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Topic 1: Basic Concepts A. Foreign Exchange Market Exchange Rate: the price of one currency in terms of another. In this course, unless otherwise indicated, the exchange rate is defined to be the domestic currency price of one unit of foreign currency. e.g., the exchange rate between the Canadian dollar and the euro is S ($/) = 1.6. The price of one euro is 1.6 Canadian dollars. Higher S implies the Canadian dollar depreciates in its value. Say, if S changed to S = 1.8, it now takes more Canadian dollars to buy one euro. Lower S implies the Canadian dollar appreciates in its value. That is, the foreign currency now costs less. Spot rate is the exchange rate that calls for delivery of the currency purchased within two business days.

A cross-rate is a bilateral rate calculated from two other bilateral rates. For example, the spot rate for the British pound is 2.3647 $/, and the spot rate on the euro is 1.6641 $/ in Toronto. What is the implied British pound price of the euro (/)? Note that / = ($/)-1 ($/). In this example, (1/2.3647) (1.6641) = 0.7037 /. Triangular Arbitrage Suppose the actual British pound price of the euro in London is S (/) = 0.7100 and that you have $1 million line of credit. Since the euro is more expensive (in terms of the pound) in London, you should buy the euro in Toronto and sell them in London. $1 million buy 1/1.6641 = 600,925 in Toronto sell the euro in London for 600,925 0.7100 = 426,657 convert the pound back to 426,657 2.3647 = $1,008,916 in Toronto.


Ignoring transaction costs, this arbitrage activity netted a profit of $8,916. In practice, taking into account transaction costs, arbitrage opportunity that yields net positive profit is rare. (Why?) Similarly, spatial arbitrage opportunity exists if a currency exchange rate in one market is different from the exchange rate in another market. Suppose S ($/) = 1.66 in Toronto and S ($/) = 1.67 in Hong Kong. Buy euro in Toronto and sell them in Hong Kong. Again, net positive profit (after transaction costs) opportunity of this type is rare. The bid-ask spread reflects, in general, the cost of transacting in that currency. The bid is the price the bank is willing to pay for the currency, e.g., 1.2148 US$/. The ask is the price the bank is willing sell the currency for, e.g., 1.2158 US$/.


The bid-ask spread = 1.2158 1.2148 = 0.001 The margin is the spread expressed as a percent of the ask, e.g., [(1.2158 1.2148)/1.2158] 100 = 0.082%. Real Exchange Rates (RER) The real exchange rate adjusts the nominal exchange rate for changes in nations price levels. A real exchange rate is an index. Hence, we compare its value for one period relative to its value in another period, or the change in the index from one period to another. Define RER, Q = SP*/P. Currency Jan. 2000 May 2004 US$/ 1.05 1.19 US CPI 112.7 122.2 Euro-area CPI 107.5 116.4 In nominal terms, the euro appreciated relative to the US dollar. The percent change is [(1.19 1.05)/1.05]100 = 13.3%.

The January 2000 real exchange rate is 1.05(107.5/112.7) = 1.0016. The May 2004 real rate is 1.19(116.4/122.2) = 1.1335. In real terms, the euro appreciated relative to the U.S. dollar. The rate of appreciation is [(1.1335 1.0016)/1.0016]100 = 13.17%. Effective Exchange Rates (EER) On any given day, a currency may appreciate in value relative to some currencies while depreciating in value against others. An effective exchange rate is an index of the weighted-average value of a currency relative to a select group of currencies. Thus, it is a guide to the general value of the currency. To construct an EER, we must: Select a basket of currencies (important trading partners) Assign relative weights (bilateral or multilateral weights) Choose a base year (reference point)

Real EER: an effective exchange rate based on real exchange rates as opposed to nominal exchange rate. We also need CPI data for the countries in the index. Suppose that of all the trade of the US with Canada, Mexico, and the UK, Canada accounts for 50%, Mexico for 30%, and the UK for 20%. These constitute our weights (0.50, 0.30, and 0.20). Currency 2004 Value 2003 Value Canadian Dollar 1.31 C$/US$ 1.39 Mexican Peso 11.4 P/$ 10.9 British Pound 0.56 /$ 0.64 Let 2003 be the base year In 2003, EER = [(1.39/1.39)0.50 + (10.9/10.9)0.30 + (0.64/0.64)0.20]100 = 100. In 2004, EER = [(1.31/1.39)0.50 + (11.4/10.9)0.30 + (0.56/0.64)0.20]100 = 96. The US dollar, therefore, has experienced 4% depreciation in weighted value.

