1 international linkages through foreign exchange rates topic 10 blackwell, griffiths, and winters,...

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International Linkages Through Foreign Exchange Rates

Topic 10

Blackwell, Griffiths, and Winters, Chapter 8

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Foreign Exchange Rates

The rate at which one nation’s currency can be exchanged for another

Cash Flows--Investment Cash Flows

However, foreign investments have an additional risk, which is exchange rate risk.

The reason that foreign investments are exposed to exchange rate risk is that domestic investors demand their compensation in the domestic currency, so the cash flow from a foreign investment must be converted in the domestic currency.

Political cash flows (often called capital flight) are cash flows out of a foreign country.

The reason for political cash flows is political instability in a country. These cash flows occur because the government is unwilling or unable to protect property rights, so investors move their funds out of the country.

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Cash Flows--Political Cash Flows

Political cash flows (often called capital flight) are cash flows out of a foreign country.

The reason for political cash flows is political instability in a country. These cash flows occur because the government is unwilling or unable to protect property rights, so investors move their funds out of the country.

Political cash flows often flow to the U.S. because the U.S. has strong laws protecting property rights and the U.S. government has not defaulted on any of its debt and is considered default-free.

Almost all other national governments have defaulted on their debt at some point in time, so foreign government debt is rated (Fig. 8-2)

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Cash Flows—Speculative Cash Flows

Speculation is bearing risk for an expected return and speculation usually involves taking an investment position in the hope that a favorable price movement will occur.

Pure speculation is very risky because it is a bet on the direction of future market movements, and in efficient markets, market movements occur because of the arrival of new information.

But, speculative movements in the form of currency attacks can be in anticipation of an inability of central banks to stem movement

Therefore, the speculators take positions betting that when the temporary bank intervention stops, the exchange rate will return to (or at least move toward) their prior levels

Recent case study: the dollar against European currencies in 1978 and 1979

5

Exchange Rate Regimes

The gold standard

Bretton Woods Agreement: 1944-1971

• Set $35 equal to one ounce of gold and then set the exchange rate of all other currencies relative to the U.S. dollar.

• Required that every country manage its exchange rate within a band of +1% or -1% of its pre-determined exchange rate. After Bretton Woods,

After Bretton Ewoods• The exchange markets evolved

through several phases to our current market of free floating exchange rate blocs.

In the floating bloc system currencies are grouped together in a bloc with one lead currency.

• The other currencies in the bloc tie their exchange rates to the lead currency and these exchange rates are fairly constant.

Then between the blocs (or lead currencies) exchange rates float freely based on supply and demand.

This system allows for market determined exchange rates between the major currencies and reduces problems with ‘stale’ exchange rates with currencies that do not trade very much.

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How Are Exchange Rates Expressed

American convention: exchange rates may be expressed as the number of foreign units per dollar

96 yen per dollar

1.45 marks per dollar

0.63 pounds per dollar

European convention: Exchange rates may also be expressed as the number of dollars per foreign currency unit

$0.0104167 per yen

$0.6896552 per mark

$1.5873016 per pound

Current exchange rates are available elsewhere on the course web site

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FX Rates and the Value of GoodsExamples

CD ROM disk drive priced in yen (Y30,000) and exported to US

• If Y/$ is 120, the $ price is $250

Cellular telephone is price in dollars ($225) and exported to Japan

• If yen/$ rate is 120, the yen price is Y27,000

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Appreciation

When the dollar appreciates it rises in value relative to the other country’s currency

• This means that it takes more of the foreign currency to by one dollar

• Example: Yen/$ rises from 96 to 99

When the dollar appreciates, the other currency depreciates

• This means that one unit of the foreign currency buys fewer dollar

• Example: $/Yen falls from $0.0104167 to $0.010101

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Effects of Appreciation of the Dollar

Dollar price of imports falls

Example of an import: If a CD-ROM is priced at 25000 yen, and the Y/$ rate is 96, the dollar price would be 25000/96

or

$260.42

If Dollar appreciates so yen/$ is 99, the dollar price of the CD-ROM is 25000/99

or

$252.52

Dollar price of exports rises

Example of an export to Japan: If a cellular phone priced at $125, and the Y/$ rate is 96, the phone’s yen price would be 125*96

or

Y12,000

If dollar appreciates so yen/$ is 99, the yen price of the phone is 125*99

or

Y12,375

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Depreciation

When the dollar depreciates it falls in value relative to the other country’s currency

