0:11

In this video,

Â we want to start developing the foundations for an analysis of the foreign

Â exchange market in order to understand what determines the exchange rate.

Â In order to do that, we're going to start from some basics.

Â The exchange rate is determined in the foreign currency market by supply and

Â demand in that market.

Â However, things are not straightforward, because currencies are assets.

Â You can keep them, buy them at different times, resell them.

Â So you need to take into account what is happening in the market now versus what

Â might be happening in the future in order to decide whether to buy now or

Â not to buy, or to sell, and what to do in the future.

Â The demand for foreign currency comes from firms,

Â households, governments in trading countries.

Â Banks usually are the intermediaries, central banks,

Â commercial banks, also financial firms.

Â There are also small traders, speculators, many people are involved.

Â What we want to know is the incentives of these people to buy or

Â sell in each market now versus the future.

Â 1:17

And for now, we're going to be focusing on two markets.

Â One is the spot trade, which is now,

Â transacting now and deciding whether to buy foreign currency now or

Â sell that foreign currency now, or not do anything at this point.

Â Versus participation in the forward market, which is making a contract over

Â the exchange rate and selling or buying foreign exchange in the future.

Â The spot market is about agreeing now and transacting right now,

Â versus forward market, which is agree now but transact later.

Â Basically, you sign a contract that you're going to be selling or

Â buying foreign currency at a given rate.

Â And you're supposed to deliver that when the time of the contract comes.

Â If you want to know more about foreign currency,

Â forward markets, or futures markets, you can go to this website.

Â And if you would like to see you quotes of forward rates,

Â there's a foreign exchange street.com site that provides that information.

Â One thing to keep in mind when you look at the exchange rates and the quotations,

Â foreign currencies, major foreign currencies are usually quoted with

Â four decimal points, which are known as percentage in point, or pip.

Â The whole idea of this is to make sure the round-off error is not that large.

Â To analyze the foreign exchange market,

Â you want to start by looking at the incentives of participants in the market,

Â whether they want to buy or sell in the spot market versus the forward market.

Â 2:49

First, let me ask you this question, why is there a forward market?

Â Why is there demand for agreeing now and transacting later?

Â I guess you know the answer to that.

Â It's basically hedging, or insurance against currency fluctuations.

Â So what this means is that people who go to the forward market

Â versus spot market are not taking any risks.

Â In both cases, you know how many foreign currency units you're going to get for

Â your domestic currency, or vice versa.

Â In order to analyze the decision to buy in the spot market versus forward market or

Â to sell in each market, let me give you an example.

Â Let me start with this example of a CD importer who has signed a contract to

Â buy CDs a year from now from a producer of CDs in Britain

Â with the amount of 10,000 pounds that needs to be delivered one year from now.

Â Suppose that that contract is signed, the CDs are coming, and

Â the importer now needs to figure out how to pay this 10,000 pound.

Â One option of buying the 10,000 pounds in the spot market right now,

Â keep it for a year, and then pay, get the CDs.

Â 4:01

An alternative strategy is to sign a forward contract,

Â buy 10,000 pounds a year from now, at whatever the exchange rate

Â is between pound and the US dollar one year from now.

Â There's going to be no risk.

Â She will know exactly how many dollars she

Â has to give in order to get the 10,000 pounds.

Â So which option is better, do you think?

Â 4:28

Buying in the spot market, forward market, or maybe you need more information?

Â I hope that you've chosen the third option, need more information.

Â Because I'm pretty sure you understand that you need to know the exchange

Â rates, right?

Â So here are the exchange rates.

Â Suppose that the spot rate is 0.50 pounds per dollar,

Â and the exchange rate you get in the forward market is 0.51 pound per dollar.

Â So now which one is a better deal?

Â Should the importer buy the pound in the spot market, sign a contract in

Â the forward market, or maybe she needs more information to make a decision?

Â Think about this for a moment.

Â 5:13

Again, I hope you have selected C, because you do need more information.

Â The reason you need more information is that once the pound is bought now,

Â or the dollar is kept for one year, in either case,

Â you need to know what the importer can earn on that money in the meantime.

