BEE2037- MONEY AND BANKING

The foreign exchange market: an asset approach

Week 10
 Outline

1 Introduction

2 The basics of exchange rates

3 The foreign exchange market

4 UIP condition

5 Graphical analysis of the UIP condition

6 Summary

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 Last week

Financial innovation and types of financial innovations.

Securitisation and the shadow banking system.
» Securitisation and trading of subprime mortgages increased systemic
risk in the financial markets prior to the GFC.
Mobile banking can promote financial inclusivity economies.
Financial innovations has led to the decline of traditional banking
globally.

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 Introduction

Introduction

Figure 1: G-7 Currency Volatility Surpasses Emerging-Market Peers With ‘British Peso’
Plunge Source: Bloomberg (2022)

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 Introduction

Introduction

Therefore, this week we address the following questions:

1 What is the definition of the exchange rate?
2 Who are the players in the foreign exchange market?
3 How can we model the link between monetary policy and the foreign
exchange rate market?
4 How do expectations and interest rate arbitrage determine the
exchange rate?

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 The basics of exchange rates

Defining the nominal exchange rate

Price of a foreign currency expressed in terms of a home currency.

Denote the nominal exchange rate as e.
Two definitions of nominal exchange rates.
1 Define e as the number of units of home currency per unit of foreign
currency.
no. units of home currency
e= (1)
one unit of foreign currency
£
For example, e = $1
.
2 Exchange rates can also be quoted as number of units of foreign
currency per unit of domestic currency.
Most commonly used in the financial markets.
In this module, we use the first definition.

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 The basics of exchange rates

Defining the nominal exchange rate

Why is the exchange rate important and what does it mean to us?
» Exchange rates allow us to denominate the cost or price of a good or
service in a common currency.
» Exchange rates represent a cost to firms.
» Exchange rate changes create a risk to those firms that hold assets in
currencies other than Sterling.
» Exchange rates affect the price of exports.

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 The basics of exchange rates

Defining the nominal exchange rate

Depreciation and appreciation of home’s currency.

» Depreciation of a currency relative to another currency implies it is less
valuable.
» Appreciation is a rise in the value of a currency relative to another
currency.

If the value of e increases, then

it is a depreciation of home’s
currency.
Why?
» One unit of foreign’s currency
will buy more units of home’s
currency.
Plot of e against time.

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 The basics of exchange rates

Defining the nominal exchange rate

Assumption: exchange rate is a jump variable affected by news.

Figure 2: Exchange rates jumps in the UK. Source: Bank of England (2023), BBC (2019,
2022)

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 The basics of exchange rates

Defining the nominal exchange rate

Other important definitions:

» Spot rates: exchange rates for currency exchanges ‘on the spot,’ or
when trading is executed in the present.
» Forward rates: exchange rates for currency exchanges that will occur
at a future (‘forward’) date.
What is a disadvantage of forward rates?

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 The basics of exchange rates

Real exchange rate

Concept of the real exchange rate
Home’s real exchange rate (RER or Q):

price of foreign goods expressed in home currency P ∗e

Q≡ = (2)
price of home goods P
where P ∗ is the foreign price and P is the home price.
A rise in Q is a real depreciation of the home currency.
The real exchange can also be in terms of costs:

ULC∗ e
RULC =
ULC
where ULC is the unit labour cost and RULC is the relative unit
labour cost.

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 The basics of exchange rates

Real exchange rate

Time for task 1.

Task 1
In this task, I would like you to do the following.
Using any database or news website, analyse the movement of the US
dollar (USD) against either the Euro (EUR), Japanese Yen (JYN),
Renminbi (CNY), Sterling pound (GBP) or Swedish krona (SEK) between
1 August 2020 and 26 November 2023. Do you observe any jumps?

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 The foreign exchange market

The foreign exchange market

The set of markets where foreign currencies and other assets are
exchanged for domestic ones.
What is the average daily volume in global foreign exchange (FX)
market?
» The BIS (2022), Triennial Central Bank Survey of FX and
over-the-counter (OTC) derivatives market:
In April 2022, trading in FX market reached $7.5 trillion per day.
In April 2019, trading in FX market reached $6.59 trillion per day.
In 2016, daily volume of the FX market was $5.1 trillion per day.
» In 2016, daily volume of the stock market had $84 billion for equities
worldwide.
Statistics imply that forex market is the largest financial market in the
world.

