Chapter Twelve

The Foreign Exchange Market

Exchange Rates, 1974–2002

Slide 12–3
Foreign Currency Assets of Canadian Banks

Source: The Canadian Banking System, Charles Freedman, 1998 Slide 12–4
The Foreign Exchange Market
• Definitions
1. Spot exchange rate: The rate at which you can buy or sell
currency for settlement today
2. Forward exchange rate: The rate at which you can buy
or sell currency for settlement in the future, at a price
agreed upon today
3. Appreciation: A currency appreciates when it takes less
of it to purchase one unit of foreign currency
4. Depreciation: A currency depreciates when it takes more
of it to purchase one unit of foreign currency

Slide 12–5
The Foreign Exchange Market
• When a domestic currency appreciates:
– Exports become less competitive
– Imports become less expensive
– Domestic businesses become less competitive
– Consumers benefit from lower prices

• FX traded in over-the-counter market

1. Trade is in bank deposits denominated in different
currencies

Slide 12–6
Law of One Price

• An identical good should cost the same,

irrespective of the currency it is valued in
• Example:
– Canadian steel costs $100 per ton,
– Japanese steel costs 10,000 yen per ton
• What does this infer about the exchange rate between
Canadian dollars & yen?

Slide 12–7
Law of One Price

If the Exchange ra
would be:
If the Exchange ra
Canad
are:
In Canada $100
• Law of one price ⇒ Exchange Rate = 100 yen/$
Slide 12–8
Purchasing Power Parity (PPP)
• The theory ⇒ Purchasing-power parity says that in the long
run, exchange rates should move towards rates that would
equalize the prices of an identical basket of goods and
services in any two countries.
• PPP implies that if the domestic price level ↑ 10%, the
domestic currency should ↓ 10%
1. Application of law of one price to price levels
2. Works in long run not short run
• Problems with PPP
1. All goods not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded (e.g., haircuts)

Slide 12–9
Big Mac Index:
The Economist

The concept of Purchasing Power Parity is the thinking

behind The Economist's Big Mac index. Invented in 1986
as a light-hearted guide to whether currencies are at their
“correct” level, the “basket” is a McDonalds' Big Mac,
which is produced locally in almost 120 countries.

Slide 12–10
Big Mac Index
• Burgernomics is based on the theory of purchasing-power
parity, the notion that a dollar should buy the same amount in
all countries.
• In the long run, the exchange rate between two countries
should move towards the rate that equalises the prices of an
identical basket of goods and services in each country.
• The "basket" is a McDonald's Big Mac, which is produced in
about 120 countries.
• The Big Mac PPP is the exchange rate that would mean
hamburgers cost the same in America as abroad.
• Comparing actual exchange rates with PPPs indicates whether
a currency is under- or overvalued.

Slide 12–11
Big Mac Index
• The Big Mac PPP is the exchange rate that would leave a
burger in any country costing the same as in America.
• The first column of the table converts the local price of a Big
Mac into dollars at current exchange rates.
• The average price of a Big Mac in four American cities is
$2.90 (including tax).
• The cheapest shown in the table is in the Philippines ($1.23),
the most expensive in Switzerland ($4.90).
• In other words, the Philippine peso is the world's most
undervalued currency, the Swiss franc its most overvalued.

Slide 12–12
Big Mac Index
• The second column calculates Big Mac PPPs by dividing the
local currency price by the American price. For instance, in
Japan a Big Mac costs ¥262. Dividing this by the American
price of $2.90 produces a dollar PPP against the yen of ¥90,
compared with its current rate of ¥113, suggesting that the yen
is 20% undervalued.
• In contrast, the euro (based on a weighted average of Big Mac
prices in the euro area) is 13% overvalued.
• Perhaps the most interesting finding is that all emerging-
market currencies are undervalued against the dollar. The
Chinese yuan, on which much ink has been spilled in recent
months, looks 57% too cheap.

Slide 12–13
Slide 12–14
Big Mac Index
• The Big Mac index was never intended as a precise
forecasting tool. Burgers are not traded across borders as the
PPP theory demands; prices are distorted by differences in the
cost of non-tradable goods and services, such as rents.
• Yet these very failings make the Big Mac index useful, since
looked at another way it can help to measure countries'
differing costs of living. That a Big Mac is cheap in China
does not in fact prove that the yuan is being held massively
below its fair value, as many American politicians claim. It is
quite natural for average prices to be lower in poorer countries
and therefore for their currencies to appear cheap.
• The prices of traded goods will tend to be similar to those in
developed economies. But the prices of non-tradable products,
such as housing and labour-intensive services, are generally
much lower. A hair-cut is, for instance, much cheaper in
Beijing than in New York.
Slide 12–15
 Big Mac Index

• One big implication of lower prices is that converting

a poor country's GDP into dollars at market exchange
rates will significantly understate the true size of its
economy and its living standards.
• If China's GDP is converted into dollars using the Big
Mac PPP, it is almost two-and-a-half-times bigger
than if converted at the market exchange rate.
• Meatier and more sophisticated estimates of PPP,
such as those used by the IMF, suggest that the
required adjustment is even bigger.

Slide 12–16
PPP: Canada and U.S.

