Chapter 3

Chapter 3
Exchange Rates and the

Foreign Exchange Market:
An Asset Approach
Learning Objectives
3.1 Relate exchange rate changes to changes in the relative
prices of countries’ exports.
3.2 Describe the structure and functions of the foreign
exchange market.
3.3 Use exchange rates to calculate and compare returns on
assets denominated in different currencies.
3.4 Apply the interest parity condition to find equilibrium
exchange rates.
3.5 Find the effects of interest rates and expectation shifts on
exchange rates.
3.6 Classification of exchange rates
3 By Ngoc Thang Doan, BAV
Preview
• The basics of exchange rates
• Exchange rates and the prices of goods
• The foreign exchange markets
• The demand of currency and other assets
• A model of foreign exchange markets
– role of interest rates on currency deposits
– role of expectations of exchange rates
By Ngoc Thang Doan, BAV

Definitions of Exchange Rates
• Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency.
– How much can be exchanged for one dollar?
– How much can be exchanged for one yen? $$0.01027

¥
• Exchange rates allow us to denominate the cost or price of
a good or service in a common currency.
– How much does a Nissan cost? ¥2,500,000
– Or, ¥2,500,000 ´ $0.01027 = $25,672.50

¥
Table 3.1 Exchange Rate Quotations (1 of 5)
CURRENCIES
DOLLAR EURO EURO POUND POUND
DOLLAR Day’s Closing Day’s Closing Day’s
Jan 19 Currency Closing Mid Change Mid Change Mid Change
Argentina Argentine Peso 15.9795 0.0015 16.9597 −0.1293 19.6613 −0.0603
Australia Australian Dollar 1.3250 0.0031 1.4061 −0.0076 1.6303 −0.0014
Bahrain Bahrainin Dinar 0.3771 0.0000 0.4001 −0.0030 0.4639 −0.0014
Bolivia Bolivian Boliviano 6.9300 - 7.3538 −0.0568 8.5267 −0.0269
Brazil Brazilian Real 3.2087 −0.0094 3.4049 −0.0363 3.9480 −0.0241
Canada Canadian Dollar 1.3327 0.0233 1.4142 0.0139 1.6398 0.0235
Chile Chilean Peso 661.4250 2.0350 701.8740 −3.2428 813.8212 −0.0597
China Chinese Yuan 6.8766 0.0424 7.2971 −0.0110 8.4610 −0.0256
Colombia Colombian Peso 2942.8500 7.4950 3122.8189 −16.0953 3620.9004 −2.1895
Costa Rica Costa Rican Colon 553.0400 3.3600 586.8608 −0.9380 680.4637 1.9971
Czech Republic Czech Koruna 25.4634 0.1957 27.0206 0.0007 31.3303 0.1426
Denmark Danish Krone 7.0073 0.0534 7.4358 −0.0003 8.6218 0.0387
Egypt Egyptian Pound 18.9085 0.0350 20.0648 −0.1175 23.2651 −0.0303
Hong Kong Hong Kong Dollar 7.7569 0.0008 8.2313 −0.0626 9.5441 −0.0291

DOLLAR EURO POUND
DOLLAR Day’s EURO Day’s POUND Day’s
Jan 19 Currency Closing Mid Change Closing Mid Change Closing Mid Change
Hungary Hungarian Forint 290.9580 3.0774 308.7513 0.9071 357.9963 2.6673
India Indian Rupee 68.1625 0.1060 72.3309 −0.4451 83.8675 −0.1342
Indonesia Indonesian Rupiah 13373.5000 31.0000 14191.3620 −76.4156 16454.8381 −13.7391
Israel Israeli Shekel 3.8222 0.0157 4.0559 −0.0145 4.7029 0.0045
Japan Japanese Yen 115.2950 2.0200 122.3458 1.2155 141.8596 2.0450
..One Month Blank 115.2949 2.0198 122.3458 1.2156 141.8596 2.0449
..Three Month Blank 115.2945 2.0191 122.3458 1.2156 141.8594 2.0445
..One Year Blank 115.2927 2.0155 122.3459 1.2156 141.8596 2.0437
Kenya Kenyan Shilling 103.9000 - 110.2539 −0.8512 127.8392 −0.4039
Kuwait Kuwaiti Dinar 0.3054 0.0002 0.3240 −0.0023 0.3757 −0.0009
Malaysia Malaysian Ringgit 4.4490 0.0045 4.7211 −0.0316 5.4741 −0.0117
Mexico Mexican Peson 21.9550 0.1729 23.2976 0.0050 27.0136 0.1280
New Zealand New Zealand Dollar 1.3942 0.0049 1.4795 −0.0061 1.7154 0.0007
Nigeria Nigerian Naira 304.7500 −10.0000 323.3868 −13.1902 374.9662 −13.5278
Norway Norwegian Krone 8.4894 0.0389 9.0086 −0.0279 10.4454 0.0151