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 The foreign exchange market

The foreign exchange market

Task 2
You will see the task as you watch the lecture recordings.

Participants or actors:
1. Commercial banks and other depository institutions.
2. Non-bank financial institutions e.g. mutual funds, hedge funds,
securities firms, insurance companies, pension funds.
3. Non-financial businesses conduct foreign currency transactions.
4. Central banks: conduct official international reserves transactions.

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 The foreign exchange market

The foreign exchange market

Buying and selling in the foreign exchange market are dominated by
commercial and investment banks.
» Interbank transactions of deposits in foreign currencies occur in
amounts $1 million or more per transaction.

Big FX traders
Large interbank FX players
1 Deutche bank
2 UBS
3 Citigroup
4 Bank of America
5 Goldman Sachs
6 HSBC
George Soros, Bill Lipschutz.

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 The foreign exchange market

The foreign exchange market

Interbank
» Central banks sometimes intervene, but the direct effects of their
transactions are small and transitory in many countries.
» FX dealers set a price discovery (benchmark) for different currencies
depending on:
1 Supply and demand.
2 Macroeconomic and microeconomic factors.
» (1) and (2) determine the fluidity of a currency.
The US dollar is the most fluid currency in the world.
Figure 3 provides empirical evidence on the fluidity of the US dollar.

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 The foreign exchange market

The foreign exchange market

Figure 3: US Dollar is total king Source: Wolf Street (2019) and BIS (2019)

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 The foreign exchange market

The foreign exchange market

Figure 4: Percentage share of FX turnover, April 2019 & percentage of major currency pairs
Source: Wolf Street (2019) and BIS (2019)

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 The foreign exchange market

The foreign exchange market

At the onset of the Covid-19 pandemic how did the US dollar
perform?

Figure 5: US dollar performance 1 January 2020 to 21 February 2020 Source: Thomson

Reuters (2020)
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 The foreign exchange market

The foreign exchange market

What is the confidence in the US dollar as a store of value?

Figure 6: Foreign exchange reserves Source: Board of Governors of the Fed (2021)

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 The foreign exchange market

The foreign exchange market

How has the US dollar dominance changed over the past 20 years?

Figure 7: Index of international currency usage Source: Board of Governors of the Fed (2021)

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 The foreign exchange market

The foreign exchange market

The integration of financial markets implies that there can be no

significant differences in exchange rates across locations.
» Arbitrage: buy at low price and sell at higher price for a profit.
Exception to the above rule exists.
» A powerful financial player.

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 Progress so far

Remember the questions that we are looking at this week...

1 What is the definition of the exchange rate? ✔
2 Who are the players in the foreign exchange market? ✔
3 How can we model the link between monetary policy and the foreign
exchange rate market? Next slides...
4 How do expectations and interest rate arbitrage determine the
exchange rate? Next slides...

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 UIP condition

The uncovered interest parity (UIP) condition

How do expectations and interest rate arbitrage determine the

exchange rate?
» The uncovered interest parity (UIP) condition can help us answer this!
The UIP condition dictates the interaction between the nominal
exchange rate and the interest rate, and it can be represented as:

eE
t+1 − et
it − i∗t = (3)
| {z } et
interest rate gain (loss)
| {z }
expected depreciation (appreciation)

where t is the time period, i denotes the home or domestic nominal

interest rate, i∗ is the foreign nominal interest rate, e the nominal
exchange rate of the home country and eE the expected nominal
exchange rate of the home country.

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 UIP condition

The uncovered interest parity (UIP) condition

Why is the UIP condition important?

» The link between monetary policy and the foreign exchange market.
» Predicts movement of the nominal exchange rate - forex traders
responses.
» Implies 2 stabilisation channels in an open economy:
1 interest rate.
2 exchange rate.
» So CBs change the interest rate by less when responding to shocks in
an open economy.
What happens to bring about the UIP condition?
The UIP condition implies two things:
1. that deposits in all currencies are equally desirable assets.
2. that arbitrage in the foreign exchange market is not possible.

