an
appreciation.

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1 Exchange Rate Essentials
Appreciations and Depreciations
To determine the size of an appreciation or depreciation, we
compute the proportional change, as follows:
• In 2011, the dollar value of the euro was
E$/€ = $1.298.
• In 2012, the dollar value of the euro was
E$/€ = $1.318.
• The change in the dollar value of the euro was
Δ E$/€ = 1.318 − 1.298 = + $0.020.
• The percentage change was
Δ E$/€/E$/€ = +0.020/1.298 = +1.54%.
• Thus, the euro appreciated against the dollar by 1.54%.
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1 Exchange Rate Essentials

Appreciations and Depreciations

Similarly, over the same year:
• In 2011, the euro value of the dollar was
E€ /$ = €0.770.
• In 2012, the euro value of the dollar was
E€ /$ = €0.759.
• The change in the dollar value of the euro was
ΔE€ /$ = 0.759 − 0.770 = −€0.011.
• The percentage change was
ΔE€/$ / E€/$ = −0.011/0.770 = −1.43%.
• Thus, the dollar depreciated against the euro by 1.43%.
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1 Exchange Rate Essentials
Multilateral Exchange Rates
Economists calculate multilateral exchange rate changes by
aggregating bilateral exchange rates using trade weights to construct
an average of all bilateral changes for each currency in the basket.
The resulting measure is called the change in the effective exchange
rate. For example:
• Suppose 40% of Home trade is with country 1 and 60% is with
country 2. Home’s currency appreciates 10% against 1 but
depreciates 30% against 2.
• To find the change in Home’s effective exchange rate by multiply
each exchange rate change by the trade share and sum:
(−10% • 40%) + (30% • 60%) = (−0.1 • 0.4) + (0.3 • 0.6) =
−0.04 + 0.18 = 0.14 = +14%.
• Home’s effective exchange rate has depreciated by 14%.
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2 Exchange Rates in Practice
Exchange Rate Regimes: Fixed Versus Floating

There are two major types of exchange rate regimes—

fixed and floating:
• Fixed (or pegged) exchange rates fluctuate in a narrow
range (or not at all) against some base currency over a
sustained period. A country’s exchange rate can remain
rigidly fixed for long periods only if the government
intervenes in the foreign exchange market in one or both
countries.
• Floating (or flexible) exchange rates fluctuate in a wider
range, and the government makes no attempt to fix it against
any base currency. Appreciations and depreciations may
occur from year to year, each month, by the day, or every
minute.
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3 The Market for Foreign Exchange
The Spot Contract
• The simplest forex transaction is a contract for the immediate
exchange of one currency for another between two parties.
This is known as a spot contract.
• The exchange rate for this transaction is often called the spot
exchange rate.
• The use of the term “exchange rate” always refers to the spot
rate for our purposes.

• The spot contract is the most common type of trade and

appears in almost 90% of all forex transactions.

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5 Arbitrage and Interest Rates
An important question for investors is in which currency they
should hold their liquid cash balances.
• Would selling euro deposits and buying dollar deposits make a
profit for a banker?
• These decisions drive demand for dollars versus euros and the
exchange rate between the two currencies.
The Problem of Risk
A trader in New York cares about returns in U.S. dollars. A dollar
deposit pays a known return, in dollars. But a euro deposit pays a
return in euros, and one year from now we cannot know for sure
what the dollar-euro exchange rate will be.
• Riskless arbitrage and risky arbitrage lead to two important
implications, called parity conditions.
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5 Arbitrage and Interest Rates
Riskless Arbitrage: Covered Interest Parity
Contracts to exchange euros for dollars in one year’s time carry
an exchange rate of F$/ € dollars per euro. This is known as the
forward exchange rate.
• If you invest in a dollar deposit, your $1 placed in a U.S. bank
account will be worth (1 + i$) dollars in one year’s time. The
dollar value of principal and interest for the U.S. dollar bank
deposit is called the dollar return.
• If you invest in a euro deposit, you first need to convert the
dollar to euros. Using the spot exchange rate, $1 buys 1/E $/€
euros today.
• These 1/E $/€ euros would be placed in a euro account earning
i €, so in a year’s time© they would be worth (1 + i €)/E$/€ euros.
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5 Arbitrage and Interest Rates
Riskless Arbitrage: Covered Interest Parity
To avoid that risk, you engage in a forward contract today to
make the future transaction at a forward rate F$/€.

• The (1 + i €)/E$/€ euros you will have in one year’s time can
then be exchanged for (1 + i €)F$/€/E$/€ dollars, or the dollar
return on the euro bank deposit.
F$ / €
1 i$   1  i€ 
E$ / €
Dollar return on dollar deposits   
Dollar return on euro deposits

• This is called covered interest parity (CIP) because all

exchange rate risk on the euro side has been “covered” by use
of the forward contract.
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5 Arbitrage and Interest Rates
Risky Arbitrage: Uncovered Interest Parity
• In this case, traders face exchange rate risk and must make a
forecast of the future spot rate. We refer to the forecast as
e
E$/€ , which we call the expected exchange rate.
• Based on the forecast, you expect that the (1  i€ ) / E$/€ euros you
e
will have in one year’s time will be worth (1  i€ ) / E$/€ / E$/€
when converted into dollars; this is the expected dollar return
on euro deposits.
• The expression for uncovered interest parity (UIP) is:
e
E
1 i$   1  i€  $/ €

E$ / €
Dollar return on     
dollar deposits Expected dollar return
on euro deposits
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5 Arbitrage and Interest Rates
Risky Arbitrage: Uncovered Interest Parity
What Determines the Spot Rate?
• Uncovered interest parity is a no-arbitrage condition that
describes an equilibrium in which investors are indifferent
between the returns on unhedged interest-bearing bank
deposits in two currencies.
• We can rearrange the terms in the uncovered interest parity
expression to solve for the spot rate:

e 1  i€
E$ / €  E $/ €
1  i$

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Assets and Their Attributes
• An investor’s entire portfolio of assets may include stocks, bonds,
real estate, art, bank deposits in various currencies, and so on. All
assets have three key attributes that influence demand: return,
risk, and liquidity.
• An asset’s rate of return is the total net increase in wealth
resulting from holding the asset for a specified period of time,
typically one year.
• The risk of an asset refers to the volatility of its rate of return.
• The liquidity of an asset refers to the ease and speed with which it
can be liquidated, or sold without incurring significant loses.
• We refer to the forecast of the rate of return as the expected rate
of return.

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5 Arbitrage and Interest Rates
Uncovered Interest Parity: A Useful Approximation
E$e/ €
i$  i€ 
  E$ / €
Interest rate
on dollar deposits
Interest rate
on euro deposits

= Expected rate of depreciation
of the dollar
Dollar rate of return
on dollar deposits
           
Expected dollar rate of return
on euro deposits

• The UIP approximation equation says that the home interest rate
equals the foreign interest rate plus the expected rate of
depreciation of the home currency.

• Suppose the dollar interest rate is 4% per year and the euro 3%.
If UIP is to hold, the expected rate of dollar depreciation over a
year must be 1%. The total dollar return on the euro deposit is
approximately equal to the 4% that is offered by dollar deposits.
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