Development Finance: Part
1
Exchange Rate
Reference: P. Krugman, M. Obstfeld and M.J. Meliz, International
Economics: Theory and Policy, 11th , Peason ISBN-10:1-292-21487-2
Asso. Prof. Masakazu Someya
Graduate School of International Development, Nagoya University

Exchange rate
• Exchange rates are the price of the currency measured by othercurrencies.
• How does depreciation affect the domestic exports and imports?
• How does appreciation affect the domestic exports and imports?
• How does depreciation affect the debt repayment to external
creditors?
• How does appreciation affect the debt repayment to external
creditors?

The Foreign Exchange Market• Actors:• Commercial banks: banks buy and sell on behalf of their customers,
which is retail sales and to buy and sell among themselves, interbank
trading, which are called “wholesales”. Banks serving many customers
and dealing a large volume have a advantages in finding someone whowants to buy or sell rather than companies find counterparties to sell andbuy.
• Corporations: corporations who have operations in different countries
need to make payment and receive payments in different currencies.
• Non-bank Financial Institutions: As financial market globalizes, non-bankfinancial institutions such as mutual funds, insurance firms and pension
funds offer a broader range of financial services indistinguishable tothose offered by banks• Central Banks: central banks intervene the foreign exchange markets
particularly in case of countries which employ fixed or pegged exchange
rate regime.

Arbitrage• Europe/US• JapanGoldGold

1g=10g Silver
1g=5g Silver• Which one is more expensive in Japan than Europe and US?
• What business opportunity is there if any?
• What is the reason why silver was more expensive in Japan
than Europe and US?

Arbitrage: Buy Cheap and Sell High• To take advantages of different prices. For example, the exchange
rate in Tokyo is 100JPY/$ while 50JPY/$ in NY. What would you do?
• Because investors are watching foreign exchange market for 24hours, the arbitrage opportunities are very few and short-lived.
• The US$ is a vehicle currency since US$ involves in more than 85%
of transactions. JPY holders who want to exchange Jordan Dinarwith JPY, first exchange JPY with US$, and then with JD. Why1?

Spot and Forward Rate
• Spot Transaction: Exchange rates at which two parties agree to an
exchange of bank deposits and execute the deal immediately arecalled “on-the-spot” .
• Forward Transaction: Foreign exchange deals sometimes specify afuture transaction date̶one that may be 30 days, 90 days, 180 days,or even several years away. The exchange rates quoted in suchtransactions are called “forward exchange rates”. When you agree tosell JPY for dollars on a future date at a forward rate agreed on today,
you have “sold JPY forward” and “bought dollars forward.” The futuredate on which the currencies are actually exchanged is called thevalue date. Forward contract is OTC (Over-the-Counter) and have to
execute the contract (settlement) on a specified day.

Hedging• TOYOTO exports a car at US$100 to USA. The car is sold threemonths later, July 1 2021 and the retailer will send you US$100. The
current exchange rate is JPY100/1US$. TOYOTO is afraid that theexchange rate could be JPY50/1US$ in July 1. The profit is
100x50=5000. TOYOTAʼs profit will be squeezed.
• However, what if you find someone who agree to buy your JPY10,000
at 100 on July 1 2021. TOYOTA pay JPY500 for this contract will
receive JPY100/US$1=10,000. TOYOTA exchange US$100 for
JPY10,000 with This person. TOYOTA receives JPY10,000500=JPY9,500. This operation is called “Hedging”.

• Would it be possible to find someone who sell the dollars at JPY100?

