Understanding Exchange Rates: Short-Run Behavior and Market Equilibrium

1. Lecture 5 UNDERSTANDING EXCHANGE RATES (2)

2. A typical trading desk for spot forex

3. Volatility USD/EUR, tick chart

4. Exchange rates in the short run • The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates. • In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $).

5. Comparing expected returns across nations • We consider Euroland the “home country”, and the domestic currency €. • The USA are the “foreign country” with the foreign currency $. Euro deposits bearan interest rate i€. Dollar deposits bearan interest rate i$. How does Hans, the European, compare the return on dollar deposits abroadwith the return on domesticinvestments in € ?

6. Comparing expected returns across nations • If Hans invests in the USA, he must realize that his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €. • If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%.

7. Comparing expected returns across nations • More formally

8. Comparing expected returns across nations • If Bill invests in Euroland, he must realize that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $. • If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€  ), then the expected return is 3% + 10% = 13%.

9. Comparing expected returns across nations • More formally

10. The key point: RET$ and RET€ are symmetrical (with opposite sign) As the relative expected return on €-deposits increases, both domestic and foreign residentsrespond in the same way: they want to holdmore €-deposits and fewer deposits in $.

11. Interest parity condition • At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk. • When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:

12. Why? Arbitrage and liquidity trading • Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition

13. Market adjustment: Examples We assume: i$ = 10%, and wet+1 = 1 $/€. • When wt = 1.0 $/€, the expected appreciation/ depreciation of the €  = 0% and the expected return in € is then equal to i$ = 10% (Point B). • When wt = 0.95 $/€, wet = 0.052 =5.2%, and the expected return in € = 4.8% (Point A). • When wt = 1.05 $/€, wet = -0.048 =-4.8%, and the expected return in € = 14.8% (Point C).

14. E D Equilibrium in forex markets wt ($/€) RET$ RET€ 1.05 C 1.00 B 0.95 A 14.8% 5.2% 10% Expected return (€)

15. What happens in disequilibrium • When w ≠ 1.0, there is a market reaction: • w > 1: People will try to sell € and buy $.=> “Selling €” and “buying $” • But no one holding $ will sell at that price, there is “excess supply” of euros;i.e. the price of €-deposits relative to $-deposits must fall. • The amount of dollars per euro falls, the euro depreciates.

16. What happens in disequilibrium • When : • w < 1: People will try to sell $ and buy €.=> “Selling $” and “buying €” • But no one holding € will sell at that price, there is “excess supply” of dollars;i.e. the price of $-deposits relative to €-deposits must fall. • The amount of dollars per euro increases, the euro appreciates.

17. Change in the foreign interest rate • If the foreign interest rate increases, the expected return RET$ also increases. • This leads to a depreciation of the euro. • The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate).

18. Equilibrium in forex markets wt ($/€) RET$ RET€ RET$ wB B C wC iD Expected return (€)

19. Change in the domestic interest rate • An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET€ schedule to the right, and leads to a rise in the exchange rate. • It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €.

20. Equilibrium in forex markets wt ($/€) RET€ RET$ RET€ wC C wB B i€C i€B Expected return (€)

21. What about inflation ? • If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific • Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate. • On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate.

22. Factors that affect the exchange rate Change invariable Exchange rate change

23. The analysis of forex markets

24. Share of financial innovations Volume of forex transactions, in bill.$ Daily, month of April

25. € 30 ¥ 20 3 £ 11 2 $ € Other SFr 5 1 Other 25 2 2 Forex turnover by currency pairs (in per cent)

26. Forex transactions by market place (April 2001)

27. Volume of trading by groups of actors Bill. US dollars per day With traders With other financial institutions With non-financial institutions Actors in forex markets

28. Citygroup 9,74 Deutsche Bank 9,08 Goldman Sachs 7,09 JP Morgan 5,22 Chase Manhattan Bank 4,69 Credit Suisse First Boston 4,10 UBS Warburg 3,55 State Street Bank & Trust 2,99 Bank of America 2,99 Morgan Stanley Dean Witter 2,87 The forex market is highly concentrated

29. And will be concentrated even more … • Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology. • On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction.

30. Short and long run: the $/DEM-market

31. Short and long run: the $/£-market

32. Pound sterling during the 1992 crisis • Mastertextformat bearbeiten • Zweite Ebene • Dritte Ebene • Vierte Ebene • Fünfte Ebene

33. The Asian crisis 1997-98

34. The crisis of the Argentinian peso

35. Systemic stability of the financial sector

36. Factors driving the financial sector • The financial system is in a continuing flux driven by transactions costs motives. • The developments of forex markets demonstrate the importance of cost reduction. • The strategies are • Bundling of funds (economies of scale) • Risk reduction through diversification • Explicit Hedging • Expertise (legal, technological)

37. Information inefficiencies • Market participants can have insufficient information about their counterparts (asymmetric information). It leads to • Adverse selection. This is an information problem occurring before the transaction:Potential bad credit risks are those who seek loans most actively. • Moral hazard. This occurs after the trans-action: Borrowers may take on big risks.

