Exchange Rates and the

currency market
Chapter 4
 What we are going to see in this
chapter
1) What is an exchange rate?
• Price comparisons
• Relation with the interest rate
2) What is the exchange market?
• Who are the players?
• What products are traded?
3) How the exchange market functions?
• The return on assets
• The principle of interest rates parity
 1) What is an exchange rate?
• Definition: it is the price of a currency, expressed in
terms of another currency. This price may be
« indirect »: 20000 dong for 1 dollar, or « direct »: 50
dollars per million dong. This for Vienameses. Usually,
economists use the letter E to design the indirect
exchange rate of a country.
• Observation: exchange rates vary widely in time. On the
table below is the evolution of the dong value of a dollar.
But euro and dollar vary one against the other in both
directions. This is called depreciation or appreciation.

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

11038 11033 11683 13268 13943 14168 14725 15280 15510 15644
 Market and other exchange rates
• The rates above are yearly averages of the official
exchange rate of the dong
• In certain countries, the official ex-rate reflects the
market rate. In other countries, it does not
• A market rate means that it is possible to acquire as
much foreign currency as desired at this rate
• In Vietnam, there is a «black market» rate which
corresponds to this idea. It is located near the Post
Office. Traders are ready to buy dollars at a higher rate
than the official. The market rate is the black rate
• Thus, the official rate in Vietnam is not a market rate. But
we will do in this course as if it were
• One condition for Vietnam to become a real market
economy is to liberalise its exchange rate.
First function of an exchange rate :
price comparison
• Suppose Krugman’s book costs 80 euro in Paris
and and 2.5 mn dong in Hanoi. In order to
compare the two prices, we need to have the ex-
rate of dong in euro.
• If it is 25000, then there are good reasons to
import many books and sell them in Hanoi.
• However, if the euro depreciates (and the dong
appreciates for instance to 15000), then it might
become profitable to export Krugman’s books
from Hanoi to Paris.
 Second function of an exchange
rate : intertemporal comparison
• The exchange rate is the price of a currency
unit, which is an asset (as are bonds, equity,
houses etc). This means that moneys allow the
transportation of wealth (or purchasing power)
through time
• However, all moneys do not share this quality
equally: some lose their purchasing power,
others gain. A deposit in a given currency yields
more or less interests. Thus, the exchange rate
is closely related to the interest rate.
 2) What is the exchange market?
A) The players
• Mainly commercial banks: international
transactions are most of the time transfers of
bank accounts. Think at what happens if you
settle a debt of 100$ to a foreign creditor by a
banking operation: this will end up with the
exchange of two bank deposits.
• This exchange will take place on the interbank
currency exchange market
• Other actors (TNC, bon-bank financial
institutions) are less important. Note that Central
Banks also participate in this market
B) Characteristics of the market
• A world market : established in London,
Frankfurt, NewYork and Singapore, it
remains permanently open
• A very large volume of transactions: the
daily volume is several thousands of billion
dollars (US GDP is 12000 bn yearly). The
first cause is the use of vehicle currencys.
But the main cause is speculation and
« arbitrage »
• A unified market thanks to the permanent
action of traders who do arbitrage
• A market with a wide choice of products:
the spot market is not the only one; it is
possible to postpone an operation of
exchange (from 30 days to 1 year) which
has been decided today. These are
forward markets, where the price of one
euro in dollar in a year (the forward rate) is
fixed now.
• More complex operations are possible:
currency swaps; options  leverage
 3) How the exchange market
functions?
A) The assets : return, risk and liquidity
• All assets have these three components
• Your deposit is a loan to your bank and
normally yields an interest. This is its
return. Other assets also yield a return
• But various assets are more or less risky:
an equity is more risky than a bond, and it
gives a higher return
• Assets are also more or less liquid
B) The principle of interest rates parity
• The return of a currency is the interest rate
yielded by a deposit in that currency
• Suppose you can hold in Vietnam two
bank deposits, one in dong and the other
in euro; the first one gives you 9% and the
second one 5% only
• If you expect that the exchange rate will
remain stable until next year, then you
should hold only dong deposits
• However, if you expect that the dong will
depreciate against he dollar by 9%, then it
means that after one year, your dong deposit
converted into dollars will bring you 0%
whereas the dollar one still brings you 5%
• If people do hold both kinds of bank
accounts, then it means that on average
people expect a similar return on both kinds
of assets, including exchange rate
expectations
• This means that on average, a depreciation
of the dong by 4% is expected
C) We thus have the following equality:
• Ra = R* + Ėa (equivalent to 9%=5%+4%)
• where Ra is the expected return on domestic
assets, R* is the return on foreign assets, and
Ėa is the expected change in the exchange
rate.
• Notice that if Ėa is positive, this means that
you expect a rise of the indirect exchange
rate (dongs for one dollar), so that you expect
a depreciation of the dong
• In fact, other factors, like risk, may play. The
vietnamese interest rate includes a spread
4) A formalisation of the equilibrium
on the exchange market
• How can we determine the present
exchange rate of a currency?
• If we know the interest rates both
domestic and foreign, then for a given
level of the expected exchange rate, it is
possible to draw a relation between the
present exchange rate and the interest
rate
• This relation is decreasing (see graph
below)
We represent the relation between R and E
according to the equation :
R = R* + (Ea – E)/E
The Equilibrium of the Exchange Market
E
IF Ea RISES AND R* STAYS
IF R* RISE S AND Ea REMAINS STABLE ,
STABLE, THE RED CURVE
T HE RE D CURVE SHOULD MOVE UP
MOVES UP

R =R* +(Ea – E)/E

Ea

E1

R
Retur n on deposi ts R1
R*
 What does the graph show?
Other things beeing equal:
• A rise of the domestic interest rate brings an
appreciation of the currency
• A rise in the foreign interest rate brings a
depreciation of the currency
• A rise in the expected future exchange rate (the
expectation of a future depreciation) brings an
immediate depreciation of the currency
• If the market exchange rate has to remain fixed,
then the interest rate has to react quickly to any
move of the red curve (changes in Ea or R*)
 End of the lesson
• Any question?
• Exercises:
• Find on internet the monthly evolution of
the exchange rate of Vietnam since 1990
• Draw a graph representing this evolution