Foreign Exchange Swap
• A foreign exchange swap is a spot sale of a currency combined with aforward repurchase of that currency.
• For example, suppose the US Toyota auto company has 1 million
dollars of idle cash now and will have to pay 1 million dollars to a
California supplier in year t+1. US Toyota borrows 1 million € for one
year from KKR while collateralizing 1 million dollars for one year
(secured borrowing). TOYOTA pays commissions at 1%of 1 million$ to KKR. KKR gets 1 thousand $ .
• US Toyota invests 1 million € in EURO bonds for one year. In year t+1,
US Toyota repurchases 1 million dollars as swap contract pledges.
• This usually involves two transaction, buying € and selling € andrequires US Toyota pays two transaction fees, 1% foe each transaction, tobrokers. However, swap transaction requires only comission fee.
• Swaps makes up a signiﬁcant proportion of all foreign exchange
trading.

• You have US$1 and now the exchange rate is 1 EURO /US$. However,EURO is expected to appreciate by 10% in one year time. EURO interest
rate is 20%. Compute the return if you invest US$1 into EURO deposit
for one year. You pay commission of 5% each time in original currency,
which means US$ when you convert from US$ to EURO and EUROwhen converted from EURO to US$.
• (1- 1*0.05)*1 EURO /US$. in t!"#$%&• (1- 1*0.05)*1 *1.2 in t+1 in EURO)*+,%-#./"%01%&2"• ((1- 1*0.05)*1 *1.2 *0.95)/0.9 in t̶1 in $ 344"&4%#&%&
5#..#$%-#./"%01%&2"344"&4%#&%&!"#$%&'()*+,%-#./"%01%&2"344"&4%#&%&'(

5#..#$%-#./"%01%&2"344"&4%#&%&'(

• Q3. You have US$1 and now the exchange rate is 1 EURO /US$.
However, EURO is expected to appreciate by 10% in one year time.
EURO interest rate is 20%. Now, you borrow 1 EURO from KKR with acommission of 3% so that you do not have to convert US$1. You pay
commission when you repay in t+1. But, you have to convert your returnin EURO into US$. The commission for conversion fee from EURO to
US$ is 5% of original currency value. Compute the return.

You borrow 1 EURO in t
Your asset in t+1 1*1.2
You repay 1 EURO and pay commission
1.2 - 1 - 1*0.03 in t+1 in EURO(1.2 - 1 - 1*0.03 )*(1-0.05)/0.9=0.179

Foreign Exchange Swap with Interest rate for Toyota• TOYOTA have 1$ while KKR has 1EURO. US interest rate is 5% while
EURO interest rate is 20%. TOYOTA invest in US market and gets 5%
while it gets 20% if invested in EURO market. TOYOTA has a swap at
ex=1$/€ in one year later while KKR expect 1.2 $/€.
• TOYOTA, initial position is 1$ and is 1.20$ in one year later.

!"#$%&'&%(."/
2345#564$#7456
0$<57#$=745#089
0>:; -)*+&,00101:;90>:; 1Foreign Exchange Swap with Interest rate for KKR• KKR: initial position is 1 € but 1.167 $ in on year time. What will happen if 1.1$/€. What if the commission is 0.05US$ after one year from Toyota to KKR.

!"#$%%&,"0123#342$#5234.$:35#$;523#+.+
67.<96 +'(&)*+
.
.<8

/
./
897
.<8= /

Future Contract• You are in Japan and will have US$ 100 on Jan 10. In case that as of today,
Oct 10, you buy a three month forward contact for US$100 at
JPY120/1US$ on the settlement day of Jan 10, you are entitled to exchange
US$100 at JPY120/1US$ and receive JPY12,000 on Jan 10. But what if theexchange rate is JPY140/1US$?
• In future contract, you buy a promise that a specified amount of currency,
JPY12,000 is delivered in exchange for US$100 at a specified rate,
JPY120/USD$ on specified day, Jan 10, three month from the deal.
• What if the exchange rate is JPY140/USD as of Dec 10. In case of futurecontract, you can sell future contract on an organized future exchange tosomeone in the future market, who expects the exchange rate will be lessthan JPY120/USD, i.e., JPY100/USD in one month time of Jan 10. On Jan 10,
the exchange rate is JPY130/USD if not JPY140/USD and this person
receivesJPY13,000 and sold USD100.