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 UIP condition

Relevant markets: international financial markets

The relevant markets are:

1 The foreign exchange market: currencies are traded.
2 The government bond market (or money market): bonds issued by
governments are traded.
If we want to buy US dollar-bonds we need US dollars.
This implies we need to focus on both the forex market and bond
market.

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 UIP condition

Key assumptions of international financial markets

1. Perfect international capital mobility.

2. Home country is a small open economy.
3. Home households can hold two assets.
i. Money: only home money.
ii. Bonds:
Home bonds BH , whose return is the home nominal interest rate.
Foreign bonds BF , whose return is the foreign nominal interest rate.
4. Perfect asset substitutability (PAS) between BH and BF .

Task 3
You will see the task as you watch the lecture recordings.

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 UIP condition

Key assumptions of international financial markets

PAS: usually an innocuous assumption when analysing advanced
economies.

Figure 8: Interest rate on 10 year government bonds. Source: European Central Bank

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 UIP condition

Other assumptions of international financial markets

Under PAS, BH and BF are perfect substitutes thus only two things
influence the choice between them
1. i and i∗ .
eE
t+1 −et
2. View about change in e: et
Other assumptions of international financial markets:
» Forward looking central bank (monetary policy) and participants in the
foreign exchange market.
» The exchange rate is a variable that jumps in response to arbitrage
opportunities.

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 UIP condition

The UIP condition: numerical example

Suppose the UK is the home economy and US the foreign economy.

Assume there is an initial equilibrium: it = i∗t , eE
t+1 = et .
Suppose Bank of England suddenly announces it is increasing the
nominal interest rate by 2.5% such that i > i∗ for one period.
Assume the expected exchange rate remains unchanged.
What must happen now to the nominal exchange rate?

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 UIP condition

The UIP condition: numerical example

Figure 9: Response of the nominal exchange rate to Bank of England announcement

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 Graphical analysis of the UIP condition

Graphical analysis of the UIP condition

In this section we formalise the UIP condition and use a graphical

analysis to understand it better.
We proceed as follows:
1 Illustrate how the UIP curve is pinned down by the foreign nominal
interest rate, i∗ and the expected exchange rate, eE
t+1 .
2 Show what happens to the nominal exchange rate, e when there are
unanticipated and anticipated changes.

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 Graphical analysis of the UIP condition

Graphical analysis of the UIP condition

We can approximate the percentage growth of the exchange rate by

the change in the (natural) log of the exchange rate and rewrite (3)
as:
it − i∗t = log eE
t+1 − log et (4)
| {z } | {z }
interest rate gain (loss) expected depreciation (appreciation)

» UIP curve is pinned down by the foreign nominal interest rate, i∗ and
the expected exchange rate, eE
t+1 .

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 Graphical analysis of the UIP condition

Graphical analysis of the UIP condition

Key features of the UIP diagram with i and log e on the axes.

Figure 10: The UIP condition: it − i∗t = log eE

t+1 − log et

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 Graphical analysis of the UIP condition

Graphical analysis of the UIP condition

Using Figure 10 the key features are:

» Each U IP curve has a slope of −450 and must go through the point
(log eE , i∗ ).
» A change in home’s interest rate causes a movement a long the UIP
(for a given log eE and i∗ ).
» For a given expected exchange rate , any change in the foreign interest
rate shifts the UIP curve.
» For a given foreign interest rate , any change in the expected exchange
rate shifts the UIP curve.

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 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Suppose the Bank of England announces a rise in the UK interest

rate.
How would the nominal exchange rate respond if the rise in interest
rate is:
1 Unanticipated (unexpected) by the international financial markets?
2 Widely anticipated (expected) in the international financial markets?
To answer the above two questions we need to think of the
participants in the foreign exchange market.

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 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

If the announcement of the interest rise is unexpected and the

expected exchange rate remains constant:
» First we have to assume when the announcement is made. We assume
beginning period t = 1.
» Then i is expected to exceed i∗ for one period, say one year.
» The gain from holding UK bonds over this time needs to be offset by a
depreciation of the Sterling pound (£).
» This implies the exchange rate must immediately appreciate, so
that it can depreciate over the following year when there is an interest
rate differential between home and foreign.
Result is the standard prediction of the UIP condition in Figure 9.

