The Foreign Exchange Market Flashcards
Defining the nominal exchange rate
Assumption: exchange rate is a jump variable affected by news
Why is the exchange rate important
- » Exchange rates allow us to denominate the cost or price of a good or service in a common currency.
- » Exchange rates represent a cost to firms.
- » Exchange rate changes create a risk to those firms that hold assets in currencies other than Sterling.
- » Exchange rates affect the price of exports.
Depreciation and appreciation of a home currency
» Depreciation of a currency relative to another currency implies it is less valuable.
» Appreciation is a rise in the value of a currency relative to another currency.
If the value of e increases, then it is a depreciation of home’s currency.
Why?
» One unit of foreign’s currency will buy more units of home’s currency.
Spot and forward rates
Spot rates: exchange rates for currency exchanges ‘on the spot,’ or
when trading is executed in the present.
» Forward rates: exchange rates for currency exchanges that will occur
at a future (‘forward’) date.
Real exchange rate
Concept of the real exchange rate Home’s real exchange rate (RER or Q):
The foreign exchange market
The set of markets where foreign currencies and other assets are exchanged for domestic ones.
Statistics imply that forex market is the largest financial market in the world.
Arbitrage in the forex market
In order to take advantage of arbitrage opportunities in the bond market, an agent must have the relevant national cur¬ rency. For example, to buy US Treasury Bills, it is necessary to have US dollars; to buy German government Bunds, it is necessary to have euros. The exchange rate will depend on supply and demand in the foreign exchange market. An important source of demand and supply of foreign exchange arises from the desire of economic agents to buy and sell government bonds in order to take advantage of differences in interest rates.
Take the possibility of profiting from an interest rate differential opened up by a decision of one central bank to change its interest rate. This is a form of arbitrage opportunity. If, for example, the Bank of England increased the UK interest rate so that the return on UK bonds was higher than on US bonds, there would be a rush into UK pounds and out of US dollars until the chance of profiting from one rather than the other kind of bond has vanished.
In this example, we as¬sume that the UK is the home economy and the US is the foreign economy. There will therefore be a rush out of US dollars and into UK pounds, due to the higher return on UK bonds. What happens to the exchange rate between UK pounds and US dollars as a result of this?
In this example, the interest differential in favour of UK bonds results in stronger demand for UK pounds, which forces the currency to appreciate.
An appreciated currency will increase the price of the home economy’s exports in terms of foreign currency, depressing demand for home-produced goods in foreign markets.
It will also reduce the price of foreign-produced goods that are imported to the home economy (in terms of home currency), boosting demand for foreign goods.
In other words, it will make the British economy less competitive and depress aggregate demand for home-produced goods and services.
Two different channels
in addition to the interest rate channel, there is a second channel operating to produce the central bank’s desired negative output gap: this is the exchange rate channel. With the higher interest rate in the UK and the appreciation of the UK pound both bearing down on output, the central bank will know that it needs to raise the interest rate by less than would be the case in the closed economy to achieve the same negative output gap.
Both parties solve the central bank’s stabilization problem-this implies an assumption that both the central bank and the foreign exchange market form expectations rationally.
The 3 Equation Model in the Open Economy
IS relation
Central bank behaviour, MR curve
Phillips curve, PC
IS relation
the IS, we need to amend the model to recognize that home’s households, firms and government spend on imported as well as home-produced goods, and that foreigners buy goods produced at home. Since imports will depend on the level of activity in the home economy, some of the additional demand generated by higher incomes will leak abroad because of purchases of imports.
An improvement in home’s competitiveness, i.e. a depreciation of the real exchange rate, boosts the demand for exports and dampens the demand for imports as home goods become relatively more attractive both abroad and at home.
What shifts the IS curve
In graphical terms, the presence of imports in reducing the multiplier makes the IS curve steeper because a given fall in the interest rate is associated with a smaller increase in output; and a depreciation of the real exchange rate shifts the IS curve to the right. An appreciation of the real exchange rate-a deterioration in home’s competitiveness-shifts the IS to the left.
Phillips curve
As in the closed economy, we shall assume that households use domestic inflation in their wage-setting calculations.
This means we can continue to work with a situation in which the equilibrium rate of unemployment is unique, i.e. it only shifts as a consequence of supply-side shifts in the WS curve (changes in the cost of job loss, wage¬ bargaining arrangements, employment regulation, etc.) or in the PS curve (changes in the degree of monopoly, the tax wedge, etc.).
Central Bank behaviour and marginal revenue curve
There is no reason why opening the economy to international trade and capital flows should affect the policy maker’s preferences, and hence, the MR curve.
