Exchange rates and the foreign exchange market

Exchange rates and the foreign exchange market

Données clés

Professeur(s)	Sbergami, Federica Céline Carrère
Cours	International Economy

Lectures

• Ricardo's model: productivity differences as a determinant of trade
• The Heckscher-Ohlin model: differences in factor endowments as a determinant of trade
• Economies of scale as a determinant of trade: beyond comparative advantage
• Trade policy instruments
• Multilateral trade agreements
• Preferential Trade Agreements
• The Free Trade Challenge
• International Macroeconomics: Issues and Overview
• National Accounts and Balance of Payments
• Exchange rates and the foreign exchange market
• Short-term exchange rates: the asset-based approach
• Long-term exchange rates: the monetary approach
• Domestic product and short-term exchange rates
• Floating exchange rates
• Fixed exchange rates and intervention on the foreign exchange market

What is the link between the balance of payments and the foreign exchange market?

What is the exchange rate of a currency and what are its main sources of fluctuation?

Who are the main players in the foreign exchange market?

What is the forward exchange rate?

What is the role of expectations in the foreign exchange market?

What is the relationship between the interest rate and the exchange rate?

Is the foreign exchange market efficient?

Reminder: neglecting the capital account ($CK=0$) to simplify the analysis, the balance of payments equilibrium is written as follows: $CC+CF\equiv 0$.

Both CC and CF depend on the exchange rate, $E$ = price of one currency in terms of another currency.

Within CF, it is useful to distinguish between private transactions, $CF_{p}$, and the reserve assets, RES, the latter being assumed to be independent of $E$. Then we get: $CC(E,...)+CF_{p}(E,...)+RES=0$

Two approaches to the determination of the equilibrium exchange rate related to two different historical situations :

1. Current account approach (1950-70)
2. Approach by financial account (>1970)

1) Current account approach (1950-70):

$CF_{p}$ is exogenous = control of international capital flows. $E$ is determined by the current transactions -> flow balance. Historically, controls on capital movements (poorly integrated financial markets) until the early 1970s => $E$ fixed, but adjustable (Bretton Woods regime).

2) Financial Account Approach (1970+)

$CC$ is exogenous = capital flows are free, and react much faster than real (fixed short-term) transactions. $E$ is determined by the capital transactions balance of stocks. Historically, integrated financial markets since the 1970s => $E$ flexible.

Languages

Français

The foreign exchange market

Foreign exchange quotation conventions

Rating conventions

In this lecture, writing XXX/YYYY indicates the number of units of currency XXX that is needed for one unit of currency YYY, regardless of whether XXX is the domestic or foreign currency.

Therefore, regardless of the quotation conventions, if we find 1.10 XXX/YYYY, it means that we exchange 1.10 units of XXX for 1 unit of YYYY. This is just a simple rating convention and as such is obviously not universal. The FT, for example, and many newspapers adopt the same notation, but the KO (as well as the quotation agency Reuters) adopts the reverse presentation convention (in the KO 1.10 XXX/YYYY indicates that 1.10 units of YYY are needed for 1 XXX).

Concretely, in the following, given the rating and quotation conventions adopted, 1.26 CHF/USD means that 1.26 Swiss francs are needed for 1 US dollar and that the Swiss franc is the national currency (=> if the rate were to rise to 1.33 this would indicate a depreciation of the CHF).

Exchange rates and prices of goods

As discussed in the lecture on national accounts and balance of payments, the exchange rate is used to compare the prices of goods sold in different locations. Effects of a change in the exchange rate on the prices of goods :

A depreciation of the national currency (CHF) reduces the relative price of the exported goods (watches in the example opposite). See also Box 13.1 of the KO on overnight stays of US tourists in Paris and the EUR/USD rate.

The foreign exchange market

Main players in the asset market: Commercial banks (main player: the 10 largest banks account for 75% of the market) and the interbank market ('wholesale' market); commercial companies (operating in several countries); non-bank financial institutions, e.g. pension funds (since the deregulation of financial markets); central banks (small volume of transactions when they are involved but high impact because of the signal effect).

Amounts: Trading volume around $1500 billion per day. In 6 days one exceeds world trade by one year!

Characteristics: Exchange of currencies on many financial markets, with few opportunities for effective arbitrage because information circulates very quickly. The USD is still the dominant vehicle currency as most transactions are still between one currency and the USD.

