International Business Chapter 14 Exchange Rates And The Foreign Exchange Market Asset Approach Organization

Unlock access to all the studying documents.

View Full Document

Chapter 14 (3)

Exchange Rates and the Foreign Exchange Market:

An Asset Approach

◼ Chapter Organization

Exchange Rates and International Transactions

Domestic and Foreign Prices

Exchange Rates and Relative Prices

The Foreign Exchange Market

The Actors

Box: Exchange Rates, Auto Prices, and Currency Wars

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

APPENDIX TO CHAPTER 14 (3): Forward Exchange Rates and Covered Interest Parity

76 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

◼ 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.

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(9).

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[7].)

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. Because a command of

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

employ this diagram.

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 77

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.

Figure 14(3)-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.

78 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

◼ Answers to Textbook Problems

1. At an exchange rate of 1.05 $ per euro, a 5 euro bratwurst costs 1.05$/euro  5 euros = $5.25. Thus,

the bratwurst in Munich is $1.25 more expensive than the hot dog in Boston. The relative price is

2. If it were cheaper to buy Israeli shekels with Swiss francs that were purchased with dollars than to

directly buy shekels with dollars, then people would act upon this arbitrage opportunity. The demand

for Swiss francs from people who hold dollars would rise, causing the Swiss franc to rise in value

3. Take for example the exchange rate between the Argentine peso, the US dollar, the euro, and the

British pound. One dollar is worth 5.3015 pesos, while a euro is worth 7.0089 pesos. To rule out

triangular arbitrage, we need to see how many pesos you would get if you first bought euros with

We need to say that triangular arbitrage is “approximately” ruled out for several reasons. First,

rounding error means that there may be some small discrepancies between the direct and indirect

4. A depreciation of Chinese yuan makes the import more expensive. Since the demand for oil is

inelastic, China needs to import oil from the oil exporting countries. This leads to spending more on

5. The dollar rates of return are as follows:

c. There are two parts to this return. One is the loss involved due to the appreciation of the dollar;

the dollar appreciation is ($1.38 − $1.50)/$1.50 = −0.08. The other part of the return is the interest

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 79

6. Note here that the ordering of the returns of the three assets is the same whether we calculate real or

nominal returns.

a. The real return on the house would be 25 percent − 10 percent = 15 percent. This return could

also be calculated

by first finding the portion of the $50,000 nominal increase in the house’s price due to inflation

7. The expected rate of MYR depreciation against the euro is (3.15- 3.00)/3.00 =0.05 or 5% per year.

The expected gain to Volkswagen, if there is no change in exchange rate, was = 700,000 × 0.05 =

35,000 euro.

8. If market traders learn that the dollar interest rate will soon fall, they also revise upward their expectation

of the dollar’s future depreciation in the foreign exchange market. Given the current exchange rate

and interest rates, there is thus a rise in the expected dollar return on euro deposits from

EU,1

EU,2

. At the current exchange rate of E1, the dollar return on a European asset exceeds the dollar

9. The analysis will be parallel to that in the text. As shown in the accompanying diagrams, a movement

down the vertical axis in the new graph, however, is interpreted as a euro appreciation and dollar

depreciation rather than the reverse. Also, the horizontal axis now measures the euro interest rate.

80 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

The two diagrams below show the effects of an increase in European interest rates and an increase in

the expected future exchange rate in terms of euros per dollar. In the first case, an increase in European

interest rates raises the euro return on a European asset above the euro return on an American asset.

This will cause the exchange rate to fall (euro appreciation, dollar depreciation) from E1 to E2.

In the second case, the expected appreciation of the dollar raises the euro return on an American asset

from

US,1

US,2 .

At the current exchange rate, American assets pay a higher euro return and the

exchange rate must rise (euro depreciation, dollar appreciation) to restore interest rate parity.

10. a. If the Federal Reserve pushed interest rates down, with an unchanged expected future exchange

rate, the dollar would depreciate (note that the article uses the term “downward pressure” to mean

pressure for the dollar to depreciate). If there is a “soft landing,” and the Federal Reserve does

not lower interest rates, then this dollar depreciation will not occur.

b. The “disruptive” effects of a recession make dollar holdings more risky. Risky assets must offer

some extra compensation such that people willingly hold them as opposed to other, less risky

assets. This extra compensation may be in the form of a bigger expected appreciation of the

11. If the Japanese yen gives 15% interest rate against 10% interest rate of euro deposits, people will

prefer to hold Japanese yen deposits as it gives more return. However, a depreciation of 10%

Japanese yen would give 5% more return on the euro deposits. No rational consumer will prefer to

hold Japanese Yen. The holders of yen will try to sell it for the euro deposits. This would increase

12. The chapter states that most foreign exchange transactions between banks (which accounts for the vast

majority of foreign exchange transactions) involve exchanges of foreign currencies for U.S. dollars, even

when the ultimate transaction involves the sale of one nondollar currency for another nondollar

currency. This central role of the dollar makes it a vehicle currency in international transactions. The

reason the dollar serves as a vehicle currency is that it is the most liquid of currencies because it is

easy to find people willing to trade foreign currencies for dollars. The greater liquidity of the dollar as

compared to, say, the Mexican peso, means that people are more willing to hold the dollar than the

peso, and thus, dollar deposits can offer a lower interest rate, for any expected rate of depreciation

against a third currency, than peso deposits for the same rate of depreciation against that third currency.

Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 81

As the world capital market becomes increasingly integrated, the liquidity advantages of holding

dollar deposits as opposed to euro deposits will probably diminish. The euro represents an economy

13. The expected depreciation rate of yen is (2.4 – 2)/2 = 0.2 or 20%

The expected rate of return from rupee deposits will be 0.05 + (2.4 – 2)/2 = 0.25

14. A tax on interest earnings and capital gains leaves the interest parity condition the same because all

its components are multiplied by one less the tax rate to obtain after-tax returns. If capital gains are

15. A devaluation of the exchange rate will make export cheaper for the foreign nationals and the import

16. The value should have gone down as there is no more need to engage in intra-EU foreign currency

trading. This represents the predicted transaction cost savings stemming from the euro. At the same

17. If the dollar depreciated, all else being equal, we would expect outsourcing to diminish. If, as the

problem states, much of the outsourcing is an attempt to move production to locations that are relatively

cheaper, then the United States becomes relatively cheap when the dollar depreciates. Although it

may not be as cheap a destination as some other locations, at the margin, labor costs in the United

States will have become relatively cheaper, making some firms choose to retain production at home.

For example, we could say that the labor costs of producing a computer in Malaysia is $220 and the

82 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

18. They key here is to compute the return on the carry trade by accounting for not only the difference

between Korean and American interest rates, but also the percentage change in the value of the

Korean won against the dollar. The risk of the carry trade is that the won might depreciate against the

dollar, thus negating the higher interest rate paid on Korean bonds. Using data from Jan 2009 through

Oct 2013, a carry trade described in this problem would have the following cumulative return:

19. As per the question, a currency depreciation benefits exporters and hurts consumers by raising the

cost of living. Exporters tend to have more influence with the government for two reasons. First,

there are fewer exporters than there are consumers, so the gains from a currency depreciation are

much more heavily concentrated than the losses. As a result, each individual exporter will put forth

more effort in lobbying the government than each individual consumer. Second, exporters are much