Slide 12–17
Factors Affecting The Exchange Rate in the
Long Run

• Basic Principle: If a factor increases demand

for domestic goods relative to foreign goods, the
exchange rate should rise (i.e. the domestic currency
will appreciate)
• Domestic price level – if the domestic price level rises
while the foreign price level remains fixed, domestic
goods become relatively more expensive. Demand
for the foreign goods will rise; demand for domestic
goods will fall.

Slide 12–18
Factors Affecting The Exchange Rate in the
Long Run

• Trade barriers – Two forms

– Tariffs – taxes on imported goods
– Quotas – limits on the amount of foreign goods that can
enter the country
• Both tariffs & quotas tend to increase demand for
domestic goods & reduce demand for foreign goods

Slide 12–19
Factors Affecting The Exchange Rate in the
Long Run

• Import demand – if import demand rises (Canadians

prefer to purchase Japanese cars rather than cars
made in Canada), the exchange rate will depreciate

• Export demand – if foreigners demand more of

Canada’s natural resources, the demand for Canadian
goods rises, pushing the exchange rate higher.

Slide 12–20
Factors Affecting The Exchange Rate in the
Long Run

• Productivity – If a country becomes more productive

than its foreign counterparts (produces more units of
output per unit of input), then domestic businesses
can lower their prices and still earn a profit.
• The demand for domestic goods rises and the
domestic currency appreciates

Slide 12–21
Factors Affecting The Exchange Rate in the
Long Run

Slide 12–22
Factors Affecting The Exchange Rate in the
Short Run
• We know of five factors that affect LR exchange rate
behaviour
• What factors affect the spot exchange rate?
• A spot exchange rate is the price of a domestic bank deposit
(denominated in Canadian dollars) in terms of a foreign bank
deposit (denominated in the foreign currency)
• Earlier models of exchange rate determination emphasized the
flow of imports & exports. However, total yearly foreign
exchange transactions in Canada are approximately 25 times
as large as the flow of imports & exports.
• Therefore, want to focus on the decision whether to hold a
domestic or a foreign asset (T bill or bank deposit)

Slide 12–23
Comparing Expected Returns on Domestic &
Foreign Deposits

• Expected return drives the demand for both domestic

& foreign assets (bank deposits)
• If foreign assets have a higher expected return,
investors will shift deposits from Canadian dollar
assets into foreign currency assets
• When comparing expected returns, must consider two
things
– The interest rate earned
– The impact of an appreciating or depreciating currency
(when the return is earned in a foreign currency)

Slide 12–24
Comparing Expected Returns on Domestic &
Foreign Deposits
RForeign = I Foreign + Appreciation in Foreign Currency
= I Foreign + Depreciation in Domestic Currency
= I Foreign − Appreciation in Domestic Currency
= I Foreign − Depreciation in Foreign Currency

Where:
RForeign = the total expected return on a foreign asset
IForeign = the interest rate in the foreign country

Slide 12–25
Comparing Expected Returns on Domestic &
Foreign Deposits

• Example: Assume that you have the following

information
– Yield on 90 day US dollar investments = 4%
– Yield on 90 Canadian dollar investments = 4.25%
– Spot exchange rate = 1.1500 Canadian dollars / US dollar
– 90 Forward exchange rate = 1.1550 Canadian $/US $
• Should we invest in Canada or US?

Slide 12–26
Comparing Expected Returns on Domestic &
Foreign Deposits

ET +1 − Et
RForeign = I Foreign +
ET
1.1550 − 1.1500
= 0.04 +
1.1500
= 0.0443
= 4.43%

Since the yield on Canadian dollar investments is 4.25%, we

should sell Canadian dollars & invest in US dollar
instruments on a fully hedged basis.

Slide 12–27
Interest Rate Parity
• Interest rate parity states:
– The domestic interest rate must equal the foreign interest
rate plus the expected appreciation in the foreign currency
• If this were not the case, investors would be able to
make risk-free profits through arbitrage
• The corollary of this is that the forward exchange rate
is driven strictly by interest rate differentials between
two countries

Slide 12–28
Interest Rate Parity
 n
 1 + rDomestic 
F=S 
B
 n
1 + rForeign 
 B
Where :
F = Forward exchange rate
S = Spot exchange rate
rDomestic = interest rate in Canada
rForeign = interest rate in foreign country
n = days to maturity
B = Annual Basis
Slide 12–29
Interest Rate Parity
• Example (Globe & Mail, March 29, 2006)
– Spot exchange rate = 1.1698 Canadian dollars / US dollar
– 1 year forward rate = 1.1584 Canadian dollars / US dollar
– Yield on one year Canadian T bills = 4.07%
– Yield on one year US T bills = 4.77%

 n Our calculation would suggest a one

 1 + rDomestic 
F=S  B year forward rate of 1.1620, which is
 n higher than the quoted rate of
 1 + r Foreign 
 B 1.1584, although it does show the
 365  expected appreciation of the
 1 + .0407  Canadian dollar vis-à-vis the US
= 1.1698  365 
dollar. The difference is probably
 360 
 1 + .0477  due to the nature of the data I used.
 360 
= 1.1620
Slide 12–30
Profiting from FX Forecasts

• Forecasters look at factors discussed here

• FX forecasts affect financial institutions
managers' decisions
• If forecast Euro to appreciate & yen to depreciate
– Sell yen assets & buy Euro assets
– Make more euros loans & less yen loans
– FX traders sell yen & buy euros

Slide 12–31