Week 4 Part 2: Exchange rates
Roadmap
1. Types of exchange rates
a. Spots vs. forward
b. Nominal vs. real
2. Exchange rate movements
a. Appreciation/depreciation
b. Drives of exchange rate movements
3. Arbitrage in the foreign market
Types of exchange rates
(nominal) exchange rate
Exchange rate = price of one currency in terms of another (relative value of two currencies)
o The exchange rate between two currencies (e.g. EUR and $) can be expressed
in two ways:
Value of the Euro in terms of the %: $/EUR
Value of the $ in terms of the Euro: EUR/$
o Definition used in the textbook: value of the foreign currency in terms of the
home currency: HCU/FCU
If EUR is the home currency and $ the foreign currency: EUR/$
o a rise in the exchange rate implies an appreciation of the foreign currency
and a depreciation of the home currency.
Appreciation and depreciation
What does it mean when the exchange rate goes up or goes down?
Example: $/EUR (value of the euro expressed in $)
If the $/EUR rate increases, the euro becomes more expensive relative to the $ (you
have to pay more $ to obtain one euro). I.e. the euro gains in value (appreciates) and the $
loses in value (depreciates). The other way around when the $/EUR rate falls: the $
appreciates and the euro depreciates.
Effective exchange rate
The price of one currency can be expressed in relation to many different currencies: What
can we say about the overall value of a country’s currency?
effective exchange rate= weighted average of the values of a country’s currency relative
to various (major) currencies.
Effective exchange rate: example
,Spot rate and forward rate
Spot rate = price of buying or selling a currency at this moment
Forward rate = price of buying or selling a currency at a specific date in the future
Note: forward rate future spot rate. The former refers to a future rate locked in today,
the latter to the rate prevailing in the future spot market.
Spot and forward rate of a foreign currency can differ:
- Spot rate > forward rate: foreign currency is cheaper in the future than today
foreign currency is selling at a forward discount
- Spot rate < forward rate: foreign currency is more expensive in the future than today
foreign currency is selling at a forward premium.
Nominal and real exchange rate
Nominal exchange rate (e) = the relative value of two currencies
Real exchange rate ( )= the relative value of two currencies adjusted for differences in
prices in the two countries.
movements in the real exchange rate indicate changes in the international price
competitiveness of a country’s products.
Real exchange rate example
,Real exchange rate
An increase in implies:
- Foreign prices have increased relative to domestic prices and/or
- The foreign currency has become more expensive
Implies that the home country’s products have become more competitive compared to
the foreign country’s products.
Analog for a fall in : Foreign products have become more competitive compared to home
products.
Exchange rate movements
- Like any other commodity, the value of a currency is determined by supply and
demand.
- An increase in the supply of a currency reduces its value (depreciation)
- An increase in demand for a currency increases its value (appreciation)
- Changes in supply and demand for different currencies can come from international
trade and international investment.
- Exports of products or capital imports create demand for the domestic currency and
supply of foreign currency: the domestic currency appreciates ( ).
- Imports of goods from abroad or capital export create demand for the foreign
currency and supply of domestic currency: the domestic currency depreciates ( ).
, The role of exchange rate policies
- When supply and/or demand for a currency change, the value of the currency
(exchange rate) changes.
- This creates exchange rate fluctuations.
- The extent to which this happens has to do with exchange rate policy.
- There are two major exchange rate systems:
o Floating (flexible) exchange rates
o Fixed exchange rates
Exchange rate policies
- In a flexible rate regime, the relative value of a currency is market-driven (supply &
demand)
- Example: The Euro-Dollar rate is flexible
- In a fixed exchange rate regime, the central bank determines a target rate and a
band around it.
- By intervening in foreign exchange markets, i.e. by buying and selling domestic and
foreign currency, the central bank can keep the exchange rate fixed (or within the
pre-defined band).
