8.3 Other foreign exchange market rules

Exercise 8.2 requires you to think about the relationship between spot and forward

rates of exchange.

Exercise 8.2

At close of trading on 26 May 2006, the exchange rates for Japanese yen against the US dollar were:

Spot $1 ¥112.625;one-month forward $1 ¥112.15;

three months forward $1 ¥111.23

(a)	Was the yen at a forward premium or discount against the dollar?

(b)	What were the annual percentage premiums or discounts for yen one month and three months forward?

(c)	Given that US dollar one-month interest rates were 5.05 per cent, approximately what must have yen one-month interest rates been?

Answers at end of chapter

8.3Other foreign exchange market rules

We have thus established a relationship between spot and forward exchange rates.

Several other questions follow, however:

l	Why do interest rates differ among countries?
l	What determines the existing spot rates of exchange?
l	What causes spot rates of exchange to change over time?

Each of these questions may also be approached by a rule based upon arbitrage

operations.

8.3.1Differences in interest rates among countries – the Fisher effect

We saw in section 7.1 that nominal rates of interest consist of two elements: (a) the

real rate of interest, and (b) the expected rate of ination. It follows that differences

in expected ination rates provide onecause of differences in international interest

rates.

But what about real rates of interest? Ignoring the issue of exchange rate risk dis-

cussed above, and assuming perfect markets with perfect capital mobility and perfect

information, we saw also in Chapter 7 that market theory tells us that capital should

move from capital-rich countries in which the real rate of return on capital is low to

capital-scarce countries with high real rates of return on capital, and that this move-

ment should continue until real rates of interest are equal across countries.

We also noted in section 7.2 that this does not happen in practice. There we

identied the existence of risk – for example, foreign exchange risk, default risk

and sovereign risk – as one reason for the failure of capital to move in the direction

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Chapter 8 • Foreign exchange markets

suggested by economic theory. Ifall the necessary assumptions did hold, however,

and real rates of interest were equal across countries, international interest rates would

differ only because of: (a) expected exchange rate changes; (b) differences in expected

rates of ination among countries.

This second point allows the application to the explanation of the differences in

interest rates of the Fisher effect, which we introduced in section 7.1 as:

rige

(8.1)

Applying this to the explanation of differences in interest rates between the US

and the UK, we can say that with real interest rates equal across countries and the

foreign exchange market in equilibrium, the difference in nominal interest rates on

dollars and sterling depends on the difference between the expected ination rates

in the US and the UK.

			ee
(i		i)	(gg)
$		£	$£	(8.2)
		
			e
(1		i)	(1 g)
		£	£

This is sometimes known as the Fisher closed hypothesis.

8.3.2

The determinants of spot exchange rates – purchasing power parity

Ifreal interest rates were equal across all countries, however, and there were no

international capital ows, the balance of payments balance would depend solely on

international trade in goods and services. If we then ignored differences in quality

among goods and services and assumed perfect information, the only reason for pre-

ferring foreign goods to home goods or vice versa would be differences in price.

If, at the existing exchange rate, goods were cheaper in the US than in the UK, UK

citizens would switch to US goods. To do this they would sell sterling and acquire

dollars, forcing down the value of the £ relative to the $. This process of goods

arbitrageshould continue until prices in the two countries expressed in a common

currency were equal. This is the essential principle of purchasing power parity(PPP).

In this form – absolute PPP – spot exchange rates in equilibrium are a reection of

differences in price levelsin different countries.

Yet people are generally interested not in absolute exchange rates but rather in

changes from existing rates. Thus, PPP is usually expressed in relative terms. This sug-

gests that changes in spot exchange rates reect differences in ination rates among

countries.

ee	e	e
(gg)	(S	S)
$£	t1	t	(8.3)
		0
e
(1 g)	S
£	t
	0

Purchasing power parity (PPP):The exchange rate between two currencies depends

on the purchasing power of each currency in its home country and the exchange rate

changes to keep the home purchasing power of the two currencies equal.

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