Options• As of Oct 10, the JPY is JPY100/USD. You expect to pay USD 1 on Jan
10 and you assume the JPY will be 120/USD. You pay JPY5 and buy acall option, the right to buy US dollars at JPY110 on Jan 10. On Jan 10,
the JPY is in fact 120/USD. Your total payment is
JPY110+JPY5=JPY115, lower than JPY120. You saved 5 JPY.
• As of Oct 10, the JPY is JPY100/USD. You expect to receive USD 1 on
Jan 10 and you assume the JPY will be JPY80/USD on Jan 10. You pay
JPY5 and buy a put option, the right to sell US dollars at JPY90 on Jan
10. On Jan 10, the JPY is in fact 80/USD. Your total payment is JPY90JPY5=JPY85, lower than JPY80. You saved 5 JPY.
• American option can be exercised at any point of time during threemonth while European option can on the specified data, Jan 10.

Assets Return• What are the determinants for the demand for foreign currencies?
1. Future changes in foreign currency against other currencies.
2. Interest rates.
What are assets? The asset is an instrument to transfer the purchasing
power into the future.
What is the asset return?: the percentage increase in value of theassets over some time period.
Q: Asset A increased from 100 in January 1 to 120 at April 1. Asset B
from 100 in January 1 to 140 at September 1. Derive annualized returnof the asset in %.

Real Return• The expected real rate of return is, the rate of return computed bymeasuring asset values in terms of some broad representative basketof products that savers regularly purchase. Only the real return canmeasures the goods and services a saver can buy in the future in
return for giving up some consumption (that is, saving) today.
• The dollar prices of all goods and services (rate of inflation) also
increase by 10 percent. What is the real return of a rare bottle of wine
whose dollar price rises by 25 percent during the same period? Whatis a real return of bond whose dollar value rises by 20 percent?
1+𝑖 = 1+𝑟 1+𝜋 ≈𝑖 =𝑟+𝜋
Where i= nominal interest rate, r= real interest rate and π= rate of
inflation.

MR=MC
5656
5657

!"#$%
76
77

&"'()!"#$%
89666
89666

*$+,
869666889666-(.(/0( 1%$203,4$/
86666
86
88666
88

1%43(
7666
7666

5656
5657

!"#$%
76
77

&"'()!"#$%
89666
89666

*$+,
869666889666-(.(/0( 1%$203,4$/
86666
86
8:666
8:

1%43(
7666
7666

• In 2021, the factory will employ one labor, market wage is 10,000 JPY/Day.
• What is the marginal cost and marginal revenue?
• Would you like to employ?
• What about the case at the bottom?

Real Interest Rate
You borrow $100 at 2% in Year t, buy the machines, produce two apples(1$), sell
the machines(no depreciation) and two apples and repay.
!""#$"/,-.'$&*,)*+&,-.'$&*,
0
A#'5+$!"#

B0$%&'()*#"+'!"#$%&'()*#"+',
A/*4%#
!"#

B,
$%

!""#$
1'.2#
CBB
#$$
-../#
0*)1/
CBB
!"#

%&'(&&$&#"

9':&,'.
/,$#5#"$/,$#5#"$;#<#,2#" 4'=>#,$%*',+8
;'$#
8
8?9@
CDBB
BDBB
BDBB
EDBB0
CBB
!"##
!"##
!"##$
%##
!"##

!33.#
+!33.#
45*627$&*, 45&7#+8B&

8*9"'*)&'#/4/.#&'#/4/.#:/;/'1/. 3*<=/'#@+*'%7
:*#/
7
7>8?
CDBB
BDBB
BDBB
BDBB,
CBB
!"#$
!"#$
!"#$
!"#$%
&##

-22)/
%-22)/
34+516#"+' 34"6/%7B!