Spot exchange rate

Spot foreign currency transactions use spot exchange rates ($E$ or sometimes $S$ for spot exchange rate). The validation day of a cash transaction = $j+2$ (2 days after the conclusion of the transaction).

When transactions specify a release date with $d>2$ (for example d = 30, d = 60, d = 90), the rates used are forward exchange rates. ($F$ = forward exchange rate). Cf. later.

A foreign exchange swap or currency swap is a spot sale of a currency combined with a forward purchase of the same currency.

Arbitrage ensures that there are no major differences between, for example, $E_{GBP/USD}^{NY}$ and $E_{GBP/USD}^{London}$

Example of quotations

Notes

Quotation to the certain of the euro.

The ECB rate is the reference exchange rate set by the European Central Bank.

The over-the-counter rate is always less favourable than the interbank market rate.

The spread between the ask price and the ask price is the profit margin for commercial banks (transaction cost) and is generally higher for the rarer currencies.

As a result of arbitrage, the direct exchange rates are equivalent to the product of the cross-exchange rates (example: CHF/USD = CHF/EUR ∙ EUR/USD).

Forward transactions are used by economic agents to hedge against the risk of unexpected exchange rate fluctuations. Example of KO players p. 361: a player sold in France for 100 euros and paid 9,000 yen to the Japanese supplier. Compare the gain per player sold in the case of i. immediate payment at the spot exchange rate YEN/EUR = 95.25, ii. future payment at a future spot exchange rate YEN/EUR = 86.95 (yen appreciation), iii. future payment covered by a yen purchase at the forward rate (YEN/EUR) = 93.46].

Spot and forward exchange rates

Spot and forward exchange rates are closely related (especially as the term approaches).

Forward Contracts and options

Currency forwards, futures and options are derivatives, which have grown considerably since the 1970s.

The forward purchase of a currency on the futures market is binding. Once the terms of the contract (amount, maturity) have been agreed, there is no going back even if expectations change. See example on the next page.

In the case of currency forwards (futures), the promise to deliver a given amount of a currency at an agreed term is purchased, and this promise can be resold (realizing a gain or loss in the futures market) at any time. More flexible than the forward, even if the terms of the futures contracts are standardized (= not possible to negotiate the amounts or maturity as in the case of forwards).

Example of forward contracts:

• The Chinese currency (remninbi or Chinese Yuan, CNY) is still non-convertible, i.e. it can only circulate within China and non-residents cannot hold accounts in CNY. How does a US exporting company (which fears a depreciation of the yuan) go about eliminating the exchange rate risk on the 10m of CNY (at a spot rate of 6 CNY/USD) that it will receive in 3 months, knowing that, being the non-convertible currency, it is not possible to use the futures market?
• Solution: the US company enters into a forward contract which consists in paying or receiving the difference, in dollars, compared to the agreed rate (e.g. stability at 6 CNY/USD). For example, if the yuan appreciates to $5.5$, it will pay $({\frac {1}{5.5}}-{\frac {1}{6}})\times 10=0.15$m of USD to the People's Bank of China, and, vice versa, it will receive 0.13m of USD from the Chinese central bank if the yuan depreciates to 6.5 CNY/USD → paris.

Typical case where the financial market develops a new instrument to circumvent a (probably transitory) difficulty → creation of a CNY vs. USD forwards market.

Alternative :

A currency option gives the right to buy or sell a specific amount of a currency at a fixed price at any time until the expiration of the specified maturity date (the other party -- seller of the option -- must sell or buy at the discretion of the owner, who in turn has no obligation to actually exercise his right).

Example: You will receive a foreign currency payment on an uncertain date in the next month. To eliminate any risk (of the foreign currency depreciating), you buy a put option that allows you to sell the currency at the fixed rate at any time during the month. In case you need to make a payment you buy a call option.

Demand for foreign currency assets

The financial account approach

Quotation convention: In the following we will always use the uncertainty quotation (= KO) -> we will always put the national currency in the numerator.

Central idea:

The foreign exchange market is in equilibrium when all assets denominated in all currencies offer the same expected rate of return (non-arbitrage).

${\textstyle E}$, the exchange rate, reflects the price of a (foreign) asset. Asset = transfer of purchasing power in the future. Its current price depends on the anticipation of its future price.

Rating : $E^{e}$ = anticipated exchange rate (expected, expected). e.g: $E^{e}=1.25CHF/USD$, $E=1.20CHF/USD$ -> anticipated appreciation of the USD.