38. Adverse selection: The ‘lemons problem’ • A ‘lemon’ is a bad car purchased second hand. • Akerlof studied the used-car market and found an asymmetric information problem: • Potential buyers can’t tell a ‘lemon’ from a good car. • They offer an average price,between the value of a lemon and a good car. George Akerlof *1940, Nobel Prize 2001

39. The owner of a used car knows whether the car is good or bad. If the car is a lemon, he is of course happy to sell at the average price. If the car is good, the owner has little incentive to sell at average prices. Transaction volumes are low and the market may even break down. Similar problems arise in the securities markets (bonds, and stocks). An investor will only pay a price that reflects the average quality of firms. Bad firms are happy to take loans from investors. Good firms are not willing to borrow on this market. The ‘lemons problem’

40. Moral hazard in equity contract (1) • Equity contracts (shares) are subject to a particular ‘principal-agent problem’. • Stockholders (principals) are not the same as managers (agents). This separation involves moral hazard because managers may act in their own interest. • Example: Steve has an ice-cream shop, and you become his silent partner. The capital is shared at 10:90. Profits are also shared in these proportions.

41. Moral hazard in equity contract (2) • Option 1: Steve works hard and provides good service, but earns only 10% or the profit. • Option 2: Steve does not provide good service, and uses the capital to buy artwork for his office, a luxury car for business; he thus acquires ‘fringe benefits’ at your expense. • Option 3: Steve is not only a poor manager, but also dishonest. In this case the moral hazard problem may become extreme.

42. Elimination of asymmetric information (1) • A first solution to the problem is the private production and sale of information. • There are professional rating agencies (Standard and Poor’s, Moody’s, Value Line), and you can set up costly monitoring and auditing (state verification) of the firm. • But there is s ‘free-rider problem’ to this. If you buy a security, people my simply copy your behavior without paying for the information. • This erodes potential extra profits, and you may not have bought the information in the first place.

43. Elimination of asymmetric information (2) • A second possibility could be to involve the government in regulating the market. • The objective is to make firms reveal honest information by adhering to standard accounting practices and to disclose pertinent information. • Government can also impose stiff criminal penalties to contain fraud. • Government regulation may ease the asymmetric information problems, but it is difficult to eliminate them totally.

44. Elimination of asymmetric information (3) • A third solution is to involve financial intermediaries as experts in the production of information. • A private loan is not traded, so others cannot watch and imitate (no free rider). • This explains why indirect finance is more important than direct finance. • Larger firms (because they are better known) obtain easier access to capital markets than smaller firms.

45. Systemic instability and financial crises • Financial crises are characterized by abrupt declines in asset prices and by insolvencies of financial and non-financial firms. • Such crises are reoccurring in many countries. They are caused by a sharp increase in adverse selection and moral hazard problems. • Four categories of factors trigger crises: • Increases in interest rates; • Increases in uncertainty; • Asset market effects on balance sheets; and • (Multiple) bank failures.

46. Asset market effects on balance sheets • Balance sheets have important repercussions on the financial system: • A deterioration (fall in stock or housing prices) of the balance sheet reduces the ‘net worth’ of a firm. • Lenders are less willing to lend because of reduced collateral. • This induces moral hazard because borrowers take higher risks. • The increase in moral hazard makes lending less attractive … this reduces economic activity.

47. Typical financial crises Increase inuncertainty Stock marketdecline Increase ininterest rates Deterioration of a bank’s balance sheet Adverse selection andmoral hazard problems worsen Economic activity declines Bank panic Adverse selection andmoral hazard problems worsen Economic activity declines

48. The stock market and speculative frenzies • Stock markets have indeed often created havoc to the economy and to people’s life • Early example: the ‘tulip bubble’ in the Netherlands (approximately 1620 to 1637)

49. The tulip boom • The boom involved rare tulips • Bulb prices rose steadily throughout the 1630s, as ever more speculators wedged into the market. • In 1633, a farmhouse in Hoorn changed hands for three bulbs • In 1637 the bubble stretched ……. and burst !!

50. Precedents of the crisis • The basis of the bubble was an economic boom caused by shocking “new technologies” (Amsterdam merchants were at the center of the new and lucrative East Indies trade) • But enabling the bubble was leveraged through credit, future contracts, and an innovative climate of Dutch finance (that coined new instruments such as options) Did the burst of the bubble drag down the Dutch economy?