DOLLAR DOLLAR EURO POUND
Closing Day’s EURO Day’s POUND Day’s
Jan 19 Currency Mid Change Closing Mid Change Closing Mid Change
Pakistan Pakistani Rupee 104.8050 - 111.2143 −0.8587 128.9527 −0.4075
Peru Peruvian Nuevo Sol 3.3408 −0.0062 3.5451 −0.0340 4.1105 −0.0206
Philippines Philippine Peso 49.9875 0.1900 53.0445 −0.2064 61.5049 0.0402
Poland Polish Zloty 4.1188 0.0378 4.3707 0.0067 5.0678 0.0306
Romania Romanian Leu 4.2381 0.0334 4.4973 0.0010 5.2146 0.0248
Russia Russian Ruble 59.8644 0.5419 63.5254 0.0890 73.6575 0.4361
Saudi Arabia Saudi Riyal 3.7505 −0.0001 3.9798 −0.0308 4.6146 −0.0147
Singapore Singapore Dollar 1.4296 0.0082 1.5170 −0.0029 1.7590 0.0046
South Africa South African Rand 13.6088 0.1300 14.4410 0.0275 16.7443 0.1075
South Korea South Korean Won 1177.6000 10.8500 1249.6154 1.9545 1448.9259 8.8139
Sweden Swedish Krona 9.0063 0.0963 9.5571 0.0292 11.0814 0.0839
Switzerland Swiss Franc 1.0107 0.0091 1.0725 0.0014 1.2435 0.0072
Taiwan New Taiwan Dollar 31.5900 0.0465 33.5219 −0.2091 38.8685 −0.0654
Thailand Thai Baht 35.3785 0.0680 37.5420 −0.2171 43.5299 −0.0536
Tunisia Tunisian Dinar 2.3061 0.0244 2.4471 0.0072 2.8374 0.0212

Turkey Turkish Lira 3.8317 0.0630 4.0660 0.0359 4.7145 0.0628
United Arab
Emirates UAE Dirham 3.6731 0.0001 3.8977 −0.0300 4.5194 −0.0142
United Kingdom Pound Sterling 0.8127 0.0026 0.8624 −0.0039 - -
..One Month blank 0.8128 0.0026 0.8624 −0.0039 - -
..Three Month blank 0.8130 0.0026 0.8623 −0.0039 - -
..One Year blank 0.8141 0.0026 0.8616 −0.0039 - -
United States
United States Dollar - - 1.0612 −0.0082 1.2304 −0.0039
..One Month blank - - 1.0610 −0.1731 1.2305 −0.0039
..Three Month blank - - 1.0607 −0.1731 1.2307 −0.0039
..One Year blank - - 1.0589 −0.1732 1.2318 −0.0038
Venezuelan
Venezuela Bolivar Fuerte 9.9950 0.0050 10.6062 −0.0765 12.2979 −0.0327
22565.000
Vietnam Vietnamese Dong 0 −8.0000 23944.9840 −193.3965 27764.1271 −97.6229

European Union Euro 0.9424 0.0072 - - 1.1595 0.0052
..One Month blank 0.9422 0.0072 - - 1.1594 0.0053
..Three Month blank 0.9419 0.0072 - - 1.1594 0.0052
..One Year blank 0.9401 0.0072 - - 1.1587 0.0053
Rates are derived from WM Reuters Spot Rates and MorningStar (latest rates at time of production). Some
values are rounded. Currency redenominated by 1000. The exchange rates printed in this table are also
available at www.FT.com.

Depreciation and Appreciation (1 of 4)
• Depreciation is a decrease in the value of a currency
relative to another currency.
– A depreciated currency is less valuable (less
expensive) and therefore can be exchanged for (can
buy) a smaller amount of foreign currency.
– $1/€ → $1.20/€ means that the dollar has depreciated
relative to the euro. It now takes $1.20 to buy one euro,
so that the dollar is less valuable.
– The euro has appreciated relative to the dollar:
it is now more valuable.