Is it necessary to invest in CHF or in foreign currencies? Capital $C_{0}$ (en CHF) -> choice:

• If we place $C_{0}$ in CHF -> interest rate $R$
• If we place$C_{0}$ in USD -> interest rate $R^{*}$

But this information is not enough to make a comparison between the two investments -> calculation of the expected return

Expected rate of return

Wealth is held in various forms of assets and transfers purchasing power in the future the desirability of an asset will depend on its rate of return, but the rate of return is rarely known (e.g. the dividend associated with a share might be known, but the value of the security changes over time).

The expected real rate of return is the expected nominal rate of return deflated by a price index. As assets are held in different currencies, they must be expressed in the same currency in order to be comparable.

Other things being equal (which is rarely the case), investors prefer to hold assets with a higher expected real rate of return.

Two other criteria influence the choice of an asset:

• Risk (savers prefer assets with little uncertainty).
• Liquidity (savers prefer more liquid assets).

Hypothesis for the rest: comparable risk and liquidity between securities => we focus on the differences in expected real return, which are closely related to the differences in interest rates between different currencies.

Interest rates

Interest rates on different currencies are usually different because they depend on national conditions. On the other hand, when two countries adopt the same currency, such as France and Germany in 1999, interest rates converge and then equalise. (... Is this still true today?)

Expected return on a foreign currency investment ($RA^{*}$)

Hp: the expected return is the only criterion (risk and liquidity are not taken into account).

Investment in USD → 3 transactions:

• USD purchase in $t=0$ → ${\frac {C_{0}}{E}}$ [USD]
• USD investment → ${\frac {C_{0}}{E}}1+R^{*}$ [USD]
• sale USD in $t=1$ → $E^{e}{\frac {C_{0}}{E}}1+R^{*}$ [CHF]

Anticipated return on USD :

$RA^{*}={\frac {C_{0}(1+R^{*}){\frac {E^{*}}{E}}-C_{0}}{C_{0}}}=(1+R^{*}){\frac {E^{e}}{E}}-1=R^{*}{\frac {E^{e}}{E}}+{\hat {E}}^{e}$

where ${\hat {E}}^{e}\equiv {\frac {E^{e}}{E}}-1={\frac {E^{e}-E}{E}}$

is the anticipated depreciation rate of the CHF.

=> $RA^{*}=R^{*}({\hat {E}}^{e}+1)+{\hat {E}}^{e}=R^{*}+{\hat {E}}^{e}+R^{*}\times {\hat {E}}^{e}$

Approximation

If $R^{*}$ and ${\hat {E}}^{e}$ are low enough, their product can be neglected (e.g: $R^{*}=0.5$% and ${\hat {E}}^{e}=0.2$% => $R^{*}\times {\hat {E}}^{e}=0.001$%) → rule of thumb.

The expected return on the USD then becomes, approximately :

$RA^{*}=R^{*}+{\hat {E}}^{e}\equiv R^{*}+{\frac {E^{e}-E}{E}}$

Intuition : $RA^{*}\cong interest+gain\ (loss)\ of\ change$. If a depreciation (appreciation) of the national currency is anticipated in the future, this means that when the USD is converted into CHF (at the end of the investment period), a foreign exchange gain (loss) is expected.

On what depends $RA^{*}$? Three determinants...

Variation of E

How is it evolving $RA^{*}$ when $E$ varies ?

→ Example (table 14.4 of KO) with $R^{*}=6$%, $E=1.0$ and $E^{e}=0.95$ : the more $E$ is low ceteris paribus, the more the $RA^{*}$ is high. Intuition: the cheaper the currency, the higher the expected return on that currency, all other things being equal.

$R^{*}+{\hat {E}}^{e}=0.06+{\frac {0.95-1.0}{1.0}}=0.06-0.05=0.01$

If $E^{e}$ remains unchanged, as $E$ depreciate (appreciation of EUR), the rate of anticipated depreciation increases as well as the $RA^{*}$:

An appreciation today of the national currency at an anticipated exchange rate ($E^{e}$) which remains constant implies an expectation of a larger future foreign exchange gain (or a smaller foreign exchange loss) as the expected depreciation margin increases (or the margin of appreciation decreases).

Negative relationship between $E$ and $RA^{*}$. All other things being equal, an appreciation of the national currency (here CHF) increases the AR of a foreign currency investment (here USD).

Influence de $E$ sur $RA^{*}$

Donc, en général, si on observe aujourd’hui une...