Â 5:35

So before we proceed further, let's first figure out exactly

Â how much each option costs at the time when the pound is delivered.

Â If the importer pays now in the spot market, she needs 10,000 pounds,

Â so she needs to deliver $20,000.

Â A year from now, the forward rate is 0.51.

Â So she needs to buy 10,000 pounds at the rate of 0.5 pounds per dollar.

Â That means that she needs $19,608.

Â This sounds like the spot market is more expensive and

Â she should go to the forward market.

Â But all this depends on how much she can earn on the pound versus the dollar.

Â So let me provide the information now for you on the interest rates.

Â Suppose that the exchange rates are the same, the dollar interest rate is 5%,

Â pound interest rate is 10%.

Â Should she buy in the spot market, buy in the forward market, or

Â do we still need more information?

Â 6:41

Do the calculation for yourself and

Â see if the answer that I'm going to give you in a moment matches what you found.

Â I hope you're not going to be asking for more information,

Â because I don't have any more information.

Â And I think this is enough to make a decision.

Â 7:22

If she buys pounds right now, she can earn the pound interest rate on it.

Â So that means that you take the final value divided

Â by 1 plus interest rate of the pound, which is 1.1.

Â So this whole ratio shows how many pounds she needs to buy right now.

Â And in order to figure out how many dollars that is,

Â you divide it by the exchange rate of pounds per dollar, which is 1 over e.

Â So once you put 0.5 for e in this formula,

Â you get $18,181.82.

Â 8:13

Well, she first needs to figure out how many dollars she will need a year from

Â now, so she divides the 10,000 pound by ef, and that gives her

Â the number of dollars she needs to buy the pounds necessary a year from now.

Â So, this is the dollars that she needs a year from now.

Â To have this many dollars a year from now,

Â she needs to figure out how many dollars she needs to commit now, plus interest,

Â in order to be able to have sufficient dollars, and that means that you need

Â to divide that number by, 1 plus dollar interest rate, which is 5%.

Â So, you replace 1 + i$, it becomes 1.05,

Â and you replace also, ef, by .51, and

Â you get the number $18,674.14, needs to be committed now.

Â So, if you compare these two numbers, it's obviously the case that

Â going to the stock market is a better choice for this importer.

Â 9:17

Notice that the reason for this is that, the interest rate in pound is much higher,

Â and therefore, although the forward rate gives her a better deal in terms of

Â the exchange rate for her dollar, but she loses a lot in terms of interest rate,

Â if she goes to the forward market right now.

Â So, she better of take advantage of high interest rates,

Â and buy the pound in the spot market.

Â 9:43

Let me generalize what I said.

Â Suppose you have one unit of home currency, let's say the dollar, and

Â you want to figure out how many foreign currency units you will have,

Â a year from now.

Â If you go to the forward market, meaning that you keep your money in home currency,

Â earn interest on it, i, and then turn it into foreign currency, ef.

Â That is how many foreign currency units you'll have a year from now.

Â Compare this with the other alternative.

Â 10:15

You buy foreign currency units right now in the spot market, and

Â that every home currency gives you, e, units of foreign currency, and

Â then you earn interests, i* on it, during the year.

Â So, (1 + i*)e is how many foreign currency units you are going to have

Â a year from now if you go to the spot market.

Â The comparison between these two values,

Â determines the choice of the participants in the foreign currency market.

Â So, if (1 + i)ef is bigger than (1 + i*)e, what would you do?

Â 10:55

Notice that, the left hand side is keeping your home currency,

Â the right hand side is keeping foreign currency.

Â And if the left hand side is bigger,

Â it means that you should keep your home currency.

Â If you have home currency, you will do the forward market in this case.

Â 11:24

In the example that they had given you before, interest rate at home was 5%,

Â the exchange rate in the forward market that's .51,

Â the exchange rate in the spot market is .5,

Â and interest rate in the foreign currency accounts was 10%.

Â So, is this relationship correct,

Â that the left hand side is bigger than the right hand side?

