FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES RELATIVE PURCHASING POWER PARITY

FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES RELATIVE PURCHASING POWER PARITY I Terminology 1 An American Depositary Receipt (ADR) is a security issued in the United States that represents shares of a foreign stock, allowing that stock to be traded in the United States 2 The cross rate is the implicit exchange rate between two currencies (usually non U S ) when both are quoted in some third currency, usually the U S dollar 3 A Eurobond is a bond issued in multiple countries, but denominated in a.

FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES - RELATIVE PURCHASING POWER PARITY I Terminology An American Depositary Receipt (ADR) is a security issued in the United States that represents shares of a foreign stock, allowing that stock to be traded in the United States The cross-rate is the implicit exchange rate between two currencies (usually non-U.S.) when both are quoted in some third currency, usually the U.S dollar A Eurobond is a bond issued in multiple countries, but denominated in a single currency, usually the issuer’s home currency Such bonds have become an important way to raise capital for many international companies and governments Eurocurrency is money deposited in a financial center outside of the country whose currency is involved Foreign bonds, unlike Eurobonds, are issued in a single country and are usually denominated in that country’s currency Often, the country in which these bonds are issued will draw distinctions between them and bonds issued by domestic issuers, including different tax laws, restrictions on the amount issued, and tougher disclosure rules 6.Gilts, technically, are British and Irish government securities, although the term also includes issues of local British authorities and some overseas public sector offerings 7.The London Interbank Offered Rate (LIBOR) is the rate that most international banks charge one another for loans of Eurodollars overnight in the London market LIBOR is a cornerstone in the pricing of money market issues and other short-term debt issues by both government and corporate borrowers 8.There are two basic kinds of swaps = exchanging: Interest rate and currency An interest rate swap occurs when two parties exchange a floating-rate payment for a fixed-rate payment, or vice versa Currency swaps are agreements to deliver one currency in exchange for another Often, both types of swaps are used in the same transaction when debt denominated in different currencies is swapped II FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES 1.Foreign Exchange Markets The foreign exchange market (also called the forex or FX market) is the world’s largest financial market in which one country’s currency is traded for another country’s currency The foreign exchange market is an over-the-counter market, so there is no single location where traders get together Instead, market participants are located in the major commercial and investment banks around the world They communicate using computer terminals, telephones, and telecommunications devices One communications network for foreign transactions is maintained by the Society for Worldwide Interbank Financial Telecommunication (SWIFT), a Belgian not-for-profit cooperative Using data transmission lines, a bank in New York can send messages to a bank in London via SWIFT regional processing centers The many different types of participants in the foreign exchange market include the following: Importers who pay for goods using foreign currencies Exporters who receive foreign currency and may want to convert to the domestic currency Portfolio managers who buy or sell foreign stocks and bonds Foreign exchange brokers who match buy and sell orders Traders who “make a market” in foreign currencies Speculators who try to profit from changes in exchange rates 2.Exchange Rates a Exchange Rate Quotations A direct quote is a foreign exchange rate quoted in fixed units of foreign currency in variable amounts of the domestic currency In other words, a direct currency quote asks what amount of domestic currency is needed to buy one unit of the foreign currency—most commonly the U.S dollar (USD) in forex markets In a direct quote, the foreign currency is the base currency, while the domestic currency is the counter currency or quote currency This can be contrasted with an indirect quote, in which the price of the domestic currency is expressed in terms of a foreign currency, or what is the amount of domestic currency received when one unit of the foreign currency is sold The use of direct quotes versus indirect quotes depends on the location of the trader asking for the quote, as that determines which currency in the pair is domestic and which is foreign Non-business publications and other media usually quote foreign exchange rates in direct terms for the ease of consumers However, the foreign exchange market has quoting conventions that transcend local borders A direct quote can be compared to an indirect quote as its inverse, or by the following expression: DQ = 1/IQ b Cross-Rate Triangle Arbitrage A cross rate is a foreign currency exchange transaction