International Economics

An Overview

Foreign exchange

Foreign exchange market
 Largest and most liquid market in the world __ total world turnover in a

single day in 2006 was USD 1400 billion (approx).  No central market - key markets in several cities around the world  Participating banks and brokers are in constant contact via phone and computer
 Three general types of transaction
  

Between banks and their customers Domestic interbank market conducted through brokers Trading with overseas banks____

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The Major Players
      

The major players are____ Individuals: tourists, migrants Firms: importers and exporters Banks: short position, long position, square position Governments/ monetary authorities: market intervention International agencies: lending Two tier market: First tier: ultimate customer and banker  Second tier: between banks

Classifications of participants__

 Non-banking entities: business transactions and hedging  Banks: foreign exchange dealers  Arbitrageurs: profit seeking from variations in rates in

different markets  Speculators: profit seeking from movements in exchange rates
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Foreign exchange

Types of FX transactions
 Spot transactions - executed nearly immediately  Forward transactions - agreement to buy or sell a currency

at a date in the future, at a rate agreed in advance
 Currency swaps - agreement to trade one currency for

another now, and to trade currencies back again later, both at prices agreed at the beginning

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Foreign exchange

Foreign exchange quotations
 Exchange rate is the price of one currency in terms of another  One country’s currency has depreciated when more of it is

needed to buy a unit of a foreign currency (is worth less relative to the other currency) [ direct quote like $ 1 = Rs. 39.75]
 A currency has appreciated when less of it is needed to buy a

foreign currency (is worth more relative to the other currency)
 Two –way quote: $ 1 = INR 39.72 / 77  With a spread of .05

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Foreign exchange

Foreign exchange quotations
 Cross exchange rate between two currencies is

calculated from their exchange rates with a third, benchmark currency - frequently the US dollar
 Since USD is the anchor currency, any INR / CAD

rate will be given by dealer in India with the help of cross rates___ through INR / USD and CAD / USD rates

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Foreign exchange markets

Forward markets, futures & options
 Forward contracts obligate buyer to buy or sell a certain amount

of foreign currency at a future date_ margin money deposited with the seller bank

Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement

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Some concepts
 Appreciation  Depreciation  Cross rates  Anchor currency  Arbitrage  Speculation  Open position  Close position

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Foreign exchange markets

Forward markets, futures & options
 Futures, traded on special exchanges, are contracts

to trade given amounts of currencies at a specified date

Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates

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Foreign exchange markets

Forward markets, futures & options
 Options provide the holder with the right (but not the obligation)

to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option

Options to buy are called call options, and those to sell are called put options Options are frequently used to reduce risk from exchange rate changes Other concepts__ Option : In-the-money: Out-of-the money: At –the- money Asset price, strike price
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Foreign exchange markets

Exchange rate determination

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Theory #1: Purchasing power parity [ Cassel, 1927]

Law of One Price Versions of PURCHASING POWER PARITY

Absolute PPP

Relative PPP

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The Law of One Price
 A commodity will have the same price in terms of common

currency in every country  In the absence of frictions (e.g. shipping costs, tariffs,..)

Example Price of wheat in France (per bushel): P€ Price of wheat in U.S. (per bushel): P$ S€/$ = spot exchange rate

P€ = s€/$ • P$
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Absolute PPP
 Extension of law of one price to a basket of goods  Absolute PPP examines price levels

Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):

where P€ = Σi (wFR,i • p€,i ) PUS = Σi (wUS,i • pUS,i )
S€/$ = P€ / PUS
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Relative PPP Absolute PPP:

P€ = s€/$ • P$

For PPP to hold in one year: P€ (1 + i€) = E(s€/$) • P$ (1 + i$), or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] • P$ (1 + i$) Using absolute PPP to cancel terms and rearranging:

Relative PPP:

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1 + i€ = E(s€/$) 1 + i$ s€/$

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Relative PPP
 Main idea – The difference between (expected) inflation

rates equals the (expected) rate of change in exchange rates:

