Chapter 13

Asset-Market Approach to the Exchange Rate

To understand short-run exchange rate behavior, it is important to recognize that foreign-exchange market activity is dominated by investors in assets such as Treasury securities, corporate bonds, bank accounts, stocks and real property. Today, only about 2 percent of all foreign exchange transactions are related to the nancing of exports and imports. This suggests that most foreign-exchange transactions are attributable to assets being traded in global markets. We take this attribute of the foreign exchange market into account, and will set up a short-run exchange rate model that focuses on investors decisions to purchase assets internationally. The model is appropriately called an asset-market approach to the exchange rate

13.1

Asset-Market Approach to the Exchange Rate

Investors make their nancial decisions by comparing the rates of return of foreign investment with those of domestic investment. If rates of return from foreign investment are larger, they will desire to shift their funds abroad. Interest arbitrage refers to the process of moving funds into foreign currencies to take advantage of higher investment yields abroad. But investors assume a risk when they have foreign investments: when the investments proceeds are converted back into the home currency, their value may fall because of a change in the exchange rate. Example. Suppose you have $100,000 and want to decide if you want to invest in a dollardenominated asset or a euro-denominated asset for a year. To see which asset you want to buy, you need to calculate the rate of return for both assets. You will then choose the currency with the highest rate of return. Lets rst calculate the rate of return to the dollar-denominated asset. Suppose that the interest rate for the dollar-denominated assets is 10%. This implies that if you invest your money into the dollar-denominated assets, your dollar-denominated asset will be worth $100,000*(1+0.1) =

$110,000 in a year. In other words, the rate of return to the dollar-denominated asset will equal the U.S. interest rate. Next, we want to calculate the rate of return to the euro-denominated asset. The rate of return on the euro-denominated asset will not only depend on the interest rate on the euro-denominated asset (8%), but also on the expected change in the currencys exchange rate. To demonstrate this, we need to take a number of steps: 1. Convert $100,000 into euros at the current exchange rate of E euro = 0.8. This will give you $ $100,000 * 0.8 euro/$ = 80,000 euro. 2. With an interest rate of 8%, the euro-denominated asset will be worth euro 80,000*(1+0.08) = euro 86,400 after a year. 3. The nal worth of the euro-denominated asset needs to be reconverted into dollars. Suppose that the dollar is expected to depreciate from 1.3 to 1.354 in a year (depreciation of 4%). In that case, the euro-denominated asset will be worth euro 86,400 * $/euro 1.354 = $116,985.6.

Investing in euro assets is clearly more protable than investing in dollar assets, since you receive $116, 985.6 $10, 000 = $6, 985.6 more from doing so. In conclusion, despite the fact that the interest rate on U.S. deposits is higher than that of European deposits, the rate of return of holding your money in Euro deposits for a year is higher than that of holding it in dollar deposits. The reason is that the depreciation of the dollar has increased the rate of return of holding money in euros.

13.1.1

Simple Rule

The dollar rate of return on dollar deposits is the US interest rate:

(13.1)

Rate of return on dollar-denominated assets = RU S

The dollar rate of return on euro deposits is approximately the euro interest rate plus the expected rate of depreciation of the dollar against the Euro:
e (E$ /euro E$/euro )

(13.2)

Rate of return on dollar-denominated assets = REU +

E$/euro

13.2

Equilibrium in the Foreign Exchange Market: Interest Parity

(E e E$/euro )

If RU S > REU + $/euro E$/euro investors buy dollar deposits. If RU S < REU + $/euro E$/euro buy euro deposits.
(E e

, dollar deposits yield the higher expected rate of return and

E$/euro )

, euro deposits yield the higher expected rate of return and investors

We have already mentioned above that the foreign exchange market is ecient. Foreign exchange traders arbitrage away all dierences in the rate of return of dierent currencies. As a result, the foreign exchange market is in equilibrium when deposits of all currencies oer the same expected rate of return. Only in that case is there no excess supply of some type of deposit and no excess demand of another. This is the interest parity condition.
e (E$ /euro E$/euro )

(13.3)

RU S = REU +

E$/euro

The interest parity condition states that the foreign exchange market is in equilibrium when deposits of all currencies oer the same expected rate of return.

13.3

Exchange Rate as the Equilibrating Force

So how does the interest parity condition nd its equilibrium? As you might expect, the exchange rate will be the equilibrating factor. (E e E$/euro ) Suppose the interest parity condition does not hold. If RU S < REU + $/euro , then nobody E$/euro will want to continue to hold dollar deposits and everybody will want to hold Euro deposits. As a result, investors will start selling dollars for euros in the foreign exchange market, thus inducing a depreciation of the dollar until the interest parity condition holds again. Exercise: What happens to the exchange rate if RU S > REU +
e (E$ E$/euro ) /euro ? E$/euro

Exercise: What happens to the current exchange rate if investors suddenly expect a future depreciation?