Another Determinants: Risk and Liquidity• Risk WHY?: An assetʼs real return is usually unpredictable and mayturn out to be quite different from what savers expected when theypurchased the asset.
• Which assets would you buy? Asset A has a mean annual return of 5%with the 95% of probability of getting returns for 4.5% to 5.5%. Asset B
has a mean annual return of 6% with 30% of probability of getting 4%
to 8%.
• Liquidity: Assets also differ according to the cost and speed at whichsavers can dispose of them. A house, for example, is not very liquidbecause its sale usually requires time and the services of brokers andinspectors. To sell a house quickly, one might have to sell at a
relatively low price. In contrast, cash is the most liquid of all assets: It
is always acceptable at face value as payment for goods or otherassets.

Interest Rate
• When you buy two currencies, what factors do you consider?
• Current and future exchange Rate is crucial.
• How do investors keep or store their assets after they buy thecurrencies?
• What does saving account offer you?
You are in the USA. Which one would you buy to invest in one year?
The exchange rate of USD and EURO is 1EURO/1USD, now. It is
expected to be 1.1 EURO/1USD in one year later. Appreciation or
depreciation for USD? Saving account of USD offers 10% of interest
rates while EURO saving account offers 20%.

How to Compare Return of the Currencies?
• You are in the USA. Suppose that today's exchange rate (quoted in
American terms) is $1.10 per euro, but that you expect the rate to be$1.165 per euro in a year (perhaps because you expect unfavorable
developments in the U.S. economy). Suppose also that the dollar
interest rate is 10 percent per year while the euro interest rate is 5
percent per year. This means a deposit of $1.00 pays $1.10 after ayear while a deposit of € 1 pays € 1.05 after a year. Which of these
deposits offers the higher return?

How to Convert the Currencies?
• Convert $ to €,

€
€

$

€

=$

€
=$
＄

How to Convert the Currencies?
• Convert $ to €,

€
€

X

$

€

=$

€
=$
＄

How to Convert the Currencies?
• Convert $ to €,

€
€

X
÷

$

€

=$

€
=$
＄

• The exchange rate is 0.5$/ €, compute how much in $ is 1€?
1 € * 0.5 ($/ €) =0.5$• The exchange rate is 0.5 € /$, compute how much in $ is 1€?
1 € ÷0.5 (€ /$) =0.5$• The exchange rate is 1.5€ /$, compute how much in $ is 10€?
10 € ÷1.5 (€ /$) =6.66…$• The exchange rate is 1.5$/ €, compute how much in $ is10€?
10 € * 1.5 ($/ €) =1.5$

• The exchange rate is 0.8 € /$, compute how much in$ is 56€?
56 € ÷0.8 (€ /$) =70$
• The exchange rate is 0.8 $/ €, compute how much in$ is 56€?
56 € * 0.8($/ €) =44.8$• The exchange rate is 0.8 € /$. You have to pay 10% ofcommission when you convert € to $. Compute howmuch in $ is 56€?
56 € ÷{0.8(€ /$)*1.1} =63.6$

• The exchange rate is 0.8 € /$. You have to pay 10% of
the dollar value after you convert € to $. Compute howmuch in $ is 56€?
{ 56 € ÷0.8 ($/ €) ) }*0.9=63$• The exchange rate is 0.8 $/ €. You have to pay 10% ofcommission when you convert € to $. Compute howmuch in $ is 56€?
56 € * 0.8($/ €) =44.8${56 € * 0.8 ($/ €) *0.9=40.3$

How to Compare Return of the Currencies?
• You have one ＄ today and what is the EURO value of one ＄ today
in one year later?
• What is the US$ value of one ＄ today invested in EURO in one year
later?
• Exchange rates change from 1.1 to 1.165. Has the $ depreciated orappreciated?

!"#$% &'()*($+),$-(+(./012304& 565
56578
9/01:
;65
9/304&;6;8
304&)<$=>( ?
?
01@)<$=>()"A)5)304&)-"#$%
5?

