1 Exchange rate and interest parity Jan J. Michalek Exchange rate Exchange rate: the price of one currency expressed in another currency Definition: how many units of domestic currency are needed to buy one unit of foreign currency: e.g. 3,9 PLN/$ Changes in exchange rates: Fixed exchange rate: devaluation and revaluation Flexible exchange rates: depreciation and appreciation. JJ Michalek
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Exchange rate
and interest parity
Jan J. Michalek
Exchange rate
Exchange rate: the price of one currency expressed in another currency
Definition: how many units of domestic currency are needed to buy one unit of foreign currency: e.g. 3,9PLN/$
Changes in exchange rates:
Fixed exchange rate: devaluation and revaluation
Flexible exchange rates: depreciation and appreciation.
JJ Michalek
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Echange rate changes:
Exchange rate
regime
Flexible Stable
Increase of
exchange rate
Depreciation Devaluation
Decrease of
exchange rate
Appreciation Revaluation
JJ Michalek
Two types of changes in exchange rates:
Depreciation of home country’s currency
A rise in the home currency prices of a foreign currency
It makes home goods cheaper for foreigners and foreign
goods more expensive for domestic residents.
Appreciation of home country’s currency
A fall in the home price of a foreign currency
It makes home goods more expensive for foreigners and
foreign goods cheaper for domestic residents.
Exchange Rates and
International Transactions
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Major exchange regimes and their
characteristics
JJ Michalek
Exchange regimes in Poland
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Exchange rate regimes in Central and
Eastern European countries (IMF report
2014)
Jan J. Michałek
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Domestic and Foreign Prices
If we know the exchange rate between two
countries’ currencies, we can compute the price of
one country’s exports in terms of the other
country’s money.
Example: The dollar price of a £50 sweater with a
dollar exchange rate of $1.50 per pound is (1.50 $/£) x
(£50) = $75.
Exchange Rates and
International Transactions
Exchange rate: major world
actors
Size of the market:
For example: 1999:$1,7 trillion per day: $637 billion in London, $350 in New York, $150 billion in Tokyo.
Major actors and foreign exchange markets:
Commercial banks (interbank trading: retail operations less than $1 million, wholesale: above $1 million: more favorable rates: 90 percent of all foreign exchange rate transactions)
Multinational corporations;
Non bank financial institutions;
Central banks
Foreign exchange brokers.
JJ Michalek
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Foreign exchange arbitrage
When banks or economic agents seek to earn benefit from discrepancies among exchange
rates prevailing simultaneously in different markets.
Example: the Exchange rate of dollar to pound sterling ES/Ł equals:
00,2NYE 20,2LE
With 100$
We can buy 50Ł in NY in exchange for $100
And sell 50Ł In London for: 50*2,20= $110
Immediate profit of 10 $ or 10% (very profitable)
Many transactions of this sort are done
Price of Ł raises (increased demand) in NY e.g. to 2,09
Price of Ł decreases (increased supply) In London e.g. to 2,11
A very small difference In Exchange rates between different foreign exchange markets
JJ Michalek
Spot Rates and Forward Rates
Spot rates are exchange rates for currency exchanges “on the spot”, or when trading is executed in the present.
Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.
forward dates are typically 30, 90, 180 or 360 days in the future.
rates are negotiated between individual institutions in the present, but the exchange occurs in the future.
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Spot and Forward Rates
Hedging: covering against the risk of
exchange rate fluctuations:
If we have to pay 1000 € in three months and we have 4000 PLN & E=4,00PLN/€
We can exchange today: 4000 PLN-> 1000€ (so called balanced or closed position)
If zloty appreciates (e.g.. E=3,9) ---> we gain 100 PLN (in one month it would be possible to buy 1000 € in exchange for 3900 PLN)
If zloty depreciates (e.g. E=4,1) --> we loose 100 PLN
Another option: to keep 4000 PLN as a bank deposit and exchange PLN against Euro after 3 months. Risk of depreciation short position (short of Euro).
JJ Michalek
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Speculation: the opposite of hedging
Making transactions on spot foreign exchange market;
Deliberately willing to profit from exchange rate changes;
- Long position: buying deposit denominated in foreign currency in the hope that currency price will raise (depreciation of domestic currency)
- Short position: promising to sell foreign currency deposit in the future (in the hope that its price will fall: expectation of appreciation of the domestic currency).
JJ Michalek
Figure 13-2: Interest Rates on Dollar and Deutschemark Deposits,
1975-1998
The Demand for
Foreign Currency Assets
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Exchange rate equilibrium under flexible exchange
rate system
S€: supply of foreign deposits (denominated in €) expressed in PLN
D€: demand for foreign deposits (depending on real rate of return)
EPLN/€=3.8
EPLN/€=4.2
EPLN/€=4.0
EPLN/€
S€
D€
Foreign exchange in €
),,,(
))()()((
* fe EERRDD
JJ Michalek
Equilibrium under stable exchange rate regime:
Exchange rate is too high
If Exchange rate is fixed (e.g. EPLN/€=4.20) --> agents are not buying sufficient amount of €-->
excess supply of €--> BOP surplus---> Central Bank purchases € in exchange for PLN (foreign