• Appréciation de monnaie nationale ($E$↘) $RA^{*}$↗ (gain de change)
• Dépréciation de monnaie nationale ($E$↗) $RA^{*}$↘ (perte de change)

La courbe décrit l’évolution de $RA^{*}$ en fonction de <mathE</math>

Influence de $E^{e}$ (et $R^{*}$) sur $RA^{*}$

Si on s’attend à terme à une..

• Appréciation de monnaie nationale ($E^{e}$↘) => $RA^{*}$↘ (perte de change)
• Dépréciation de monnaie nationale ($E^{e}$)↗ => $RA^{*}$↗ (gain de change)

-> dans ce cas : déplacement de toute la courbe (idem si $\Delta R^{*}$)

Erreur lors de la création de la vignette : Fichier manquant

Equilibre sur le marché des changes : $PTI_{NC}$

Condition d’équilibre : $PTI_{NC}$

Hypothèses: Les agents partagent les mêmes anticipations ($E^{e}$) et font face aux mêmes taux d’intérêt $R=R_{0}$ et $R^{*}=R_{0}^{*}$ exogènes. En cas de déséquilibre sur le marché des changes, c’est le taux de change au comptant, E, qui s’ajuste.

Intuition : $E$ va varier jusqu’à ce qu’il n’y ait plus d’incitation à modifier l’allocation du portefeuille entre les deux monnaies = lorsque les rendements anticipés sur les deux monnaies deviennent égaux.

Notation : ED: excès de demande ; ES: excès d'offre

• Si $R_{0}<RA^{*}=R_{0}^{*}+{\hat {E}}^{e}:ED_{devise}$ => $E$↗ => ${\hat {E}}^{e}$↘ => $RA^{*}$↘ = réduit l’écart $RA^{*}-R_{0}$
• Si $R_{0}>RA^{*}=R_{0}^{*}+{\hat {E}}^{e}:ES_{devise}$ => $E$↘ => ${\hat {E}}^{e}$↗ => $RA^{*}$↗ = réduit l’écart $R_{0}-RA^{*}$

Equilibre pour l’investisseur correspond à une situation de « non-arbitrage » lorsque:

$R=RA^{*}=R*+{\hat {E}}^{e}=R^{*}+{\frac {E^{e}-E}{E}}$ [1]

= relation de parité des taux d’intérêt non couverte ($PTI_{N}C$), qui correspond à l’équilibre du marché des changes ($E$ s’ajuste). Cette relation nous donne un modèle de détermination du taux de change spot. Si on connait le différentiel de taux d’intérêt et le taux de change anticipé on connaît le taux de change spot.

Représentation graphique de l’équilibre

Si $R=R_{0}$, la seule valeur de $E$ qui satisfait la condition $R_{0}=RA^{*}$ est celle qui se trouve à la verticale de $R_{0}$ sur la courbe $RA^{*}(E)$. Toute autre valeur de $E$ en dessous ou au dessus de cette courbe conduira à un ajustement immédiat de $E$ et à un retour sur la courbe $RA^{*}(E)$ => condition d’équilibre :

$R=R^{*}+{\frac {E^{e}-E}{E}}=RA^{*}(E_{-},R_{+}^{*},E_{+}^{e})$

La courbe $RA^{*}(E,...)$, décrit les couples ($R$, $E$) qui satisfont la condition de non-arbritrage (= $PTI_{nc}$)

Statique comparative: hausse de R

Une augmentation du taux d’intérêt domestique rend les actifs nationaux plus attractifs, ce qui conduit à une demande excédentaire pour la monnaie nationale (= $ES_{devises}$) => appréciation de la monnaie nationale ($E$↘)

Statique comparative: hausse de $E^{e}$

Anticipation que la monnaie nationale se dépréciera amène les agents à réallouer leur richesse sur les placements en devises => $ED_{devises}$ => la monnaie nationale se déprécie ($E$↗)

Statique comparative : hausse de $R^{*}$

Les actifs étrangers deviennent plus attractifs => les agents vont augmenter leur demande d’actifs de l’étranger => $ED_{devises}$ => La monnaie nationale se déprécie ($E$↗)

Erreur lors de la création de la vignette : Fichier manquant

Résumé de la $PTI_{NC}$

Détermine la valeur de E qui satisfait la condition de non-arbitrage. Tous les points le long de la courbe sont des points d’équilibre.

Mais: de quoi dépendent $R$, $R^{*}$, $E^{e}$ ? chap.12-15.

Suite...

