1、An Introduction to Exchange Rate DeterminationWONG Ka Fu10th January 2000And ArbitrageHow would you explain the movement of Japanese Yen? (source: )How would you explain the movement of Japanese Yen? (source: )How would you explain the movement of European Euros? (source: )How would you explain the

2、movement of European Euros? (source: )How do we explain the movement of foreign exchange?ArbitragePurchasing Power ParityHong Kongs Currency Board mechanismUC MacDonaldNA MacDonaldPrices of Big Mac7.8015.60Case 1What would you do?What would you do?Choose the cheaper MacDonald for lunch.Buy Big Mac f

3、rom UC and sell at NA.Effect of our actionOur action:Choose the cheaper MacDonald for lunch.Buy Big Mac from UC and sell at NA.More supply of Big Mac, less demand for Big MacAt NAPrice of Big Mac falls.Greater demand for Big Mac, less supply for Big MacAt UCPrice of Big Mac increases.UC MacDonaldNA

4、MacDonaldWhat would you do in the absence of transaction costs?PUCPNACase 2PUCPNACase 3Arbitrage activities continue until prices equalize. That is,PHK = e PUS and e = PHK / PUSPrices at different locations, when expressed in the same currency, have to equalize. That is, Purchasing Power ParityExcha

5、nge rate implied by PPPe = PHK / PUSPHK = e PUS.If e is fixed, PUS has to adjust when there is a change in PHK . Purchasing Power ParityThree variables in the relation: Knowing any two of them, we can compute the third.PHK = e PUS.e PHK PUSIf PUS is fixed, e has to adjust when there is a change in P

6、HK . Other arbitrage opportunities across spaceInternational phone call: HK direct to Beijing (Price= P1)HK to Canton province, from where the call is redirected to Beijing (Price= P2)Arbitrage opportunities exists when P1 P2, or P1-P2 0. Arbitrage activities (though illegal) will drive P1-P2 toward

7、s zero.Arbitrage opportunities across spaceABXP2P1Other arbitrage opportunities across spaceBuying or selling Japanese Yen HKD direct to JPY (Price= P1)HKD to Swedish Krona and Swedish Krona to Yen (Price= P2)Arbitrage opportunities exists when P1 P2, or P1-P2 0. Arbitrage activities will drive P1-P

8、2 towards zero.Arbitrage across timeTodayTomorrow189200StockpricesIf cost of interest is zero, one would like to buy stock today, hold it for a day and sell it tomorrow. Profit= 11.Arbitrage across time in real lifeIn real life, interest rate is nonzero and we do not know tomorrows stock price for s

9、ure. Thus, economic theory has to adjust for these factors but still uses this idea of arbitrage.What does PPP tell us about exchange ratesBig Mac Index by Economists:“Big Mac Currencies 11 April, 1998.HKs Big MacJapans Big MacHKD 10.2Yen 280e = PHK / PJP = 10.2 / 280 = HKD 364.29 per 10000 YenWhy i

10、s Big Mac Index so far off from the actual exchange rates?Adjustment of prices slow in general (price rigidity)Noise need to use econometrics to test the theoryOther factors (and also noise) that determines the exchange rate.Transportation takes time (some goods are perishable)The Idea of Hong Kongs

11、 Currency boardBank ABank B10Exchangerate quotes(per USD)7.8Arbitrage will eliminate the difference.The Idea of Hong Kongs Currency boardHKMABank B10Exchangerate quotes(per USD)7.8Because HKMA will supply and demand HKD at 7.8, arbitrage will push HKs exchange rate to 7.8.Why would the supply of HK

12、dollar fall into a shortage when speculators attack HKD?Speculators attack HKD because they expect HKD to devalue. E.g., from 1:7.8 to 1:15.6.If you know that HKs exchange rate will devalue from 1:7.8 to 1:15.6, you can sell HKD and buy USD today buy HKD and sell USD after devaluationWho would trade

13、 with you? When you (the public) sell HKD and buy USD today, HKMA buys HKD and sells USD. Interest rate has to go up given money and loan demand by the public.The HKMA promises to buy and sell HKD at 1:7.8 . Less money is in publics hand. That is money supply decreases. Why would the supply of HK do

14、llar fall into a shortage when speculators attack HKD?Effect of high interest rate?Investment ConsumptionWhen will interest rate return to a “normal level?What does PPP say?What does interest parity say?Will interest rate be back to the normal level if the government go fishing or golfing?- End -Prices at different locations, when expressed in the same currency, have to equalize. That is, Purchasing Power ParityExchange rate implied by PPPe = PHK / PUSPHK = e PUS.Speculators attack HKD because they expect HKD to devalue. E.g., from 1:7.8 to