Lecture 1 1-1

ECN732: International Finance

Lecture 1
International Setting
Dr Arshad Ali Bhatti
School of Economics, IIIE
Spring, 2018

Course Information
 Recommended Texts
 Copeland, L.: Exchange Rates and International Finance, Pearson, 2014.
 Terra, C.: Principles of International Finance and Open Economy
Macroeconomics, Elsevier, 2015.
 Gandolfo, G.: International Finance and Open Economy Macroeconomics,
Springer, 2e, 2016.
 Hallwood, C. P. and McDonald, R.: International Money and Finance, 3rd Ed.,
Blackwell, 2000.
 Krugman, P.R., Obsfeld, M., and Melitz, M.J.: International Economics: Theory
and Policy, 9th Ed., Addison-Wesley, 2012. [undergraduate level]
 Above texts will be supplemented with other books and reading material
 Assessment
 Group Project/ Assignments 30%
 Mid Term Exam 20%
 Final Exam 50%
 Late and copied assignments shall carry ZERO reward.
 Course Material: https://www.ecopulsars.blogspot.com
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Lecture 1 1-2

Writing an Empirical Project

 Integral part of this course

 Objective is to provide you hands-on experience of
exploring practical issues, problems and new ideas.
1. Introduction
2. Literature Review
3. Methodology and Data
Theoretical background, Model, Description of variables and source,
Estimation method, Diagnostics
4. Results and Discussion
5. Conclusion and Policy Recommendations
6. References [APA 6 using EndNote]
7. Appendix

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Some Suggested Areas

 You can choose any topic from

 International financial environment

 Balance of payments analysis

 Purchasing power parity- empirical testing

 Managing currency risk

 Foreign investment decisions

 Financing foreign operations

 Integration of World stock markets

 Economics of exchange rates

 Exchange rate pass through,…, bla bla bla

 Sample list of topics is posted on EcoPulsars

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Lecture 1 1-3

Lecture Plan

An introduction to the following topics

 The basics of exchange rates
 Exchange rates and the prices of goods
 The foreign exchange markets
 The demand for currency and other assets
 A model of foreign exchange markets
 role of interest rates in currency deposits
 role of expectations of exchange rates
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Definitions of Exchange Rates

 Exchange rates are quoted as foreign currency per unit

of domestic currency or domestic currency per unit of
foreign currency.
 How much can be exchanged for one dollar? PKR110.62/$
 How much can be exchanged for one Rupee? $0.0090/PKR

 Exchange rates allow us to denominate the cost or price

of a good or service in a common currency.
 How much does a Honda City cost? PKR1600,000
 Or, PKR1600,000 x $0.0090/PKR = $14464

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Lecture 1 1-4

Exchange Rate Quotations

FT: 20FEB2018

Currencies GBP £ EUR € USD $ JPY ¥

Australia (1 AUD) 0.5639 0.6392 0.7879 84.55

China (1 CNY) 0.1127 0.1277 0.1574 16.891

Hong Kong (1 HKD) 0.0915 0.1037 0.1278 13.7132

India (1 INR) 0.011 0.0125 0.0154 1.6548

Indonesia (1 IDR) 0.00005 0.00006 0.00007 0.0079

Japan (1 JPY) 0.0067 0.0076 0.0093 N/A

Malaysia (1 MYR) 0.1834 0.2077 0.2563 27.4706

New Zealand (1 NZD) 0.5252 0.5952 0.7338 78.74

Singapore (1 SGD) 0.5421 0.6145 0.7575 81.2817

South Korea (1 KRW) 0.0007 0.0008 0.0009 0.0999

Taiwan (1 TWD) 0.0245 0.0278 0.0343 3.6724

Thailand (1 THB) 0.0227 0.0257 0.0317 3.4042

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Pakistan Rupee Exchange Rate

http://hamariweb.com/finance/forex/foreign_exchange_rate.aspx (20FEB2018)

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Lecture 1 1-5

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. It now takes $1.20 to
buy one euro, so that the dollar is less valuable.
 The euro has appreciated relative to the dollar:
it is now more valuable.

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Cont.

 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. It now takes
only $0.90 to buy one euro, so that the dollar is more
valuable.
 The euro has depreciated relative to the dollar:
it is now less valuable.