Le modèle qui se base sur la parité des taux d’intérêt non couverte représente une première étape dans la détermination du taux de change. Il nous reste maintenant à le compléter en développant une théorie de la formation du taux d’intérêt et des anticipations.

rNB: $i_{\$}=R$ et $i_{\mathrm {\euro} }=R^{*}$ dans notre notation (Source: Feenstra-Taylor).

Vérifications empiriques

Vérification de la $PTI_{NC}$ : anticipations parfaites

La condition de $PTI_{NC}$ est particulièrement intéressante à des fins de prévisions. Sous l'hypothèse d'anticipations parfaites (${\hat {E}}^{e}={\hat {E}}$), le différentiel $R-R^{*}$ pourrait être utilisé comme prédiction de ${\hat {E}}$.

Idée de base : si les hypothèses sous-jacentes à la $PTI_{NC}$ (en particulier neutralité face au risque) sont correctes et que les agents sont rationnels (ie. utilisent toute l'information disponible et ne font pas d'erreurs systématiques), le taux de dépréciation effectif de la monnaie nationale, ${\hat {E}}={\frac {E_{t+1}-E_{t}}{E_{t}}}$ devrait être égal au taux de dépréciation anticipé ${\hat {E}}^{e}={\frac {E_{t+1}^{e}-E_{t}}{E_{t}}}$, (égal à $R-R^{*}$ selon la $PTI_{NC}$) plus un « bruit blanc » : ${\hat {E}}=R-R^{*}+u$, où $u$ est une erreur de prévision d'espérance mathématique nulle.

Or, dans la réalité la $PTI_{NC}$ est très mal vérifiée, tant sur le plan de l'ampleur des variations que sur le plan de leur direction.

Efficience du marché des changes

Comment interpréter cela ? => marché des changes pas efficients? S’il y a biais systématique dans les prévisions -> test de « l’efficience» des marchés, un marché efficient étant défini comme un marché où les participants sont neutres face au risque et forment leurs anticipations de façon rationnelle [ils prennent en compte toute l’information dont ils disposent plutôt que de baser leurs prédictions seulement sur le passé (anticipations adaptatives)].

Si les marchés sont efficients, à n’importe quel moment les prix des devises, ou des actions, sont correctement évalués (pas de surestimation ni de sous-estimation) et l’évolution des prix suivra un sentier aléatoire.

Les tests économétriques ont révélé que les marchés ne sont pas efficients dans ce sens.

Trois explications possibles :

1. rôle de la prime de risque ($\rho$) : $R+\rho =R^{*}+{\hat {E}}^{e}$
2. rôle des évènements imprévisibles ("news")
3. rationalité des investisseurs limitée ?

Prime de risque: dans ce cas le biais de prévision proviendrait de variables omises qu’il s’agit de modéliser.

Il est probable que le rôle des «nouvelles» (évènements non- prévus) soit une cause prépondérante des changements dans les valeurs des taux de change.

Les participants pourraient faire des erreurs systématiques malgré leur rationalité et apprendre le comportement du marché par un processus d’apprentissage (anticipations adaptives) se basant sur le passé → anticipations irréalistes des prix futurs (à l'origine de la bulle de l'immobilier et de la dernière crise financière)

Résumé

L'approche par compte financier se focalise sur le CF de la balance des paiements comme déterminant du taux de change (particulièrement pertinent à partir des années 70 avec la libéralisation progressive du marché des capitaux et l'importance grandissante des volumes de transactions sur le marché des actifs)

Il existe deux cotations du taux de change: la cotation à l'incertain (= unités de monnaie nationale par unité de devise étrangère) et la cotation au certain (unités de devise étrangère par unité de monnaie nationale)

Les décisions d'investissement dépendent (entre autres) du taux de rendement des actifs

Le taux de rendement attendu d'un placement en devise étrangère dépend du taux d'intérêt étranger et des anticipations de gain (ou perte) de change

Le marché des actifs est à l'équilibre quand la condition de parité des taux d'intérêt non couverte est vérifiée ($PTI_{NC}$)

Le taux de change au comptant s'ajuste pour garantir l'équilibre sur le marché des actifs => la $PTI_{NC}$ peut être utilisée pour faire des prédictions sur l'évolution du taux de change

Une hausse du taux d'intérêt étranger, une anticipation de dépréciation de la monnaie nationale ou une baisse du taux d'intérêt domestique provoquent une hausse du taux de change (= dépréciation de la monnaie nationale)