International Economics Lecture 17

Exchange Rate Determination in the Short Term: FOREX Markets, Interest Parity and Overshooting

1. Exchange rate determination Introduction: Characteristics of the Foreign Exchange Market and demand for foreign currency Exchange rate determination in the short run, medium run and long run
i. ii. Short term: Interest rate parity, sticky prices and overshooting Long term:
– – Price Neutrality and nominal exchange rates Puchasing Power Parity and real exchange rates


1. Foreign Exchange Market Basics
• Exchange Rate Quote:
– Direct: the price of foreign currency in terms of domestic currency – Indirect: vise versa

• We stick to the indirect quote in this course unless otherwise stated..
– i.e. exchange rate increase means depreciation

• The exchange rate is determined by supply and demand for foreign currency3

The Foreign Exchange Market
• The exchange rate is determined in the FOREX Market
– Exception: non-market determined official exchange rates, controls and rationing of FX, occurrence of dual exchange rates

• Actors: FOREX markets:
– Commercial banks (inter-bank market, retail) – Corporates with international operations (current transactions and hedging) – Non-bank financial institutions (pension-, mutual funds) – Central banks (foreign exchange intervention)

The Foreign Exchange Market
• Inter-bank “wholesale” trading: the largest part of foreign currency trading • FOREX trading volumes are enormous, have exploded in recent years
– International financial integration – IT, internet – Arbitrage is instantaneous


FOREX Instruments
• Spot market:
– over the counter (OTC) – Bid-Ask spreads

• Currency Derivatives (hedging instruments):
– Forward exchange market:
• Contract to buy/sell FX at a specified price (forward price) and future date • OTC – tailor made • Sell and buy currency forward

FOREX Instruments
• Futures:
– Standardized and traded forward contract – Trade on Exchange – Contracts are bought and sold on the Exchange

• Options
– Right to buy (call-option) or sell (put-option) FX at future date and specified price (strike price) – Option price: premium – Trade on Exchange and OTC – American and European Options 7

FOREX Instruments
• Currency Swaps
– OTC – Combination of a spot and a forward transaction

• Currency Swaptions!! Option on a future
currency swap..


Demand for Foreign Currency Assets
• The exchange rate is determined as any other asset price
– the price of one currency against another that ensures equilibrium between supply and demand for foreign currency

Demand for an asset depends on three factors:
1. Expected rate of return 2. Risk (variability of return) 3. Liquidity

Demand for an asset denominated in foreign currency, but which is otherwise identical to domestic asset, is additionally affected by exchange rate risk


Interest Parity
Equilibrium foreign exchange market: UIP or CIP • Given perfect capital mobility, the no-arbitrage condition in the FOREX market leads to the UIP: rt = rft + (Et(st+1) - st)/ st + ηt • Where (Et(st+1) - st)/ st = Expected depreciation of domestic currency = expected appreciation of foreign currency

Covered Interest Partity, CIP
• Using the forward market, financial market participants can hedge (cover) the risk, so that the CIP becomes: rt = rft + (tft+1 - st )/st • (tft+1 - st )/ st : forward exchange premium = 1forward exchange discount • CIP and UIP Assumptions: – Perfect asset substitutability – No liquidity risk – No political risk – Perfect capital mobility


Deviations from CIP
• Empirically, we observe deviations from CIP. Why?
– – – – Perfect asset substitutability, pas Perfect capital mobility, pcm No political risk, pr No liquidity risk, lr

• Differences in these four factors can cause deviations from CIP: rt = rft + (tft+1 - st )/st + ηtpas + ηtpcm + ηtpr + ηtlr

Measuring international capital mobility using CIP
• When capital mobility is not perfect: arbitrage activity is hampered, deviations from CIP • Use this to measure the degree of capital mobility:
– Find two assets similar with respect to risk/return profile and liquidity – Compare two countries with similar political risk factor – Then:

• Deviation from CIP (∆CIP) due to restrictions to or cost of capital flows • ∆CIP = rt – rft – (tft+1 - st )/st = ηtpcm

• EU countries over the last 20 years • Asset: 3 month interbank deposits • Data requirement:
– Interest rate: interbank deposit rates (ex: libor, fibor, cibor) at time t. – Spot exchange rates at time t. – 3 month forward exchange rate at time t.

• Picture shows that capital mobility has increased in last 20 years!

2. Exchange rate determination
• • We want theories to explain the empirical regularities! Stylized facts:
Short term (today): High short term nominal exchange rate volatility – High correlation between short term nominal and real exchange rates Long term (next time(s)): – Nominal exchange rates movements reflect relative price movements in the long term – Long term real exchange rates exhibit long cyclical movements

Exchange rate determination – Short Run
• Short term exchange rate volatility high and exceeds by far price volatility • Theory which explains this: monetary shocks and exchange rate overshooting • Mechanism: Prices are sticky, so monetary shocks are immediately absorbed in exchange rate changes in short run • We develop a simplified graphical version of the standard Dornbusch overshooting model

1. Exchange rates are “jump” variables respond immediately to changing economic environment 2. Volatility can be explained by overshooting behavior 3. Hence high short term volatility of exchange rates 4. In the longer term, prices adjust 5. Hence high correlation between real and nominal exchange rates: the movements are driven by nominal exchange rate volatility, while price movements are only evident in longer-term real exchange rates (next time) 17

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