between two currencies that are both valued against a third currency In the foreign currency exchange markets, the U.S dollar is the currency that is usually used to establish the values of the pair being exchanged When a cross-currency pair is traded, two transactions are actually involved The trader first trades one currency for its equivalent in U.S dollars The U.S dollars are then exchanged for another currency In the transaction described above, the U.S dollar is used to establish the value of each of the two currencies being traded For example, if you were calculating the cross rate of the British pound versus the euro, you would first determine that the British pound, as of Dec 18, 2020, was valued at 0.74 to one U.S dollar, while the euro was valued at 0.82 to one U.S dollar Triangular arbitrage is the result of a discrepancy between three foreign currencies that occurs when the currency's exchange rates not exactly match up These opportunities are rare and traders who take advantage of them usually have advanced computer equipment and/or programs to automate the process A trader employing triangular arbitrage, for example, would exchange an amount at one rate (EUR/USD), convert it again (EUR/GBP), and then convert it finally back to the original (USD/GBP), and assuming low transaction costs, net a profit Example of Triangular Arbitrage: As an example, suppose you have $1 million and you are provided with the following exchange rates: EUR/USD = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939 With these exchange rates there is an arbitrage opportunity: Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110 Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171 Sell pounds for dollars: £591,171 x 1.6939 = $1,001,384 Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384 c Types Of Transactions There are basic types of trades in the foreign exchange market: spot trades and forward trades 3.1 Spot trade A spot trade is an agreement to exchange currency “on the spot”, which means that the transactions will be completed or settled within two business day The exchange rate on a spot trade is called the spot exchange rate All of the exchange rates and transactions we have discussed so far have reffered to the spot market 3.2 Forward trade A forward trade is an agreement to exchange currency at some time in the future The exchange rate that will be used is agreed upon today and is called the forward exchange rate A forward trade will normally be settled sometime in the next 12 months 3.3 Figure 21.1 If you look at Figure 21.1, you will see forward exchange rates quoted for some of the major currencies Suppose the spot exchange rate for the Swiss franc is SF 1=$1.1373 The 180-day (6 months) forward exchange rate is SF 1=$1.1391 This means you can buy a Swiss franc today for $1.1373, or you can agree to take delivery of a Swiss franc in 180 days and pay $1.1391 at that time The Swiss franc is more expensive in the forward market ($1.1391>$1.1373) Because the Swiss franc is more expensive in the future than it is today It is said to be selling at a premium relative to the dollar For the same reason, the dollar is said to be selling at a discount relative to the Swiss franc The forward market exists to allow businesses and individuals to lock in a future exchange rate today, thereby eliminating any risk from unfavorable shifts in the exchange rate III Purchasing Power Parity 1,Absolute purchasing power parity: a, Definition: Absolute purchasing power parity (APPP) is the basic PPP theory, which states that a commodity costs the same regardless of what currency is used to purchase it or where it is sold A more simple idea is once two currencies have been exchanged, a basket of goods should have the same value ⇒ The theory is based on converting other world currencies into the US dollar For example: If the price of a can of coca cola cost $1.50 USD in The US, and the exchange rate is €0.7 per euro, then through APPP a coca cola can should cost €2.14 EUR in Germany ⇒ In other words, absolute PPP implies that $1.50 USD will buy you the same number of coca cola can anywhere in the world b, How to calculate using APPP: To be more specific, if: · S0 is the spot exchange rate between the EUR and the USD (Time 0) · PUS and PEU as the current US and Europe prices Respectively, on a particular commodity, using Absolute PPP will tell us that: PEU = S0 × PUS ⇒ This means the Europe price for something is equal to the U.S price for that same thing multiplied by the exchange rate The rationale behind PPP is similar to that behind triangle arbitrage Unless PPP hold, arbitrage would be possible if apples were moved from one country to another Suppose apples are selling in The US for $4, whereas in Europe the price is €2.40 Absolute PPP can implies that: €2.40 = S0 × $4 S0 = €2.40/$4 = £0.60 That is, the implied spot exchange rate is€ 0.60 per dollar Finally, a euro is worth: $1/€0.60 = $1.67 Suppose that, instead, the exchange rate is €0.50 Starting with $4, a trader could buy apples in The US, ship them to Europe, and sell them there for €2.40 Our trader could then convert the €2.40 into dollars at the prevailing exchange rate, S0 = €0.50, yielding