978-0132146654 Chapter 14 Lecture Notes

Unlock access to all the studying documents.

View Full Document

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 69

Chapter 14

Exchange Rates and the Foreign Exchange Market:

An Asset Approach

.1  Chapter Organization

Exchange Rates and International Transactions

Domestic and Foreign Prices

Exchange Rates and Relative Prices

The Foreign Exchange Market

The Actors

Characteristics of the Market

Spot Rates and Forward Rates

Foreign Exchange Swaps

Futures and Options

The Demand for Foreign Currency Assets

Assets and Asset Returns

Box: Nondeliverable Forward Exchange Trading in Asia

Risk and Liquidity

Interest Rates

Exchange Rates and Asset Returns

A Simple Rule

Return, Risk, and Liquidity in the Foreign Exchange Market

Equilibrium in the Foreign Exchange Market

Interest Parity: The Basic Equilibrium Condition

How Changes in the Current Exchange Rate Affect Expected Returns

The Equilibrium Exchange Rate

Interest Rates, Expectations, and Equilibrium

The Effect of Changing Interest Rates on the Current Exchange Rate

The Effect of Changing Expectations on the Current Exchange Rate

Case Study: What Explains the Carry Trade?

Summary

70 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

APPENDIX TO CHAPTER 14: Forward Exchange Rates and Covered Interest Parity

Chapter Overview

The purpose of this chapter is to show the importance of the exchange rate in translating foreign prices into

domestic values as well as to begin the presentation of exchange rate determination. Central to the

treatment of exchange rate determination is the insight that exchange rates are determined in the same way

as other asset prices. The chapter begins by describing how the relative prices of different countries’ goods

are affected by exchange rate changes. This discussion illustrates the central importance of exchange rates

for cross-border economic linkages. The determination of the level of the exchange rate is modeled in

the context of the exchange rate’s role as the relative price of foreign and domestic currencies, using the

uncovered interest parity relationship.

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 71

The euro is used often in examples. Some students may not be familiar with the currency or aware of

which countries use it; a brief discussion may be warranted. A full treatment of EMU and the theories

surrounding currency unification appears in Chapter 20.

The description of the foreign exchange market stresses the involvement of large organizations (commercial

banks, corporations, nonbank financial institutions, and central banks) and the highly integrated nature

of the market. The nature of the foreign exchange market ensures that arbitrage occurs quickly, so that

common rates are offered worldwide. A comparison of the trading volume in foreign exchange markets to

that in other markets is useful to underscore how quickly price arbitrage occurs and equilibrium is restored.

Forward foreign exchange trading, foreign exchange futures contracts, and foreign exchange options play

an important part in currency market activity. The use of these financial instruments to eliminate short-run

exchange rate risk is described.

The explanation of exchange rate determination in this chapter emphasizes the modern view that exchange

rates move to equilibrate asset markets. The foreign exchange demand and supply curves that introduce

exchange rate determination in most undergraduate texts are not found here. Instead, there is a discussion

of asset pricing and the determination of expected rates of return on assets denominated in different

currencies.

Students may already be familiar with the distinction between real and nominal returns. The text demonstrates

that nominal returns are sufficient for comparing the attractiveness of different assets. There is a brief

description of the role played by risk and liquidity in asset demand, but these considerations are not

pursued in this chapter. (The role of risk is taken up again in Chapter 18.)

Substantial space is devoted to the topic of comparing expected returns on assets denominated in domestic

and foreign currency. The text identifies two parts of the expected return on a foreign currency asset

(measured in domestic currency terms): the interest payment and the change in the value of the foreign

currency relative to the domestic currency over the period in which the asset is held. The expected return

on a foreign asset is calculated as a function of the current exchange rate for given expected values of the

future exchange rate and the foreign interest rate.

The absence of risk and liquidity considerations implies that the expected returns on all assets traded in the

foreign exchange market must be equal. It is thus a short step from calculations of expected returns on foreign

assets to the interest parity condition. The foreign exchange market is shown to be in equilibrium only when

the interest parity condition holds. Thus, for given interest rates and given expectations about future exchange

rates, interest parity determines the current equilibrium exchange rate. The interest parity diagram introduced

here is instrumental in later chapters in which a more general model is presented. Since a command of this

interest parity diagram is an important building block for future work, we recommend drills that employ

this diagram.

The result that a dollar appreciation makes foreign currency assets more attractive may appear

counterintuitive to students—why does a stronger dollar reduce the expected return on dollar assets? The

key to explaining this point is that, under the static expectations and constant interest rates assumptions, a

dollar appreciation today implies a greater future dollar depreciation; so, an American investor can expect

to gain not only the foreign interest payment but also the extra return due to the dollar’s additional future

depreciation. The following diagram illustrates this point. In this diagram, the exchange rate at time t  1 is

expected to be equal to E. If the exchange rate at time t is also E, then expected depreciation is 0. If, however,

the exchange rate depreciates at time t to E then it must appreciate to reach E at time t 1. If the exchange

rate appreciates today to E then it must depreciate to reach E at time t 1. Thus, under static

expectations, a depreciation today implies an expected appreciation and vice versa.

72 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

Figure 14-1

This pedagogical tool can be employed to provide some further intuition behind the interest parity

relationship. Suppose that the domestic and foreign interest rates are equal. Interest parity then requires

that the expected depreciation is equal to zero and that the exchange rate today and next period is equal

to E. If the domestic interest rate rises, people will want to hold more domestic currency deposits. The

resulting increased demand for domestic currency drives up the price of domestic currency, causing the

exchange rate to appreciate. How long will this continue? The answer is that the appreciation of the

domestic currency continues until the expected depreciation that is a consequence of the domestic

currency’s appreciation today just offsets the interest differential.

The text presents exercises on the effects of changes in interest rates and of changes in expectations of

the future exchange rate. These exercises can help develop students’ intuition. For example, the initial

result of a rise in U.S. interest rates is a higher demand for dollar-denominated assets and thus an increase

in the price of the dollar. This dollar appreciation is large enough that the subsequent expected dollar

depreciation just equalizes the expected return on foreign currency assets (measured in dollar terms) and

the higher dollar interest rate.

The chapter concludes with a case study looking at a situation in which interest rate parity may not hold:

the carry trade. In a carry trade, investors borrow money in low-interest currencies and buy

high-interest-rate currencies, often earning profits over long periods of time. However, this transaction

carries an element of risk as the high-interest-rate currency may experience an abrupt crash in value. The

case study discusses a popular carry trade in which investors borrowed low-interest-rate Japanese yen to

purchase high-interest-rate Australian dollars. Investors earned high returns until 2008, when the Australian

dollar abruptly crashed, losing 40 percent of its value. This was an especially large loss as the crash

occurred amidst a financial crisis in which liquidity was highly valued. Thus, when we factor in this

additional risk of the carry trade, interest rate parity may still hold.

The Appendix describes the covered interest parity relationship and applies it to explain the determination

of forward rates under risk neutrality as well as the high correlation between movements in spot and

forward rates.