Page 163 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 14 : Exchange Rate : Meaning and Components

Notes

Changes in the price of a currency are referred to as appreciation and depreciation.
Appreciation occurs when a currency becomes more valuable (i.e. more expensive),
and depreciation occurs when a currency becomes less valuable (i.e. less expensive).

Similarly, if an exchange rate decreases, the currency in the denominator of the exchange rate
depreciates relative to the currency in the numerator. This concept can be a little tricky, since it’s easy
to get backwards, but it makes sense : for example, if the USD/EUR exchange rate were to go from 2
to 1.5, a Euro buys 1.5 US dollars rather than 2 US dollars. The Euro therefore depreciates relative to
the US dollar, since a Euro doesn’t trade for as many US dollars as it used to.
14.1 Meaning of Exchange Rate

The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another.
It is the price of one currency in terms of another currency. It is customary to define the exchange rate
as the price of one unit of the foreign currency in terms of the domestic currency. The exchange rate
between the dollar and the pound refers to the number of dollars required to purchase a pound. Thus
the exchange rate between the dollar and the pound from the US viewpoint is expressed as $ 2.50 = £ 1.
The Britishers would express it as the number of pounds required to get one dollar, and the above
exchange rate would be shown as £ 0.40 = $ 1.
The exchange rate of $ 2.50 = £ 1 or £ 0.40 = $ 1 will be maintained in the world foreign exchange
market by arbitrage. Arbitrage refers to the purchase of a foreign currency in a market where its price is low
and to sell it in some other market where its price is high. The effect of arbitrage is to remove differences in
the foreign exchange rate of currencies so that there is a single exchange rate in the world foreign
exchange market. If the exchange rate is $ 2.48 in the London exchange market and $ 2.50 in the New
York exchange market, foreign exchange speculators, known as arbitrageurs, will buy pounds in
London and sell them in New York, thereby making a profit of 2 cents on each pound. As a result, the
price of pounds in terms of dollars rises in the London market and falls in the New York market.
Ultimately, it will equal in both the markets and arbitrage comes to an end. If the exchange rate
between the dollar and the pound rises to $ 2.60 = £ 1 through time, the dollar is said to depreciate
with respect to the pound, because now more dollars are needed to buy one pound. When the rate of
exchange between the dollar and the pound falls to $ 2.40 = £ 1, the value of the dollar is said to
appreciate because now less dollars are required to purchase one pound. If the value of the first
currency depreciates that of the other appreciates, and vice versa. Thus a depreciation of the dollar
against the pound is the same thing as the appreciation of the pound against the dollar, and vice
versa.
14.2 Components of Exchange Rate

Forward and Spot Exchange Rates
There is much empirical work on forward foreign exchange rates as predictors of future spot exchange
rates. There is also a growing literature on whether forward rates contain variation in premiums.
There is a general concensus that forward rates have little if any power to forecast changes in spot
rates. There is less consensus on the existence of time varying premiums in forward rates. Frankel
(1982) and Domowitz and Hakkio (1983) fail to identify such premiums, while Hsieh (1982). Hansen
and Hodrick (1983), Hodrick and Srivastava (1984), and Korajczyk (1983) find evidence consistent
with time varying premiums.
This unit tests a model for joint measurement of variation in the premium and expected future spot rate
components of forward rates. Conditional on the hypothesis that the forward market is efficient or
rational, we find reliable evidence that both components of forward rates vary through time. More
startling are the conclusions that (a) most of the variation in forward rates is variation in premiums, and
(b) the premium and expected future spot rate components of forward rates are negatively correlated.

LOVELY PROFESSIONAL UNIVERSITY 157