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Chapter 14: Exchange Rates and the Foreign Exchange Market – An Asset…
Chapter 14: Exchange Rates and the Foreign Exchange Market – An Asset Approach
An exchange rate is the price of one currency in terms of another
They allow comparison of prices across countries by expressing costs in a common currency.
Example (U.S. as domestic, $ as domestic currency, € as foreign):
If E$/€ decreases → the dollar appreciates (fewer $ needed per €)
If E$/€ increases → the dollar depreciates (more $ needed per €)
Depreciation and Appreciation
Depreciation (+E)
The domestic currency loses value relative to a foreign currency. A depreciated currency is less valuable and therefore can be exchanged for a smaller amount of foreign currency.
Imports become more expensive, exports become cheaper.
Appreciation (-E)
The domestic currency gains value relative to a foreign currency. An appreciated currency is more valuable and therefore can be exchanged for a larger amount of foreign currency.
Imports become cheaper, exports become more expensive.
Effect on relative prices
Depreciation lowers the relative price of exports and raises the price of imports.
Appreciation raises the relative price of exports and lowers the price of imports.
The foreign exchange market is where currencies and financial assets are traded across countries.
Commercial and investment banks are the main players
Due to global financial integration, exchange rates are nearly the same worldwide
The Demand for Currency Deposits
Key Factors Influencing Demand
Real rate of return: inflation-adjusted rate of return, which represents the additional amount of goods and services that can be purchased with earnings from the asset. People prefer assets with the highest expected real return.
Expected Exchange Rate Changes
If a foreign currency is expected to appreciate, deposits in that currency become more attractive.
If it’s expected to depreciate, demand for those deposits falls.
Rate of return (interest rate): the percentage change in value that an asset offers during a time period. Higher interest rates make deposits more attractive.
Risk: Riskier assets are less attractive unless they offer higher returns.
Liquidity: More liquid assets are preferred because they’re easier to use for transactions.
To decide between domestic and foreign deposits, investors compare
Domestic interest rate vs.
Foreign interest rate + expected exchange rate of foreign currency relative to the domestic currency
Model of Foreign Exchange Markets
Effect of Spot Exchange Rate Changes (Holding Interest Rates & Expectations Fixed)
Change in Spot Exchange Rate: Depreciation of domestic currency (↑ E$/€)
Effect on Expected Return of Foreign Deposits: ↓ Expected return on foreign deposits
Change in Spot Exchange Rate: Appreciation of domestic currency (↓ E$/€)
Effect on Expected Return of Foreign Deposits: ↑ Expected return on foreign deposits
This is because the initial cost of buying foreign currency rises with depreciation and falls with appreciation, altering the effective return.
Key Concept: Interest Parity Condition
The foreign exchange market is in equilibrium when:
Expected return on domestic deposits = Expected return on foreign deposits (in domestic currency terms). Investors are indifferent.
Interest parity implies that arbitrage in the foreign exchange market is not possible.
When this condition holds, the foreign exchange market is in equilibrium (no excess demand or supply of both domestic and foreign currencies).
Interest parity implies that deposits in all currencies are equally desirable assets.
If Interest Parity Doesn’t Hold
Arbitrage opportunity exists
Investors move funds to the higher-return deposit
This shifts supply/demand and forces exchange rate adjustment until equilibrium (interest parity) is restored
Figure: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits
Figure: Determination of the Equilibrium Dollar/Euro Exchange Rate