How to Compare Return of the Currencies?
!"#$% &'()*($+),$-(+(./012304& 565
56578
9/01:
;65
9/304&;6;8
304&)<$=>( ;6?5;6?801@)<$=>()"A)5)304&)-"#$%
55655!"#$%&!"#$%&''()*+,-+./%#,-)
0102

'())

• What is the return of the USD currency in one year?
• What is the return of the EURO currency in one year?
• Which currency would you hold?
• What is the percentage change of US $ depreciation?
• Sum up the rate of US$ depreciation and the EURO interest rates.
• Is this foreign exchange market between EURO and USD at equilibrium?

Fill in using the exchange rate in previous slide but in EURO/USD.

Today

O ne Y ear Later

R eturn

ex_E U R O /U S

?

?

?

i_U SD

0.1

i_EU R O

0.05

EU R O V alue

?

?

?

U S$ V alue of 1 EU R O today

1

?

?

Today

O ne Y ear Later

R eturn

ex_E U R O /U S

0.91

0.86

0.06

i_U SD

0.1

i_EU R O

0.05

EU R O V alue

0.91

0.95

1.11

U S$ V alue of 1 EU R O today

1

1.11

0.11

EU R O A ppreciation R ate

EU R O A ppreciation R ate

Interest Parity• The foreign exchange market is in equilibrium when deposits of all
currencies offer the same expected rate of return. The condition thatthe expected returns on deposits of any two currencies are equal
when measured in the same currency is called the interest parity
condition.
• Suppose the dollar interest rate is 10 percent and the euro interest
rate is 6 percent, but that the dollar is expected to depreciate
against the euro at an 8 percent rate over a year.
• In the circumstances described, no one will be willing to continue
holding dollar deposits, and holders of dollar deposits will be trying
to sell them for euro deposits. There will therefore be an excess
supply of dollar deposits and an excess demand for euro deposits inthe foreign exchange market.

(6718901.&
5718>
5701.&
01.&)@$A/(
18B)@$A/()"C):)01.&)-"#$%

!"#$%
:
<;:
<;<?
:;<<

&'()*($+),$-(+
:;<=

:

:;:D

.(-/+':;<?
<;:D01.&)233+(45$-5"').$-(<;<=

Interest Parity• Suppose that dollar deposits again offer a 10 percent interest rate
but euro deposits offer a 12 percent rate and the dollar is expected
to appreciate against the euro by 4 percent over the coming year.
Now the return on dollar deposits is 2 percent higher. In this case no
one would demand euro deposits, so they would be in excess supply
and dollar deposits would be in excess demand.

!"#$% &'()*($+),$-(+ .(-/+'
450674.&
89:::
:9;<
3?450
:98
3?74.&:98@74.&)A$B/(
8898@45C)A$B/()"D)8)74.&)-"#$%
89:::
89:E
:9:E

0(1+(23$-3"').$-(=:9:>Interest Parity II• Only when all expected rates of return are equal̶that is, when theinterest parity condition holds̶is there no excess supply of some
type of deposit and no excess demand for another. The foreignexchange market is in equilibrium when no type of deposit is inexcess demand or excess supply.
$/€

0 = 𝑅$ − 𝑅"#$% −$/€&'!"# (&'!
$/€
&'!

$/€

or 𝑅$ = 𝑅"#$% +$/€&'!"# (&'!
$/€

&'!

What if US interest rises? Investors buy which currency and what will
happen to the exchange rate as a consequence?

