Chapter 14,Exchange Rates and the Foreign Exchange Market: An Asset Approach,14-2,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,14-3,Definitions of Exchange Rates,Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. Suppose you are U.S. citizen: How much $ can be exchanged for one yen? E$/=$0.011185/ (direct or “American” term) How much yen can be exchanged for one dollar? E/$=89.40/$ (indirect or “European” term) 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 x E$/ (0.011185) = $27,962.50,Examples(cont),The price of one iphone 6(16G) in HK is $720. The exchange rate is ￥6.21/$ ,then： $720 ￥6.21/$ =￥4470 In mainland China, the price is￥5288！ Whats the dollar price of iphone in mainland China？,14-4,14-5,Table 14-1: Exchange Rate Quotations,Data from Bank of China: EYuan/(100 Other Currency),14-6,14-7,Depreciation and Appreciation,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 (or E / $ decreases). 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.,14-8,Depreciation and Appreciation (cont.),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 (or E $/ increases). 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.,14-9,Depreciation and Appreciation (cont.),A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency. A Nissan costs 2,500,000 = $25,000 at E$/=0.01 becomes more expensive $27,962.50 at E$/= 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. (China?),14-10,Depreciation and Appreciation (cont.),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 = $27,962.50 at E$/= 0.011185 becomes less expensive $25,000 at E$/= 0.010 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.,14-11,Table 14-2: $/ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters,Relative price (in the same currency) =Price of Sweater/Price of Jeans =(50*E$/)/$45 =50/($45*E/$),14-12,Foreign Exchange Markets,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.,14-13,Foreign Exchange Markets,The participants: Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. Central banks: conduct official international reserves transactions.,14-14,Foreign Exchange Markets (cont.),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, the impact of their transactions may be large even though the volume of transactions is small.,14-15,Foreign Exchange Markets (cont.),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