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1、An Introduction to Exchange Rate DeterminationWONG Ka Fu10th January 2000And ArbitrageHowwouldyou explainthe movement of Japanese Yen?(source:http:/merce.ubc.ca/xr/plot.html)Howwouldyou explainthe movement of Japanese Yen?(source:http:/merce.ubc.ca/xr/plot.html)Howwouldyou explainthe movement of Eur
2、opean Euros?(source:http:/merce.ubc.ca/xr/plot.html)Howwouldyou explainthe movement of European Euros?(source:http:/merce.ubc.ca/xr/plot.html)Howdoweexplainthemovementofforeignexchange?ArbitragePurchasing Power ParityHong KongsCurrencyBoardmechanismUCMacDonaldNAMacDonaldPricesofBigMac7.8015.60Case 1
3、What would youdo?What would youdo?Choosethe cheaperMacDonaldforlunch.BuyBig Macfrom UC andsell at NA.Effectofour actionOuraction:Choosethe cheaperMacDonaldforlunch.BuyBig Macfrom UC andsell at NA.More supplyofBigMac,less demandforBig MacAtNAPriceofBigMac falls.Greater demandforBig Mac,lesssupplyfor
4、BigMacAtUCPriceofBigMac increases.UCMacDonaldNAMacDonaldWhat would youdointheabsenceoftransactioncosts?PUCPNACase 2PUCPNACase 3Arbitrageactivitiescontinueuntilpricesequalize.That is,PHK= ePUSande =PHK/ PUSPricesatdifferent locations,whenexpressedinthe samecurrency, havetoequalize.That is,Purchasing
5、Power ParityExchangerate impliedbyPPPe =PHK/ PUSPHK= ePUS.Ife is fixed,PUShastoadjust whenthereisachangeinPHK.Purchasing Power ParityThreevariablesinthe relation:Knowing anytwoofthem,wecan computethe third.PHK= ePUS.e PHKPUSIfPUSisfixed,ehastoadjust whenthereisachangeinPHK.Otherarbitrageopportunitie
6、sacrossspaceInternational phone call:HKdirecttoBeijing(Price= P1)HKtoCantonprovince, fromwherethe callisredirectedtoBeijing (Price=P2)ArbitrageopportunitiesexistswhenP1 P2,orP1-P2 0.Arbitrageactivities(though illegal)will drive P1-P2 towardszero.ArbitrageopportunitiesacrossspaceABXP2P1Otherarbitrage
7、opportunitiesacrossspaceBuyingorsellingJapaneseYenHKDdirect to JPY(Price= P1)HKDtoSwedishKronaandSwedishKronatoYen(Price=P2)ArbitrageopportunitiesexistswhenP1 P2,orP1-P2 0.Arbitrageactivitieswill drive P1-P2 towardszero.Arbitrageacross timeTodayTomorrow189200StockpricesIfcost of interest is zero,one
8、wouldliketobuystocktoday, holditfor aday andsell it tomorrow.Profit=11.Arbitrageacross timeinreallifeInreal life, interest rateisnonzeroandwedonot knowtomorrowsstockpriceforsure.Thus,economictheoryhas to adjustforthesefactorsbutstilluses thisideaofarbitrage.What doesPPP tellusaboutexchangeratesBigMa
9、c Index by Economists:“Big MacCurrencies”11April,1998.HKsBigMacJapans BigMacHKD10.2Yen280e= PHK/ PJP= 10.2/280= HKD364.29per 10000 YenWhyisBig MacIndexsofaroff fromthe actualexchangerates?Adjustment of pricesslow in general(price rigidity)Noiseneed to useeconometricstotestthetheoryOtherfactors (anda
10、lsonoise)thatdeterminestheexchangerate.Transportationtakestime (some goods areperishable)TheIdeaofHong KongsCurrencyboardBank ABank B10Exchangerate quotes(per USD)7.8Arbitragewilleliminatethe difference.TheIdeaofHong KongsCurrencyboardHKMABank B10Exchangerate quotes(per USD)7.8Because HKMAwillsupply
11、and demandHKDat7.8,arbitragewillpushHKsexchangerate to 7.8.Whywouldthe supplyofHKdollarfallinto ashortagewhenspeculatorsattackHKD?SpeculatorsattackHKD becausetheyexpectHKD to devalue.E.g.,from 1:7.8 to 1:15.6.IfyouknowthatHKsexchangerate willdevaluefrom 1:7.8 to 1:15.6,you cansell HKDandbuy USDtoday
12、buyHKD andsell USDafterdevaluationWhowouldtradewithyou?When you(the public)sellHKDand buyUSDtoday, HKMAbuysHKDand sells USD.Interestrate hastogoupgivenmoneyandloandemandbythe public.TheHKMApromisestobuyand sellHKD at 1:7.8 .Less money is in publics hand.That is money supplydecreases.Whywouldthe supp
13、lyofHKdollarfallinto ashortagewhenspeculatorsattackHKD?Effectofhighinterestrate?InvestmentConsumptionWhen willinterestratereturntoa“normal”level?What doesPPP say?What doesinterestparity say?Will interest ratebebacktothenormal level if thegovernment go fishingorgolfing?-End-Pricesatdifferent locations,whenexpressedinthe samecurrency, havetoequalize.That is,Purchasing Power ParityExchangerate impliedbyPPPe =PHK/ PUSPHK= ePUS.SpeculatorsattackHKD becausetheyexpectHKD to devalue.E.g.,fr
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