Find todayʼs exchange rate UIP suggests.
(6718901.&
5718=
5701.&
01.&)?$@/(18A)?$@/()"B):)01.&)-"#$%

!"#$%
:
<;:
<;<>
:;<<

&'()*($+),$-(+
:;:

:

:;:C

.(-/+':;<><;:C01.&)233+(45$-5"').$-(<;:<

Interest Parity: What will happen to exchange rates?
(4567896.&
35670
3596.&
96.&)?$@/(67A)?$@/()"B):)96.&)-"#$%

!"#$%
:;:
>;:
>;>=
:
:;:

&'()*($+),$-(+:;:<=(4567896.&
35670
3596.&
96.&)?$@/(67A)?$@/()"B):)96.&)-"#$%

!"#$%
:;:
=;:
=;=>
:
:;:

&'()*($+),$-(+
:;<:=

:;>=>
:;CCD

:;=>=
:;<C:

.(-/+'

0(1+(23$-3"').$-(
>;><

>;::

.(-/+'=;:D

0(1+(23$-3"').$-(=;:=

Interest Parity: how changes in today's exchange rate affect the
expected return on a foreign currency deposit when interest rates
and expectations about the future exchange rate do not change.
What will happen if the market is on the upper table?
(4567896.&
35670
3596.&
96.&)?$@/(67A)?$@/()"B):)96.&)-"#$%

!"#$%
:;:
>;:
>;>=
:
:;:

&'()*($+),$-(+:;:<=(4567896.&
35670
3596.&
96.&)@$A/(
67B)@$A/()"C):)96.&)-"#$%

!"#$%
:;::<
?;:
?;?>
:
:;::<

&'()*($+),$-(+
:;:=>

:;>=>
:;CCD

:;?>?
:;<<D

.(-/+'

0(1+(23$-3"').$-(
>;><

>;::
.(-/+'?;:?

0(1+(23$-3"').$-(?;?>

!"#$%&!"#$%&'()*+,%-#./"%01%&2"344"&4%#&%&)*+,%-#./"%01%&2"344"&4%#&%&'(

5#..#$%-#./"%01%&2"344"&4%#&%&

5#..#$%-#./"%01%&2"344"&4%#&%&'(

Algebra of Measuring Investment in the EURO asset
by Dollar𝐴) : Initial Asset, 𝑒𝑥) exchange rate ($/€) at year t, 𝑖 €: Interest rate inEURO area!"#$%&!"#$%&'(

$
A
!
A€! =
𝑒𝑥!

A€! 1 + 𝑖 €
A$"
=
1
+
𝑖€
𝑒𝑥

A$!

"

+$!
&'!
A$),-

1 + 𝑖 € 𝑒𝑥),-=Linearization• 𝑌𝐶 = 𝑃 ∗ 𝑌𝐾 where YC=nominal GDP, P = GDP deflator and YK= real GDP
𝑌𝐶! = 𝑃! ∗ 𝑌𝐾!

and𝑌𝐶!"# = 𝑃!"# ∗ 𝑌𝐾!"#$%&
𝑌𝐶!"# = 𝑌𝐶! 1 + 𝑔!"#
, 𝑃!"# = 𝑃! (1 + 𝑔!"#),$'
𝑌𝐾!"# = 𝑌𝐾! (1 + 𝑔!"#
)

$%
&
$'
𝑌𝐶! (1 + 𝑔!"#
) = 𝑃! (1 + 𝑔!"#) ∗ 𝑌𝐾! (1 + 𝑔!"#)Where g stands for growth rates.
$%&$'• 𝑌𝐶! (1 + 𝑔!"#
) = 𝑌𝐶! (1 + 𝑔!"#) ∗ (1 + 𝑔!"#
)
$%
&
$'
• (1 + 𝑔!"#) = (1 + 𝑔!"#) ∗ (1 + 𝑔!"#)Linearization$%&$'• 𝑔!"#≈ 𝑔!"#+ 𝑔!"#

Algebra
.!
•
&'!

1+

𝑖€

𝑒𝑥),- = 𝐴) 1 +1+𝑖Taking a natural log,

€

𝑖€

&'!"'
= 𝐴),&'!

𝑒𝑥!12 𝐴!12=
= 1 + 𝑖$𝑒𝑥!
𝐴!

𝑙𝑛 1 + 𝑖 € + ln

&'!"'
&'!

= ln

.!"'
.!