Â If you do the calculation, you're going to see that this is actually not correct,

Â the inequality should go the other way around.

Â 11:58

And the reason for this is that, if you compare the interest rates, the foreign

Â accounts give you 5% more interest than domestic accounts, so that's 5% gain.

Â You get 2% better deal on your currency and your dollar,

Â if you go to the forward market, but that's only 2% versus 5% better payoff,

Â or better higher revenue from buying the foreign currency,

Â and therefore holding foreign currency is the better deal, and

Â that's why the inequalities going to be going the other way, and

Â if you have dollars as we've seen before, you buy foreign currency.

Â 12:40

One more step in looking at this the inequality that we just saw.

Â And to make sure we understand it correctly,

Â let me start with the inequality the way I had written it, (1+i)ef for

Â a forward rate, bigger than (1 + i*)e, the spot rate.

Â 13:01

One can actually reorganize this inequality, and

Â put all the e's on one side then all the i's on the other side, and you get,

Â (ef- e)/e, which we call excess value of domestic currency in the forward market,

Â 13:19

and on the right hand side everything is in terms of interest rates,

Â which is (i*- i)/(1 + i).

Â This is essentially the excess return,

Â on accounts, on money, on foreign currency versus domestic currency.

Â 13:38

Looking at this kind of inequality, this kind of relationship, you can see here

Â that the inequality that we had before is, basically, telling us, that you need to

Â compare the excess value of your currency in the forward market versus spot market,

Â and compare it with, the excess return on foreign currency versus domestic currency.

Â If the excess value of home currency in the forward market exceeds

Â the excess return on forward currency, then you keep the home currency.

Â Otherwise, as in the case of the example we had before,

Â the excess return could be very high, and therefore you switch and

Â buy the foreign currency from the beginning.

Â 14:23

Okay, now we going to proceed, and develop our model of foreign

Â exchange market further, but we can, I need to start some terminology,

Â the terminology that economist used very often.

Â The issue of exogenous versus endogenous variables.

Â Exogenous variables are the variables that are determined outside the module, or

Â the system you're analyzing.

Â For example, if you want to examine climate change on earth, sun rays,

Â and sun spots are a given, we assume they're exogenous.

Â Whatever happens in the model, that we want to analyze and

Â understand how it's determined, is called endogenous.

Â The endogenous variables are driven by exogenous variables,

Â exogenous variables are given for us.

Â Sometimes this is actually true, like the example of the sun,

Â that they've given you that, there is some factors that are completely exogenous, but

Â sometimes in economics we make assumptions about some variables being outside

Â the system to carry on the analysis, figure out what happens,

Â and then go back, and endogenize those exogenous variables.

Â Figure out, where they come from, and how they're determined, and

Â how that will change the entire analysis.

Â It's often easier to start with a simple model where a lot things are taken as

Â exogenous, the analysis is done on a few variables, and then the model expanded,

Â and made more complicated by endogenizing more variables.

Â 16:03

What we want to do is to figure out, how participants in the market decide

Â into which market to go, and where to offer their foreign currency, or

Â domestic currency, or where to buy the two currencies.

Â And we've seen that they're going to be weighing the excess value in the forward

Â market versus the spot market, and comparing it with the existing return on

Â foreign currency asset versus domestic currency assets.

Â 16:31

In analyzing the spot market, and

Â modeling the spot market, we're going to assume that e is the endogenous variable,

Â the variable that we're interested in, and everything else is exogenous.

Â So, ef, i and i* will be treated as exogenous variables for now.

Â 16:50

These variables are in turn determined by other variables, we need to model them

Â separately, we're going to do that later on, and add to the model of spot market.

Â But for now, let's just stick to this assumption.

Â 17:06

Okay.

Â Suppose that ef, i, domestic interest rate, i*,

Â foreign interest rates, are given.

Â We know the forward rate, we're going to discuss what determines it later on, but

Â for now, let's take it as given.

Â 17:21

So, let's see what happens to the spot market, if we do the calculation and

Â we see that (1 + i)ef is bigger than (1 + i*)e.