• Appreciation is an increase in the value of a currency
relative to another currency.
– An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for (can
buy) a larger amount of foreign currency.
– $1/€ → $0.90/€ means that the dollar has appreciated
relative to the euro. It now takes
only $0.90 to buy one euro, so that the dollar is more
valuable.
– The euro has depreciated relative to the dollar:
it is now less valuable.

• A depreciated currency is less valuable, and therefore it
can buy fewer foreign produced goods that are
denominated in foreign currency.
¥2,500,000 ´ $0.01027
– A Nissan costs = $25,672.50
¥
– Less expensive than $27,962.50 at $0.011185
¥
• A depreciated currency means that imports are more
expensive and domestically produced goods and exports
are less expensive.
• A depreciated currency lowers the price of exports relative
to the price of imports.
An appreciated currency is more valuable, and therefore it
can buy more foreign produced goods that are denominated
in foreign currency.
– A Nissan costs ¥2,500,000 = $27,962.50 at $0.011185
¥
$0.010
– becomes less expensive $25,000 at
¥
• An appreciated currency means that imports are less
expensive and domestically produced goods and exports
are more expensive.
• An appreciated currency raises the price of exports relative
to the price of imports.
Table 3.2 $/£ Exchange Rates and the Relative Price
of American Designer Jeans and British Sweaters
Exchange rate $/£ 1.25 1.50 1.75
Relative price (pairs of jeans/sweater) 1.39 1.67 1.94
Note: The above calculations assume unchanged money prices of $40 per pair
of jeans and £50 per sweater.

Foreign Exchange Markets (1 of 4)
• The set of markets where foreign currencies and other
assets are exchanged for domestic ones
– Institutions buy and sell deposits of currencies or
other assets for investment purposes.
• The daily volume of foreign exchange transactions was
$4.0 trillion in April 2010
– up from $500 billion in 1989.
• Most transactions (85% in April 2010) exchange foreign
currencies for U.S. dollars.

The participants:
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in
different currencies for investment purposes.
2. Non-bank financial institutions (mutual funds, hedge
funds, securities firms, insurance companies, pension
funds) may buy/sell foreign assets for investment.
3. Non-financial businesses conduct foreign currency
transactions to buy/sell goods, services and assets.
4. Central banks: conduct official international
reserves transactions.
• Buying and selling in the foreign exchange market are
dominated by commercial and investment banks.
– Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more
per transaction.
– Central banks sometimes intervene, but the direct
effects of their transactions are small and transitory
in many countries.

• Computer and telecommunications technology transmit
information rapidly and have integrated markets.
• The integration of financial markets implies that there can
be no significant differences in exchange rates across
locations.
– Arbitrage: buy at low price and sell at higher price for a
profit.
– If the euro were to sell for $1.1 in New York and $1.2 in
London, could buy euros in New York (where cheaper)
and sell them in London at a profit.

Spot Rates and Forward Rates
• Spot rates are exchange rates for currency exchanges
“on the spot,” or when trading is executed in the present.
• Forward rates are exchange rates for currency
exchanges that will occur at a future (“forward”) date.
– Forward dates are typically 30, 90, 180, or 360 days
in the future.
– Rates are negotiated between two parties in the
present, but the exchange occurs in the future.

Figure 14.1 Dollar/Pound Spot and
Forward Exchange Rates, 1983–2016
Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spot
exchange rates, at end of month.
Other Methods of Currency Exchange (1 of 3)
• Foreign exchange swaps: a combination of a spot sale
with a forward repurchase.
• Swaps allow parties to meet each other’s needs for a
temporary amount of time and often cost less in fees than
separate transactions.
– For example, suppose Toyota receives $1 million from
American sales, plans to use it to pay its California
suppliers in three months, but wants to invest the
money in euro bonds in the meantime.

• Futures contracts: a contract designed by a third party
for a standard amount of foreign currency
delivered/received on a standard date.
– Contracts can be bought and sold in markets, and only
the current owner is obliged to fulfill the contract.

• Options contracts: a contract designed by a third party
for a standard amount of foreign currency
delivered/received on or before a standard date.
– Contracts can be bought and sold in markets.
– A contract gives the owner the option, but not
obligation, of buying or selling currency if the need
arises.

