Ec392

Front 1

Depreciation

Back 1

An increase in a country A's exchange rate: More units of the domestic (country A) currency is needed to buy foreign (country B) currency

Front 2

Exchange rate

Back 2

Price of one country's currency in terms of another country's currency. Important because movements in the exchange rate alter the competitiveness of a country's goods and change the rate of return on domestic assets relative to foreign assets. Home countries exchange rate is the number of units of its own home currency that must be given up to buy one unit of the foreign country's currency

Front 3

Appreciation

Back 3

A decrease in a country A's exchange rate: Fewer units of the domestic (country A) currency is needed to buy foreign (country B) currency

Front 4

Exchange rate

Back 4

Price of one country's currency in terms of another country's currency. Important because movements in the exchange rate alter the competitiveness of a country's goods and change the rate of return on domestic assets relative to foreign assets. Home countries exchange rate is the number of units of its own home currency that must be given up to buy one unit of the foreign country's currency

Front 5

Depreciation

Back 5

An increase in a country A's exchange rate: More units of the domestic (country A) currency is needed to buy foreign (country B) currency

Front 6

Appreciation

Back 6

A decrease in a country A's exchange rate: Fewer units of the domestic (country A) currency is needed to buy foreign (country B) currency

Front 7

Effective exchange rate

Back 7

Used to measure the average change in the value of a country's currency. Changes in a country's effective exchange are equal to the weighted average of changes in its exchange rate across all of that country's trading partners. Key point: If the prices of goods are fixed in a country's own currency, then their foreign currency price moves proportionally with changes in the country's exchange rate

Front 8

Exchange rate regime

Back 8

the amount of effort that a government exerts to control the exchange rate

Front 9

Floating (flexible) exchange rate regime

Back 9

Government may not make no effort whatsoever to control the exchange rate and instead leave it to be determined on the foreign exchange markets.

Front 10

Fixed (pegged) exchange rate regime

Back 10

Government exerts as much effort as necessary to keep the exchange rate constant. Cost of maintaining fixed regime may be high and may be abandoned which can lead to exchange rate crisis the variability of the exchange rate being very low at some times only to be very high at other times

Front 11

Band

Back 11

More moderate regime than float or fixed regime where government sets range around some rate that the exchange rate is permitted to float within, but will take action when exchange rate moves outside of this band

Front 12

Currency board

Back 12

Occasionally adopted by countries that want maintain very stable exchange rates and government makes it very difficult to drop fixed exchange rate

Front 13

Dollarization

Back 13

When countries drop their currency altogether in favor of a relatively stable currency

Front 14

Currency union

Back 14

Countries sharing a single currency so that there is no exchange rate variability across countries within the union

Front 15

Foreign exchange market

Back 15

Where exchange rates are determined

Front 16

Spot transaction

Back 16

Most widespread foreign exchange transaction that provides the immediate delivery of foreign exchange. The rate at which currencies exchange is known as the spot exchange rate

Front 17

Spread

Back 17

The difference between the rates at which traders of foreign exchange sell a given currency and buy the same currency. Spreads reflect market frictions or transaction costs and differ between clients and are lowest between banks who are the most influential in the foreign exchange market.

Front 18

Interbank trading

Back 18

Transfer of deposits between commercial banks that is involved during most foreign exchange transactions. Governments often intervene in foreign exchange markets and can surppress foreign exchange trading by imposing capitol control or by buying and selling foreign exchange rates

Front 19

Derivatives

Back 19

Forwards, Swaps, Futures and Options contracts with prices derived at least in part from the spot rate because these contracts involve future trades in the foreign exchange, the allow investors to hedge against risk or to take risks through speculation

Front 20

Vehicle currency

Back 20

When the market for exchanging one currency for another is small, it may be quicker and less costly to use a vehicle currency to make the transaction. For instance, for someone who wants to sell Thai baht and buy Mexican pesos, it may be better to buy US dollars for baht and then buy pesos for dollars than to try to find someone else who wants to sell pesos and buy baht. The dollar is the vehicle currency in this transaction.

