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Econ 2164 Notes.docx

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Western University
Economics 2164A/B
Russ Boyer

The Spot FOREX Market Two markets Spot and Forward marketsSpot affected by only current conditions forward less affected by current economic conditionsSpot is an immediate market delivery in one business day Forward is larger and involves signing a contract promising delivery at a future periodPrices are the same everywhere E12Price of 2s currency in terms of 1s currency In order to measure the value of a currency in terms of a foreign currency a better approach is to use an Exchange Rate Index published by Bank of Canada Uses weight values of currencies that reflect trade patterns Weights sum to 1If Canadian currency rises by 10 against each of the currencies then the index rises in value by 10 If it rises against one currency then the whole index will change by the weight of the currency times the increase Active forward Futures markets exist for some major currencies out to ten years The contract is signed at the present time but delivery does not take place until the specified future closing date Most activity in the Forex market has some financial speculative purpose Imports and exports are not important factors in the marketSince almost all participants switch back and forth between being suppliers and being demanders there is no point in using demand curvesA better way to think about it is to use a Monetary model In this context the supply of money depends on the ER negatively reflecting central bank behaviour to stabilize the values of the exchange rate and money supplyThe demand for money depends positively on the value of the exchange rateMarket has two main participants Arbitragers Do not take risks Act as brokers and have covered positions as they do not take up net positions in any currency Make modest profits by buying low and selling high at virtually the same amount Operate in both markets to eliminate risk they would otherwise faceSpeculators Takes risks Wants to make profit on average Will invest in particular currencies hoping for those currencies to appreciate Takes uncovered positions so changes in the market will have immediate reflections upon his net worth They operate mainly in the forward market so as to tie up less capital more leveragedForward ContractsForward transactions involve a delivery date further into the future possibly as far as a year ahead Traders agree to buy and sell currencies for settlement at least three days later at predetermined exchange rates This type of transaction is often used by businesses to reduce their exchange rate risk By buying or selling in the forward market one can protect the present value of a particular currency from exchange rate volatility You lock in todays exchange rate instead of a volatile currency exchange rate in the future that could significantly devalue your purchasing power Option A forex option is a contract between a buyer and a seller under which the buyer has the rightbut not the obligation to sell or buy a specific amount of one currency against another at a predetermined price and on or before a preset date in the future In return for this right the forex option buyer will have to pay a onetime sum called premium to the seller Long Position Someone owes foreign exchange currency to you Short Position You owe foreign exchange currency to someoneIntertemporal arbitrage condition P i ijcj Ic and Ij denote nominal market interest rates in Canada and country j Pj denotes the percentage more expensive is currency j for forward delivery than it is for spot deliveryGold Standard Era Gold standards it was felt may have provided a suitable model for a new international monetary system in which greater fixity of exchange rates was desirable This was thought good as each country would only trade its currency and gold and not interfere with the value of foreign currenciesUnder this system each countrys Central Bank would set the price for its currency in terms of gold and act as a buyer and seller of last resort to guarantee the price This indirectly pegs the price of exchange rates between countriesHowever if there was a variation in the price of the currency in one part of the country then this would stimulate trade there Thus gold would flow to one country and supply of the other countries currency
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