Lecture 8 - Foreign Exchange Rates (cont.)

China holds 31% of the US trade deficit. Compare to the appreciation of their currency.
Euro Areas holds about 11%. Japan 10.4%. Mexico 9.5%.

Spot Exchange Rate vs Forward Exchange Rate

Spot exchange rate: Executed immediately.
Forward exchange rate: A future date is specified for delivery of funds.

Why use forward exchange rates?

Suppose you need to make a payment of 1 million Yen in 3 months. If there's a concern that in 3 months the Yen will appreciate, you may want to use a forward contract.

(i) Suppose e = 100 yen/$; you have to pay $10k.
(ii) Suppose the rate appreciates to e = 80 yen/$; you will have to pay $12.5k.
Now,
(iii) If you lock into a forward exchange rate of f = 90 yen/$; you will then pay $11.1k and can be sure of the price. This is a foreign exchange hedge.

This situation involves a zero-sum game. One party always wins and the other loses. There is also a default risk. The futures exchanges reduce the risk of one party running away by requiring a deposit and margin calls (additional deposits) when the chances of losing increase on one side. Transaction costs are reduced by having fixed, standard contracts and regular delivery dates. CME is a major player in this market.

Foreign Exchange Market

We graphed exchange rate (euro/$) vs foreign exchange mkt for $. The supply of dollars is fixed, regardless of the exchange rate and is therefore vertical. The demand for dollars slopes downward since the demand goes up as the (future) exchange rate goes down (relative to today's rate).

What shifts the supply and demand curves?

Demand-shift factors

(i) interest rate differential: iUS-iEuro
If iUS goes up relative to iEuro, then US$ assets become more attractive and the demand for the dollar will rise and the demand curve shifts out (to the right).

(ii) inflation differential: ΠUS - ΠEuro
If ΠUS goes up relative to ΠEuro, US$ assets become less attractive and the demand for the dollar will fall and the demand curve shifts in (to the left).

(iii) (very important) expected future exchange rate
Arbitrage can take place between two places or between two points in time.
Say, for example, the current exchange rate is e=1 euro/$ and you expect the future rate to be 0.5. In such a case, you should by Euros.

In general, if you believe a currency will rise (relative to another), you should buy that currency. Caveat: Since we live in the US, we need dollars for daily living. The above strategy is only for investment purposes.

George Soros profited from currency speculation in UK pound when it collapse on Black Wednesday - Sept 16, 1992.

(iv) Risk of US$ relative to foreign assets

If risk increases, demand for the US$ falls.

* Page 3 of articles: Greenback continues its dramatic slide
*Page 2 of articles: Economic data proves saving grace for yen

100 basis points = 1 percentage point

Carry-trade is a form of arbitrage. In Japan, the interest rate is almost 0%. You can practically borrow money for free. Then you can lend in another place at a profit. (need additional explanation here.)

Purchasing Power Parity (PPP)

Purchasing power parity is a long-run equilibrium condition for exchange. Assume no tariff barriers & no transaction costs.

Arbitrage situation in sweater market between US ($45) and UK (27 pounds). If exchange rate e = 0.7 (pound/$), then 45$ x 0.7 pound/$ = 31.5 pounds. It's cheaper in London!

Buy in London & resell in Chicago. Eventually price in UK will fall and price in US will increase and the arbitrage will stop.

After arbitrage, price will be the same. Equilibrium. No arbitrage condition. e x P-US = P-UK

e = P-UK/P-US

Generalize this to any market, not just sweaters. P-UK and P-US are a price index, like CPI, for a common basket.

%De = %DP-UK - %DP-US
= ΠUK - ΠUS

Higher inflation leads to currency depreciation