EXCHANGE RATES & FOREIGN EXCHANGE MARKET: An asset approach

1. EXCHANGE RATES & FOREIGN EXCHANGE MARKET: An asset approach Teacher: Ing. Veronika Miťková, PhD. Subject: International economy Prepared by: Peter Golobar Bratislava, May 2013

2. THEORETICAL ABSTRACT I. • Exchange rates = the price of one‘s country currency in terms of another country‘s currency; they enable us to translate different countries‘ prices into comparable terms; • Changes in exchange rate = depreciation or appreciation; • Depreciation: a rise in the home currency prices of foreign currency, • Appreciation: a fall in the home currency prices of foreign currencies. • Foreign exhange market = market where it is traded in international currencies and where exchange rates are determined; • Spot exchange rates = exchange rates at this point • Forward exchange rate = exchange rate in the future

3. THEORETICAL ABSTRACT II. • The demand for a foreign currency asset: determined by the expected future value: • Interest rate = value of the money in one year, • Expected change of the exchange rate. • Rate of return = the percentage of increased value over some period of time. • Savers care about risks and liquidity. • Dollar rate of return = measured in U.S. dollars. • Interest parity condition = equal expected returns in any currency. DEMAND = desirability

4. NUMERICAL EXAMPLE I. • R€ = today‘s interest rate on a one-year euro deposit; • R$= today‘s interest rate on a one-year dollar deposit; • E$/€ = today‘s dollar/euro exchange rate; • Ee$/€= dollar/euro exchange rate expected to prevail a year from now; • We will calculate a dollar rate of return on a euro deposit in two ways. Which curreny will have a higher rate of return? R€= 0,05 R$= 0,10 E$/€ = 1,10$ Ee$/€ = 1,165$

5. First option through 5 steps: • 1.) Dollar price for 1€ is 1,1$ • 2.) 1€ will be worth in 1 year exactly 1,05€ • 3.) Expected dollar value: 1,165$×1,05€=1,223$ • 4.) Dollar rate of return: (Ee$/€ – E$/€) / E$/€= _% (1,223 – 1,10)/1,10 = 0,123/1,10 = 0,11 –> 11% • 5.) 0,11 > 0,10 ... It is better to hold on to € Dollar return rate on euro deposits Dollar return rate on dollar deposits

6. Second option with a simple rule: • The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of the depreciation of the dollar against the euro (Krugman 200, 334). • Rate of depreciation: (1,165 – 1.10)/1.10 = 0,059 –> 6% R€+ (Ee$/€ – E$/€)/E$/€ = 0,05 + 0,06 = 0,11 -> 11% Expected change – depreciation of the $ DEMAND Interest rate

7. NUMERICAL EXAMPLE II. • Rate of return: R$ – (R€ + (Ee$/€ – E$/€) / E$/€)= R$ – R€ – (Ee$/€ – E$/€) / E$/€ (Krugman 2012, 335) When the difference is positive, dollar deposits yield the higher expected rate of return and when it is negative, euro deposits yield the higher expected rate of return.

8. Data: - A deposit of 10000£/for a year - R$= 0,10 - R£ = 0,10 - E$/£ = 1,50 - Ee$/£ = 1,38 • Rate of apreciation: (1,38 – 1,50)/1,50 = - 0,08 • Dollar rate of return on pound deposit: 0,10 + (- 0,08) = 0,02

9. NUMERICAL EXAMPLE III. (Krugman 2012, 339) How changes in current exchange rates affect expected return: A rise in today‘s euro/dollar exchange rate always lowers the expected dollar return on euro deposits and vice versa.

10. NUMERICAL EXAMPLE IV. • Equilibrium in the foreign exchange market: • The foreign exchange market is in equilibrium when deposits of all currencies offer thesame expected rate of return. • R$ =R€+ (Ee$/€ – E$/€)/E$/€ • Equilibrium

11. Based on: Krugman, P. R., Obstfeld, M. and Melitz M. J. 2012. International Economics – 9th edition. Addison Wesley: U.S.