• This means that it takes fewer foreign currency units to by one dollar

• Example: Yen/$ falls from from 96 to 93

When the dollar depreciates, the other currency appreciates

• This means that one unit of the foreign currency buys more dollar

• Example: $/Yen rises from $0.0104167 to $0.0107527

Effects of the dollar’s depreciation is the opposite from effects of appreciation

•Dollar price of imports rises

•Foreign unit price of US exports falls

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Valuation Effects of Appreciation of the Dollar

Value of Foreign-Denominated Investment Abroad

Suppose that a US firm owns an office building in Tokyo valued at 1,152,000,000 yen

If the dollar exchange rate is 96, this investment is worth $12,000,000 to the US firm

Suppose that the $ appreciates so that the Y/$ rate is 99

The dollar value of the foreign investment is $11,636,364.

Result of the appreciation of the dollar: the dollar value of foreign-denominated US investments abroad declines as the dollar appreciates

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Value of Foreign-Denominated Cash Flow From Abroad

Suppose that a US firm has a subsidiary located in Thailand

The Thai subsidiary is to send a dividend of 42,350,000 baht to the parent firm

• The parent firm must exchange the baht for dollar

• At a baht/dollar rate of 30, the dividend is worth $1,411,667

• If the dollar appreciates to 45 baht per dollar, the cash flow is worth $941,111.

Result of the appreciation of the dollar: the $ value of the repatriated foreign-denominated cash flows is reduced

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Value of Dollar-Denominated (US) Investment to a Foreigner

Suppose that a Japanese firm owns a US Treasury bond valued at $10,000,000.

• If the dollar exchange rate is 96, this investment is worth 960,000,000 yen to the Japanese firm

• Suppose that the $ appreciates so that the Y/$ rate is 99

• The yen value of the US asset 990,000,000 yen

Result of the appreciation of the dollar: the value of $-denominated investments in US by foreigners rises as the dollar appreciates (as the foreign currency depreciates).

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Value of Dollar-Denominated Cash Flow From US to Foreign Investor

Suppose that a Japanese firm has a subsidiary located in the US

• The US subsidiary is to send a dividend of $5,000,000 to the parent firm in Tokyo

• The parent firm must exchange the dollar for yen

• At a yen/$ of 96, the dividend is worth 480,000,000 yen

• If the dollar appreciates to 99 yen per dollar, the cash flow is worth 495,000,000 yen.

Result of the appreciation of the dollar: the foreign-currency value of the dollar-denominated cash flow increases

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Valuation Effects of Depreciation of the Dollar

Opposite from appreciation

• Dollar price of imports rises

• Foreign currency price of US exports falls

• Dollar value of foreign-denominated investments abroad rises

• Dollar value of foreign-denominated cash flow increases

• Foreign value of $-denominated US investments held by foreigners falls

• Foreign value of $-denominated US cash flows to foreigners falls

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The Arithmetic Of Appreciation and Depreciation

Results Depends on the Measurement Convention

Suppose• The euro/dollar rate is 0.90 and the dollar/euro rate is

1.1111

Next, suppose the dollar appreciates against the euro by 7.5%

• The new euro/dollar rate is 0.9675• The new dollar/euro rate is 1.033592

Based on $/euro convention the depreciation is 6.98

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Influences on Exchange Values

Merchandise Trade Balance:• Difference between goods and services exported and imported• large deficits would

• Increase the supply of the domestic currency abroad• Increase the demand for the foreign currency to pay for the

growing volume of importsCapital Account

• If supply of a country’s securities held by foreigners increases, the demand for dollars increases to pay for those securities

Official Accounts• Changes reflect purchases/sales of current by central banks

These accounts are mirrors of each other and cancel each other out

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Influences on Exchange Values

0 = Current Account Balance + Capital Account Balance +

Official Accounts Balance

Financial flows today dominate the determination of exchange rates

• Funds flow in response to expectations of financial gain

• As these funds shift, the exchange rate shifts

• The sheer size of financial flows and the churning in financial flows elevates the importance of capital flows in determining exchange rates

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Historical Movements in Exchange RatesDollar Versus Currencies of Industrialized

Countries

German mark price of the dollar fell from 1975 through the end of 1979.

