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The Asset Approach to Exchange Rates and the Foreign Exchange Market!
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The price of 10 planes in millions ! price A-380 747-8 0.84 2,180 2,331 0.76 2,180 2,109 $ price A-380 747-8 2,595 2,775 2,868 2,775
0.84 0.76
! change $ change
-222 273
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Exchange rate allow us to denominate the cost or price of a good or service in a common currency. !
How much does a Honda cost? 3,000,000! Or, 3,000,000 x #0.0098/1 = #29,400!
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2. 3. 4. 5.
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Foreign exchange swaps: a combination of a spot sale with a forward repurchase, both negotiated between individual institutions.!
swaps often result in lower fees or transactions costs because they combine two transactions.!
Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date. !
contracts can be bought and sold in markets, and only the current owner is obliged to fulll the contract.!
Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. !
contracts can be bought and sold in markets.! a contract gives the owner the option, but not obligation, of buying or selling currency if the need arises.!
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The euro deposit has a lower expected rate of return: all investors will prefer dollar deposits and none are willing to hold euro deposits.!
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R# + (Ee$/# - E$/#)/E$/# !
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The difference in the rate of return on dollar deposits and euro deposits is ! "R$ - (R# + (Ee$/# - E$/#)/E$/# ) =! "R$ " "- R# - (Ee$/# - E$/#)/E$/# !
interest rate! on euro deposits!
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The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.!
interest parity implies that deposits in all currencies are deemed equally desirable assets.!
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Suppose R$ > R# + (Ee$/# - E$/#)/E$/# . ! Then no investor would want to hold euro deposits, driving down the demand and price of euros.! Then all investors would want to hold dollar deposits, driving up the demand and price of dollars.! The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved.!
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Appreciation of the domestic currency today raises the expected return of deposits in foreign currency.!
A current appreciation of the domestic currency will lower the initial cost of investing in foreign currency, thereby raising the expected return in foreign currency.!
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the parity curve! The Current Exchange Rate and ! the Expected Return on Dollar Deposits!
Basically, the higher the dollar is today, for a given expected future rate,! the greater the expected depreciation later. !
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R$ = R# + (F$/# - E$/#)/E$/# !
forward exchange rate " " " "forward premium!
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When the covered interest parity and the (uncovered) interest parity condition, we nd that: !
F$/#= Ee$/#!
Forward rates reect expectations. Because unexpected events tend to affect longterm expectations (and not so much short-term rates) this relationship means that forward and spot rates tend to move together. (They are both affected by unexpected events.)!
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It says that rates of return on dollar deposits and covered foreign currency deposits are the same.!
You could make easy, risk-free money in the foreign exchange markets if covered interest parity did not hold?! Covered positions using the forward rate involve little risk.! This holds in a given exchange, but does not always hold across exchanges (due to capital controls, transaction costs, etc).!
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Summary!
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GDP
A countrys GNP is roughly equal to the income received by its factors of production.!
2. In an open economy, GNP equals the sum of consumption, investment, government purchases, and the current account.! 3. GDP is equal to GNP minus net receipts of factor income from abroad. It measures the output produced within a countrys borders.!
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Summary (cont.)!
GDP
4. National saving minus domestic investment equals the current account ($ exports minus imports).! 5. The current account equals the countrys net foreign investment (net outows of nancial assets).! 6. The balance of payments accounts records ows of goods & services and ows of nancial assets across countries.!
It has 3 parts: current account, capital account and nancial account, which balance each other.! Transactions of goods and services appear in the current account; transactions of nancial assets appear in the nancial account.!
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Summary (cont.)!
7. "There are major global imbalances and ! trends apparent in simple national income accounting:! 8. "Exchange rates are prices of foreign currencies in terms of domestic currencies, or vice versa. ! 9. "Depreciation of a countrys currency means that it is less expensive (valuable): exports are cheaper, imports more expensive.! A depreciation will hurt consumers of imports but help producers of exports.! Airbus is now losing competitiveness, and Boeing is beneting from the fall in the dollar, for example. This is bad for U.S. airlines (if prices go up) but good for Boeing.!
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10. "Appreciation of a countrys currency means that it is more expensive (valuable) and goods denominated in it are more expensive: exports are more expensive and imports cheaper.!
An appreciation will help consumers of imports but hurt producers of exports.! Airbus is now losing competitiveness, and Boeing is beneting from the fall in the dollar, for example. This is good for EU airlines (if # prices go down) but bad for Airbus.!
Summary ! (continued...)!
11. "Commercial banks that invest in deposits of different currencies dominate the foreign exchange market.!
Expected rates of return are most important in determining the willingness to hold these deposits.!
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Summary ! (continued...)!
12. "Returns on bank deposits in the foreign exchange market are inuenced by interest rates and expected exchange rates.! 13. "Equilibrium in the foreign exchange market occurs when returns on deposits in domestic currency and in foreign currency are equal: interest rate parity.! 14. "An increase in the interest rate on a currencys deposit leads to an increase in the rate of return and to an appreciation of the currency.!
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Summary ! (continued...)!
15. "An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and leads to an actual appreciation. ! 16. "Covered interest parity says that rates of return on domestic currency deposits and covered foreign currency deposits using the forward exchange rate are the same.! 17. "Uncovered interest parity says that forward rates and expectations should reect each other.!