1 + i€ = E(s€/$) 1 + i$ s€/$

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Interest Rate Parity
START (today) year) $117,228 (Invest in $) END (in one r$=2.24%
$117,228 • 1.0224 = $119,854

s€/$=0.83215

One year

f€/$=0.83435

$117,228 • 0.83215 = 97,551€

(Invest in €) r€=2.51%

97,551€ • 1.0251 = 100,000€
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Summary of theories #1 and #2:
.
Difference in interest rates 1 + r€ 1 + r$
Interest Rate parity

Exp. difference in inflation rates 1 + i€ 1 + i$
Relative PPP

Difference between forward & spot rates f€r/$ s€/$

Expected change in spot rate E(s€/$) s€/$
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Theory #3: The Fisher condition
 Main idea: Market forces tend to allocate resources to their

most productive uses
 So all countries should have equal real rates of interest  Relation between real and nominal interest rates:

(1 + rNominal) = (1 + rReal)(1 + i ) (1 + rReal) = (1 + rNominal) / (1 + i )
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Theory #4: Expectations theory of forward rates
 Main idea:

The forward rate equals expected spot exchange rate f€/$ = E(s€/$)

Expectations theory of forward rates:

f€/$ = E(s€/$ ) s€/$ s€/$

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Important Relations
 1. i = R + п [ nominal interest = real interest + inflation rate]  Fisher Equation  2. F = S + S [ ( i – i* )/ 1+i* ] , or  (F – S )/ S = ( i – i* ) [ approx.]  Covered interest parity  3. i = r + x  [ nominal rate = real rate + expected rate of depreciation of

exchange rate] ==, uncovered interest parity

 4. Forward rate is the unbiased expected value of future

spot rate  These four relations can be related like the next slide==. 
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Summary of all four theories .
Difference in interest rates 1 + r€ 1 + r$
Interest Rate parity

Fisher Theory

Exp. difference in inflation rates 1 + i€ 1 + i$
Relative PPP

Difference between forward & spot rates f€/$ Exp. Theory s€/$ of forward
rates

Expected change in spot rate E(s€/$) s€/$
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Foreign exchange

Impact of an appreciating Indian Rupee
 Pros  Lower prices on foreign goods  Keeps inflation down  Foreign travel is cheaper  Less expensive to invest abroad  Cons  Exporters’ products become more expensive abroad  Imports-competing firms face price competition  Travel more expensive for foreign tourists  Slows inflow of foreign investment
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Foreign exchange

Impact of a depreciating Indian Rupee
 Pros  Exporters can sell abroad more easily  Less competition for Indian firms from imports  Foreign tourism is encouraged  Indian capital markets more attractive  Cons  Higher prices on imports  Upward pressure on inflation  Travel abroad more expensive  Harder for Indian firms to expand into foreign markets

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Foreign exchange markets

Arbitrage and hedging
 Exchange arbitrage involves taking advantage of exchange rate

differences in different markets to make a profit  Helps equalize exchange rates globally

Three point Arbitrage__ Pound, Dollar and Euro__ example

 Three point arbitrage___ let GBP 1 = $ 1.50,

GBP 1 = franc 4, and franc 1 = $ 0.50  arbitrage facility can make a profit by buy and sell of currency through 3-point arbitrage

 Interest arbitrage involves taking advantage of differences in

international interest rates to get a higher return__  Subject to exchange rate risk

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Foreign exchange markets

Arbitrage and hedging
 Hedging involves making use of forward contracts or options to

minimize exchange rate risk in international transactions

Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings

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Foreign exchange markets

Speculation
 Speculation differs from arbitrage, in that it involves the

purchase or sale of a currency in the expectation that its value will change in the future__ basically a position is created in the expectation of positive gain

 Speculation can either reduce or increase volatility in foreign exchange

rates
 

If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency
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What about Indian rupee ?
 How rupee’s exchange rate is determined ?  Present scenario___ INR has appreciated about 12 % in the

last one year…..

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Big Mac Index

Index

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