Front 21

Spot rate

Back 21

An exchange rate at a given moment in time, as opposed to an exchange rate at which two parties agree to exchange currencies at some future time (forward rate).

Front 22

Forward premium

Back 22

The forward rate (F) minus the spot rate (E) divided by the spot rate. (F – E)/E. It can be positive or negative. The forward rate is the exchange rate (price of a unit of foreign currency in the domestic currency that the market has set for some future date) and the spot rate is exchange rate for a transaction today.

Front 23

Swap

Back 23

A foreign exchange or FX swap occurs when one party buys a specified amount of foreign currency at the spot rate today and agrees to sell a specified amount of the foreign currency at a specified rate at a future date. The FX swap may include investing in a bond in the foreign currency between the two dates.

Front 24

Real exchange rate

Back 24

Equals the spot rate (E) times foreign prices (Pf) divided by domestic prices (Pd) or E*(Pf)/(Pd). It is a measure of the spot rate adjusted for foreign and domestic inflation.

Front 25

Trade weighted exchange rate

Back 25

Is an index of bilateral exchange rates (between the domestic currency and a foreign currency) weighted by the foreign country’s share of the domestic country’s total trade.

Front 26

Covered interest parity

Back 26

Holds when there are no barriers to capital flows between countries. With completely open capital markets, the return to investing in a risk-free asset at home (id) must equal the return to investing in a risk free asset abroad, including both interest income (if) abroad and changes in the exchange rate. 1 + id = (1 + if) F /E

Front 27

Basis point

Back 27

One hundredth of one percent = .0001 or .01%. Used in connection with interest rates and other percentages.

Front 28

Pass through

Back 28

Occurs when foreign producers pass through any change in the exchange rate to their customers. If the exchange rate depreciates and there is full passthrough, the domestic price of foreign imports should increase by the full amount of the depreciation. ΔPd = ΔE*Pf . If pass through is less than 100%, ΔPd < ΔE*Pf

Front 29

You run a hedge fund. You notice that you can buy or sell a euro for US $1.25 you can buy or sell a Swiss franc for 63 US cents and you can buy or sell a euro for 2 SF. You have $100 million to speculate with. Which currencies should you buy or sell to take advantage of arbitrage opportunities? How much money can you make in one roundtrip if prices don’t change? Would you consider that amount a good day’s pay if you had no expenses? Suppose you had to pay one day’s interest at an annual rate of 5% on the $100 million and there are 250 days in a year. Is it still a good day’s pay?

Back 29

If you buy euros with your $100 million, you will have 100/1.25 = 80 million euros. Then use these euros to buy 80*2 = 160 million Swiss francs. Then use these Swiss francs to buy 160*0.63 = $100.8 million. From this roundtrip you now have $800,000 more than you started with.

If you have interest expenses of 5 percent per year for one day, you must pay $100 million * 0.05/250 = $20,000. That leaves you with $780,000, not bad for one day’s pay

Front 30

What are the equations for the following Absolute PPP? What is the evidence for and against it? Draw a diagram to show whether they are valid.

Back 30

Absolute PPP. Pd = E *Pf for all goods or E = Pd / Pf The exchange rate = the ratio of domestic prices to foreign prices The evidence is that market exchange rates rarely satisfy the PPP equation, but they have a tendency to drift back towards PPP by about 15% per year. For exchange rates between developed and developing countries, absolute PPP is even less accurate than between developed countries. Market exchange rates tend to reflect prices for traded goods in two countries, but PPP includes nontraded goods as well, which tend to be much less expensive in developing countries. The figure below shows the general tendency for the exchange rate to fluctuate around Pd/Pf but rarely equal it.

Front 31

What are the equations for Relative PPP? What is the evidence for and against it? Draw a diagram to show whether they are valid.