The Demand for a Currency The demand for a currency is a derived demand. That is, the demand for the currency is derived from the demand for the goods, services, and financial assets the currency is used to purchase. If foreign demand for European goods and services increases, the demand for the euro increases. The demand curve is downward sloping. If, for example, the euro depreciates (i.e., the price of the euro is lower), European goods, services, and financial assets become less expensive to foreign residents. Foreign residents will increase their quantity demanded of the euro to purchase more European goods, services, and financial assets. The downward slope of the demand curve shows the negative relationship between the exchange rate (the price of foreign currency)


and the quantity of foreign currency demanded. The Demand Curve


($ C )




The euro depreciates when it moves from A to B (the price of the euro is lower) higher demand for the now less-expensive European goods, services, and assets higher quantity of the euro demanded. Note this is a change in the quantity demanded represented by a movement along the curve.

If foreign demand for European goods and services and euro-denominated assets increases at every exchange rate the demand curve shifts to the right a change in the demand. The Supply of a Currency The supply of one currency is derived from the demand for another currency. If the European residents want to purchase Canadian goods, services, and financial assets, they must exchange the euro for the dollar. This constitutes the supply of the euro. The supply curve is upward sloping. If, for example, the euro appreciates (i.e., the price of the euro is higher), Canadian goods, services, and financial assets become less expensive to European consumers. They will increase their quantity supplied of the euro (in exchange for the Canadian dollars) to purchase more Canadian goods, services, and assets.


The upward slope of the supply curve shows the positive relationship between the exchange rate (the price of foreign currency) and the quantity of foreign currency supplied. The Supply Curve

( C)
$ S2 S1 A B




The euro appreciates when it moves from A to B (the price of the euro is higher) higher demand for the now less-expensive Canadian goods, services, and assets higher quantity of the euro supplied (in exchange for Canadian


dollars). Note this is a change in the quantity supplied represented by a movement along the curve. If European demand for Canadian goods, services, and assets increases at every exchange rate higher supply of euro at every exchange rate the supply curve shifts to the right a change in the supply. Market Equilibrium

S Sb Se Sc D Q1 Qe Q2 QC E



At exchange rate Sb the quantity supplied of the euro exceeds the quantity demanded and the euro will depreciate. At exchange rate Sc, the quantity of euros demanded exceeds the quantity supplied and the euro will appreciate. At the equilibrium exchange rate Se, the quantity of euros demanded equals the quantity supplied. B. Purchasing Power Parity (PPP) The absolute PPP says that the same goods or basket of goods should sell for the same price in different countries when measured in a common currency. Thus, P = SP*. P, P* are the respective prices (or price indexes) in the home and foreign nations, and S is the exchange rate. The absolute PPP has been used as: A theory of price level: if the exchange rate S is fixed and the home country is small,


foreign prices P* will determine domestic prices. A theory of the exchange rate which postulates that the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two nations. Specifically, S = P/ P*. A currency can be said to be overvalued or undervalued relative to the exchange rate level implied by the absolute PPP. The absolute PPP implies RER = 1. Q = SP*/P = (P/ P*)(P*/P) = 1. The absolute PPP can also be considered as a generalization of the law of one price (LOOP). LOOP says that in the absence of impediments to international trade, such as tariff barriers and transaction costs, an identical tradable commodity should have the same price when expressed in terms of the same currency. Specifically, Pi = SP*i, where Pi and P*i are the


respective prices of the good i, in the home and foreign nations. If the LOOP does not hold then a profitable commodity arbitrage exists. Suppose The Economist magazine sells for 3 in Paris and $4.8 in Toronto. The LOOP implies that S = 1.6 $/ . Suppose the actual S = 1.7 the dollar price of the magazine in Paris = 3 1.7 = $5.1 buy the magazine in Toronto and sell it in Paris. Transaction costs would modify the above equality in the sense that they create a neutral band within which it is unprofitable to engage in arbitrage. Some Shortcomings of Absolute PPP The LOOP refers to internationally traded goods and services; therefore, if the general price level (such as the consumer price index,


CPI) includes both traded and non-traded goods and services, the absolute PPP will not lead to the exchange rate that equilibrates trade. Producer price index (PPI) is sometimes preferred since it is more heavily weighted toward tradable goods and excludes such nontraded items as housing services, family doctors. The price levels in different countries may be based on different sets of goods and services. Different countries may use different price index weights to calculate price levels. Markets can be non-competitive so that a single firm may sell the same good at different prices in different countries because of different market structures. Relative PPP Relative PPP postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period.


