Topic 2 -- M14_Krugman_46657_09_IE_C14_F_GE

Copyright©2012PearsonEducation.Allrightsreserved.Chapter14ExchangeRatesandtheForeignExchangeMarket:AnAssetApproachCopyright©2012PearsonEducation.Allrightsreserved.14-2Preview•Thebasicsofexchangerates•Exchangeratesandthepricesofgoods•Theforeignexchangemarkets•Thedemandofcurrencyandotherassets•Amodelofforeignexchangemarkets–roleofinterestratesoncurrencydeposits–roleofexpectationsofexchangeratesCopyright©2012PearsonEducation.Allrightsreserved.14-3DefinitionsofExchangeRates•Exchangeratesarequotedasforeigncurrencyperunitofdomesticcurrencyordomesticcurrencyperunitofforeigncurrency.–Howmuchcanbeexchangedforonedollar?¥89.40/$–Howmuchcanbeexchangedforoneyen?$0.011185/¥•Exchangeratesallowustodenominatethecostorpriceofagoodorserviceinacommoncurrency.–HowmuchdoesaNissancost?¥2,500,000–Or,¥2,500,000x$0.011185/¥=$27,962.50Copyright©2012PearsonEducation.Allrightsreserved.14-4Table14-1:ExchangeRateQuotationsCopyright©2012PearsonEducation.Allrightsreserved.14-5DepreciationandAppreciation•Depreciationisadecreaseinthevalueofacurrencyrelativetoanothercurrency.–Adepreciatedcurrencyislessvaluable(lessexpensive)andthereforecanbeexchangedfor(canbuy)asmalleramountofforeigncurrency.–$1/€→$1.20/€meansthatthedollarhasdepreciatedrelativetotheeuro.Itnowtakes$1.20tobuyoneeuro,sothatthedollarislessvaluable.–Theeurohasappreciatedrelativetothedollar:itisnowmorevaluable.Copyright©2012PearsonEducation.Allrightsreserved.14-6DepreciationandAppreciation(cont.)•Appreciationisanincreaseinthevalueofacurrencyrelativetoanothercurrency.–Anappreciatedcurrencyismorevaluable(moreexpensive)andthereforecanbeexchangedfor(canbuy)alargeramountofforeigncurrency.–$1/€→$0.90/€meansthatthedollarhasappreciatedrelativetotheeuro.Itnowtakesonly$0.90tobuyoneeuro,sothatthedollarismorevaluable.–Theeurohasdepreciatedrelativetothedollar:itisnowlessvaluable.Copyright©2012PearsonEducation.Allrightsreserved.14-7DepreciationandAppreciation(cont.)•Adepreciatedcurrencyislessvaluable,andthereforeitcanbuyfewerforeignproducedgoodsthataredenominatedinforeigncurrency.–ANissancosts¥2,500,000=$25,000at$0.010/¥–becomesmoreexpensive$27,962.50at$0.011185/¥•Adepreciatedcurrencymeansthatimportsaremoreexpensiveanddomesticallyproducedgoodsandexportsarelessexpensive.•Adepreciatedcurrencylowersthepriceofexportsrelativetothepriceofimports.Copyright©2012PearsonEducation.Allrightsreserved.14-8DepreciationandAppreciation(cont.)•Anappreciatedcurrencyismorevaluable,andthereforeitcanbuymoreforeignproducedgoodsthataredenominatedinforeigncurrency.–ANissancosts¥2,500,000=$27,962.50at$0.011185/¥–becomeslessexpensive$25,000at$0.010/¥•Anappreciatedcurrencymeansthatimportsarelessexpensiveanddomesticallyproducedgoodsandexportsaremoreexpensive.•Anappreciatedcurrencyraisesthepriceofexportsrelativetothepriceofimports.Copyright©2012PearsonEducation.Allrightsreserved.14-9Table14-2:$/£ExchangeRatesandtheRelativePriceofAmericanDesignerJeansandBritishSweatersCopyright©2012PearsonEducation.Allrightsreserved.14-10ForeignExchangeMarkets•Thesetofmarketswhereforeigncurrenciesandotherassetsareexchangedfordomesticones–Institutionsbuyandselldepositsofcurrenciesorotherassetsforinvestmentpurposes.•Thedailyvolumeofforeignexchangetransactionswas$4.0trillioninApril2010–upfrom$500billionin1989.•Mosttransactions(85%inApril2010)exchangeforeigncurrenciesforU.S.dollars.Copyright©2012PearsonEducation.Allrightsreserved.14-11ForeignExchangeMarketsTheparticipants:1.Commercialbanksandotherdepositoryinstitutions:transactionsinvolvebuying/sellingofdepositsindifferentcurrenciesforinvestmentpurposes.2.Non-bankfinancialinstitutions(mutualfunds,hedgefunds,securitiesfirms,insurancecompanies,pensionfunds)maybuy/sellforeignassetsforinvestment.3.Non-financialbusinessesconductforeigncurrencytransactionstobuy/sellgoods,servicesandassets.4.Centralbanks:conductofficialinternationalreservestransactions.Copyright©2012PearsonEducation.Allrightsreserved.14-12ForeignExchangeMarkets(cont.)•Buyingandsellingintheforeignexchangemarketaredominatedbycommercialandinvestmentbanks.–Inter-banktransactionsofdepositsinforeigncurrenciesoccurinamounts$1millionormorepertransaction.–Centralbankssometimesintervene,butthedirecteffectsoftheirtransactionsaresmallandtransitoryinmanycountries.Copyright©2012PearsonEducation.Allrightsreserved.14-13ForeignExchangeMarkets(cont.)•Computerandtelecommunicationstechnologytransmitinformationrapidlyandhaveintegratedmarkets.•Theintegrationoffinancialmarketsimpliesthattherecanbenosignificantdifferencesinexchangeratesacrosslocations.–Arbitrage:buyatlowpriceandsellathigherpriceforaprofit.–Iftheeuroweretosellfor$1.1inNewYorkand$1.2inLondon,couldbuyeurosinNewYork(wherecheaper)andselltheminLondonataprofit.Copyright©2012PearsonEducation.Allrightsreserved.14-14SpotRatesandForwardRates•Spotratesareexchangeratesforcurrencyexchanges“onthespot,”orwhentradingisexecutedinthepresent.•Forwardratesareexchangeratesforcurrencyexchangesthatwilloccuratafuture(“forward”)date.–Forwarddatesaretypically30,90,180,or360daysinthefuture.–Ratesarenegotiatedbetweentwopa