0:11

In this video,

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

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

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

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

demand in that market.

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

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

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

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

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

The demand for foreign currency comes from firms,

households, governments in trading countries.

Banks usually are the intermediaries, central banks,

commercial banks, also financial firms.

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

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

sell in each market now versus the future.

1:17

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

One is the spot trade, which is now,

transacting now and deciding whether to buy foreign currency now or

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

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

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

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

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

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

buying foreign currency at a given rate.

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

If you want to know more about foreign currency,

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

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

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

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

foreign currencies, major foreign currencies are usually quoted with

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

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

To analyze the foreign exchange market,

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

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

2:49

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

Why is there demand for agreeing now and transacting later?

I guess you know the answer to that.

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

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

versus spot market are not taking any risks.

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

your domestic currency, or vice versa.

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

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

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

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

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

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

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

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

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

4:01

An alternative strategy is to sign a forward contract,

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

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

There's going to be no risk.

She will know exactly how many dollars she

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

So which option is better, do you think?

4:28

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

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

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

rates, right?

So here are the exchange rates.

Suppose that the spot rate is 0.50 pounds per dollar,

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

So now which one is a better deal?

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

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

Think about this for a moment.

5:13

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

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

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

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

5:35

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

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

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

so she needs to deliver $20,000.

A year from now, the forward rate is 0.51.

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

That means that she needs $19,608.

This sounds like the spot market is more expensive and

she should go to the forward market.

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

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

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

pound interest rate is 10%.

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

do we still need more information?

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Do the calculation for yourself and

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

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

because I don't have any more information.

And I think this is enough to make a decision.

7:22

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

So that means that you take the final value divided

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

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

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

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

So once you put 0.5 for e in this formula,

you get $18,181.82.

8:13

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

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

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

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

To have this many dollars a year from now,

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

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

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

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

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

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

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

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

9:17

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

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

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

if she goes to the forward market right now.

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

and buy the pound in the spot market.

9:43

Let me generalize what I said.

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

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

a year from now.

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

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

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

Compare this with the other alternative.

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

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

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

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

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

The comparison between these two values,

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

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

10:55

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

the right hand side is keeping foreign currency.

And if the left hand side is bigger,

it means that you should keep your home currency.

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

11:24

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

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

the exchange rate in the spot market is .5,

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

So, is this relationship correct,

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

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

the inequality should go the other way around.

11:58

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

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

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

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

or better higher revenue from buying the foreign currency,

and therefore holding foreign currency is the better deal, and

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

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

12:40

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

And to make sure we understand it correctly,

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

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

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One can actually reorganize this inequality, and

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

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

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

which is (i*- i)/(1 + i).

This is essentially the excess return,

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

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

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

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

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

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

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

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

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

buy the foreign currency from the beginning.

14:23

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

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

the terminology that economist used very often.

The issue of exogenous versus endogenous variables.

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

the system you're analyzing.

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

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

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

understand how it's determined, is called endogenous.

The endogenous variables are driven by exogenous variables,

exogenous variables are given for us.

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

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

sometimes in economics we make assumptions about some variables being outside

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

and then go back, and endogenize those exogenous variables.

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

how that will change the entire analysis.

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

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

and made more complicated by endogenizing more variables.

16:03

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

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

domestic currency, or where to buy the two currencies.

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

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

foreign currency asset versus domestic currency assets.

16:31

In analyzing the spot market, and

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

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

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

16:50

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

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

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

17:06

Okay.

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

foreign interest rates, are given.

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

for now, let's take it as given.

17:21

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

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

Meaning they are keeping domestic currency pays off more than

keeping foreign currency.

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

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

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

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

The result is going to be,

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

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

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

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

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

Domestic currency owners, want to buy foreign currency, and

the opposite of what we've seen before happens.

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

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

18:45

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

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

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

19:18

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

we need to look at this equation,

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

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

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

So, eventually, the market comes to rest

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

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

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

but they're essentially equivalent,

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

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

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

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

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

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

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

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

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

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

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

20:51

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

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

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

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

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

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

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

21:30

And to figure that out,

you basically start with the covered interest parity condition,

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

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

the spot rate turns out to be 0.91.

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

higher than the forward rate, because foreign accounts are giving

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

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

However, the forward rate is smaller for

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

If the currency gives you high interest, and

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

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

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

that currency is expected to lose value, then they

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

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

What the covered interest parity basically tells us is that,

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

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

but overall, the payoff should be exactly the same.

If you are a currency trader, for example,

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

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