We continue to assume that the central bank suffers a loss of utility according to how far away it is from its inflation target and from equilibrium output. We keep to the simple case where the central bank targets domestic inflation.
Simplifying assumptions for 3 equation model
- There is perfect international capital mobility. This means that home residents can buy or sell foreign bonds with the fixed nominal world interest rate, /*, in unlimited quantities at low transactions costs.
- The home country is assumed to be small in the sense that its behaviour cannot affect the world interest rate.
- Just as in the closed economy, we assume there are just two assets that households can hold-bonds and money. But now they can hold foreign or home bonds. We assume that they hold only home money.
- There is perfect substitutability between foreign and home bonds. This assumption means that the riskiness of foreign and home bonds is identical, so the only relevant difference between them is the expected return.
The last assumption means we rule out differences in the risk of default of bonds issued by different governments and we assume that investors do not care about the balance between home and foreign bonds in their portfolio
Participants and actors
- Commercial banks and other depository institutions.
- Non-bank financial institutions e.g. mutual funds, hedge funds, securities firms, insurance companies, pension funds. Non-financial businesses conduct foreign currency transactions.
- Central banks: conduct official international reserves transactions.
Buying and selling in the foreign exchange market are dominated by commercial and investment banks.
The Uncovered interest parity condition (UIP)
How do expectations and interest rate arbitrage determine the exchange rate?
» The uncovered interest parity (UIP) condition can help us answer this! The UIP condition dictates the interaction between the nominal
exchange rate and the interest rate, and it can be represented as:
other assumptions
Under PAS, BH and BF are perfect substitutes thus only two things influence the choice between them
Suppose the UK is the home economy and US the foreign economy. Assume there is an initial equilibrium: it = i∗t , eEt+1 = et.
Suppose Bank of England suddenly announces it is increasing the nominal interest rate by 2.5% such that i > i∗ for one period.
Assume the expected exchange rate remains unchanged. What must happen now to the nominal exchange rate?
Suppose that initially the interest rate on both bonds is 4%. Now let us see what happens if the Bank of England suddenly raised the UK interest rate to 6.5%. This case is shown in Fig. 9.2, where e is used to denote the UK pound nominal exchange rate (i.e. £/$), t is used to denote the time period, i is used to denote the home interest rate and i* is used to denote the world (or foreign) interest rate.
The interest rate change makes UK bonds more attractive, and investors will sell US dollars and buy UK pounds in order to take advantage of the higher expected return. But the move out of dollars and into UK pounds leads the US dollar to depreciate (weaken) and the UK pound to appreciate (strengthen).
As investors try to maximize their returns, the UK pound will appreciate by exactly 2.5% so that the expected return on UK and US bonds is identical. An American investor holding UK bonds for the duration of the interest differential (i.e. one year) gets 2.5% more in interest receipts than he would holding US bonds. On the flipside, however, the American investor loses 2.5% as the UK pound depreciates back to its ‘normal’ level over the course of the year. We assume that the underlying expected level of the exchange rate is exogenous and remains constant. The American investor will have to buy UK pounds at the start of the year in order to purchase the UK bonds but wants US dollars at the end of the year to spend in the US (Assumption 3). Figure 9.2 shows how this process of arbitrage in the international bond markets works to equalize the expected return on bonds.
The Log formulation of the UIP condition
Shifting the UIP curve
The shift in the UIP curve from UIP to UIP’ due to the fall in the world interest rate is shown in Fig. 9.4.
The economy is initially at point A on the UIP curve. With the expected exchange rate equal to logeE and with home’s interest rate unchanged and now above the world interest rate of /, arbitrage in the financial market will lead to an immediate appreciation of the home exchange rate as shown by point B on the new UIP curve, UIP’. At the end of the period, / reverts to its initial level (and the UIP curve reverts to the original one). There is no interest differential and the exchange rate is back at its initial level.
Explaining the response to interest rate changes
In this case, just as in the closed economy, the central bank will raise the interest rate in order to reduce output and dampen inflation.
However, the foreign exchange market will also react to the knowledge that home’s interest rate will be kept above that of the rest of the world for some time. The UIP condition tells us that home’s exchange rate will therefore appreciate, as there will be increased demand for home’s currency. This occurs as investors buy home currency to buy home bonds so as to take advantage of their higher yields.
We know from the IS curve that the appreciation of the exchange rate will depress demand by reducing net exports. This means the central bank will not have to raise the interest rate as much as they would in the closed economy, as they correctly anticipate some of the adjustment will take place through the foreign exchange market.
In other words, in the open economy, the dampening of demand needed to get the economy back onto the MR curve occurs through a combination of a higher interest rate and exchange rate appreciation.
if the change in interest rate is widely anticipated diagram
Diagram 2
