global econ - foreign exchange - lecture

8/9/2019 Global Econ - Foreign Exchange - lecture

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Dr. Katherine Sauer

Global Economic Issues

ECON 241

Foreign Exchange

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I. Currency

Currency is a unit of exchange. It is exchanged for:

- goods

- services

- other currency

Most countries have control over the supply and production of

their currency.

Usually Central Banks or Ministries of Finance control the

currency.

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There are about 175 currencies in current circulation.

- several countries use the same name for their currency

dollarUnited States

Belize

Canada

Hong Kong

pesoPhilippines

Uruguay

Mexico

To avoid confusion, the ISO 4217 classification

system is used. (three letter currency code)

- several countries use the same currency

ex: the euro is used by France, Germany, Italy

- some countries declare another countrys currency to be

legal tender

ex: Panama and El Salvador have USD as legal tender

USD

BZD

CAD

HKD

PHP

UYU

MXN

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Examples of spot rates: Seoul, South Korea

May 2008

1USD = 991won

1yen = 9.54 won

Similarly:

1won = 0.00101USD

1won= 0.10482 yen

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How much is a Subway Club going to cost you?

The price is 4,300won.

The exchange rate is 991USD per won.

4300w x 1 $991w

= $4.34

If instead the exchange rate was 950USD per won

4300w x 1 $

950w= $4.50

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Salzburg, Austria

June 2007

1$ = 0.74270euro1euro x 1$ = $1.35

0.742708


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Prague, Czech Republic

June 2007

1$ = 21.3830 koruna

(CZK)

20kc x $1 = $0.94

21.38309


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Budapest, Hungary

July 2007

1$ = 181.3730 forint (HUF) 690ft x 1$ = $3.80

181.373010


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Xian, China

May 2008

1$ = 6.98560yuan

(CNY)

6yuan x 1$ = $0.86

6.9856011


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B. Exchange Rate Fluctuations

Suppose that in 2005, eJPY/USD = 120. In 2006, eJPY/USD = 150.

- initially, one dollar could buy 120 yen

- now, one dollar can buy 150 yen

- the dollar has appreciated against the yen

- initially, it took 120 yen to buy one dollar

- now, it takes 150 yen to buy one dollar

- the yen has depreciated against the dollar

As eA/B increases, currency B is appreciating against currency A.

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Exchange Rates and Trade

Suppose a US importer orders a shipment of BMWs.

- shipment will arrive in 60 days- shipment costs 1,000,000

- spot rate is 1.20$/

The US importer knows that if they paid for the shipment

today it would cost

1,000,000 x 1.20$

1 = $1,200,000

If the shipment isnt arriving for 60 days, the importer probably

wants to hold off on payment for 60 days as well.

- the $1.2 million could be earning interest!

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What if instead the importer paid at the time of delivery?

- the exchange rate 60 days from now is uncertain!

- if the dollar depreciates, the order will cost more- if the dollar appreciates, the order will cost less

The importer wants to guard against a dollar depreciation.

One way to protect against exchange rate uncertainty is to buy a

forward contract.

A forward exchange rate is the rate that appears on a contract to

exchange currencies 30, 60, 90, or 180 days in the future.

The forward rate takes into account predictions about the

currencys future value.14


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Suppose the 60-day forward rate is $1.25/.

(think the dollar might depreciate)

- The BMW importer could lock in that rate by signing a

forward contract .

-The shipment would then cost $1,250,000.

- This is $50,000 more than if paid for the order right away.

Why pay $50,000 more for a shipment?

- certainty is very valuable

- otherwise, theyd pay according to whatever the spot

rate happens to be in 60 days

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Profiting from Exchange Rate Fluctuations

Suppose you have $10,000 to invest.

Youve been watching the Mexican economy and think that the

peso might be getting ready to appreciate.

You buy $10,000 worth of Mexican pesos at the spot rate of10.93713MXN/USD

You now have $10,000 x 10.93713MXN = 109,371pesos

1$

Suppose that you are correct and over the next 6 months, the peso

appreciates to 8.56771MXN / USD

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You decide it is time to convert your pesos back to US dollars.

Now you have

109,371pesos x $1 = $12,765.49

8.56771pesos

Because of exchange rate fluctuations, you have turned your

$10,000 into $12,765.

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Suppose a US investor has $1000 and wants to buy a 6 month CD.

- the interest rate in the US is 2.37%

- the interest rate in the UK is 4.83%

In which country should the investor purchase the CD?

- the spot rate is 1.96$/

- the 180 day forward rate is 2.05$/

In the US: $1000 x (1 + 0.0237) = $1023.70

In the UK: $1000 x 1

1.96$= 510.2040816

510.2040816 x (1 + 0.0483) = 534.8469387

534.8469387 x 2.05$

1= $1096.44

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C. The Market for Foreign Exchange

The FOREX market is one of the largest in the world.

