International Finance Theory and Policy Analysis, Term Paper Example

Chapter 10

Exchange rate is defined as the total number of units for which a certain currency exchanges for a single unit of another currency. The rate can be expressed in two different ways, for example, the exchange rate for a dollar compared to a pound can be represented as either Dollar/Pound or its reciprocal, Pound/Dollar. The currency value of one currency is usually given in relation to another currency. For example, the value or a British Pound can be given in terms of a Dollar as Dollar/ Pound. The value of a Kenyan shilling is given in terms of a Japanese yen as Yen/ shilling. This value of a currency is the one used in the determination of an exchange rate. For example, the Dollar/Euro exchange rate is the value of the Euro given in terms of the Dollar.

Currency appreciation refers to the increase in value of one currency in relation to another currency. To illustrate this, a dollar and a Euro, the dollar appreciates with respect to the Euro if the Euro/Dollar rate of exchange increases. On the same note, when the Value of exchange of Euro/Dollar decreases, the dollar is said to have depreciated with respect to the Euro. An important point to note is that if the Euro/Pound exchange rate increases, then the reciprocal falls and therefore if one currency appreciates against another, the other currency is said to have depreciated. Again if the currency depreciates, the reciprocal is said to have appreciated. The percentage of increase or decrease over time of a currency value is termed as the rate of appreciation or depreciation.

Currency Arbitrage means the buying of a currency when the buying price is low and resells it when the price increases. The Sport Exchange Rate is the rate of exchange at that time. Forward Exchange Rate is the rate which will appear on the exchange currency contract in the future date. A currency trader is said to be Hedging if he enters into a forward contract with a view of protecting himself from the downward losses.

The foreign exchange market refers to the major international bank activities in currency trading, which act as the middle men between a seller and a buyer of a certain currency. The participants of this foreign exchange market can be grouped into two, namely, the importers and exporters and the investors. The importers and exporters also referred to as current account, involves any person who is either importing or exporting commodities. They will need to exchange their currencies in order to be able to get the commodities of to sell the commodities in a different country. The investors refer to the banks, the international investors among others who may be owners of companies who make investments with a view of getting greater outcome in the future. They form the bulk of the foreign exchange market.

Investors in the foreign exchange market have three main concerns as they make their investment. These include the rate of return of an investment, the amount of risk involved in the investment and the liquidity of the investment. The rate of return is the percentage at which the value of an asset changes in a certain period of time. Most of the investors wish to have a very high rate of return from their investments. The risk of an investment is another primary concern of investors. In general terms, if the expected rate of return is high then the risk is also high. A very important concern in any investment is the balancing between the risk of the investment and the rate of return. The investor must weigh between the rates at which the investment will bring returns to the amount of risk involved.

The higher the risk taken by the investor, the higher the expected rate of return should be. Therefore, it an investor wishes to have a high rate of return he must also be ready to take higher risks in the investment. The liquidity refers to the easiness of an asset at which it can be converted to become cash.

Chapter 20

The IRP (interest rate parity) is true if only for example the rate of return on the deposits of dollar is equal to the rate of return which is expected from the British deposits. In calculation of this, the interest terms of the final British terms can be dropped in the calculation of the interest rate of parity. This will only give a true figure if the rate of the interests in a country is not high. For example in the year 1997, the Russia’s short-term interest rates were as high as sixty percent (60%) and in the same year the interest rate for Turkey was seventy five percent per year. With these high interest rates, the approximate rates of return can not be calculated accurately with omission of the final countries interest terms.

To illustrate the above, Lets consider the interest rate for a dollar to be two point three seven (2.37) percent per year, that of a pound to be four point eight three (4.83) percent, the Exchange rate for a pound in the year 2004 to be one point nine six (1.96) Dollars/ Pound and the exchange rate of the for the year 2005 to be one point seven five (1.75) Dollars/ Pound. The investment decision is supposed to be made in 2004, but looking forward to 2005. Therefore, the expected exchange rate for the 2005 is determined and we use the 2004 exchange rates to be the sport rate. Therefore, the rate of return for a British deposit is calculated as:

Rate of Return for the pound = (0.0483) + (1 + 0.0483) (1.75 – 1.96)/ 1.96.

If the rate of return turns out to be negative, then the investor has lost money which is in terms of dollars when he purchased an asset in Britain. Since the Rate of Return of the Dollar (2.37) is higher than the rate of return on the pound (-6.4), then, an investor who is seeking to have the highest rate of return should deposit the money in an account in the United States. A positive value means that the investor has gained by depositing his or her currency in the account of that country.

