Lecture 5: international financial investment and exchange rate movements

Transaction risk: Value of a transaction is unknown.

Translation risk: Value of a firm’s assets and liabilities is unknown.

Hedging: Seeking a balance between liabilities in foreign currency and assets in foreign currency to cover the risk.
Speculating = Taking over net asset or net liability positions in foreign currency to make a (potential) profit
Arbitrage:Taking advantage of price differences in two markets.(buy cheap and sell expensive to make a profit)

Covered investment

Assumption: Foreign and domestic assets are perfect substitutes.

● Invest in domestic assets (H): earn interest rate iH
● Invest in foreign asset (F): earn interest rate iF
● Investments in both assets have to be expressed in the same currency:

1 domestic currency unit (HCU) today is worth 1/e foreign currency units (FCU).
1 FCU earned in the future is worth f HCU

CIP implies that the interest rate differential should be approximately equal to the forward premium (f – e)/e.

1 HCU invested in domestic assets yields a return of:

1 HCU invested in foreign assets yields a return of:

If many investors take advantage of international arbitrage opportunities, exchange rates will adjust and in
equilibrium foreign and domestic assets yield the same return (no arbitrage possibilities).
● Covered interest parity condition:

Implications: Increase in iF : Foreign assets more attractive → increased demand for foreign currency in
Changes in interest spot market → foreign currency appreciates in spot market (e ↑).
rates will trigger
changes in the Increase in iH: Home assets more attractive → reduced demand for foreign currency in
current spot rate. spot market → foreign currency depreciates in spot market (e ↓).
 Implications: Increase in iF : Foreign assets more attractive → increase in sales (supply) of foreign
Changes in interest currency in forward market → foreign currency depreciates in forward market (f↓).
rates will trigger
changes in the Increase in iH: Home assets more attractive → fewer sales of foreign currency in forward
forward rate. market → foreign currency appreciates in forward market (f↑)

Implications: Increase in e: Foreign asset less attractive (more expensive)→ fewer sales of foreign
Changes in the currency in forward market → foreign currency appreciates in forward market (f ↑).
current spot rate will
trigger changes in Fall in e: Foreign asset more attractive (cheaper)→ more sales of foreign currency in
the forward rate. forward market → foreign currency depreciates in forward market (f ↓).

Uncovered investment

Uncovered investment
● Invest in domestic assets: earn interest rate iH
● Invest in foreign asset: earn interest rate iF
● Investments into both assets have to be expressed in the same currency:

1 domestic currency unit (HCU) today is worth 1/e foreign currency units (FCU).

1 FCU earned in the future is expected to be worth ex HCU.

1 HCU invested in domestic assets yields a return of:

› 1 HCU invested in foreign assets yields an expected return of:

› Investors will invest in the currency that offers the highest expected return.

If many investors take advantage of international arbitrage opportunities, exchange rates will adjust and in
Equilibrium foreign and domestic assets will yield the same return (no arbitrage possibilities).
→ Uncovered interest parity condition:

In the end the two will be the same, there are no differences in the end. The returns in the 2 markets will be equal to
each other.
● Using this condition we can calculate the value of whichever paramenter
 Implications: increase in iH: Domestic assets more attractive → increased demand for domestic currency
Changes in interest → domestic currency appreciates (e ↓).
rates will trigger
changes in the Increase in iF : Foreign assets more attractive → increased demand for foreign currency →
current spot rate. foreign currency appreciates (e ↑).

implications: Rise in e ex ( = expected appreciation of foreign currency) → foreign assets more attractive
Changes in the → increased demand for foreign currency in today’s spot market → foreign currency
expected future appreciate (e ↑).
spot rate will
trigger changes in This implies self-fulfilling expectations: Expectations of an appreciation of a currency will
the current spot trigger actual appreciation of the currency.
rate.

that under uncovered investment, the actual future return on the foreign asset is unknown!
Investors make comparisons and investment decisions based on the expected future exchange rate.
If the expectations turn out to be wrong, the actual return on investment will be different.
Risk averse investors prefer covered investment if otherwise the conditions are the same.

