FINA2330 tutorial 7
Foreign exchange market
Foreign exchange rates
Foreign exchange rates in Hong Kong are usually quoted
as 1 (or 100) unit of foreign currency against x units of
domestic currency (direct quote).
Example: 1 USD = 7.77 HKD as of Nov 13
1 GBP (Pound Sterling) = 10.19 HKD
100 HKD = 91.5 CNY (indirect quote)
Foreign exchange rate fluctuates over time.
Purchasing power parity (PPP)
Theoretically, if basket of goods on average
worth the same across the world, exchange
rates across the globe should match the
purchasing power of each country.
Big Mac index, using price of Big Mac across the
world, often used to illustrate PPP and FX rates
should follow PPP in the long run
Non tradable goods, Capital flows, Trade
barriers are not taken into account, limiting
usefulness
Interest rates and exchange rates
As the Fed rises interest rates significantly
recently, USD appreciates against all major
currencies. Reasons are given as following:
US interest rates rise more significantly than other
countries, causing traders sell foreign currencies
and purchase USD denominated bonds for
profit (carry trade)
Interest rates and exchange rates
Demand for USD denominated assets rises, then
USD appreciates against foreign currencies.
Investors can benefit from the trade because
they can borrow foreign bonds at lower interest
rate and purchase USD bonds at higher interest
rate.
Factors affecting exchange rates
Import barrier (tariff): appreciation
It makes foreign goods more expensive for domestic consumers, reducing
the demand for those goods. Since foreign currency is needed to buy
foreign goods, a lower demand for imports means a lower demand for
foreign currency.
Higher productivity growth: appreciation
This makes a country's exports cheaper and more competitive on the global
market. To buy these exports, foreign buyers need to purchase the domestic
currency, increasing its demand and causing appreciation.
Rising expected domestic price level: depreciation
makes domestic assets less attractive. To avoid losses, investors may sell
domestic assets and move their money to other countries, leading to selling of
the domestic currency and causing depreciation.
Factors affecting exchange rates
Rising expected import demand: depreciation
If a country is expected to import more in the future, it will need more foreign
currency to pay for those goods. This increases the supply of the domestic currency
on the forex market (as people sell it to buy foreign currency) and increases the
demand for foreign currencies.
Rising expected foreign export demand: appreciation
If foreign countries are expected to buy more of your exports, they will need to buy
your currency to pay for them. This increased demand for the domestic currency
leads to appreciation.
Exchange rate in the short run: mainly through asset demand
If interest rates in the United States rise significantly above those in Europe, investors
worldwide will sell their low-yielding Euro-denominated bonds and buy high-yielding
US Dollar-denominated bonds.
Long run: mainly through price level and export/ import
demand
A country that is highly productive and produces goods the world wants will run
a trade surplus (exports > imports). To buy those exports, foreign customers need to
buy the country's currency, creating long-term, structural demand for it.
International assets at central banks
Central banks across the world hold some assets
denominated in major foreign currencies in international
reserves.
For example, Chinese and Japanese central banks hold
billions of US treasury securities in international reserves
Both international reserves and domestic assets kept at
the Fed are used to issue USD notes, their total levels
determine the monetary base (then the money supply).
Unsterilized Sale of foreign assets
If the fed wants to let USD appreciate, they can sell
foreign assets in exchange for US Dollars. These are the
effects:
Decrease in international reserves
Decrease in monetary base (Currency in Circulation +
Reserve held by Commercial bank at central bank)
Like contractionary monetary policy (selling domestic
assets), domestic interest rate also rises.
USD appreciates against foreign currencies
Sterilized Sale of foreign assets
The fed may sell foreign assets and buy domestic assets
that worth the same as the former, so monetary base
remains unchanged.
International reserve drops but NO change in USD
exchange rate.
The exchange rate may still move if this policy gives
signal to market for expected change in future
monetary policies.
Practice Question 7 Q3
If the inflation rate in the United States is higher than that in
Germany and productivity is growing at a slower rate in
the United States than it is in Germany, in the long run,
A) the euro should appreciate relative to the dollar.
B) the euro should depreciate relative to the dollar.
C) there should be no change in the euro price of dollars.
D) it is not clear what will happen to the euro price of
dollars.
Practice Question 7 Q6
Evidence from the United States during the period 1973-
2012 indicates the correspondence between nominal
interest rates and exchange rate movements is
A) much closer than that between real interest rates and
exchange rate movements.
B) not nearly as close as that between government
spending and exchange rate movements.
C) not nearly as close as that between government
deficits and exchange rate movements.
D) not nearly as close as that between real interest rates
and exchange rate movements.
Practice Question 7 Q7
With the start of the subprime financial crisis in August 2007, the
dollar ________ in value against the euro as the Fed lowered
interest rates. By December of 2008, with the financial crisis
spreading throughout Europe, foreign central banks cut their
interest rates, leading to a ________ in the value of the dollar
relative to the euro.
A) rose; further increase
B) rose; decline
C) declined; rise
D) declined; further decline
Practice Question 7 Q10
Holding other factors constant, which of the following
would decrease the size of the U.S. current account
deficit?
A) An increase in the amount of services purchased from
foreigners
B) An increase in the amount of goods purchased from
foreigners
C) An increase in the amount of goods sold to foreigners
D) Only A and B of the above