Back 31

(Et - Et-1 )/ Et = Δ Et / Et = Δ Pd /Pd – Δ Pf /Pf = πd – πf The percentage change in the market exchange rate = the difference in inflation rates. Relative PPP explains changes in exchange rates over long periods of time when cumulative inflation is large, or over shorter periods of time for countries with very high inflation rates. When cumulative inflation is low, relative PPP does not explain changes in exchange rates very well, because its effect is outweighed by the many other factors that affect exchange rates. The figure below shows the high correlation between the rate of depreciation and the difference between foreign and US inflation rates during 1975-2005.

Front 32

What are the equations for the Fisher effect? What is the evidence for and against it? Draw a diagram to show whether they are valid.

Back 32

US Inflation and Nominal Interest Rate i = r + πe The nominal exchange rate = real exchange rate + inflation rate. The evidence is strong that an increase in the inflation rate soon results in an increase in the nominal interest rate. Occasionally this occurs with a lag, since it may take a short while for expectations about inflation to catch up with reality, but often the lag is quite short. There may also be a lag when inflation falls – the nominal interest rate may not fall at the same time, so the real interest rate can rise, as it did during the 1980s in the US when inflation fell rapidly but nominal interest rates fell more slowly.

Front 33

Assume that real interest rates around the world are 3% and that PPP and the Fisher effect both hold. If inflation in Russia is 10% and in Switzerland it is 2% and GDP growth rates are 2% in both countries a. What will happen to the ruble/Swiss franc exchange rate over the next year? b. What are the nominal interest rates in Russia and Switzerland? c. How fast is the money supply growing in Russia and Switzerland?

Back 33

a. Relative PPP predicts that inflation differentials are matched by changes in the exchange rate. Under relative PPP, the ruble/franc exchange rate would rise (depreciate) by 8 percent with inflation rates of 10% in Russia and 2% in Switzerland. πr - πs = (Et - Et-1)/ Et = 0.10 – 0.02 = 0 .08 b. The Fisher effect says that the nominal interest rate = real rate + inflation. In Russia ir = rr + πr = .03 + .10 = .13 or 13% In Switzerland is = rs + πs = .03 + .02 = .05 or 5% c. The quantity theory of money says that the rate of inflation = rate of money supply growth minus the growth rate of real income. If real income is not growing, then the inflation rate and money supply growth rates are the same: 10% in Russia and 2% in Switzerland.

Front 34

a. Explain the difference between a nominal exchange rate and an exchange rate calculated at PPP. b. Why do Big Macs cost much less in Indonesia than in the US but about the same or more in other developed countries?

Back 34

a. The nominal exchange rate The number of units of domestic currency needed to buy a unit of foreign currency in the market. To calculate the PPP exchange rate First define a market basket of goods that reflects spending patterns. Calculate its price in the domestic country in local currency and in the US in dollars. Divide the domestic price of the market basket by the US price. The result is the PPP exchange rate = the number of units of domestic currency needed to buy the same basket of goods that would cost $1 in the US. b. Calculated at nominal exchange rates, Big Macs cost less in India and in other developing countries than in the US because a Big Mac contains nontradeables such as rent and the labor of restaurant workers in addition to tradables such as hamburger rolls. Developed countries tend to have higher productivity in tradables but not in nontradables, because tradables tend to be more capital intensive. If tradables prices are similar internationally, then exchange rates will tend to reflect productivity differences in the tradables sector, and wage rates in different countries will reflect these differences. Therefore wages in developing countries will be much lower than in developed countries. But because productivity differences in nontradeables are small, the prices of nontradables will be much lower in developing countries.

Front 35

Consider the United States and the countries it trades with the most (measured in trade volume): Canada Mexico China and Japan. Assume these are the only four countries with which the United States trades. Trade shares and exchange rates for these four countries are in table. a. Compute the percentage change from 2009 to 2010 in the four U.S. bilateral ex- change rates (defined as U.S. dollars per units of foreign exchange or FX) in the table provided. b. Use the trade shares as weights to compute the percentage change in the nominal effective exchange rate for the United States between 2009 and 2010 (in U.S. dollars per foreign currency basket). c. Based on (b) what happened to the value of the U.S. dollar against this basket between 2009 and 2010? How does this compare with the change in the value of the U.S. dollar relative to the Mexican peso? Explain your answer.