Exchange rates short run

In the short run, exchange rate movements are driven In the long run, exchange rate movements are driven by
by the behavior of financial investors (supply and the demand and supply for different countries’ goods
demand for financial assets). and services.

Reason: Differences in returns to financial investments If there are price differences between Home and
are easily observable and financial portfolios can be Foreign on a tradable good, some people will take
repositioned almost very quickly and at almost zero cost advantage of this: Buy where it is cheap and sell where
it is expensive.
Uncovered interest parity implies a link between
interest rates, expected, and actual exchange rates. If many people do so, exchange rates will adjust so that
prices between Home and Foreign converge → Law of
→ Short-run exchange rate movements are driven by one price/Purchasing power parity (PPP).
changes in interest rates and expected exchange rates
(pp. 31) In the long-run, exchange rate movements are driven
by the demand and supply for different countries’
→ Anything that changes the expected return on products (PPP condition).
foreign assets relative to domestic assets will trigger
changes in the spot exchange rate.. International price differences and changes in domestic
and foreign prices will cause adjustments in the
exchange rate.

Hence, in the long-run exchange rates will move toward

values that are consistent with PPP.
Law of one price/purchasing power parity

Products that are easily and freely tradable should have the same price everywhere (ε = 1) so that there are no
international arbitrage opportunities:

Works well for heavily traded products (e.g. crude oil, gold, other metals.)

Exchange rates in the long run

Increase in PH → domestic goods less competitive → more demand for foreign goods (imports) and foreign currency
→ foreign currency appreciates (e ↑).

› Increase in PF → foreign goods less competitive → more demand for domestic goods (exports) and domestic
currency → foreign currency depreciates
(e ↓).

PPP exchange rate

The nominal exchange rate consistent with PPP is called the PPP exchange rate.

This is the exchange rate at which 𝜀 = 1.

› In the long-run, we expect the nominal exchange rates to move in the direction of the PPP exchange rate.

Relative PPP
Changes in the exchange rate are related to changes in countries’ prices over time (= inflation):

Rate of change in exch. Rate between time t and time t+1 = Difference in inflation rates
Implications of relative PPP

A country with a relatively high inflation rate will have a depreciating currency (= declining nominal exchange rate
value of its currency).

A country with a relatively low inflation rate will have an appreciating currency (= increasing nominal exchange rate
value of its currency).

The rate of appreciation or depreciation will be approximately equal to the percentage-point difference in the
inflation rates.

Adjustment to the PPP exchange rate

What is driving the adjustment of the nominal exchange rate to the PPP exchange rate? Suppose domestic prices are
higher/rise faster than foreign prices:
● Domestic goods become more expensive for foreigners/foreign goods become cheaper.
● Decline in exports/rise in imports.
● Less demand for domestic currency.
● Depreciation of the domestic currency.

Testing for PPP

Absolute PPP holds if the (effective) real exchange rate equals 1 (= 100%).

● Real exchange rate equals 1

Relative PPP holds if the (effective) real exchange rate is a horizontal line (→ movements in e follow movements in
PH and PF so that the real exchange rate remains constant.)

● Change in exchange rate equals change in prices.

Determinants of prices
PPP theory predicts that exchange rates are closely related to price differences across countries and the rate of
appreciation/depreciation is related to differences in inflation across countries.

What can explain the national price level and the inflation rate?

The Monetary Approach predicts that country’s inflation rates are directly linked to their rates of money growth and
income growth.

Money supply (MS) must equal money demand (MD).

The latter depends on transaction demand, which is proportional to a country’s gross domestic product (Y)
and price level (P) [k is a parameter]:
Quantity theory of money
Rewriting leads to:

In terms of percentage changes:

Inflation equals: change in price = change in
money supply - change in gross output.

Quantity theory of money

Combining with the relative PPP condition implies:

Difference in change in money supply home -

foreign country - change in smth

Money supply change can explain

Country very high rate of money growth, you

can imagine that this country will experience
inflation= higher prices = currency will
experience depreciation

PPP and international income comparisons

Lots of research devoted to understanding why there are differences in standards of living across countries.
Requires a proper measurement of standard of living differences. Usually, researchers use income data.\
Problem: Standard income data are not comparable because of price differences across countries.