• This can be further approximated as𝑖 € + ∆𝑒𝑥),- = ∆𝐴),- = 𝑖 $= 𝑙𝑛 1 + 𝑖 $!"#$%&'()
3;<<<
3;<?<
3;<A<
3;<><
3;<D<
3;3<<
3;3?<
3;3A<
3;3><

*+,-./
<;<=
<;<=
<;<=
<;<=
<;<=
<;<=
<;<=
<;<=
<;<=

!"#$*0$123
3;3
3;3
3;3
3;3
3;3
3;3
3;3
3;3
3;3

,456716'.61890$&0,-./$(::61:
<;3>
<;3@

B
<;<C
<;<E

B
<;<@
<;<3
<;<<

!"#$%&'()*+,-./!"#$*0
123

3=>>>
3=>A>
3=>D>
3=>@>
3=>B>
3=3>>
3=3A>
3=3D>
3=3@>

>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?

3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3

.(14$&5$#
677849*(1*&0
>=3>
>=>B
>=>@
>=>D
>=>A
>=>>
H>=>A
H>=>D
H>=>?

,:74914'.41;80$&0,-./$(<<41<
>=3@
>=3C
E
>=>F
>=>G
E
>=>C
>=>3
>=>>

The relation between currency exchange rates and$ values of return
Previous tables show that the more the currency today appreciates,
the lower the return of the currency is, which describe downward
sloping schedule between the exchange rate and return of thecurrency today provided that expected exchange rates and interest
rates of both currencies are the same.
A current € appreciation raises the cost of acquiring 1 €. This change
naturally makes euro deposits less attractive relative to dollars since
expected future exchange rate and interest rate are the same.

Expected return of EURO assets lowers as the EURO today
appreciates as in the previous slide.
The return ofdollar assets isvertical. WHY?
𝑖 € + ∆𝑒𝑥'()= ∆𝐴'()

Exchange Rate(V) & Dollar Return of EURO Assets
1.180
1.160
1.140
1.120

1.100
1.080
1.060
1.040
1.020
1.000
0.980
-0.02
0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

What happen if the exchange rates is at ex=1.1 and return of
EURO=0.05?
𝑖 € + ∆𝑒𝑥'() = ∆𝐴'()$/€𝑒𝑥
𝑖 € + '()
− 1 = ∆𝐴'()$/€𝑒𝑥'
The return of EURO asset is lower
than that of the dollar asset, which
creates excess demand for dollar
assets and leads to depreciation of$/€EURO, which is a decrease in 𝑒𝑥' .
As a consequence, returns of theEURO asset rise until both returns
from dollar asset and EURO assets
are the same.

What happen if the exchange rates, $/€, is at ex=1.0 and return of
EURO=0.155?
𝑖 € + ∆𝑒𝑥'() = ∆𝐴'()$/€𝑒𝑥
𝑖 € + '()
− 1 = ∆𝐴'()$/€𝑒𝑥'
The return of EURO asset is higher
than that of the dollar asset, which
creates excess demand for EUROassets and leads to appreciation ofEURO. At year t, appreciation of$/€EURO is an increase in 𝑒𝑥' . As aconsequence, returns of the EUROasset falls until both returns fromdollar asset and EURO assets are thesame.

What happen to the exchange rates, $/€, if the US interest rates is raised
to 13% from 10%?
$/€

𝑖€ +

𝑒𝑥!"#
$/€
𝑒𝑥!

− 1 = ∆𝐴!"#

The return of EURO asset is 10% whilethat of the dollar asset is now 13%,higher than that of the EURO asset,
which creates excess demand for dollar
assets and leads to depreciation ofEURO. The depreciation of EURO is an$/€
decrease in 𝑒𝑥! , which implies higher
rate of return in EURO asset in year t+1.
As a consequence, returns of the EUROasset rises until both returns from dollar
asset and EURO assets are the same.

!"#
$%&'(
3=>>>
3=>A>
3=>D>
3=>@>
3=>B>
3=3>>
3=3A>
3=3D>
3=3@>

)*+,-.
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?