Back 35

a. ( %ΔE$/C$) = (0.9643 – 0.9225)/0.9225 = 4.53% (%ΔE$/peso) = (0.0788 – 0.0756)/0.0756 = 4.23 % (%ΔE$/yuan) = (0.1473 – 0.1464)/0.1464 = 0.61% (%ΔE$/¥) = (0.0112 – 0.0105)/0.0105 = 6.67% b. %ΔE = 0.36 ( %ΔE$/C$) + 0.28 (%ΔE$/peso) + 0.20 (%ΔE$/yuan) +0.16 (%ΔE$/¥) = %ΔE = 0.36 (4.53%) + 0.28 (4.23%) + 0.20 (0.61) +0.16 (6.67%) = 4.01% c. The dollar depreciated by 4.01% against the basket of currencies. Visa-vis the peso, the dollar depreciated by 4.23%

Front 36

Consider a Dutch investor with 1000 euros to place in a bank deposit in either the Netherlands or Great Britain. The (one-year) interest rate on bank deposits is 2% in Britain and 4.04% in the Netherlands. The (one-year) forward euro–pound exchange rate is 1.575 euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions using the exact equations for UIP and CIP as necessary a. What is the euro-denominated return on Dutch deposits for this investor? b. What is the (riskless) euro-denominated return on British deposits for this investor using forward cover? c. Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market? d. If the spot rate is 1.5 euros per pound and interest rates are as stated previously what is the equilibrium forward rate according to CIP? e. Suppose the forward rate takes the value given by your answer to (d). Calculate the forward premium on the British pound for the Dutch investor (where ex- change rates are in euros per pound). Is it positive or negative? Why do investors require this premium/discount in equilibrium? f. If UIP holds what is the expected depreciation of the euro against the pound over one year? g. Based on your answer to (f ) what is the expected euro–pound exchange rate one year ahead?

Back 36

a. Euro denominated return on Dutch deposits = €1040.04 ( = €1ooo × (1+0.0404)) b. Euro denominated return on Britsih deposits using forward cover is = €10710 ( = €1ooo × (1.575/1.5) × (1+0.02)) c. Yes, there is an arbitrage opportunity.The euro-denominated return on British deposits is higher than that on Dutch deposits.The net return on each euro deposit in a Dutch bank is equal to 4.04% versus 7.1% (= (1.575 / 1.5) × (1 + 0.02)) on a British deposit (using forward cover).This is not an equilibrium in the forward exchange market.The actions of traders seeking to exploit the arbitrage opportunity will cause the spot and forward rates to change. d. CIP implies F€/£ = E€/£ (1+i€)/(1+i£) = 1.5 × 1.0404/1.02 = €1.53 per £ e. Forward premium = (F€/£ = E€/£ - 1) = (1.53/1.50) – 1 = 0.03 = 3%. The existence of a positive forward premium would imply that investors expect the euro to depreciate relative to the British pound. Therefore, when establishing forward contracts, the forward rate is higher than the current spot rate. f. According to UIP approximation ΔEe£/€ = E£/€ = i£-i€ = 2.04%. Therefore, the euro is expected to depreciate by 2.04%. Using exact UIP condition we first need to convert the exchange rate into pound-euro terms to calculate deprecation in the euro. From UIP, ΔEe£/€ = E£/€ × (1+i£)/(1+i€) = (1/1.5)×(1+0.02)/(1+0.0404) = £0.654 per € ; Therefore the depreication in the euro = 1.95% (0.654 – 0.667)/0.667 g. Using exact UIP (not approximation) we know the following is true: Ee£/€ = E£/€ × (1+i€)/(1+i£) = 1.5×1.0404/1.02 = (€1.53 per £) Using the approximation, E£/€decreases by 2.04% from 0.667 to 0.653. This implies a new spot rate, E€/£ =1.53