German mark price of the dollar rose from 1980 through late 1985. The dollar appreciated

Yen price of the dollar was more stable.

Between 1986 and 1988, the foreign unit price of the dollar fell, i.e., dollar depreciated, against both the mark and the yen

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The Arithmetic of Cross Rates

Suppose that the euro/dollar is: 0.90

Suppose that the yen/dollar rate is: 120

The yen/euro rate is

(1/.90) x 120 = 1.3333

euro

yen

dollar

yen

euro

dollar

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Changes in Nominal Exchange Rate

If the exchange rate is expressed in terms of foreign units per dollar, the percent change in the nominal exchange rate can be expressed as

If the exchange rate is expressed in terms of dollars per foreign units, the percent change in the nominal exchange rate can be expressed as

)inf(1

)inf(1))(%(1)(%1

d

frn e

efxchgfxchg

)inf(1

)inf(1))(%(1)(%1

f

drn e

efxchgfxchg

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Changes in Nominal Exchange Rate(Continued)

When the exchange rate is expressed in terms of foreign currency units per dollar (e.g. yen /$ or euro/$):• If the calculated %chg in the nominal FX rate is positive: the

dollar appreciates• If the calculated %chg in the nominal FX rate is negative: the

dollar depreciates

When the exchange rate is expressed in terms of foreign currency units per dollar (e.g. yen /$ or euro/$):• If the calculated %chg in the nominal FX rate is positive: the

dollar depreciates• If the calculated %chg in the nominal FX rate is negative: the

dollar appreciates

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Rationale

If domestic inflation is faster than foreign inflation,

• the nominal value of the exchange rate will fall by the difference between the inflation rates

WHY?

• Inflation is the rate at which a nation’s money losses value

• Movements in exchanges rates will reflect the relative change in the rate at which a country’s currency looses value compared with the rate at which other currency’s loose value

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Implications of Different Inflation Rates Between Trading Partners

Suppose

• The pound/dollar rate is 0.606061.

• US inflation rate is expected to be 2.5%

• UK inflation rate is expected to be 3.5%

• no change in real rates is expected

Then:

% in nominal rate = ((1.00 x 1.035% / 1.025)-1)*100 = 0.97%

The dollar is expected to appreciate about 1% a year and the pound/dollar rate should rise from 0.606061 to 0.612122

Implications of Different Inflation Rates Between Trading Partners

Suppose

• The dollar/pound is 1.65

• US inflation rate is expected to be 2.5%

• UK inflation rate is expected to be 3.5%

• no change in real rates is expected

Then:

% in nominal rate = ((1.00 x 1.025% / 1.035)-1)*100 = - 0.97%

The dollar is expected to appreciate about 1% a year and the dollar/pound rate should fall from 1.65 to 1.6341

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Dollar Depreciation

If expected US inflation is 5% and expected Euro currency area inflation is 3% over the next year, and the change in the real FX rate is 0, the dollar will depreciate by about 2%:

Expressed as /$

If the $/euro rate was 1.1500, the euro would depreciate and the dollar appreciate to 1.17233

Expressed as $/e

If the euro/$ rate was 0.8696, the euro would depreciate and the dollar appreciate to 0.8530

94.11.03

1.051.00)(%1 fxchg

905.11.05

1.031.00)(%1 fxchg

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Interest Rates Also MatterHigher Real Rates Here

If real rates rise here compared with a foreign country, our currency becomes a more desirable currency

• International investors will sell the foreign currency and buy the dollar

• Demand for dollars increases and demand for foreign currency decreases

• Result: rise in the value of the dollar compared with the other currency i.e., the dollar will appreciate and the other currency will depreciate

• Real rate here will decline and real rate abroad will rise

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Interest Rates Also Matter

If real US rates fall here compared with a foreign country, the foreign currency becomes a more desirable investment

• International investors will sell the dollar and buy the foreign currency

• Demand for dollars decreases and demand for foreign currency increases

• Result: fall in the value of the dollar compared with the other currency i.e., the dollar will appreciate and the other currency will appreciate

• Real rate here will rise and real rate abroad will drop

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Implications of Different Real Interest Rates Between Trading Partners

Suppose that real rates are equal between the US and its foreign trading partners; next suppose that real US interest rates rise. This will lead to an appreciation of the dollar.

