Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,An Introduction to Exchange Rate Determination,WONG Ka Fu,10th January 2000,And Arbitrage,How would you explain the movement of Japanese Yen?,(source:),How would you explain the movement of Japanese Yen?,(source:),How would you explain the movement of European Euros?,(source:),How would you explain the movement of European Euros?,(source:),How do we explain the movement of foreign exchange?,Arbitrage,Purchasing Power Parity,Hong Kongs Currency Board mechanism,UC MacDonald,NA MacDonald,Prices of Big Mac,7.80,15.60,Case 1,What would you do?,What would you do?,Choose the cheaper MacDonald for lunch.,Buy Big Mac from UC and sell at NA.,Effect of our action,Our action:,Choose the cheaper,MacDonald,for lunch.,Buy Big Mac from UC and sell at NA.,More supply of Big Mac,less demand for Big Mac,At NA,Price of Big Mac falls.,Greater demand for Big Mac,less supply for Big Mac,At UC,Price of Big Mac increases.,UC MacDonald,NA MacDonald,What would you do in the absence of transaction costs?,P,UC,P,NA,Case 2,P,UC,P,NA,Case 3,Arbitrage activities continue until prices equalize.,That is,P,HK,=e,P,US,and,e=P,HK,/P,US,Prices at different locations,when expressed in the same currency,have to equalize.That is,Purchasing Power Parity,Exchange rate implied by PPP,e=P,HK,/P,US,P,HK,=e,P,US,.,If e is fixed,P,US,has to adjust when there is a change in P,HK,.,Purchasing Power Parity,Three variables in the relation:,Knowing any two of them,we can compute the third.,P,HK,=e,P,US,.,e,P,HK,P,US,If P,US,is fixed,e has to adjust when there is a change in P,HK,.,Other arbitrage opportunities across space,International phone call:,HK direct to Beijing(Price=P1),HK to Canton province,from where the call is redirected to Beijing(Price=P2),Arbitrage opportunities exists when P1,P2,or P1-P2 0.,Arbitrage activities(though illegal),will drive P1-P2 towards zero.,Arbitrage opportunities across space,A,B,X,P,2,P,1,Other arbitrage opportunities across space,Buying or selling Japanese Yen,HKD direct to JPY(Price=P1),HKD to Swedish Krona and Swedish Krona to Yen(Price=P2),Arbitrage opportunities exists when P1,P2,or P1-P2 0.,Arbitrage activities,will drive P1-P2 towards zero.,Arbitrage across time,Today,Tomorrow,189,200,Stock,prices,If cost of interest is zero,one would like to buy stock today,hold it for a day and sell it tomorrow.Profit=11.,Arbitrage across time in real life,In real life,interest rate is nonzero and we do not know tomorrows stock price for sure.,Thus,economic theory has to adjust for these factors but,still uses this idea of arbitrage.,What does PPP tell us about exchange rates,Big Mac Index by Economists:,“Big Mac Currencies 11 April,1998.,HKs Big Mac,Japans Big Mac,HKD 10.2,Yen 280,e=P,HK,/P,JP,=10.2/280,=HKD 364.29 per 10000 Yen,Why is Big Mac Index so far off from the actual exchange rates?,Adjustment of prices slow in general(price rigidity),Noise,need to use econometrics to test the theory,Other factors(and also noise)that determines the exchange rate.,Transportation takes time(some goods are perishable),The Idea of Hong Kongs Currency board,Bank A,Bank B,10,Exchange,rate quotes,(per USD),7.8,Arbitrage will eliminate the difference.,The Idea of Hong Kongs Currency board,HKMA,Bank B,10,Exchange,rate quotes,(per USD),7.8,Because HKMA will supply and demand HKD at 7.8,arbitrage will push HKs exchange rate to 7.8.,Why would the supply of HK dollar fall into a shortage when speculators attack HKD?,Speculators attack HKD because they expect HKD to devalue.E.g.,from 1:7.8 to 1:15.6.,If you know that HKs exchange rate will devalue from 1:7.8 to 1:15.6,you can,sell HKD and buy USD today,buy HKD and sell USD after devaluation,Who would trade with you?,When you(the public)sell HKD and buy USD today,HKMA buys HKD and sells USD.,Interest rate has to go up given money and loan demand by the public.,The HKMA promises to buy and sell HKD at 1:7.8.,Less money is in publics hand.That is money supply decreases.,Why would the supply of HK dollar fall into a shortage when speculators attack HKD?,Effect of high interest rate?,Investment,Consumption,When will interest rate return to a“normal level?,What does PPP say?,What does interest parity say?,Will interest rate be back to the normal level if the government go fishing or golfing?,-,End-,Prices at different locations,when expressed in the same currency,have to equalize.That is,Purchasing Power Parity,Exchange rate implied by PPP,e=P,HK,/P,US,P,HK,=e,P,US,.,Speculators attack HKD because they expect HKD to devalue.E.g.,from 1:7.8 to 1:15.6.,If you know that HKs exchange rate will devalue from 1:7.8 to 1:15.6,you can,sell HKD and buy USD today,buy HKD and sell USD after devaluation,Why would the supply of HK dollar fall into a shortage when speculators attack HKD?,