The Demand of Currency Deposits (1 of 12)
• What influences the demand of (willingness to buy)
deposits denominated in domestic or foreign currency?
• Factors that influence the return on assets determine the
demand of those assets.

• Rate of return: the percentage change in value that an
asset offers during a time period.
– The annual return for $100 savings deposit with an
interest rate of 2% is $100 × 1.02 = $102, so that the
rateof return =
( $102 - $100 )
= 2%
$100

• Real rate of return: inflation-adjusted rate of return,
which represents the additional amount of goods &
services that can be purchased with earnings from the
asset.
– The real rate of return for the above savings deposit
when inflation is 1.5% is 2% − 1.5% = 0.5%. After
accounting for the rise in the prices of goods and
services, the asset can purchase 0.5% more goods
and services after 1 year.

• If prices are fixed, the inflation rate is 0% and (nominal)
rates of return = real rates of return.
• Because trading of deposits in different currencies occurs
on a daily basis, we often assume that prices do not
change from day to day.
– A good assumption to make for the short run.

• Risk of holding assets also influences decisions about
whether to buy them.
• Liquidity of an asset, or ease of using the asset to buy
goods and services, also influences the willingness to
buy assets.

• But we assume that risk and liquidity of currency
deposits in foreign exchange markets are essentially
the same, regardless of their currency denomination.
– Risk and liquidity are only of secondary importance
when deciding to buy or sell currency deposits.
– Importers and exporters may be concerned about
risk and liquidity, but they make up a small fraction
of the market.

• We therefore say that investors are primarily concerned
about the rates of return on currency deposits.
• Rates of return that investors expect to earn are
determined by
– interest rates that the assets will earn
– expectations about appreciation or depreciation

• A currency deposit’s interest rate is the amount of a
currency that an individual or institution can earn by
lending a unit of the currency for a year.
• The rate of return for a deposit in domestic currency is
the interest rate that the deposit earns.
• To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider
– the interest rate for the foreign currency deposit
– the expected rate of appreciation or depreciation of
the foreign currency relative to the domestic
currency.
Figure 14.2 Interest Rates on Dollar and
Yen Deposits, 1978–2016
Since dollar and yen interest rates are not measured in comparable terms,
they can move quite differently over time.
Source: Datastream. Three-month interest rates are shown.
• Suppose the interest rate on a dollar deposit is 2%.
• Suppose the interest rate on a euro deposit is 4%.
• Does a euro deposit yield a higher expected rate
of return?
– Suppose today the exchange rate is $1/€1, and the
expected rate one year in the future is $0.97/€1.
– $100 can be exchanged today for €100.
– These €100 will yield €104 after one year.
– These €104 are expected to be worth $0.97/€1 × €104
= $100.88 in one year.

• The rate of return in terms of dollars from investing in euro
deposits is $100.88 - $100
( ) = 0.88%.
$100
• Let’s compare this rate of return with the rate of return from a
dollar deposit.
– The rate of return is simply the interest rate.
– After 1 year the $100 is expected to yield $102:
( $102 - $100 ) = 2%
$100
• The euro deposit has a lower expected rate of return: thus, all
investors should be willing to dollar deposits and none should
be willing to hold euro deposits.
• Note that the expected rate of appreciation of the euro was
$0.97 - $1
= -0.03 = -3%.
$1
• We simplify the analysis by saying that the dollar rate of
return on euro deposits approximately equals
– the interest rate on euro deposits
– plus the expected rate of appreciation of euro deposits
– 4% + −3% = 1% ≈ 0.88%
E e $ / € - E$ / €
– R€ +
E$ / €

• The difference in the rate of return on dollar deposits and
euro deposits is

Table 3.3 Comparing Dollar Rates of
Return on Dollar and Euro Deposits

Model of Foreign Exchange Markets (1 of 6)
• Construct model of foreign exchange markets using:
– the demand of (rate of return on) dollar denominated
deposits
– and the demand of (rate of return on) foreign currency
denominated deposits

• Model in equilibrium when deposits of all currencies offer
the same expected rate of return: interest parity.
– Interest parity implies that deposits in all currencies are
equally desirable assets.
– Interest parity implies that arbitrage in the foreign
exchange market is not possible.
• Interest parity says:
E e $ / € - E$ / €
R$ = R€ +
E$ / €