Take logarithms of the absolute PPP (S = P/P*). lnS = lnP lnP* d(lnS) = d(lnP) d(lnP*). Approximately, %S = %P - %P* = *, where and * are the respective inflation rates of home and foreign nations. For example, if in a given year, inflation rate in Canada is 3% while that in the U.K. is 1%, then the relative PPP predicts that the Canadian dollar depreciates by 2% against the pound in that year (%S = *= 3% - 1% = 2%) . Absolute PPP implies relative PPP but the reverse is not necessarily true. Advantages of relative PPP: The relative PPP can be used to find out the magnitude of change in exchange rate in response to changes in relative national price levels, especially in periods of high inflation. The relative PPP overcomes the issue of trade impediments such as tariffs or transaction costs or the issue of different price weighting schemes. As long as these factors remain constant over time, changes


in relative price levels will be reflected in the relative price indexes. Problems with relative PPP: Significant structural changes It does not consider international capital flows and money stocks. PPP: Empirical Evidence In general, the PPP seems more likely to hold over a long horizon (more than a decade) than over a short horizon. In the short run, exchange rates seem to be driven by news, which by its very nature is random. Deviations of exchange rates from PPP in the short run could be quite consistent. Only about 15% of the deviation from PPP would be eliminated per year. Relative PPP performs better than absolute PPP. One should expect the PPP to work well for highly traded individual commodities (arbitrage effect) and during periods of high inflation



(price changes have dominant effect on currency value). C. The Forward Currency Market and Interest Rate Parity. Forward Exchange Rate (F) F is the exchange rate (agreed upon today) that calls for delivery of the currency at one of the future days say, in 30, 90, or 180 days. For example, you could enter into an agreement today to purchase 100 six months from today at F($/) = 1.62. After 6 months, you get the 100 for $162, regardless of what the spot rate is at that time. When F > S, it is said that the foreign currency trades at a forward premium (e.g., S = 1.60); when F < S, it trades at a forward discount. We can express the premium or discount in an annualized percentage. The euro trades at
FN S 12 1.62 1.6012 100 = 100= 2.5% premium. S N 1.60 6



A Eurocurrency is a foreign currencydenominated deposit at a bank located outside the country that issues the currency. The Eurocurrency market consists mostly of shortterm funds with maturity of less than 6 months. A yen deposit at a Toronto bank is a Euro-yen deposit; a US dollar deposit at a London bank is a Eurodollar deposit; a euro deposit at a Hong Kong bank is a euro deposit. Euronotes and Eurobonds are, respectively, medium-term and long-term debt securities that are sold outside the borrowers country to raise capital in a currency other than the currency of the nation where the bonds are sold. Main uses of forward contracts Hedging refers to the act of avoiding or covering a foreign exchange risk. People who expect to make or receive payment in terms of foreign currency at a future date face the risk that they will have to pay more or will receive less in terms of domestic currency than they anticipated.


For example, a Canadian importer takes delivery of goods which require payment of 10,000 in 180 days. Suppose the spot rate of the euro today is 1.60 while the 6-month forward rate is 1.62. To hedge buy the 10,000 forward contract after 6 months, when she needs to make payments for her imports pays $16,200 to get the 10,000. Alternatively, buy the euro today at the spot rate of 1.60 holding them until the payment is due. effectively paying cash for her imports & funds are tied up for the whole 6 months hedging usually takes place in the forward market because it is simpler and does not tie up hedgers funds or capital. Speculation refers to risk-seeking activity in the forward markets in an attempt to make a profit. It is the opposite of hedging. Suppose that todays 6-month forward rate of the euro is F=1.62 and that a speculator expects that the spot rate of the euro in 6-month time will be higher, say Se = 1.64. buy, say 1,000,000


today in the forward market in 6 months, the speculator pays $1,620,000 and receives 1,000,000. If the spot rate at that time (i.e., in 6-month time) is indeed 1.64 immediately resell 1,000,000 for $1,640,000 earn $20,000 (maybe a bit less if transaction fees are taken into account). Of course, if the spot rate in 3 months turns out to be 1.61 the speculator incurs a loss of $10,000 (maybe a bit more with transaction fees). Again, speculation can also take place in the spot market buy foreign currency now and hold if you anticipate the spot rate will be higher in 6 months. However, speculation in the latter market also involves tying up funds. F < Se speculators will buy foreign currency forward, because they expect to sell the foreign currency that they will eventually get (from the forward contract) at the higher expected spot price Se. If F > Se speculators will sell foreign currency forward. Thus, equilibrium for pure speculation is attained when F = Se.


Arbitrage refers to the act of exploiting a price differential so as to make a riskless profit. Suppose the spot rate is S ($/) = 1.60 and New York London 1-year interest rate R = 4.50% R* = 2.25% To take advantage of higher interest return in NY use 1 and exchange it for dollars deposit these dollars in a NY bank earn 2.25% more per year, assuming S is unchanged in one year. Suppose in one year S+1y = 1.62 we will still earn an extra 2.25% for the one-year dollar deposit but lose [(1.62-1.60)/1.60]100 = 1.25% on the depreciation of the dollar net excess return = (4.5% - 2.25%) -1.25% = 1%. If S+1y = 1.64 the loss of 2.5% on the depreciation of the dollar more than offsets the excess return on the deposit in NY. Net excess rate of return in NY (%) = (interest rate in NY interest rate in London) - (%S). There is an exchange rate risk when the $ is converted to the at the maturity of the deposit