!"#/)0-'14/%5
123 647849)'1)%0
3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3

>=3>
>=>B
>=>@
>=>D
>=>A
>=>>
G>=>A
G>=>D
G>=>?

+:74914&,:74914'!"#$*0.(14$&5-41;80/%0!"#$%&'() *+,-./.41;80$&0123
647849*(1*&0+,-./'<<41<,-./$(<<41<
>=3@
3=>>>
>=3>
3=3
>=3>
>=?3
>=3C
3=>?>
>=3>
3=3
>=>@
>=3A
>=33
3=>B>
>=3>
3=3
>=>C
>=3C
>=>E
3=>C>
>=3>
3=3
>=>B
>=3B
>=>F
3=>@>
>=3>
3=3
>=>?
>=3?
>=>?
3=3>>
>=3>
3=3
>=>>
>=3>
>=>C
3=3?>
>=3>
3=3
D>=>?
>=>@
>=>3
3=3B>
>=3>
3=3
D>=>B
>=>C
>=>>
3=3C>
>=3>
3=3
D>=>E
>=>B

What happen to the exchange rates, $/€, if the € interest rates is raised
to 10% from 5%?
$/€

𝑖€ +

𝑒𝑥'()
$/€
𝑒𝑥'

− 1 = ∆𝐴'()

The schedule for the return of EURO asset
shifts rightward by 5%. At the exchange rate
at 1.05, the return on EURO assets is now
0.15, higher than that of the US asset andcreates excess demand for the EUROassets. This excess demand leads to an
appreciation in EURO today in year t, whichmakes EURO appreciation smaller fromyear t to year t+1. As a consequence, thereturn on EURO assets fall back to 10%.

!"#
$%&'(
3=>>>
3=>A>
3=>D>
3=>@>
3=>B>
3=3>>
3=3A>
3=3D>
3=3@>

)*+,-.
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?

!"#/)0-'14/%5
123 647849)'1)%0
3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3
3=3

>=3>
>=>B
>=>@
>=>D
>=>A
>=>>
G>=>A
G>=>D
G>=>?

+:74914&-41;80/%0+,-./'<<41<
>=3@
>=3C
>=33
>=>E
>=>F
>=>?
>=>C
>=>3
>=>>

!"#
$%&'(
3=>>>
3=>@>
3=>C>
3=>D>
3=>B>
3=3>>
3=3@>
3=3C>
3=3D>

)*+,-.
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?
>=>?

!"#/)0-'14/%5
123 647849)'1)%0
3=3?
3=3?
3=3?
3=3?
3=3?
3=3?
3=3?
3=3?
3=3?

>=3?
>=3A
>=33
>=>B
>=>D
>=>?
>=>A
>=>3
E>=>3

+:74914&-41;80/%0+,-./'<<41<
>=@3
>=3B
>=3D
>=3C
>=3@
>=3>
>=>B
>=>D
>=>C

What happen if the expected exchange rate changes, expected
appreciation of EURO?
$/€

𝑖€ +

𝑒𝑥'()
$/€
𝑒𝑥'

− 1 = ∆𝐴'()EURO is expected to appreciate more from
1.1 to 1.15 (EURO/$) in year t +1 evenmore, shifting the EURO return schedulerightward. With the same exchange rate
1.05 in year t as before and 1.15 in year
t+1 , the EURO return is higher than that on
the US asset and creates excess demandfor EURO asset. This leads to appreciationof EURO which lower the return of EUROassets in year t+1. The appreciation ofEURO continues until the return on EUROasset is equal to that on the US asset.

Interest Parity Condition
1+𝑖€𝑒𝑥),𝑒𝑥)

=

𝐴),𝐴)

=

1 + 𝑖$

Assets• Assets are the form of wealth, a way of transferring purchasing
power from the present to the future.
• The price of an asset is related to the purchasing power over gods
and services that buyers expect them to yield in the future.