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Lecture 1 1-6

Cont.

 A depreciated currency is less valuable, and therefore it

can buy fewer foreign produced goods that are
denominated in foreign currency.
 A Nissan costs ¥2,500,000 = $25,000 at $0.010/¥
 becomes more expensive $27,962.50 at $0.011185/¥

 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.

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Cont.

 An appreciated currency is more valuable, and

therefore it can buy more foreign produced goods that
are denominated in foreign currency.
 A Nissan costs ¥2,500,000 = $27,962.50 at $0.011185/¥
 becomes less expensive $25,000 at $0.010/¥

 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.

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Lecture 1 1-7

Pakistan Rupee ER (Historical View)

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Foreign Exchange Markets

 The set of markets where foreign currencies

and other assets are exchanged for domestic
ones
 Institutions buy and sell deposits of currencies or
other assets for investment purposes.
 The daily volume of World foreign exchange
transactions was around $5.3 trillion in 2014 as
compared to $4.0 trillion in April 2010.
 up from $500 billion in 1989.
 Most transactions (85% in April 2010/2014)
exchange foreign currencies for U.S. dollars.
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Lecture 1 1-8

Cont. (2014)

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Pakistan FOREX Reserves

(Historical View)

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Lecture 1 1-9

Cont.

The participants:
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in different
currencies for investment purposes.
2. Non-bank financial institutions (mutual funds, hedge
funds, securities firms, insurance companies, pension
funds) may buy/sell foreign assets for investment.
3. Non-financial businesses conduct foreign currency
transactions to buy/sell goods, services and assets.
4. Central banks: conduct official international
reserves transactions.

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Cont.

 Buying and selling in the foreign exchange

market are dominated by commercial and
investment banks.
 Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more
per transaction.
 Central banks sometimes intervene, but the direct
effects of their transactions are small and transitory
in many countries.

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Lecture 1 1-10

Cont.
 Computer and telecommunications technology
transmit information rapidly and have integrated
markets.
 The integration of financial markets implies that
there can be no significant differences in
exchange rates across locations.
 Arbitrage: buy at low price and sell at higher price for a
profit.
 If the euro were to sell for $1.1 in New York and $1.2 in
London, could buy euros in New York (where cheaper)
and sell them in London at a profit.

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Spot Rates and Forward Rates

 Spot rates are exchange rates for currency

exchanges “on the spot,” or when trading is
executed in the present.
 Forward rates are exchange rates for currency
exchanges that will occur at a future (“forward”)
date.
 Forward dates are typically 30, 90, 180, or 360 days
in the future.
 Rates are negotiated between two parties in the
present, but the exchange occurs in the future.

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Lecture 1 1-11

Dollar/Pound Spot and Forward Exchange

Rates, 1983–2011

Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange
rates, at end of month.

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Other Methods of Currency Exchange

 Foreign exchange swaps: a combination of a spot

sale with a forward repurchase.

 Swaps allow parties to meet each other’s needs for a temporary

amount of time and often cost less in fees than separate
transactions.

 Example: Suppose Toyota receives $1 million from American

sales, plans to use it to pay its California suppliers in three
months, but wants to invest the money in Eurobonds in the
meantime.

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Lecture 1 1-12

Cont.

• Example 2:
• A British Company may be long EUR from sales in Europe but operate
primarily in Britain using GBP. However, they know that they need to pay
their manufacturers in Europe in 1 months time.
• They could of course SPOT Sell their EUR and buy GBP to cover
their expenses in Britain, and then in one month SPOT Buy EUR and
sell GBP to pay their business partners in Europe.
• However, this exposes them to FX risk. If Britain has financial trouble and
the EUR/GBP exchange rate goes against them, they may have to spend
a lot more GBP to get the same amount of EUR.
• Therefore, they create a 1Month Swap, where they Sell EUR and Buy
GBP on SPOT and simultaneously Buy EUR and Sell GBP on a 1 Month
(1M) forward. This significantly reduces their risk as they know that they
will be able to purchase EUR reliably, while still being able to use the
money for their domestic transactions in the meantime.
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Cont.

 Futures contracts: a contract designed by a third

party for a standard amount of foreign currency
delivered/received on a standard date.

 Contracts can be bought and sold in markets, and only the

current owner is obliged to fulfill the contract.