We have carried out an uncovered interest arbitrage can eliminate or cover this exchange rate risk by using a forward contract. Suppose that 1-year forward pound sells for F = $1.62 (the pound is at 1.25% premium) buy this forward contract lock in 1% net excess return covered interest arbitrage 1.25% forward premium of the pound is the cost of covering. In general, covered interest arbitrage involves simultaneous buying and selling on the spot and forward markets in order to realize the highest possible rate of return, while at the same time avoiding exchange rate risk. Interest Rate Parity (IRP) In the above example, in one year, $1 investment in NY = (1 + R) in London = 1 (1+ R*)F
S Since (1+ R) > (1+ R*) F S

capital flows out of

London to NY, more and more is exchanged for $ on the spot and is bought on the forward


market R, R*, S, F covered interest arbitrage continues until (1+ R) = (1+ R*) F covered interest rate parity (CIRP). CIRP can be rewritten in an approximate form the interest rate differential R R* = F S between home and foreign assets should approximately equal the forward discount or premium. R > R*, foreign currency is sold at a forward premium. R < R*, foreign currency is sold at a forward discount. So, when CIRP holds covered interest arbitrage is precluded. Analogously, to eliminate uncovered interest arbitrage uncovered interest
Se . rate parity (UIRP) must hold: (1+ R) = (1+ R*) S

UIRP can be rewritten in an approximate form

Se S R R* = S

the interest rate differential



between home and foreign assets should approximately equal the expected appreciation or depreciation of foreign currency (in %). R > R*, foreign currency is expected to appreciate. R < R*, foreign currency is expected to depreciate. IRP - Empirical Evidence: In Figure 4-4, the 450 line is a locus of various combinations of interest-rate differentials and forward premiums/discounts that ensure the CIRP holds exactly CIRP line. At A, the excess return (3%) of domestic over foreign financial assets is exactly equal to the locked-in rate of appreciation of the foreign currency. Points below the line, e.g. B, indicate capital inflows since the excess return of the domestic asset is greater than the locked-in appreciation of the foreign currency.



Points above the line indicate capital outflows since the excess return of the domestic asset is less than the locked-in appreciation of the foreign currency. For example, at C, foreign interest rate is higher than domestic rate by 2.25 percentage point but the lock-in depreciation of foreign currency is only 1.25% capital outflows. Frenkel and Levich (JPE, 1975) use 3-month Tbills for the UK & US and Canada & US many observations do not fall on the 450 line; instead they lie around the line Do we conclude that CIRP fails to hold in practice? Transaction costs facing an investor/arbitrager who wishes to switch from domestic to foreign asset: Sell domestic asset transaction fees Buy spot foreign currency fees Buy foreign asset fees Buy forward contract (to lock in future spot rate) fees



F S S 45 A 3%

1.25% 2.25%

B RR* 2.25% 3% 1.25%

Therefore, points just above the CIRP line do not necessarily represent deviations from the covered parity. E.g. to induce capital outflows (investment in foreign asset) the forward premium on foreign currency must slightly exceeds the excess return on domestic asset to pay for all the transaction costs involved. Similarly, points just below the line may reflect transaction costs associated with


capital inflows. To account for transaction costs, consider an upper and a lower band for the CIRP line neutral band. T-Bills issued in different countries/political jurisdictions have different political/default risk use financial instruments issued in the same financial centre (such as Euro-bills) Using Euro-bills, FL (1975) report that all of the deviations from the CIRP lie within the neutral band. The UIRP is rejected in most empirical studies. Recall that an investor engaging in an uncovered interest arbitrage has a foreign exchange risk exposure. If market participants are risk neutral, they care only about the mean value of asset returns, not variations in the returns. However, not all investors are risk neutral, some are risk-averse. To induce the risk-averse investors to engage in an uncovered arbitrage there must be a higher rate of return in buying foreign financial



instruments premium p

augment the UIRP with a (risk)

Se S + p . R R* = S

Se (1+ R) = (1+ R*) + p S

If the domestic financial instrument carries a higher risk excess return on domestic asset must be high enough to cover the expected depreciation of the domestic currency plus a risk premium. A comparison of CIRP and (non-adjusted) UIRP market is in equilibrium when F = Se. If the forward rate systematically differs from the expected spot rate then a profit opportunity exists. Foreign exchange market efficiency exists when prices (forward and spot rates) and market expectations reflect all available information and adjust quickly to eliminate any potential for arbitrage profits. The most common explanation for the lack of empirical support for the UIRP is that there is, in fact, a time-varying risk premium. Also, the


way empirical researchers model expectations could be problematic. These two factors, among others, could separate the forward rate from the expected future spot rate.