Â Meaning they are keeping domestic currency pays off more than

Â keeping foreign currency.

Â 17:38

Notice [SOUND] here that, if everybody looks at this equation the same way, and

Â they see they're keeping domestic currency pays off more,

Â those who have foreign currency want to buy more domestic currency.

Â Those who have domestic currency want to keep them, don't offer them in the market.

Â The result is going to be,

Â there's a shortage of domestic currency in the foreign exchange market,

Â and that means that exchange rate of home currency is going to go up.

Â 18:13

And if the opposite is true, (1 + i)ef is less

Â than (1 + i*)e, that means that keeping foreign currency pays more,

Â and therefore foreign currency owners are going to keep their currency.

Â Domestic currency owners, want to buy foreign currency, and

Â the opposite of what we've seen before happens.

Â The domestic currency loses value in the spot market, the whole right hand side

Â goes down, and the two sides, again, get closer to each other.

Â 18:45

So, in either case if either of these inequalities hold,

Â the market is not going to be in equilibrium, e, the exchange rate is going

Â to be constantly changing, bringing the two sides close to each other.

Â 19:18

So, if you want to know what determines the exchange rate in this spot market,

Â we need to look at this equation,

Â when the two sides of the inequality are equal to each other.

Â What these two inequalities tell us is that, if the two sides

Â are not equal to each other, there are forces that bring them together.

Â So, eventually, the market comes to rest

Â at the exchange rate that makes these two sides equal to each other.

Â 19:47

This equation is [SOUND] known as covered interest parity condition.

Â What it means is that interest rates may be different across currencies,

Â but they're essentially equivalent,

Â once you take into account differences in the spot rate versus forward rate.

Â There are reasons why spot rate and forward rates might be different, and

Â what this equation tells us is that, the exchange rates adjust

Â to make sure that if you keep your foreign currency or domestic currency,

Â you get the same overall rate of return on both of these.

Â This equation is in fact true, it's been tested,

Â and in fact currency traders use it in order to figure out, what exchange rate

Â should they used in their transactions in the forward market and spot market.

Â The conditions called covered interest parity, because there is no risk involved.

Â In both cases whether you buy in the spot market, or you buy in the forward market,

Â you know exactly what the exchange rate that you get is.

Â 20:51

Let me give you an example of applying the covered interest parity condition,

Â to figure out the relationship between the spot rate, and the forward rate.

Â Let's suppose that we have the interest rates in the US as,

Â the return on assets is 4%, these are safe assets, no risk,

Â and similar assets in Europe give you a return of 3%.

Â And let's say, you go to the forward market, and you see the rate is 0.9,

Â the question is, what's the spot rate right now?

Â 21:30

And to figure that out,

Â you basically start with the covered interest parity condition,

Â put the numbers for the domestic interest rate, forward rate, foreign interest rate.

Â And we need to calculate, e, the spot rate, and

Â the spot rate turns out to be 0.91.

Â What this says is that, the spot rate is valued 1%, approximately,

Â higher than the forward rate, because foreign accounts are giving

Â you less interest, so holding foreign currency, is less rewarding.

Â Holding the dollar is more valuable, as far as the return on assets is concerned.

Â However, the forward rate is smaller for

Â the US dollar, and that compensates for those who hold foreign currency.

Â If the currency gives you high interest, and

Â also it gives you a good rate of return in the forward market, everybody of course,

Â would like to hold that asset, and that will not be an equilibrium.

Â In an equilibrium, if people are holding a currency, and

Â that currency is expected to lose value, then they

Â should be compensated by higher returns, so the market comes into equilibrium,

Â and people don't want to switch between the two currencies.

Â What the covered interest parity basically tells us is that,

Â it doesn't make much of a difference to go through the forward market or

Â through the spot market, it depends of course, on your circumstances,

Â but overall, the payoff should be exactly the same.

Â If you are a currency trader, for example,

Â you may want to help people buy one current, buys in the spot market or

Â the forward market, but overall the returns are going to be the same.

Â