- estimated 2 trillion USD worth of currency changes

hands every day

- each pair of currencies constitutes an individual

product

There is no single marketplace for foreign exchange. Centers arelocated in London, NYC, and Tokyo and in other banks around the

world.

Trading takes place 24 hours a day.

- the official end of the trading day is 5pm EST

Participants include

- importers/exporters - international investors

- banks - arbitrageurs19


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The Market for British pounds

(exchange rate between $ and )

Demand for for forex

- investors who have $ and wish to buy -denominated assets

- investors who are selling $-denominated assets and wish to

convert back to

- US importers of British goods (have $ but need to pay for theorder in )

Supply of for forex

- determined by government policy (Central Banks or Ministries

of Finance), and bank practices

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the Market for British pounds:

D

e $/

Q for forex

recall: as e$/ increases,

the is appreciating

against the $

D slopes downward

because as the depreciates,

it is cheaper to buy

using $ (as the price of a falls, the quantity

demanded of it rises).

S is vertical because there

is a certain quantity of

available for forex at any

given time.

S

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1. Flexible Exchange Rates

D

e $/

e1

Q for forex

The intersection of the

supply and demand for

determines the exchange

rate.

S

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When supply or demand changes, so does a flexible exchange rate.

D1

e $/

e1

e2

Q for forex

Suppose that $-denominated

assets are paying a higherreturn than -denominated

assets.

- D will decrease as

people sell assets in

favor of $ assets

- the exchange rate falls

( depreciates vs the $)

S

D2

[When D decreases and the exchange rate is still e1, there is a

surplus of in the market. Thus, the price of a falls until the

surplus is cleared. ]24


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2. Fixed (Pegged) Exchange Rates

Flexible (floating) exchange rates fluctuate with market forces and

may be quite volatile. To reduce the uncertainty associated with a

floating forex rate, a country might choose to peg its currency to a

certain value.

The main benefit of a pegged exchange rate is stability.- investors are more certain of a return

- import/export transactions have less risk

The drawback of a pegged exchange rate is it causes a lack of

flexibility for other policies.- the Central Bank / Ministry of Finance has to take steps to

maintain the peg

- need to have reserves of the currency you are

pegging to 25


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A pegged rate higher than the market rate:

Dpesos

e$/peso

e1

Qd Qs

Suppose Argentina pegs the

peso to the US dollar at arate of e1.

- at e1, Qs > Qd which

means there is a surplus ofpesos

- normally, the peso

would depreciate

-the Central Bank must

intervene to keep the peso

from depreciating

Spesos

Qpesos

Surplus of pesos

overvalued26


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The Central Bank must use its reserve of dollars to buy up the

surplus of pesos.

- needs to be willing to do so at the fixed exchange rate

Dpesos

e$/peso

e1

Qd Qs

Spesos

Qpesos

Surplus of pesos

- Ends up with more pesos

- Depletes reserves of US

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Implications:

An overvalued currency can lead to a trade deficit:

- decreases exports (they are more expensive)

- increases imports (they are cheaper)

It benefits imports at the expense of exports

The Central Bank reduces its foreign exchange reserves.

If a currency is overvalued for a long period of time, then abalance of payments crisis could be on the horizon.

- run out of reserves

- cant pay for imports28


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Options:

- borrow foreign exchange from another central bank or the IMF to

maintain the peg

- re-set the peg to a lower level, more consistent with the market

rate

- allow the exchange rate to depreciate down to the market level

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If investors think that a currency will be devalued, they may sell

all of their assets in that currency.

- the demand for currency falls

- This would put more pressure on the peg.

- the market equilibrium is even further below

the peg

- the surplus is larger- A government may be forced to devalue the currency.

- self fulfilling prophecy

The investors could then move back into the currency, but since

it has depreciated, they can buy much more of it.

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A pegged rate lower than the market rate:

D

e$/

e1

Qs Qd

Suppose China pegs the

yuan to the US dollar at arate of e1.

- at e1, Qd > Qs which

means there is a shortage

of yuan

- normally, the yuan

would appreciate

- to keep the currency

from appreciating, the

central bank must intervene

S

Q

shortage of yuan

undervalued31


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D

e$/

e1

Qs Qd

S

Q

shortage of yuan

The Central Bank must put yuan into the market.

- will be spending yuan to buy up dollars

- needs to be willing to do so at the fixed exchange rate

- Ends up with more

reserves of dollars

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Implications:

An undervalued currency can lead to a trade surplus:

- increases exports

- decreases imports

It benefits exports at the expense of imports

The government will increase its foreign currency reserves.