13.4

Graphical Representation of the Interest Parity Condition

In this section, we want to represent graphically the interest parity condition in such a way that we can use it to discuss changes in the exchange rate. For this purpose, we will set up a graph in which the exchange rate E$/euro is depicted on the Y-axis and the rate of return to assets is depicted on the X-axis.

A rst thing we want to know if the relation between the exchange rate E$/euro and the rate of return to U.S. assets. Since an exchange rate change has no impact on the the U.S. interest rate, RU S , the rate of return to U.S. assets remains unchanged. We can therefore represent the rate of return to U.S. assets curve as a vertical line at RU S . Suppose that, all else equal, the dollar depreciates. What happens to the rate of return of euro assets? Since the expected exchange rate has not changed, the present depreciation actually leads to an increase in the expected rate of appreciation. As a result, the rate of return of euro assets goes down. There is therefore a negative relationship between the exchange rate E$/euro and the rate of return of euro assets REU +
e (E$ E$/euro ) /euro . E$/euro

13.4.1

Graphical Representation

13.5
13.5.1

Comparative Statics
The Eect of Changing the US Interest Rates on the Current Exchange Rate

An increase in the U.S. interest rate increases the rate of return of holding US deposits relative to holding Euro deposits. This leads to an excess demand for US dollars and an excess supply of Euros. As a result, the dollar appreciates. 4

13.5.2

The Eect of Changing the European Interest Rates on the Current Exchange Rate

Euro weaker after rate cut

BBC - May 11, 2001 The euro fell to three-week lows against the US dollar on Friday after the European Central Bank (ECB) surprised the markets and cut interest rates by a quarter point to 4.5% the day before.

Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut
July 15, 2003 Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut. The Canadian Dollar has fallen almost a cent today against the U.S. Dollar after the quarter of a percent interest rate cut.

A decrease in the EU interest rate reduces the rate of return of holding euro deposits relative to holding dollar deposits. This leads to an excess demand for dollars and an excess supply of euros. As a result, the dollar appreciates. General result: All else equal, an increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies.

13.5.3

The Eect of Changing Expectations on the Current Exchange Rate

Dollar Holds Near Strongest in Almost Seven Weeks Against Euro

December 23, 2004 (Reuters) The dollar dropped to record lows against the euro on Thursday in partly technically driven trading after a mixed batch of U.S. economic reports provided no motivation to buy the currency.

Dollar Holds Near Strongest in Almost Seven Weeks Against Euro

January 10, 2005 (Bloomberg) The dollar traded near its strongest in almost seven weeks against the euro in Asia on speculation the Bush administration will act to reduce the record U.S. decits amid signs of faster economic growth. The U.S. currency drew support from comments on Jan. 7 by Treasury Secretary John Snow that policy makers want to do things to sustain the strength of the dollar, in part by reducing the U.S. budget decit. The dollar is also beneting from expectations the Federal Reserve will raise interest rates, widening the yield advantage over Europe.

Dollar Drops Against Euro, Yen After Trade Gap Widens to Record
January 12, 2005 (Bloomberg) The dollar fell by the most in more than ve weeks against the euro and declined against the yen after the U.S. trade decit unexpectedly grew to a record in November. The dollar dropped 7.1 percent against the euro and 4.3 percent versus the yen last year on concern the U.S. will fail to attract enough international investment to compensate for the shortfall in the current account.

Dollar Heading for Biggest Weekly Gain in 11 Against Euro, Yen

March 25, 2005 (Bloomberg) The dollar headed for its biggest winning week in 11 against both the euro and the yen on speculation accelerating U.S. ination will force the Federal Reserve to quicken the pace of raising interest rates.

Dollar rises to 5-1/2-month high versus yen

April 4, 2005 (Reuters) The dollar hit a fresh ve-and-a-half month high against the yen on Monday as the market shrugged o a poor U.S. jobs report and focused on the Federal Reserves plan to keep lifting interest rates. The dollar was initially dumped on Friday after a report showed the U.S. economy generated just 110,000 non-farm jobs last month, half of what economists had forecast.

But the U.S. currency soon recovered as the market zeroed in on U.S. data that showed a slight rise in hourly wages, as well as another report showing prices paid by manufacturers spiked in the same month. It found further support after Fed ocials signalled they would keep lifting rates to ght o simmering ination pressures, with St. Louis Fed President William Poole suggesting on the weekend there was a risk of higher ination. As long as expectations for further U.S. rate hikes remain, its going to be a bit hard to dump the dollar, said Toshiaki Kimura, forex manager at Mitsubishi Trust and Banking Corp.

An expected appreciation of the dollar decreases the rate of return of holding euro deposits relative to holding dollar deposits. This leads to an excess demand for dollars and an excess supply of euros. As a result, the dollar appreciates. We conclude that, all else equal, a rise in the expected future exchange rate causes a rise in the current exchange rate. Similarly, a fall in the expected future exchange rate causes a fall in the current exchange rate.