• Why should the interest parity condition hold?
– Suppose it did not. Suppose
E e $ / € - E$ / €
R$ > R€ +
E$ / €
– Then no investor would want to hold euro deposits,

driving down the demand and price of euros.
– Then all investors would want to hold dollar deposits,
driving up the demand and price of dollars.
– The dollar would appreciate and the euro would
depreciate, increasing the right side until equality was
achieved.
• How do changes in the current exchange rate affect the
expected rate of return of foreign currency deposits?
• Depreciation of the domestic currency today lowers the
expected rate of return on foreign currency deposits.
– When the domestic currency depreciates, the initial
cost of investing in foreign currency deposits increases,
thereby lowering the expected rate of return of foreign
currency deposits.

• Appreciation of the domestic currency today raises the
expected return of deposits on foreign currency deposits.
– When the domestic currency appreciates, the initial
cost of investing in foreign currency deposits
decreases, thereby lowering the expected rate of
return of foreign currency deposits.

Table 3.4 Today’s Dollar/Euro Exchange Rate and the
Expected Dollar Return on Euro Deposits When Ee$/€
= $1.05 per Euro

Figure 3.3 The Relation between the Current
Dollar/Euro Exchange Rate and the Expected Dollar
Return on Euro Deposits
An appreciation of the dollar against the euro raises the expected return
on euro deposits, measured in terms of dollars.
Figure 3.4 Determination of the Equilibrium
Dollar/Euro Exchange Rate
Equilibrium in the foreign exchange market is at point 1, where the

expected dollar returns on dollar and euro deposits are equal.
• The effects of changing interest rates:
– an increase in the interest rate paid on deposits
denominated in a particular currency will increase the
rate of return on those deposits.
– This leads to an appreciation of the currency.
– Higher interest rates on dollar-denominated assets
cause the dollar to appreciate.
– Higher interest rates on euro-denominated assets
cause the dollar to depreciate.

Figure 3.5 Effect of a Rise in the Dollar
Interest Rate
A rise in the interest rate offered by dollar deposits causes the dollar to
appreciate from point 1 to point 2.
Figure 3.7 Cumulative Total Investment Return in
Australian Dollar Compared to Japanese Yen, 2003-
2013
The Australian dollar-yen carry trade has been profitable on average

but is subject to sudden large reversals, as in 2008.
Covered Interest Parity
• Covered interest parity relates interest rates across
countries and the rate of change between forward
exchange rates and the spot exchange rate:
F$ / € - E$ / €
R$ = R€ +
E$ / €
where F$/€ is the forward exchange rate.
• It says that rates of return on dollar deposits and
“covered” foreign currency deposits are the same.
– How could you earn a risk-free return in the foreign
exchange markets if covered interest parity did not
hold?
– Covered positions using the forward rate involve little
risk.
Exchange rate classification
• Based on exchange • Based on the effect

rate policy on trade
üOfficial rate üNominal exchange rate
(NER)
üBlack market rate
üReal exchange rate
üFixed rate
(RER)
üFree floating rate
üNominal effective
üManaged floating rate exchange rate (NEER)
üReal effective
exchange rate (REER)
51
INTERNATIONAL TRADE COMPETITIVENESS

• Static form:
- If the quantity of exports is greater (or the quantity of imports is

lower) than the trading partner’s à the country has higher
competitiveness position of international trade (Net-export > 0)
- If the quantity of exports is lower (or the quantity of imports is

greater) than the trading partner’s à the country has lower
competitiveness position of international trade (Net-export < 0)
• Dynamic form:
- When the growth rate of exports in terms of quantity is faster

than that of imports, international trade competitiveness is
improved. (EX/IM increase)
- When the growth rate of imports in terms of quantity is faster

than that of exports, international trade competitiveness is
eroded. (EX/IM decrease)

Nominal bilateral exchange rate
- NER
Definition
@Nominal bilateral exchange rate (NER) is the

price of a currency denominated in another
currency without mentioning their purchasing
power of goods and services.

