Asset Approach

1. Asset Approach

2. Demand for Foreign Currency Assets • What will the deposit be worth in the future? • ① the interest rate • ② expected change in the currency’s exchange rate against other currency

3. Asset return • the percentage increase in value it offers over some time period. • Your decision must be based on an expected rate of return. • the expected real rate of return.

4. Risk and Liquidity • Risk:the variability it contributes to savers’ wealth; Savers dislike uncertainty… • Liquidity: the ease with which the asset can be sold or exchanged for goods; …the cost and speed at which savers can dispose of them.

5. Interest Rates • A charge for a loan, usually a percentage of the amount loaned. • the amount of currency an individual can earn by lending a unit of the currency for a year. • The depositor is acquiring an asset denominated in the currency it deposits.

6. Table 13-3. A Simple Rule page 345

7. When the difference above is positive, dollar deposits yield the higher expected rate of return; when it is negative, euro deposits yield the higher expected rate of return.

8. Return, Risk, and Liquidity • Because payments connected with international trade make up a very small fraction of total foreign exchange transactions, we ignore the liquidity motive for holding foreign currencies.

9. Management of International Reserve • 微观管理： 盈利性： 利率，资产收益在除去通货膨胀以后 美元 储备资产 没有倒闭，管制的嫌疑 SDRs 随时兑现，调拨 欧元 日元 马克 黄金 流动性： 安全性：

10. Equilibrium in the Foreign Exchange Market • When market participants willingly hold the existing supplies of deposits of all currencies, this implies that the foreign exchange market is in equilibrium.

11. Parity • The equivalent in value of a sum of money expressed in terms of a different currency at a fixed, official rate of exchange. • Equality of prices of goods or securities in two different markets.

12. Interest Parity • The basic equilibrium condition • The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Basic Concept

13. Current affect Expected Returns • Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Excel

14. Interest Rates, Expectations, and Equilibrium • The exchange rate (which is the relative price of two assets) responds to factors that alter the expected rates of return on those two assets.

15. The Effect of Changing Interest Rates on the Current Exchange Rate • An increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies.

16. The Perils of Forecasting Exchange Rates • Forward rates contain little information useful in predicting future spot rates. • Forward rates might be related to expected future spot rates. • Contradictions?

17. Contradictions? • A rise in the expected future exchange rate causes a rise in the current exchange rate. Similarly, a fall in the expected future exchange rate causes a fall in the current exchange rate.

18. Asset Approach • Because the exchange rate is the relative price of two assets, it is most appropriately thought of as being an asset price itself. • The basic principle of asset pricing is that an asset’s current value depends on its expected future purchasing power. • Savers care about an asset’s expected real rate of return.

19. Summary of Covered Interest Parity CIP UIP Covered transactions do not involve exchange rate risk, non-covered transactions do.

20. Empirical Evidence: Does UIP fit the facts? • In this case it is not immediately possible to compute a UIP-consistent spot rate as might be suggested by the approach to this question in the case of PPP and CIP. This is because we don’t observe Se

21. All tests of UIP face this problem and there are various possible ways of overcoming this, none of them perfect: (i) Use market survey-based forecasts of S. (ii) Use a forecasting model to generate Se. (iii) Assume rational expectations and use the actual future S on the assumption that the market gets the forecasts right on average to S if just Se with a random error. In this case the expected rate of depreciation is just the actual rate of depreciation.

22. The upshot of this discussion is that generally UIP fits the facts very poorly. This is rather surprising in the light of the close fit for the CIP model. A comparison of the two models throws some light on this:

23. CIP, UIP and Forward Market Efficiency Recall CIP and UIP: CIP: (1+i) = F.(1+i*)/S UIP: (1+i) = Se.(1+i*)/S It is clear that they are equivalent if F = Se. • This is the condition of forward market efficiency; i.e. that the forward rate equals the market’s forecast of the future spot rate.

24. CIP fits the facts and UIP doesn’t. It results from the fact that the condition for forward market efficiency doesn't hold. There has been a great deal of empirical work on this question and while there is still disagreement as to why the condition does not hold, most explanations give an important role to risk premium – the fact that taking out fwd cover means that the CIP condition does not involve FX risk but this is not the case for UIP in which case investors require a premium to bear the risk inherent in the UIP condition.