Why?• If real US rates are higher than foreign real interest rates, the

foreign currency is a more desirable investment• International investors will sell the foreign currency and buy

the dollar• This will increase the demand for dollars and decrease the

demand for the foreign currency. This will led to a rise in the value of the dollar compared with the other currency

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• The dollar will appreciate and the other currency will depreciate

• Process continues until the real interest rates are equalized between countries

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Suppose that real rates are equal between the US and its foreign trading partners; next suppose that real US interest rates fall. This will lead to a depreciation of the dollar.

Why?• If real US rates are lower than foreign real interest rates, the

foreign currency is a more desirable investment• International investors will sell the dollar and buy the foreign

currency• This will reduce the demand for dollars and increase the

demand for the foreign currency. This will led to a fall in the value of the dollar compared with the other currency

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• Process continues until the real interest rates are equalized between countries

• The dollar will depreciate and the foreign currency will appreciate

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Models of Exchange Rate Determination

Interest Rate Parity

Covered Arbitrage

Purchasing Power Parity

International Fisher Effect

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The Models

These models are mathematically identical

• BUT, their practical use differs:

Two are better suited for short-term horizons

• Interest rate parity

• Covered arbitrage

Two are better suited for long-term horizons

• Purchasing power parity

• International fisher effect

We will focus on covered arbitrage and the international Fisher effect

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Suitability of Models to Different Horizons

Covered arbitrage

• Requires forward rates (next slide)

• BUT, forward rates are typically available only over short horizons. E.g. up to 180 days

• This limits practical use of the covered arbitrage model

International Fisher Effect and PPP Models

• Depends upon inflation expectations

• Some question as to whether inflation expectations are captured in short-term rates

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Terms in the Covered Arbitrage Model

Spot exchange rate: Rate at which one nation’s currency can be exchanged for another. Currency is exchanged now.

Forward exchange rate: Rate at which one currency can be exchanged for another in agreements to exchange currencies at a specific future time.

• Most forward contracts have a maturity of less than two years

• Long-term forward contracts are not readily available and when obtainable have a large bid-ask spread

• Forward rates can be viewed as the markets forecast of the exchange rate that will prevail at the specified future time point

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Forward and Spot Rates

The relation between the forward and spot rate shows the expected appreciation or depreciation of a currency

$/pound $/yen

Spot 1.5000 .01131

Fwd: 90 days 1.4850 0.8851% .01147 5.6587

Fwd 180 days 1.4775 1.07869% .01162 5.4819

If forward rates are higher than spot rates, the $ is expected to depreciate, i.e., markets expect it to take more dollars in the future to buy a unit of foreign currency

SPOT MARKET and Dealers

Dealers quote rates at which they are willing to buy foreign currency and one at which they are willing to sell a foreign currency

This is the bid-ask spread

Both bid and asked quotations are provided in the financial press

Dealers in the foreign exchange market are large international banks and other financial institutions that specialize in making markets in foreign exchange

Large international banks dominate the market

There is no organized exchange where foreign currency is traded

Instead, dealers are linked by telephone and by various information transfer services

Consequently, the foreign exchange market can best be described as an inter-bank OTC market

3939

40

Covered Arbitrage

Based on relationship between

• domestic interest rate

• rate on foreign instrument of comparable risk

• the spot exchange rate

• the forward exchange rate

Arbitrage assured that the relationship eliminates arbitrage profits

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Covered Arbitrage

Ratio of the rate on the domestic instrument to the foreign instrument

is equal to

the ratio of the forward rate to the spot rate

Model recognizes the importance of the forward rate in determining the interest rate differential between financial instruments in two countries

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Covered Arbitrage

Where Ft is the forward rate in period t for the spot rate today (period 0)• F and S are expressed in terms of foreign currency/$• E.g. the pound/rate is 0.671141, it means each dollar

commands 0.671141 pounds

If Ft < So, $ is expected to depreciate between today and period t

t

$

1

1

F

S

r

r o

f

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Covered Arbitrage

Arbitrage look to the relationship between the domestic interest rate and the exchange rate adjusted foreign rate

t$ )1(1

F

Srr o

f

44

Covered Arbitrage

Suppose:

