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Lecture 16

ECO230Y1 Lecture Notes - Lecture 16: Spot Contract, Japanese Yen, Forward Exchange Rate


Department
Economics
Course Code
ECO230Y1
Professor
Masoud Anjomshoa
Lecture
16

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EXCHANGE RATE DETERMINATION:
AN ASSET APPROACH
Exchange Rates
If we assume that we have two countries, we can define two types of exchanges
rates
1) Nominal Exchange Rate: Exchange rate between currencies
2) Real Exchange Rate: Exchange rate between goods and services
Direct Definition: Nominal Exchange Rate, E: Price of foreign currency in terms of
domestic currency, like:
E =1. 3021$/
Indirect Definition: Normal Exchange Rate, E’: Price of domestic currency in
terms of foreign currency, like:
Nominal Depreciation: If foreign currency becomes stronger, or domestic currency
becomes weaker, or if E
Nominal Appreciation: If foreign currency becomes weaker, or domestic currency
becomes stronger, of if E
Real Exchange Rate, q: Price of foreign goods in terms of domestic goods
Real Exchange Rate, q: Price of foreign good in terms of
domestic goods:
P: Price of domestic goods
P*: Price of foreign goods
Real Depreciation: If foreign goods becomes relatively more expensive, or
domestic goods become relatively cheaper, or if q
Real Appreciation: IF foreign goods become relatively cheaper, or if domestic
goods become relatively more expensive, or if q
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EXCHANGE RATE DETERMINATION:
AN ASSET APPROACH
Spot Exchange Rate: The exchange rate for exchange trades that call for payment
within two business days from the date of the transaction
Arbitrage: guarantees consistent price cross exchange rates
Triangular Arbitrage:
But if:
You can make money by arbitrage
1 – Exchange L102 to Y9180
2 – Exchange Y9180 to $135
3 – Exchange $135 to L108
 L6 profit
 Suddenly demand for Japanese Yen rises
 Japanese Yen appreciates to Y85/L
Forward Exchange Rate:
-The forward market for foreign
exchange involves agreements to
buy and sell foreign currencies in
the future at rates agreed
today, called forward exchange rate.
-Forward exchange rate quotes for
1,3,6,9 and 12 months
maturities are available for
forward contracts
Foreign Exchange Markets:
-The set of markets where foreign currencies and other assets are exchanged
for domestic ones.
-The daily volume of foreign exchange transactions was $1.9 trillion in 2004.
About 90% of transactions were involved with USD.
-The participants:
oCommercial banks and other depository institutions: transactions
involve buying/selling different currencies for investment purposes
oNon-bank financial institution: (mutual funds, hedge funds, securities
firms, insurance companies, pension funds): buy/sell foreign assets
for investment.
oNon-financial businesses: conduct foreign currency transactions to
buy/sell goods, services and assets
oCentral banks: conduct official international reserves transactions.
Other Methods of Currency Exchange
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