MGEC61 - Chapter 2 Iris Au 1
Chapter 2: Exchange Rate and the Foreign Exchange Market: An Asset Approach &
Appendix
Learning Goals
This chapter is the first of the 2 chapters that used interest rate parity to determine exchange rate:
 Go over terms used in the course.
 Derive (uncovered) interest rate parity (IRP).
 Introduce the asset approach – using IRP to determine exchange rate.
 Examine the effects of changes in interest rates and expectations on the equilibrium exchange
rate.
Terminology
 Exchange rate: the price of one currency in terms of another.
 Given exchange rate is a relative price of a currency, there are 2 ways to quote exchange
rate:
1) The price of domestic currency (DC) in terms of foreign currency (FC), EFC/DC (i.e., #
of FC per DC).
2) The price of FC in terms of DC, EDC/FC (i.e., # of DC per FC).
 Depreciation: a decrease in the value of a currency.
 Appreciation: an increase in the value of a currency.
 In MGEC61, when EDC/FC , then DC depreciates and FC appreciates.
 Foreign exchange market: the market in which international currency trades take place.
 Spot exchange rates (EDC/FC): today’s exchange rate.
MGEC61 - Chapter 2 Iris Au 2
 Forward exchange rates (FDC/FC): the exchange rate that is contracted today for the
exchange of currencies at a specified date in the future.
 Forward discount and forward premium
 Expected exchange rates ( eDC/FCE ): the exchange rate that agents are expected to prevail in
the future.
Interest Rate Parity (IRP)
 Suppose I have two investment options:
1) Option 1 – Invest in DC denominated deposit
2) Option 2 – Invest in FC denominated deposit.
Which option should I pick?
Option 1 – Invest in DC denominated deposit:
 For each unit of DC invested, the amount of DC received a year from now = (1 + R).
 If R = 10%, the amount of DC received a year later:
MGEC61 - Chapter 2 Iris Au 3
Option 2 – Invest in FC denominated deposit:
1) Convert DC into FC: each unit of DC sold, the amount of FC received =
1
EDC/FC
.
 If EDC/FC = 1.25, the number of FC purchased per DC sold:
2) Invest in FC deposit: for each unit of DC invested in FC deposit, the amount of FC received a
year from now = (
1
EDC/FC
) (1 + R*).
 If R* = 8%, the amount of FC received a year from now (per unit of DC invested in FC
deposit):
3) When FC denominated deposit matures, I will convert the FC received into DC: the expected
amount of DC I received a year from now is (
EDC/FC
e
EDC/FC
) (1 + R*).
 If EDC/FC
e = 1.275, the amount of DC expected to receive a year from now (per unit of DC
invested in FC deposit):
MGEC61 - Chapter 2 Iris Au 4
 If (1 + R)  (
EDC/FC
e
EDC/FC
) (1 + R*), there will be arbitrage opportunity (by borrowing from the low
return country and investing in the high return country).
 If (1 + R) = (
EDC/FC
e
EDC/FC
) (1 + R*), then the expected returns on deposits (or assets) of any two
currencies are equal when measured in the same currency and investors will be indifferent
between the two options.
 This is the precise form of (uncovered) interest rate parity (UIRP or IRP).
 However, we normally express (uncovered) IRP in approximate form:1:
R = R* +
Ee− E
E
where R = return on DC deposits (or domestic assets)
R* +
Ee− E
E
= expected DC return on FC deposits (or foreign assets)
Ee− E
E
= annualized percentage change in the DC/FC exchange rate
 When UIRP holds, the foreign exchange market is in equilibrium.
 Covered interest rate parity (CIRP): R = R* +
F − E
E
 Under CIRP, we replace Ee (expected exchange rate) with F (forward exchange rate)
since agents can lock in the future exchange rate by getting a forward contract and
eliminating any uncertainty in exchange rate movements.
1
You can read the text for the actual derivation. Also, from now on, we will use E to represent EDC/FC.
MGEC61 - Chapter 2 Iris Au 5
Equilibrium in the Foreign Exchange Market – The Asset Approach to the Exchange Rate
 Assumptions:
 R, R*, and Ee are given in the meantime (we will discuss the determination of R & R* in
Chapter 3).
 The levels of output in both countries, Y & Y*, are given.
 Perfect capital mobility – no restrictions on capital movements.
 Domestic assets and foreign assets are perfect substitutes (will relax this assumption in
Chapter 6).
 Example:
 Return on DC deposit = R
 Expected DC return on FC deposit = R* +
Ee− E
E
, where R* = 0.05 and E
e
= 1.05
E R*
1.05 − E
E
R* +
Ee− E
E
1.07 0.05 – 0.019 0.031
1.05 0.05 0.00 0.05
1.03 0.05 0.019 0.069
1.02 0.05 0.029 0.079
1.00 0.05 0.05 0.10
Foreign exchange market diagram and adjustment process
E
ROR
MGEC61 - Chapter 2 Iris Au 6
The Effect of Changing Interest Rates on the Current Exchange Rate
1) Changes in R:
E Suppose R  to R1:
E
0
A
R* +
Ee− E
E
ROR
R
0
2) Changes in R*:
E Suppose R*  to R*,1:
E
0
A

R*
,0
+
Ee− E
E

ROR
R
MGEC61 - Chapter 2 Iris Au 7
The Effect of Changing Expectations on the Current Exchange Rate
E Suppose there is an expected:
depreciation of DC (E
e
 to Ee,1):
E
0
A
R* +
Ee,0− E
E
ROR
R
Note: changes in expected exchange rate can be caused by a permanent shock and/or changes in
public policy in the near future.