Here, the domestic rate is less than the exchange rate adjusted foreign rate. So, it would pay to either• sell the domestic asset and buy the foreign asset, if the

domestic asset is ownedor

• borrow dollars and invest in the foreign instrument and repay the dollar loan when the foreign instrument matures

t$ )(1 1

F

Srr o

f

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Covered Arbitrage

Market pressure released by this process will

• raise US interest rate and lower the foreign rate

and/or

• lead to depreciation of spot $ exchange rate with no change in forward rate

and/or

• lead to appreciation in the forward rate

Process continues until there is no profit opportunity

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Covered Arbitrage

Suppose:

Opposite occurs if the return on the dollar instrument exceeds the exchange rate adjusted return on the foreign investment• if the foreign instrument is owned, sell the foreign

instrument and buy dollars; use the dollar to buy the dollar instrument, or

• borrow the foreign currency and and invest in dollar instruments and repay the foreign loan when the dollar instrument matures

t

0$ )(1 1

F

Srr f

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Implication

Arbitrage come from selling (or borrowing) in one market and investing in another market

• Process continues until there is no profit opportunity in moving between currencies

Effect: a FX hedged foreign investment and a domestic investment have comparable yield for the same level of risk

• Any difference between domestic yield and FX hedged foreign yield reflects risk

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An Example

You are given the following eurocurrency rates

3-month sterling: 6.5%

(1.625% for 3 months)

3-month eurodollars: 3.5%

(0.875% for 3 months)

Pound/dollar exchange rates

spot: 0.664231

90 day forward: 0.668583

Exchange rate adjusted sterling rate

1.01625 x (0664231/0668583)

=

1.009635

or .9635% for 3 months

or 3.8539% annual rate

Decision:

•The sterling investment is preferable

RevisedRevised

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Action

Action: If the US investment is owned, sell the US instrument, buy the foreign currency, and use the foreign currency to buy the foreign asset.

or

Borrow the foreign currency , and buy the foreign asset, and repay the foreign loan when the foreign instrument matures

Covered: Simultaneously with the investment in the pound instrument, sell the pound principal plus pound interest for dollar in the forward market for delivery in 90 bays

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International Transmissions

Changes in monetary policy can be transmitted among industrialized countries through the covered arbitrage model• Suppose that the Federal Reserve changes its target for

the Federal Funds rate, raising it by 50 basis points from 5.5% to 6.0%

• All other short-term rates will likely also increase by roughly 50 bp

• Next suppose that other central banks do not follow the Federal Reserve action; I.e., they continue to peg their short-term domestic rates at a given level

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International TransmissionsContinued

In this situation, there is a disruption n the equilibrium relationship between domestic short-term rates and the FX adjusted foreign rate

• Since the domestic rate is now higher, there would likely be an appreciation of the spot rate sufficient to restore the equilibrium relationship

t$ )(1 1

F

Srr o

f

52

International TransmissionsContinued

Alternatively, suppose that the German central bank cuts its short-term target rate

• Other short-term German rates will likely follow

• Result: The US domestic rate is higher than the FX adjusted foreign rate

• If the Federal Reserve matches the German policy shift, the equilibrium would be restored

• If the Federal Reserve does not match the German move, the spot exchange rate would appreciate

Finding the Theoretical Forward Rate

The spot exchange rate and the interest rates in two countries determine the forward exchange rate of their currencies

The relationship among the spot exchange rate, the interest rates in two countries, and the forward rate is called interest rate parity

Forward rates are determined by covered interest arbitrage

Solve for the forward rate, given the spot rate and the domestic and foreign interest rate in the covered arbitrage equation

Theoretical parity is rarely attained, since it is based on several assumptions

There are no transactions costs for executing an arbitrage strategy

Investors can borrow and lend at the same rate

There are no tax differences between different economies

There are no barriers to capital mobility between economies

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t

$

1

1

F

S

r

r o

f

54

The International Fisher Effect

Domestic Fisher Effect

1 + rn = (1 + rr) x (1 + e(inf))

In the International Fisher Effect, the same must hold between countries

• 1 + rn$ = (1 + rr$) x [1 + e(inf$)]

and

• 1 + rnf = (1 + rrf) x [1 + e(inff)]

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On the assumption that real real rates are the same in both countries:

)(inf1)(inf1

11

ff ee

rr

$$

)(1

)(1 $$

ff e

err

infinf

)1(1

and

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If the domestic interest rate is less than the relative inflation adjusted foreign rate,

• It would pay to sell the domestic asset (if owned) and buy the foreign asset

• Process will continue, raising the domestic rate and lowering the foreign interest rate until the equality is restored

Why?

