MGEC61 Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach

Liquidity

liquidity, the ease with which the asset can be sold or exchanged for goods

Depreciation

A decrease in the value of currency

Arbitrage

If domestic currency deposit does not equal FC deposit, there will be an arbitrage opportunity (arbitrage profit earned from borrowing in low return country and investing in high return country).

Vehicle currency

If expected returns on deposits of any two currencies are equal when measured in the same currency. When UIRP holds, foreign exchange market in equilibrium

Exchange rate

The price of one currency in terms of another

Interest rate

currency's interest rate, the amount of that currency an individual can earn by lending a unit of the currency for a year.

Rate of depreciation

rate of depreciation of the dollar against the euro as the percentage increase in the dollar/euro exchange rate over a year. The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. In other words, to translate the euro return on euro deposits into dollar terms, you need to add the rate at which the euro's dollar price rises over a year to the euro interest rate.

Rate of return

rate of return, that is, the percentage increase in value it offers over some time period

Risk

risk, the variability it contributes to savers' wealth

Forward exchange market

the exchange rate that is contracted today for the exchange of currencies at a specified date in the future

Foreign exchange market

the market in which international currency trades take place

All else equal, a rise in dollar interest rates causes the dollar to ______________ against the euro, while rise in euro interest rate causes the dollar to ______________ against the euro. Today's interest rate is also altered by expected _________ level.

All else equal, a rise in dollar interest rates causes the dollar to appreciate against the euro while a rise in euro interest rates causes the dollar to depreciate against the euro. Today's exchange rate is also altered by changes in its expected future level. If there is a rise in the expected future level of the dollar/euro rate, for example, then at unchanged interest rates, today's dollar/euro exchange rate will also rise.

What is an exchange rate? What role do exchange rates play? How? What happens to a country's exports when a country's currency depreciates? Appreciates?

An exchange rate is the price of one country's currency in terms of another country's currency. Exchange rates play a role in spending decisions because they enable us to translate different countries' prices into comparable terms. All else equal, a deprecia- tion of a country's currency against foreign currencies (a rise in the home currency prices of foreign currencies) makes its exports cheaper and its imports more expensive. An appreciation of its currency (a fall in the home currency prices of foreign curren- cies) makes its exports more expensive and its imports cheaper.

Appreciation

An increase in the value of currency. If Edc/fc increases, then DC depreciates, and FC appreciates

What is the basic principle of asset pricing? What do savers look at when evaluating an asset? What is the expected real rate of return?

Because the exchange rate is the relative price of two assets, it is most appropriately thought of as being an asset price itself. The basic principle of asset pricing is that an asset's current value depends on its expected future purchasing power. In evaluating an asset, savers look at the expected rate of return it offers, that is, the rate at which the value of an investment in the asset is expected to rise over time. It is possible to measure an asset's expected rate of return in different ways, each depending on the units in which the asset's value is measured. Savers care about an asset's expected real rate of return, the rate at which its value expressed in terms of a representative output basket is expected to rise.

What does the equilibrium in the forex market require? Deposits of all currencies must offer what?

Equilibrium in the foreign exchange market requires interest parity; that is, deposits of all currencies must offer the same expected rate of return when returns are measured in comparable terms.

What is the foreign exchange market? Who are the major participants? What is forward trading? How does it contrast with spot trading?

Exchange rates are determined in the foreign exchange market. The major participants in that market are commercial banks, international corporations, nonbank financial institutions, and national central banks. Commercial banks play a pivotal role in the mar- ket because they facilitate the exchange of interest-bearing bank deposits, which make up the bulk of foreign exchange trading. Even though foreign exchange trading takes place in many financial centers around the world, modern communication technology links those centers together into a single market that is open 24 hours a day. An important category of foreign exchange trading is forward trading, in which parties agree to exchange currencies on some future date at a prenegotiated exchange rate. In contrast, spot trades are settled immediately.

What does the interest parity condition tell us? When expected dollar return on euro deposits exceeds that on dollar deposits, dollar immediate _____________ against the euro. Other things equal, a dollar ________ today reduces expected return on euro deposits by reducing ______________ rate of dollar against euro expected for the future. Other things equal, a current appreciation of the dollar makes euro deposits more __________ by increasing the dollar's expected future ______________ against the European currency.

For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate. When the expected dollar return on euro deposits exceeds that on dollar deposits, for example, the dollar immediately depreciates against the euro. Other things equal, a dollar depreciation today reduces the expected dollar return on euro deposits by reducing the depreciation rate of the dollar against the euro expected for the future. Similarly, when the expected return on euro deposits is below that on dollar deposits, the dollar must immediately appreciate against the euro. Other things equal, a current appreciation of the dollar makes euro deposits more attractive by increasing the dollar's expected future depreciation against the European currency.

Interbank trading

Foreign currency trading among banks—called interbank trading—accounts for much of the activity in the foreign exchange market.

Rate of appreciation

Suppose, for example, we wanted to measure the return on dollar deposits in terms of euros. Following our simple rule, we would add to the dollar interest rate R$ the expected rate of depreciation of the euro against the dollar. But the expected rate of depreciation of the euro against the dollar is approximately the expected rate of appreciation of the dollar against the euro, that is, the expected rate of depreciation of the dollar against the euro with a minus sign in front of it.

Real rate of return

The expected rate of return that savers consider in deciding which assets to hold is the expected real rate of return, that is, the rate of return computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase

Interest parity condition

The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. It implies that potential holders of foreign currency deposits view them all as equally desirable assets, provided their expected rates of return are the same.

What do returns on deposits traded in forex market depend on? How would one compare expected rates of return?

The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. To compare the expected rates of return offered by dollar and euro deposits, for example, the return on euro deposits must be expressed in dollar terms by adding to the euro interest rate the expected rate of depreciation of the dollar against the euro (or rate of appreciation of the euro against the dollar) over the deposit's holding period.

Spot exchange rate

Today's exchange rate. Exchange rates governing such "on-the-spot" trading are called spot exchange rates, and the deal is called a spot transaction.

When relative asset returns are relevant, appropriate to compare what? Participants in forex market always prefer to hold assets yielding what?

When relative asset returns are relevant, as in the foreign exchange market, it is appropriate to compare expected changes in assets' currency values, provided those values are expressed in the same currency. If risk and liquidity factors do not strongly influence the demands for foreign currency assets, participants in the foreign exchange market always prefer to hold those assets yielding the highest expected rate of return.