 Highly standardized contrary to forwards

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Lecture 1 1-13

Cont.

 Options contracts: a contract designed by a third party

for a standard amount of foreign currency
delivered/received on or before a standard date.
 Contracts can be bought and sold in markets.
 A contract gives the owner the option, but not obligation, of
buying or selling currency if the need arises.

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The Demand for Currency Deposits

 What influences the demand for (willingness to buy)

deposits denominated in domestic or foreign currency?

 Factors that influence the return on assets determine

the demand of those assets.

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Lecture 1 1-14

Cont.

 Rate of return: the percentage change in value that an

asset offers during a time period.
 The annual return for $100 savings deposit with an interest rate of
2% is $100 x 1.02 = $102, so that the rate of return = ($102 –
$100)/$100 = 2%.
 Real rate of return: inflation-adjusted rate of return,
 which represents the additional amount of goods & services that
can be purchased with earnings from the asset.
 The real rate of return for the above savings deposit when inflation
is 1.5% is 2% – 1.5% = 0.5%. After accounting for the rise in the
prices of goods and services, the asset can purchase 0.5% more
goods and services after 1 year.

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Cont.

 If prices are fixed, the inflation rate is 0% and (nominal)

rates of return = real rates of return.
 Because trading of deposits in different currencies
occurs on a daily basis, we often assume that prices do
not change from day to day.
 A good assumption to make for the short run.

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Lecture 1 1-15

Cont.

 Risk of holding assets also influences decisions about

whether to buy them.
 Liquidity of an asset, or ease of using the asset to buy
goods and services, also influences the willingness to
buy assets.

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Cont.

 But we assume that risk and liquidity of currency

deposits in foreign exchange markets are essentially
the same, regardless of their currency denomination.
 Risk and liquidity are only of secondary importance when
deciding to buy or sell currency deposits.
 Importers and exporters may be concerned about risk and
liquidity, but they make up a small fraction of the market.

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Lecture 1 1-16

Cont.

 We therefore say that investors are primarily concerned

about the rates of return on currency deposits.
 Rates of return that investors expect to earn are
determined by
 interest rates that the assets will earn
 expectations about appreciation or depreciation

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Cont.

 A currency deposit’s interest rate is the amount of a

currency that an individual or institution can earn by
lending a unit of the currency for a year.
 The rate of return for a deposit in domestic currency is
the interest rate that the deposit earns.
 To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider
 the interest rate for the foreign currency deposit
 the expected rate of appreciation or depreciation of the
foreign currency relative to the domestic currency.

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Lecture 1 1-17

Interest Rates on Dollar and Yen Deposits,

1978–2011

Source: Datastream. Three-month interest rates are shown.

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Cont.

 Suppose the interest rate on a dollar deposit is 2%.

 Suppose the interest rate on a euro deposit is 4%.
 Does a euro deposit yield a higher expected rate
of return?
 Suppose today the exchange rate is $1/€1, and the expected
rate one year in the future is $0.97/€1.
 $100 can be exchanged today for €100.
 These €100 will yield €104 after one year.
 These €104 are expected to be worth $0.97/€1 x €104 =
$100.88 in one year.

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Lecture 1 1-18

Cont.

 The rate of return in terms of dollars from investing in

euro deposits is
($100.88 – $100)/$100 = 0.88%.
 Let’s compare this rate of return with the rate of return
from a dollar deposit.
 The rate of return is simply the interest rate.
 After 1 year the $100 is expected to yield $102:
($102 – $100)/$100 = 2%
 The euro deposit has a lower expected rate of return:
thus, all investors should be willing to dollar deposits
and none should be willing to hold euro deposits.

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Cont.

 Note that the expected rate of appreciation of the euro

was ($0.97 – $1)/$1 = –0.03 = –3%.
 We simplify the analysis by saying that the dollar rate
of return on euro deposits approximately equals
 the interest rate on euro deposits
 plus the expected rate of appreciation of euro deposits
 4% + –3% = 1% ≈ 0.88%
 R€ + (Ee$/€ – E$/€)/E$/€

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Lecture 1 1-19

Cont.

