Finance 4000

Money and Capital Markets

Seventh lecture

• Brief review of efficient markets

  
  
  
  
  

• Foreign Exchange markets

  
  
  

  • What determines foreign exchange rates?

    
    
    

    • Two particularly important variables

      
      
      

      • Relative price levels

        
        
        

      • Relative interest rates

        
        
        

    • Two particularly important relationships

      
      
      

      • Purchasing power parity

        
        
        

      • Interest-rate parity

        
        
        

    • Purchasing power parity is a relationship between the relative price levels in two countries
    • Interest-rate parity is a relationship between the relative interest rates in the two countries

      
      
      

    • Both purchasing power parity and interest-rate parity are based on arbitrage arguments
• Exchange rates

• • Price at which buy one currency with another currency

Spot versus forward

• • Pounds sterling per dollar or dollars per pound sterling?

    
    
    

  • Appreciation

    
    
    

    • increase in a currency's value

      
      
      

    • increase in what can be bought with a currency

      
      
      

      • decrease in dollars per pounds sterling

        
        
        

      • increase in pounds sterling per dollar

        
        
        

  • Depreciation

    
    
    

    • decrease in a currency's value

      
      
      

    • decrease in what can be bought with a currency

      
      
      

      • increase in dollars per pounds sterling
      • decrease in pounds sterling per dollar
  • Now that we're all thoroughly flustered

    
    
    

  • Generally speaking, foreign exchange rates are quoted as dollars per unit of foreign currency

• • • Just like quotes of other assets or goods and services

      
      
      

    • Dollars per unit of what's being bought

      
      
      

  • If use dollars per unit of foreign currency

    
    
    

    • A fall in the exchange rate is an appreciation

      
      
      

    • An increase in the exchange rate is a depreciation

      
      
      

    • Seems a little strange to have an appreciation associated with a fall

      
      
      

    • So we'll quote exchange rates as the ratio of the amount of foreign currency per unit of domestic currency

      
      
      

      • If the number of pounds sterling per dollar increases, then a dollar buys more pounds sterling and the dollar appreciates

• Purchasing power parity

  
  
  

  • 

    
    
    

    • where E is the exchange rate

foreign currency relative to domestic currency

• • • P^f is the foreign price level

      
      
      

    • P^d is the domestic price level

      
      
      

  • Why should this hold?

    
    
    

    • Consider an individual good

      
      
      

      • Law of one price

        
        
        

      • Net of transportation costs and tariffs, the price of a good should be the same in any two countries

        
        
        

      • Example: steel

        
        
        

      • Can trade inputs instead of good

• • • Why might the law of one price not hold?

      
      
      

      • Goods not identical

        
        
        

      • Nontraded goods and services

        
        
        

        • Should the prices of haircuts be the same in Athens Greece and Athens GA?

          
          
          

        • How about Athens TX and Athens GA?

          
          
          

        • Why or why not?

          
          
          

  • Does purchasing power parity hold?

• • Does purchasing power parity hold?

    
    
    

    • Holds in the "long run"

      
      
      

    • The single most important factor that affects an exchange rate is the relative price level

      
      
      

    • Additional factors that have some effect on exchange rates in the long run

      
      
      

      • Demand for domestic relative to foreign goods

        
        
        

        • An increase in the demand for domestic goods relative to foreign goods -> increase in exchange rate

          
          
          

        • A decrease in the demand for domestic goods relative to foreign goods -> decrease in exchange rate

• • • • Relative productivity of domestic relative to foreign

        
        
        

        • An increase in the productivity of domestic production relative to foreign production -> increase in the exchange rate

• • • • • A decrease in the productivity of domestic production relative to foreign production -> decrease in the exchange rate

• • • • Tariffs and quotas -- not obvious