The condition of the interest parity can at times be used in the development of a model of determining the rate of exchange. It involves the interpretation of the rate of return in aggregate terms. Therefore, the interests rates of the two countries are interpreted as an average which is expected for different investors. Then, return rates result from this average on a variety of assets from the two countries. If the investors are trading in the foreign exchange market, then the supply and the demand of the pounds and its price are measured. If the Exchange rate for a pound rises, then the rate of return of the pound falls. Hence the investors in Britain will need more pounds compared to United States of America who will need less Pounds. If the exchange rates in the foreign exchange market fall, then the rate of return increases. Again, an increase in the interest rates in Britain will lead to appreciation of the pound and depreciation in the dollar. Conversely, a decrease in the interest rates of Britain will lead to a depreciation of the pound and an appreciation of the Dollar.

Increasing the exchange rate expected value, leads to an appreciation of the pound and depreciation to the dollar. On the same note, decreasing of the exchange rate expected value will lead to depreciation of the pound and an appreciation of the dollar. If two curves of the Rate of Return of two different countries, say United States and the Britain, the point of their interception is the unique Exchange rate for the pound, compared to the dollar, which is the point equalizing the countries’ rate of return, in these case, the rates of return of both the United States and Britain.

In the exchange rate equilibrium, the endogenous variable is usually the exchange rate. It is the value which is able to bring a change to the equilibrium if it changes. Therefore, changes in this endogenous value will lead to a change in the equilibrium. If the exchange rate is low, then the rate of return on the pound is higher than the rate of return on the dollar and therefore most investors shift their investments to Britain. Also, an increase in the exchange rates in the US will increase the rate of return on the dollar and investors shift to US. The same will also apply to Britain, that is, if the exchange rates increase in the Britain, the rate of return on the pound is high and hence investors shift to Britain. An increase of the expected future exchange rates of the pound against the dollar will raise the pound’s rate of return more than the one for the dollar.

Chapter 30

The purchasing power parity is an exchange theory for the determination of the exchange rate and also for the comparison of two countries average cost of services or goods. It makes an assumption that exporters and importers, who are motivated by the differences in the cross country prices, are the ones who induce the spot exchange rate changes. It also suggests that transactions in on the current accounts of a country usually affect the exchange rate value in the markets. This is the opposite of the theory of the interest rate parity which usually assumes that the investor’s actions, who have their transactions being recorded in the capital account, are the ones who induce the exchange rate changes. The purchasing power parity is based on the law of one price idea.

The law on one price states that goods which are identical are supposed to sell at one price in two different and separate markets if the transportation costs and the taxes are applied similarly on the goods in the two markets. But this is usually affected by the demand. If the demand of the goods or services in one of the markets go up then the price of these goods and services increase in that market than in the other market. This then follows that if an investor buys goods from the market with the low demand and hence lower price and sells them in a market with higher demand and hence higher prices, then the investor will make profits.

The Purchasing power parity exchange rate between two countries will equal the ratio of costs of two goods which are the same bought from different market, which are dominated by the units of the local currency. Since the cost of goods is usually written in terms of the consumer price index, then purchasing power parity is written as the relationship between the exchange rate and the price indices of the country. The purchasing power parity is just the law of one price which has been applied on an aggregate.

The consumer price index is a measure of the prices of services and goods on an average level in an economy, in relation to a reference year. The quantities of the goods which have been purchased are assumed to be the same in the different years. This is achieved by the determination of the average of all household goods which have been purchased in the years. The total of all these goods is referred to as the average market basket. The cost of this average market basket is determined by getting the average prices fir all the goods in the market. The first year on which the consumer price index was constructed is usually referred to as the base year or the reference year. The consumer price index of the different year is the ratio between the costs of the market basket in the year in question in relation to the base year. The rise in the consumer price index does not mean all the prices of the goods in the market have gone high since some of the goods prices may increase while others decrease or remain constant. The inflation rate is the percentage at which the consumer price index rises per a year.

The Purchasing power parity introduces the assumptions that exporters and importers behaviors result to changes of the relative costs in the national market baskets, therefore becoming a theory of determination of the exchange rate. In summary, an increase in the prices of goods and services in one country in relation to another country causes the latter countries currency to appreciate and the former countries currency to depreciate in accordance to the theory of purchasing power parity.

This theory has problems which include the restrictions in the trade and transportation costs, the inputs costs which are non tradable determination, perfect information regarding the individuals purchasing the goods in the two markets and the presence of other participants in the markets. The purchasing power parity has a relative theory which is called Relative PPP theory, which is more dynamic then the original purchasing power theory. In this theory, the exchange rates, which change with time, are assumed to be as a result of the inflation rates of different times. In the long run, when the purchasing power parity is applied on a real world data does not work properly.

There can be an overvaluation or undervaluation of the exchange rates of a country. With respect to the purchasing power parity, if a countries country is overvalued, then the spot exchange rate will exceed the purchasing power parity exchange rate. On the same note, the undervaluing of the exchange rate of a country’s currency, the spot exchange rate becomes less than the purchasing power parity exchange rate. One of the most important purchasing power parity applications is the making comparisons in different countries of the total incomes, the gross domestic products and the wages. It serves as one of the most useful tool in this comparison.