• Because at the original levels of interest rates, there was inadequate compensation (compared with the inflation adjusted foreign rate) for holding the domestic instrument

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International Fisher Effect and Exchange Rates

In the previous example, to invest in the foreign asset, dollars must be sold and the foreign currency purchased

• This will put downward pressure on the dollar

• It will loose value relative to the foreign currency

• That is, it will depreciate as part of the process of restoring equilibrium

Even after equilibrium between the domestic rate and the inflation adjusted foreign rate is achieved, there will be a continuous effect upon exchange rates, if there is a difference in expected inflation rates

The domestic currency is expected to depreciate at a rate equal to the ratio of the inflation rates which is approximately equal to the difference between the inflation rates

In terms of movements in the spot rate, recall from an earlier slide that the % change in the nominal spot rate is equal to the % change in the real exchange rate plus the foreign inflation rate minus the domestic inflation rate

An Example

You are given the following information:

10-year Canadian bond 6.69%

10-year US bond 6.38%

Expected US inflation 2.5%

Expected Canadian inflation ?

Based on the international fisher effect, what is the expected rate of inflation in Canada?

58

)(inf1025.1

0669.10638.1fe

1 + E(inff) = 1.0298

IF markets are in equilibrium, expected Canada inflation 3%, given the expected US inflation

59

International Transmission

If expected US inflation rises compared with Canadian inflation,

• The equilibrium would be disturbed

• Funds would flow from US to foreign countries

• Effect:• US long-term rates would rise

• and/or Canadian long-term rates would fall

• The dollar would depreciate

• Effect would be to restrain growth here relative to foreign growth

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International Fisher Effect and Covered Arbitrage

t

$$

)inf(1

)inf(1

1

1

F

S

e

e

r

r o

ff

Recall that the ratio of interest rates is equal to the ratio of the forward rate to the spot rate

This is the same as the ratio of the expected future spot rate to the spot rate

Hence, the various models can be joined together

61

Exchange Rate Changes and International Investments

Changes in the a country’s exchange will affect investment values in both countries

The dollar value of US investments in the Pacific rim countries plunged during the latter part of 1997 as a result of their currencies’ depreciation (appreciation of the dollar)

The local currency value of investments by Pacific rim countries in the US has increased as a result of the dollar’s appreciation

The were additional costs and benefits as a result of the crisis pacific rim crisis

• For US investors, the local currency value of their investment declined

• E.g., stocks on the Japanese exchanges declined in terms of yen and the dollar appreciated versus the yen

• For the pacific rim investor, the dollar price US financial assets generally rose since the crisis onset

• E.g., US bonds rose as a result of the decline in bond yields

• As a result, the yen value of bonds rose because the dollar price rose and the yen depreciated

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International Risks

The local currency price of an asset may change

• The local currency price may change due to a change in the market’s assessment of any of the general and instrument specific risks

• The local currency is the currency in which the asset is denominated

• US stock values may rise in dollar term

• British stock may rise in terms of pounds

• The value of an office building in Kuala Lumpur may change

The foreign exchange rate may change

International investors are concerned with the home currency return on an international investment

The home currency is the country in which the investor is domiciled

The home currency value of a foreign investment can change due to

• A change in the foreign currency (the local currency) value

• A change in the exchange rate between the home currency and the local currency

The Current Account

The Current Account -- (Export – Import) of goods, services, and military transactions.

Goods • Trade goods

Services • Interest & Dividend Income• Tourism Revenue / Expenses• Financial charges paid & received• Transportation expenses

Unilateral Transfers• Remittance - made / received• Foreign Aid received / given• Pensions

The Capital Account• Measures capital flows. • the difference between the wealth invested

by the public and government in other countries and the wealth invested by foreigners in the home country.

Short-term Investments < 1 Year MaturityPortfolio Investment Purchase of financial

assets with maturity > 1 YearDirect Investment (DFI – Direct Foreign

Investment) Purchase or investment in financial assets/firm that allows for management control or out of a country.

Surpluses (deficits) in the capital accounts offset deficits (surpluses) in the current account.

Pressure on exchange rates from the current account is reversed with capital account flows.

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