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1. Chapter 4: Foreign Exchange Markets and Rates of Return 2- 1 Review What is Forex? Who are the players and why do they play? Definitions Rate of Returns

2. Review: International Trade Versus Finance International trade focuses on transactions involving movement of goods and services across nations International finance focuses on financial or monetary transactions across nations 2

3. Why is this important? The most important insight of all international economics is that there are gains from trade WTO Blog | Data Blog - 24 April 2024 What Does the Bible Say About Serving The Poor? 3

4. Review: National Income and Exchange Rates National Income: GDP = C + I + G + EX – IM Exchange rate: the value of a single unit of currency measured by the number of units it can be traded for in another currency

5. What is Forex? The Foreign Exchange (Forex) market refers to the activities of major international banks that engage in currency trading and act as intermediaries (dealers) between the true buyers and sellers of currencies Foreign exchange trading is conducted during normal business hours in a given location 5

6. Participants Major international banks Bank for International Settlements (BIS) The oldest international financial institution, established in 1930 Owned by 63 central banks HQ is Basel, Switzerland with offices in Hong Kong and Mexico City Bank Objectives 6

7. Participants Importers and Exporters Firms and individuals who trade goods and services Recorded in the Current Account Relatively small compared to Investors About $75 to 100 billion per day in 2023 World Development Indicators | DataBank ( WorldBank ) Objective of Importers and Exporters 7

8. Participants Investors Investment companies, insurance companies, banks Recorded in Current Account and Financial Account Relatively large compared to Importers & Exporters About $7.5 trillion per day in April 2022 OTC foreign exchange turnover in April 2022 (BIS) Investment Objectives 8

9. Investment Objectives Rate of return ( RoR ): the percentage change in the value of an asset over some period Risk: the greater the expected rate of return, the greater the risk Liquidity: the speed with which assets can be converted to cash 9

10. Exchange Rates Quotation Direct exchange rate: Quoted as amount of domestic currency per unit of foreign currency How many dollars can be exchanged for one yen?   Indirect exchange rate: Quoted as amount of foreign currency per unit of domestic currency How many yen can be exchanged for one dollar?  

11. Exchange Rates Quotation 11 Sources: https://finance.yahoo.com/quote/EURUSD=X/history?p=EURUSD=X & https://finance.yahoo.com/quote/EUR=X/history?p=EUR=X The direct and indirect exchange rates are reciprocals of each other

12. More on Exchange Rates Exchange rates allow us to denominate the cost or price of a good or service in a common currency How much does a Nissan cost? ¥4,600,000 Or, Or,  

13. Depreciation and Appreciation Depreciation is a decrease in the value of a currency relative to another currency A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency $1/€→$1.20/€ means that the dollar has depreciated relative to the euro, moving from a 1-for-1 exchange rate to a 1.2-for-1 rate The euro has appreciated relative to the dollar; the euro is now more valuable

14. Depreciation and Appreciation Appreciation is an increase in the value of a currency relative to another currency An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency $1/€→$0.90/€ means that the dollar has appreciated relative to the euro, moving from a 1-for-1 exchange rate to a 0.9-for-1 rate The euro has depreciated relative to the dollar; the euro is now less valuable

15. Depreciation and Appreciation A depreciated currency has become valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency A Nissan costs ¥4,600,000 = $35,678.28 at But it costs $42,850.49 at A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive A depreciated currency lowers the price of exports relative to the price of imports  

16. Depreciation and Appreciation An appreciated currency has become valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency A Nissan costs ¥4,600,000 = $35,678.28 at But it costs $29,967.43 at An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive An appreciated currency raises the price of exports relative to the price of imports  

17. Other Definitions Arbitrage: taking advantage of a difference in prices in either geography or time Spot exchange rate: the exchange rate that prevails on the spot, that is, for trades to take place immediately Forward exchange rate: the rate that appears on a contract to exchange currencies in the future, often in 30, 60, 90, or 180 days

18. Other Definitions Forward premium : when the forward ER is such that a forward trade costs more than a spot trade today costs Forward discount : when a forward trade is cheaper than the spot trade is today Hedging : purchasing a forward contract to protect an existing position from a downside loss

19. Exchange Rate Quotations Currency converter - latest exchange rates and currency news - FT.com Currency Exchange Table (US Dollar - USD) - X-Rates The Fed - Foreign Exchange Rates - H.10 (federalreserve.gov)

20. Relative Prices Implied Exchange rate ($/£) Relative price 1.25 139 1.50 167 1.75 194 Relative price = pairs of jeans per 100 sweaters, assuming unchanged money prices of $45 per pair of jeans and £50 per sweater If the good’s money prices do not change, when the $ appreciates to the £, sweaters become more expensive in terms of jeans (each pair of jeans buys fewer sweaters) All else equal, an appreciation of a country’s currency raises the relative price of its exports to its imports, while depreciation lowers the relative price of its exports to its imports

21. Dollar/Pound Spot Rates https://www.investing.com/currencies/gbp-usd-historical-data

22. Interest Rates on Dollar and Yen Deposits Since dollar and yen interest rates are not measured in comparable terms, they can move quite differently over time https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm & https://fred.stlouisfed.org/series/DGS1

23. Investment Return on AUD compared JPY The AUD-JPY carry trade has been profitable on average but is subject to sudden large reversals, as in 2008. Source: Quarterly Japanese yen/Australian dollar exchange rate, 90-day Australia bank bill rate, and 90-day Japan certificate of deposit rate from FRED database. The chart compares the cumulative value over time of a ¥100 investment in Japanese interest-bearing 90-day bonds, rolled over every quarter, with the same yen investment converted into Australian dollars, invested in 90-day Australian bonds and rolled over every quarter, and then converted back into yen at the end of the investment period.