The index of nominal bilateral exchange rate
òNominal ER at the original period: E0
ò Nominal ER at the period t: Et
è Exchange rate index: e0t = (Et : E0) . 100%
e0t >100% Commodity currency(C)

Terms currency (T)
Commodity currency(C)
e0t <100%
Terms currency (T)
Example:
t0 : 1 USD = 23.000 VND
t1: 1 USD = 23.500 VND
(%C) = [(E1 – E0):E0 ]*100%
(%T) = [(E0 – E1):E1]*100%

Currency appreciation and depreciation
ò Currency appreciation is an increase in
the value of one currency in terms of
another
ò Currency depreciation is a decrease in

the value of one currency in terms of
another

Real bilateral exchange rate (RER)
Definition:
RER is the nominal exchange rate adjusted by the domestic
and foreign inflation rates; therefore, it is an indicator of the
correlation of purchasing power between domestic and
foreign currencies.

Æ RER in the absolute form
foreign price level
in domestic
currency
er = E . P* EP
. *
=
P P
domestic price
level in domestic
currency
RER indicates the comparison between foreign and

domestic price levels when both are in domestic currency
• If er > 1 à E.P*> P:
+ Foreign price level > domestic price level
+ Encourage exports, discourage imports
+ Higher international trade competitiveness
+ VND is real undervalued
• If er < 1à E.P*< P:
+ Foreign price level < domestic price level
+ Encourage imports, discourage exports
+ Lower international trade competitiveness
+ VND is real overvalued
• If er = 1 à E.P*= P à two currencies are at purchasing
power parity (PPP) By Ngoc Thang Doan, BAV
Percentage of real overvaluation or undervaluation
QF, QD are the quantities of
QF- QD. 100
vr = goods bought in the foreign
QD % and domestic country with 1
unit of currency respectively
+ If vr > 0, the currency is real overvalued

+ If vr < 0, the currency is real undervalued
+ If vr = 0, two currencies are at purchasing
power parity

Example
Ú US:
Ú Vietnam:
1 H = P*(USD)
1 H = P (VND)
1 H = E.P* (VND)
1VND = 1/P (H)
1 VND = 1/E.P* (H)
(1/E.P* - P 1
VTr = = - 1= -1
1/P)
1/P E.P er
*
VCr = er - 1
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Æ RER in the relative form
0*
CPIt . 100%
ert =et
0 0
. 0
CPIt
CPIt
0* Pt*
et =
0 Et =
E0 P0*
CPIt
0 Pt
=
P0
The ratio index of RER

ÆImplication of changes in RER
• RER increase:
§Decrease in relative purchasing power of
domestic currency
§Improve international trade competitiveness of
that country
• RER decreases:
§Increase in relative purchasing power of
domestic currency
§Erode international trade competitiveness of
that country
• RER unchanged: helps maintain international trade
competitiveness of that country By Ngoc Thang Doan, BAV
Æ RER in the relative form

Comment on international trade
Ex: competitiveness of Vietnam across periods:
t Et et0 CPIt0* CPIt0 ert0(%)

(CNY/VND) (%) (%) (%)
0 2.000 100 100 100 100
1 2.000 100 120 100 120
2 2.400 120 120 120 120
3 1.800 90 130 117 100
4 1.500 75 150 125 90

Question 1: Calculate the percentage of appreciation and depreciation of
currencies if the information is as follows:
Free market rate: USD / VND = 22,670
State Bank: USD / VND = 22,497
Question 2: Calculating the rate of devaluation and revaluation of
currencies if the State Bank adjusted the official rate from 22,505 to
22,650?
Question 3: Calculate the percentage of real overvalued and undervalued
currencies if the information is as follows: USD/CNY= 6,7268. The
“standard basket of goods” in the US and China are 1,000 USD and
5,000 CNY, respectively. Commenting on the position of international
trade competitiveness between the two countries?
Question 4: Calculate the real exchange rate in the dynamic state if you
know the following information: USD / VND exchange rate at the
beginning of the year is 22,626 and the end of the year is 22,800. Yearly
inflation of USD and VND was 2% and 9.5% respectively. Comment on
the change of international trade competitiveness between the two
countries?
Nominal effective exchange rate
• Nominal Effective Exchange Rate (NEER), also

known as the average exchange rate.
• NEER is the average exchange rate index of
one currency relative to other currencies
• NEER indicates one currency appreciates or
depreciates against the rest of the currency
basket
• What is the relationship between NEER and a
country's international trade competitiveness
???