- Example: Danish Krona/Euro rate is fixed at 7.46038 DKK/EUR with a fluctuation
band of +/- 2.25%
Roadmap
1. Types of exchange rates
a. Spots vs. forward
b. Nominal vs. real
2. Exchange rate movements
a. Appreciation/depreciation
b. Drives of exchange rate movements
3. Arbitrage in the foreign market
Types of exchange rates
(nominal) exchange rate
Exchange rate = price of one currency in terms of another (relative value of two currencies)
o The exchange rate between two currencies (e.g. EUR and $) can be expressed
in two ways:
Value of the Euro in terms of the %: $/EUR
Value of the $ in terms of the Euro: EUR/$
o Definition used in the textbook: value of the foreign currency in terms of the
home currency: HCU/FCU
If EUR is the home currency and $ the foreign currency: EUR/$
o a rise in the exchange rate implies an appreciation of the foreign currency
and a depreciation of the home currency.
Appreciation and depreciation
What does it mean when the exchange rate goes up or goes down?
Example: $/EUR (value of the euro expressed in $)
If the $/EUR rate increases, the euro becomes more expensive relative to the $ (you
have to pay more $ to obtain one euro). I.e. the euro gains in value (appreciates) and the $
loses in value (depreciates). The other way around when the $/EUR rate falls: the $
appreciates and the euro depreciates.
Effective exchange rate
The price of one currency can be expressed in relation to many different currencies: What
can we say about the overall value of a country’s currency?
effective exchange rate= weighted average of the values of a country’s currency relative
to various (major) currencies.
Effective exchange rate: example
,Spot rate and forward rate
Spot rate = price of buying or selling a currency at this moment
Forward rate = price of buying or selling a currency at a specific date in the future
Note: forward rate future spot rate. The former refers to a future rate locked in today,
the latter to the rate prevailing in the future spot market.
Spot and forward rate of a foreign currency can differ:
- Spot rate > forward rate: foreign currency is cheaper in the future than today
foreign currency is selling at a forward discount
- Spot rate < forward rate: foreign currency is more expensive in the future than today
foreign currency is selling at a forward premium.
Nominal and real exchange rate
Nominal exchange rate (e) = the relative value of two currencies
Real exchange rate ( )= the relative value of two currencies adjusted for differences in
prices in the two countries.
movements in the real exchange rate indicate changes in the international price
competitiveness of a country’s products.
Real exchange rate example
,Real exchange rate
An increase in implies:
- Foreign prices have increased relative to domestic prices and/or
- The foreign currency has become more expensive
Implies that the home country’s products have become more competitive compared to
the foreign country’s products.
Analog for a fall in : Foreign products have become more competitive compared to home
products.
Exchange rate movements
- Like any other commodity, the value of a currency is determined by supply and
demand.
- An increase in the supply of a currency reduces its value (depreciation)
- An increase in demand for a currency increases its value (appreciation)
- Changes in supply and demand for different currencies can come from international
trade and international investment.
- Exports of products or capital imports create demand for the domestic currency and
supply of foreign currency: the domestic currency appreciates ( ).
- Imports of goods from abroad or capital export create demand for the foreign
currency and supply of domestic currency: the domestic currency depreciates ( ).
, The role of exchange rate policies
- When supply and/or demand for a currency change, the value of the currency
(exchange rate) changes.
- This creates exchange rate fluctuations.
- The extent to which this happens has to do with exchange rate policy.
- There are two major exchange rate systems:
o Floating (flexible) exchange rates
o Fixed exchange rates
Exchange rate policies
- In a flexible rate regime, the relative value of a currency is market-driven (supply &
demand)
- Example: The Euro-Dollar rate is flexible
- In a fixed exchange rate regime, the central bank determines a target rate and a
band around it.
- By intervening in foreign exchange markets, i.e. by buying and selling domestic and
foreign currency, the central bank can keep the exchange rate fixed (or within the
pre-defined band).
- Example: Danish Krona/Euro rate is fixed at 7.46038 DKK/EUR with a fluctuation
band of +/- 2.25%