 The difference in the rate of return on dollar deposits

and euro deposits is
R$ – (R€ + (Ee$/€ – E$/€)/E$/€ ) =
R$ –R€ –(Ee$/€ – E$/€)/E$/€
expected current
interest rate exchange rate exchange rate
expected rate
on euro
of return =
deposits
interest rate expected rate of
on dollar appreciation of the euro
deposits

expected rate of return on euro deposits

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Comparing Dollar Rates of Return on Dollar

and Euro Deposits

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Lecture 1 1-20

Model of Foreign Exchange Markets

 We use the
 demand of (rate of return on) dollar denominated deposits
 and the demand of (rate of return on) foreign currency
denominated deposits
to construct a model of foreign exchange markets.

 This model is in equilibrium when deposits of all

currencies offer the same expected rate of return:
interest parity.
 Interest parity implies that deposits in all currencies are equally
desirable assets.
 Interest parity implies that arbitrage in the foreign exchange
market is not possible.

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Cont.

 Interest parity says:

R$ = R€ + (Ee$/€ – E$/€)/E$/€
 Why should this condition hold? Suppose it didn’t.
 Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€
 Then no investor would want to hold euro deposits, driving down the
demand and price of euros.
 Then all investors would want to hold dollar deposits, driving up the
demand and price of dollars.
 The dollar would appreciate and the euro would depreciate,
increasing the right side until equality was achieved:
R$ > R€ + (Ee$/€ – E$/€)/E$/€

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Lecture 1 1-21

Cont.

 How do changes in the current exchange rate affect the

expected rate of return of foreign currency deposits?

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Cont.

 Depreciation of the domestic currency today lowers the

expected rate of return on foreign currency deposits.
Why?
 When the domestic currency depreciates, the initial
cost of investing in foreign currency deposits
increases, thereby lowering the expected rate of
return of foreign currency deposits.

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Lecture 1 1-22

Cont.

 Appreciation of the domestic currency today raises the

expected return of deposits on foreign currency
deposits. Why?
 When the domestic currency appreciates, the initial cost of
investing in foreign currency deposits decreases, thereby
increasing the expected rate of return of foreign currency
deposits.

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Today’s $/€ Exchange Rate and the Expected Dollar

Return on Euro Deposits When Ee$/€ = $1.05 per Euro

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Lecture 1 1-23

The Relation Between the Current $/€ Exchange Rate

and the Expected Dollar Return on Euro Deposits

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Determination of the Equilibrium Dollar/Euro

Exchange Rate

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Lecture 1 1-24

Cont.

 The effects of changing interest rates:

 an increase in the interest rate paid on deposits
denominated in a particular currency will increase the
rate of return on those deposits.
 This leads to an appreciation of the currency.
 Higher interest rates on dollar-denominated assets
cause the dollar to appreciate.
 Higher interest rates on euro-denominated assets
cause the dollar to depreciate.

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Effect of a Rise in the Dollar Interest Rate

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Lecture 1 1-25

Effect of a Rise in the Euro Interest Rate

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The Effect of an Expected Appreciation

of the Euro

 If people expect the euro to appreciate in the future,

then euro-denominated assets will pay in valuable
euros, so that these future euros will be able to buy
many dollars and many dollar-denominated goods.

 The expected rate of return on euros therefore

increases.
 An expected appreciation of a currency leads to an
actual appreciation (a self-fulfilling prophecy).
 An expected depreciation of a currency leads to an
actual depreciation (a self-fulfilling prophecy).

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Lecture 1 1-26

Cumulative Total Investment Return in Australian Dollar

Compared to Japanese Yen, 2003-2010

Source: Exchange rates and three-month treasury yields from Global Financial Data.

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Covered Interest Parity

 Covered interest parity relates interest rates across

countries and the rate of change between forward
exchange rates and the spot exchange rate:
R$ = R€ + (F$/€ – E$/€)/E$/€
where F$/€ is the forward exchange rate.
 It says that rates of return on dollar deposits and
“covered” foreign currency deposits are the same.
 How could you earn a risk-free return in the foreign exchange
markets if covered interest parity did not hold?
 Covered positions using the forward rate involve little risk.
 We’ll be discussing these issues in coming lectures.

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Lecture 1 1-27

References

 Gandolfo (2016); Chaps 1 & 2

 Copeland (2014); Chap 1
 Krugman (2012); Chap 14

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