71
NEER (Cont.)
Determination of NEER:
- S1: Determination of monetary basket: it is the currency
of all countries having trade relations accounting for a large
proportion in the country's total international trade
turnover.
- S2: Determining the proportion of currencies in the
basket, which is the proportion of international trade
In particular, the country's exports to that of a

partner country, and the country's import from that of a
partner country
- S3: Multilateral nominal exchange rate (NEER) is
determined as follows:

72
NEER (Cont.)
• For example: Based on Vietnam's 2007 import and export data,
the trade shares of the Vietnam’s trading partners are as follows:
Currency Share Currency Share

US dollar 0.3927 Korean won 0.0583
Chinese yuan 0.1426 Thai baht 0.0429
Japanese yen 0.1101 Malaysian ringgit 0.0331
Euro (DM) 0.09 Hong Kong dollar 0.0227
Singapore dollar 0.0882 British pound 0.015

73
Real Effective Exchange Rate

The Real Effective Exchange Rate (REER) is the nominal multilateral exchange
rate adjusted by the domestic inflation rate with all the remaining countries.
Compute REER:
- S1: Calculate NEER

- S2: Calculate the average inflation index of all currencies in the basket with
weighted trade
B3: Calculate REER by the formula: CPI i W

REERi = NEERi
CPI iHome
In which: CPIiW average consumer n index of all currencies in the basket.

price
CPI i = å CPI i * w j
w j
CPIiHome: domestic consumer

j =1 price index

74
REER (Cont.)
§ Static form:
- REER> 100:
+ Local currency has low real valuation
+ The competitiveness position in the country is higher than that of other countries
- REER <100:
+ Local currency has a high real valuation
+ The competitiveness position in the country is inferior to that of other partners
§ Dynamic form
- REER increase: local currency devaluated, domestic competitiveness improved
- REER decrease: local currency revaluated, domestic competitiveness eroded

Summary (1 of 5)
1. An exchange rate is the price of one country’s currency
in terms of another country’s currency.
• It enables us to translate different countries’ prices
into comparable terms.

Summary (2 of 5)
2. Depreciation of a currency means that it becomes less
valuable and goods denominated in it are less expensive:
exports are cheaper and imports more expensive.
3. Appreciation of a currency means that it becomes more
valuable and goods denominated in it are more
expensive: exports are more expensive and imports
cheaper.

Summary (3 of 5)
4. Commercial and investment banks that invest in deposits
of different currencies dominate the foreign exchange
market.
– Expected rates of return are most important in
determining the willingness to hold these deposits.
5. Rates of return on currency deposits in the foreign
exchange market are influenced by interest rates and
expected exchange rates.

Summary (4 of 5)
6. Equilibrium in the foreign exchange market occurs when
rates of returns on deposits in domestic currency and in
foreign currency are equal: interest rate parity.
7. An increase in the interest rate on a currency’s deposit
leads to an increase in its expected rate of return and to
an appreciation of the currency.

Summary (5 of 5)
8. An expected appreciation of a currency leads to an
increase in the expected rate of return for that currency,
and leads to an actual appreciation.
9. Covered interest parity says that rates of return on
domestic currency deposits and “covered” foreign
currency deposits using the forward exchange rate are
the same.

Chapter 3 - Exchange Rates and The Foreign Exchange Market

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Chapter 3 - Exchange Rates and The Foreign Exchange Market

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Exchange Rates and the

By Ngoc Thang Doan, BAV

– How much can be exchanged for one yen? $$0.01027

– Or, ¥2,500,000 ´ $0.01027 = $25,672.50

By Ngoc Thang Doan, BAV

By Ngoc Thang Doan, BAV

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Exchange rate $/£ 1.25 1.50 1.75

Relative price (pairs of jeans/sweater) 1.39 1.67 1.94

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– Then no investor would want to hold euro deposits,

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Equilibrium in the foreign exchange market is at point 1, where the

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The Australian dollar-yen carry trade has been profitable on average

• Based on exchange • Based on the effect

INTERNATIONAL TRADE COMPETITIVENESS

- If the quantity of exports is greater (or the quantity of imports is

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@Nominal bilateral exchange rate (NER) is the

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e0t >100% Commodity currency(C)

(%C) = [(E1 – E0):E0 ]*100%

(%T) = [(E0 – E1):E1]*100%

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ò Currency depreciation is a decrease in

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RER indicates the comparison between foreign and

+ If vr > 0, the currency is real overvalued

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