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If a currency is undervalued for a long time, then the government

may be forced to expand the domestic money supply to get more

domestic currency.- domestic inflation

If currency speculators think that the government may re-value the

currency, then hot money may flow into the country.

- increases demand for the currency- the peg is now even further below market equilibrium

- more of a shortage

- need more domestic currency

- inflation increases

- the government re-sets the peg higher, or lets the currency

float

- speculators make a profit

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E. Exchange Rate Choice

For the vast majority of countries (except for the very largest

economies), the choice of exchange rate policy is probably theirsingle most important macroeconomic policy decision.

The Mundell-Fleming Trilemma

aka:- The Unholy Trinity

- The Incompatible Triangle

- The Irreconcilable/Incompatible Trinity

An economy can only have 2 of the following 3 policies at any

given time:

- fixed exchange rates

- control of monetary policy

- free movement in capital markets35


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For nations with small or underdeveloped capital markets (most

nations), it is usually impossible to have

- free capital markets- floating exchange rate


The choice is usually either

- capital restrictions- floating exchange rates


Or - free capital markets


- no control of monetary policy

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The IMF has usually pushed developing countries toward

- flexible exchange rates

- free capital markets

which means that the countries have to give up control over

monetary policy.

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F. Historical Exchange Rate Policies

4 periods of exchange rate policies:

1. 1870 - 1914: gold standard

- each currency was based on gold

- fixed exchange rates between all currencies

2. 1914 1946: great variation

- exchange controls

- floating exchange rates- 1920s failed attempt to restore gold standard

- 1930s failed attempt to coordinate monetary policy to stabilize

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3. 1946 1973: Bretton Woods

- commitment to keep currencies convertible for current accounttransactions


4. 1973 present: major economies float

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III. The Big Mac Index

Purchasing Power Parity (PPP):

the theory that an identical good should cost the sameamount in every nation

In the long run, two countries currencies should move toward an

exchange rate that equalizes the prices of an identical basket ofgoods.

The Big Mac is sold in 120 nations.

The Big Mac PPP index is the exchange rate that would make a BigMac cost the same amount (in US dollars) in the US and abroad.

Big Mac PPP video 41


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Big Mac Prices actual over/under

local price in PPP of exchange rate valued

price US$ US$ per US$ vs US$

US $3.57 $3.57 . . .

Brazil 7.50real $4.73 2.10 1.58 +33

________________________________________________________

To calculate the price in US$:

Multiply the local price by the actual exchange rate.

7.50real x 1$ = $4.74

1.58real

If you bought a Big Mac in Brazil, it would cost you 7.50 real. Which

means it really costs you $4.74.

- It is more expensive to buy a Big Mac in Brazil than the US.43


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US $3.57 $3.57 . . .

Brazil 7.50real $4.73 2.10 1.58 +33

________________________________________________________

To calculate the PPP of the US$:

Divide the local price in the foreign country by the local price in the US

PPP rate = 7.50 / 3.57 = 2.10

Compare the PPP rate to the actual exchange rate to see if the currency

is over or undervalued versus the US$.

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PPP rate = 2.10 real / US$

actual exchange rate = 1.58real/US$

Theory tells us that it should cost 2.10 real to buy one dollar.But, it currently only costs 1.58 real to buy one dollar.

It takes less real to buy a dollar than it should.

The real is stronger than it should be.

The real is overvalued against the dollar.

We would expect that the real will depreciate in the future.

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US $3.57 $3.57 . . .

Brazil 7.50real $4.73 2.10 1.58 +33

________________________________________________________

To calculate how much the real is overvalued by:

(PPPrate actual exchange rate) / actual exchange rate x 100

(2.10 1.58) / 1.58 x 100 = 32.9

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US $3.57 $3.57 . . .

Russia 59.0roubles $2.54 16.5 23.2 -29

________________________________________________________

T

o calculate the price in US$:59.0rouble = 1$ = $2.54

23.2rouble

If you were in Russia, your Big Mac would cost you $2.54.It is cheaper to buy a Big Mac in Russia than the US.

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US $3.57 $3.57 . . .

Russia 59.0roubles $2.54 16.5 23.2 -29

________________________________________________________

T

o calculate the PPP rate:59.0 / 3.57 = 16.5

Theory tells us it should take 16.5 roubles to buy one US dollar.

Actually it takes 23.2 roubles to buy one US dollar.

The rouble is weaker than it should be. It is undervalued versus the

US$.

(16.5 23.2) / 23.2 x 100 = - 28.8

We would expect the rouble to appreciate in the future. 48

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