Lecture 2: Exchange Rate Concepts

An exchange rate can be quoted in two ways:

Direct: The price of the foreign currency in terms of dollars

(以本國貨幣表示之外國貨幣價格)

Indirect: The price of dollars in terms of the foreign currency

(以外國貨幣表示之本國貨幣價格)

  1. International Financial Market

See the quotes on Financial Times (midpoint between bid and offer rates) and Wall Street Journal (offer or selling rate).

The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years. The Bank for International Settlements estimated the trading value was close to $600 billion per day, and reached $1.2 trillion per day in 1998.

New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

Vehicle currency: determined primarily by transactions costs.

Whenever the indirect exchange costs through the vehicle are less than direct exchange costs between two non-vehicle currencies. Example: Peso-USD and USD-Won vs. Peso-Won.

Quotes in European terms (goes up, domestic currency appreciation)

American terms (goes up, domestic currency depreciation)

Types of Transaction:

  1. Spot: Apply to exchange currencies “on the spot”
  2. Forward: Apply to exchange currencies on some future date at a prenegotiated exchange rate
  3. Future: The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.
  4. Option:The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.
  5. Swap: Spot sales of a currency combined with a forward repurchase of the currency.They make up a significant proportion of all foreign exchange trading.
  6. NDF( Non-delivery forward): Purchase/Sale Agreement is a contractual obligation to compensate the affected counterpart in the event of any difference between the market rate on any given date and the agreed rate, taking into account the contracted amount of the product (e.g., US$). At no time is there physical delivery of the product.

Arbitrage: The process of buying a currency cheap and selling it dear.

Triangular arbitrage

Assume there are no transactions costs,

The dollar price of pound (=1.60), the euro price of the pound (=1.55), and the dollar price of the euro (=1.10) respectively. Begin with 1.60 dollars and end up with 1.705 dollars.

Related Articles: *Taiwan’s exchange market (1) (2) (3)*

  1. Average Exchange Rates

(Effective Exchange Rate Index)

Nominal: A nominal effective exchange rate is the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in either the country international trade or payments.

Fed’s index has weights based on the various nations’ relative sizes in world trade

IMF bases its weights on the various volume of trade with the United States

Real: Real effective exchange rates take account of price level differences between trading partners. Movements in real effective exchange rates provide an indication of the evolution of a country’s aggregate external price competitiveness.

  1. Real Exchange Rates

Terms of Trade:

  1. Purchasing Power Parity

LOP: law of one price

Absolute PPP

Relative PPP

OECD: Purchasing Power Parities (PPPs) are currency conversion rates that both convert to a common currency and equalise the purchasing power of different currencies. In other words, they eliminate the differences in price levels between countries in the process of conversion.

How many products are included in the basket of goods and services used for the PPP calculation?

The final products list for the 1999 comparison covered around 2,500 consumer goods and services, 34 occupations in government, education and health services, 186 types of equipment goods and 20 construction projects? The large number of price specifications is to enable as many countries as possible to identify goods and services which are representative of their domestic expenditures. However, countries are expected to provide only a relatively small subset of these prices (several hundred in general).

Big Mac Parity

Exchange rate Pass Through

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  1. PPP and Non-Traded Goods

Assume that price level is the linear combination of the prices of tradables and non-tradables. (natural log)

PPP holds for tradable goods:

Real exchange rate:

Balassa (1964) andSamuelson (1964), two-sector model, free labor mobility within the country, perfect competition, and different productivities:

，

，

+

  1. Interest Parity

Eurocurrency: a foreign currency denominated deposit at a bank located outside the country where the currency is used as legal tender.

London Interbank Offer Rate (LIBOR): the rate at which banks are willing to lend to the most creditworthy banks participating in the London Interbank market.

Covered Interest Parity

Example:

1 + 0.0678 > (1 + 0.0422) = 1.0178

There is arbitrage profit.

Logarithmic approximation,

Uncovered Interest Parity

6. Forward Premium Puzzles

Market efficiency and rational expectation

Assume that covered interest rate parity (IRP):

If there is rational expectation with risk–free economic agent, market efficiency implies that the hypothesis test in the regression coefficients of

is .

Most empirical studies reject the null hypothesis.

Possible explanations:

  1. Risk premium
  1. Peso problem

One-period-ahead rationally expected future spot rate is

If the forward exchange rate is the market’s expected future spot rate, we have a rational explanation for the forward premium bias. Although the forecast errors are serially correlated, they are not useful in predicting the future depreciation.

  1. Noise traders

The market participants are not fully rational. Some (noise) traders are unable to distinguish between pseudo-signals and news. Short-horizon rational investors bear the risk that they may be required to liquidate their positions at a time when noise traders have pushed asset prices even farther away from the fundamental value.