a total of €2.40/0.50 = $4.80 The round-trip gain would be 80 cents Because of this profit potential, forces are set in motion to change the exchange rate or the price of apples In our example, apples would begin moving from The US to Europe The reduced supply of apples in the US would raise the price of apples there, and the increased supply in Europe would lower the price of apples In addition to moving apples around, apple traders would be busily converting euros back into dollars to buy more apples This activity would increase the supply of euros and simultaneously increase the demand for dollars We would expect the value of a euro to fall This means that the dollar would be getting more valuable, so it would take more euros to buy one dollar Because the exchange rate is quoted as euros per dollar, we would expect the exchange rate to rise from €0.50 c, Conclusion: Now we learn that for absolute PPP to hold absolutely, several things must be true: · The transaction costs of trading apples - shipping, insurance, spoilage, and so on, must be zero · There must be no barriers to trading apples - no tariffs, taxes, or other political barriers · Finally, traded goods in The US must be identical to the one in Europe With the example above, this means that absolute PPP won’t apply to people who send red apples to Europe if the locals eat only green apples Given the fact that the transaction costs aren’t free and that the other conditions are rarely met, it is not surprising that absolute PPP is really applicable only to traded goods, and then only to very uniform ones ⇒ For this reason, absolute PPP does not imply that a Mercedes costs the same as a Ford or that a nuclear power plant in Russia costs the same as one in Germany In the case of the cars, they are not identical In the case of the power plants, even if they were identical, they are expensive and would be very difficult to transfer On the other hand, we would be surprised to see a significant violation of absolute PPP for gold RELATIVE PURCHASING POWER PARITY Definition Relative Purchasing Power Parity (RPPP) is an expansion of the traditional purchasing power parity (PPP) theory to include changes in the exchange rate with inflation over time To make it easier to understand, RPPP does not tell us what determines the absolute level of the exchange rate Instead, it tells what determines the change in the exchange rate over time For example: Suppose the British pound–U.S dollar exchange rate is currently S0 = £.50, the inflation rate in Britain is predicted to be 10 percent over the coming year, and (for the moment) the inflation rate in the United States is predicted to be percent => The prices in Britain are rising at a rate of 10% − 4% = 6% per year, the predicted exchange rate is £.50 × 1.06 = £.53 How to calculate RPPP In general, relative PPP says that the change in the exchange rate is determined by the difference in the inflation rates of the two countries Based on our preceding discussion, to be more specific, we will use the following notation: S0 = Current (Time 0) spot exchange rate (foreign currency per dollar) E(St ) = Expected exchange rate in t periods hUS = Inflation rate in the United States hFC = Foreign country inflation rate Relative PPP says that the expected percentage change in the exchange rate ov er the next year, [E(S1 ) − S0 ]/S0 , is: [E(S1 ) − S0]/S0 = hFC − hUS => E(S1 ) = S0 × [1 + (hFC − hUS)] In words, relative PPP says that the expected percentage change in the exchange rate is equal to the difference in inflation rates In our example involving Britain and the United States, relative PPP tells us that the exchange rate will rise by hFC − hUS= 10% − 4% = 6% per year Assuming the difference in inflation rates doesn’t change, the expected exchange rate in two years, E(S2 ), will be: E(S2 ) = E(S1 ) × (1 + 06) = 53 × 1.06 = 562 So, the overall formula of exchange rate in the future is E(St ) = S0 × [1 + (hFC − hUS)]t Relative PPP also tells us that the exchange rate will rise if the U.S inflation rate is lower than the foreign country’s inflation rate This happens because the foreign currency reduce in value and weakens relative to the dollar Conclusion Relative purchasing power parity (RPPP) is an economic theory that exchange rates and inflation rates (price levels) in two countries should equal out over time Relative PPP is an extension of absolute PPP in that it is a dynamic (as opposed to static) version of PPP While PPP is useful in understanding macroeconomics in theory, in practice RPPP does not seem to hold true over short time horizons  ... debt denominated in different currencies is swapped II FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES 1 .Foreign Exchange Markets The foreign exchange market (also called the forex or FX market) is... currency reduce in value and weakens relative to the dollar Conclusion Relative purchasing power parity (RPPP) is an economic theory that exchange rates and inflation rates (price levels) in two... transfer On the other hand, we would be surprised to see a significant violation of absolute PPP for gold RELATIVE PURCHASING POWER PARITY Definition Relative Purchasing Power Parity (RPPP) is an