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 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Appreciation

i1
i
i = i∗
UIP

e1 e0
eE E
1 = e2

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Appreciation

i1
i
A
i = i∗
UIP

e1 e0
eE E
1 = e2

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Appreciation

i1
i
A
i = i∗
UIP

e1 e0
eE E
1 = e2

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Appreciation

B
i1
i
A
i = i∗
UIP

e1 e0
eE E
1 = e2

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Appreciation

B
i1
i
A
i = i∗
UIP

e1 e0
eE E
1 = e2

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Let’s turn to if the change in interest rate is widely anticipated.

In this case there is no appreciation of e. Why does this happen?
» Again, we assume the announcement will be made, beginning
period t = 1.
» Then we have to go back to period t = 0.
In this period we assume international financial markets became
convinced that the interest rate would be raised in the following period,
t = 1.
» Since the change is widely anticipated by international financial
markets in time t = 0, this will be reflected in their expectations for the
exchange rate in a year’s time.
» UIP curve shifts to UIP’ in period t = 0.
» The e immediately appreciates to eE 1 in period t = 0 for the UIP
condition to hold.

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 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

Beginning period t = 1, when the interest rate increase is actually

announced, there is no immediate change in e.
» This is because e is already in a position where it can depreciate over
the period when there is an interest rate differential between home and
foreign so as to offset the gains from holding UK bonds.

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 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
i = i∗

UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
A
i = i∗

UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
A
i = i∗

UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
A
i = i∗

UIP’ UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
B A
i = i∗

UIP’ UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

i1
i
B A
i = i∗

UIP’ UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

C
i1
i
B A
i = i∗

UIP’ UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exchange rate responses to interest rates changes

No appreciation

C
i1
i
B A
i = i∗

UIP’ UIP

e0 = e1 eE
2
eE
1

Week 10
log e −−−−−−−→
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depreciation
 Graphical analysis of the UIP condition

Exercise

All U IP diagrams must be accompanied by diagrams showing the

time path of the nominal exchange rates.
This bring us to task 4.
Task 4
In this task, I would like you to do the following.
Draw the time path of the nominal exchange rate in each of the above 2
cases that we have looked at. In essence, plot the movement of the
nominal exchange rate against time for:
1 An immediate appreciation when an interest rate change is
announced.
2 No appreciation when an interest rate change is announced.

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 Summary

Summary

An exchange rate is the price of one country’s currency in terms of

another country’s currency.
Depreciation of a currency means that it becomes less valuable and
goods denominated in it are less expensive.
Appreciation of a currency means that it becomes more valuable and
goods denominated in it are more expensive.
Exchange rate is a variable that jumps.

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 Summary

Summary

UIP condition is a no arbitrage condition.

Use the UIP condition to predict movements in the nominal exchange
rate: news about either i, i∗ or eE
t+1 affects the nominal exchange
rate.
Monetary policy in the international financial markets requires taking
into account the behaviour of participants in the forex market.
» Interest rate decisions by monetary policy committee: actual,
unanticipated and anticipated leads to exchange rate responses.

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 Summary

Summary

UIP curve is pinned down by the foreign nominal interest rate, i∗ and
the expected exchange rate, eE
t+1 .
A change in home nominal interest rate causes a movement along the
U IP curve while changes in the foreign nominal interest rate i∗ and
the expected exchange rate eE
t+1 shifts the UIP curve.
An unanticipated rise in home interest rate causes the exchange rate
to appreciate.
An anticipated rise in home interest rate causes no change in the
exchange rate when the actual announcement is made.

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 Next week...

Eurozone governance, sovereign risk and the banking system

(monetary policy in an open economy under fixed exchange rates)

A brief overview of the economics of the Eurozone.

Establish the relationship among the governments, ECB and the
commercial banks in the Eurozone.
Understand the symptoms of a sovereign debt problem.
Possible governance solutions to the current Eurozone governance
structure.
Reading material and resources:
» Carlin and Soskice (2015), Chapter 12: sections 12.1 - 12.2 and 12.5
(only these sections are relevant to our topic and examinable).

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