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ECON 332 Study Guide - Final Guide: Foreign Exchange Market, Real Interest Rate, European Emission Standards


Department
Economics
Course Code
ECON 332
Professor
Usman Hannan
Study Guide
Final

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ECON 332 Notes
Exchange Rates and the Foreign Exchange Market: An Asset Approach (Ch 13)
Exchange Rates and International Transactions
Exchange Rate:
The price of one currency in terms of another
Can be quoted either as the price of the foreign currency in terms of dollars (direct/American exchange)
or as the price of dollars in terms of the foreign currency (indirect/European terms)
Also an asset price; Thus, the principles governing the behaviour of other asset prices also govern the
behaviour of exchange rates
Allow us to compare prices of goods and services produced in other countries
Assets are a form of wealth; A way of transferring purchasing power from the present into the future
All else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners; Exports are
cheaper for foreigners and imports from abroad are more expensive for domestic residents
All else equal, an appreciation of a country’s currency makes its goods more expensive for foreigners; Exports
are more expensive for foreigners and imports from abroad are cheaper for domestic residents
Relative Prices influence import and export demands
All else equal, a depreciation of a country’s currency lowers the relative price of its exports and raises the
relative price of its imports
All else equal, an appreciation of a country’s currency raises the relative price of its exports and lowers the
relative price of its imports
Foreign Exchange Market
The market in which international currency trades is called the Foreign Exchange Market
The major participants in the foreign exchange market are:
1. Commercial Banks: At the center of foreign exchange market b/c almost every sizable international
transaction involves debiting/crediting of accounts at commercial banks in various financial centers (i.e.
the exchange of bank deposits denominated in different currencies)
2. Corporations that engage in international trade: Frequently make or receive payments in currencies
other than that of the country in which they are headquartered
3. Nonbank Financial Institutions: Institutional investors (ex. pension funds) often trade foreign currencies;
Hedge funds, which cater to very wealthy individuals and are not bound by government regulations that
limit mutual funds’ trading strategies, trade actively in the foreign exchange market (ex. hedge funds)
4. Central Banks: Sometimes intervene in foreign exchange markets; the volume of the transactions is
typically not large but may have a great impact since participants in the foreign exchange markets watch
central bank actions for clues about future macroeconomic policies (ex. the interest rate) that may affect
exchange rates (ex. appreciation and depreciation)
5. Individuals: May participate in the market (ex. tourist buying foreign currency at a hotel), but such cash
transactions are an significant fraction of foreign exchange trading
Interbank Trading is the trading of foreign currency among banks and accounts for most of the activity in the
foreign exchange market using wholesale/interbank exchange rates
Corporations trade foreign currency with commercial banks (debit/credit) using retail exchange rates; They
have the incentive to work with banks because it reduces search costs as well as the interest rate issue
Commercial bank’s profit at the retail market = wholesale exchange rate retail exchange rate
Arbitrage is the process of buying a currency cheap in one country and selling it for a higher price (dear) in
another; risk-free, rare, and short-lived since the increase in demand will drive the exchange rate back
Vehicle Currency is one that is widely used to denominate international contracts made by parties who do not
reside in the country that issues the vehicle currency (ex. USD, Euro, Pound)
Mechanisms of Foreign Exchange Markets:
Spot Exchange Rates govern “on-the-spot” trades (called spot transactions)
Forward Exchange Rates are involved in forward transactions (deals that specify a future transaction
date called the value date)

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A Foreign Exchange Swap is a spot sale of a currency combined with a forward repurchase of the currency (ex.
receive $1M in sales; owe a US supplier in 3 months; invest in $1M in euro bonds for 3 months the 3 month
swap of dollars into euros may result in lower brokers’ fees than the 2 separate transactions of selling dollars
for spot euros and selling the euros for dollars on the forward market)
A Futures Contract promises that a specified amount of foreign currency will be delivered on a specific date in
the future; buy = long; sell = short
A Forward Contract (private transaction OTC market) is an alternative way to ensure that you receive the
same amount of foreign currency on the date in question
A Foreign Exchange Option gives its owner the right to buy or sell a specified amount of foreign currency at a
specified price at any time up to a specified expiration date; the seller has no obligation to exercise the right
Put Options give the right to sell the foreign currency at a known exchange rate at any time during the period
Ex. You expect foreign currency to arrive 1 year from now. Hedge it using a put.
Call Options give the right to buy the foreign currency at a known price
Ex. You expect to make payments to a foreign country. Hedge it using a call.
Options may be written on many underlying assets (including foreign exchange futures)
Demand for Foreign Currency Assets
Asset Returns:
Desirability of an asset is judged largely on the basis of its rate of return, the percentage increase in value
it offers over some time period
Ex. Invest $100, stock price rises $10; ROR = 10%
Decisions must be based on an expected rate of return
Asset demand is driven by real rate of return, risk and liquidity
Real Rate of Return:
The expected rate of return that savers consider in deciding which assets to hold (i.e. the asset demand)
is the expected real rate of return
Is computed by measuring asset values in terms of some broad representative basket of products that
savers regularly purchase
Only the real return measures the goods and services a saver can buy in the future in return for giving up
some consumption today
Ex. Suppose the dollar value of an investment increases by 10% but the dollar prices of all goods and
services also increase by 10%. In real terms, the real rate of return is 0.
Rates of return expressed in currency (dollar returns) can still be used to compare real returns on
different assets (ex. value of bottles of wine)
All else equal, individuals prefer to hold those assets offering the highest expected real rate of return
Risk is the variability an asset contributes to savers’ wealth
An asset’s real return is usually unpredictable and may turn out to be quite different from what savers
expect when they purchase the asset
Savers dislike uncertainty and are reluctant to hold assets that make their wealth highly variable
An asset with a high expected ROR may appear undesirable to savers if the realized ROR fluctuates
widely
Liquidity is the ease/speed with which the asset can be sold for exchanged goods
Assets differ according to the cost and speed at which savers can dispose of them
Savers prefer to hold some liquid assets as a precaution against unexpected pressing expense that might
force them to sell less liquid assets at a loss
Participants in the foreign exchange market base their demands for deposits of different currencies on a
comparison of these assets’ expected rates of return
To compare returns on different deposits, market participants need to know: (1) How the money values of the
deposits will change and (2) How exchange rates will change so that they can translate RORs of other
currencies
A currency’s interest rate is the amount of the currency that an individual can earn by lending a unit of the
currency for a year
Example: Suppose that today’s exchange rate is $1.100/, but you expect the rate to be $1.165/ in 1 year.
Suppose also that the dollar interest rate is 10%/year while the euro interest rate is 5%/year. This means that

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a deposit of $1.00 pays $1.10 after a year while a deposit of 1 pays €1.05 after a year. Which of these
deposits offer the higher return?
Solution:
American Deposit:
The expected dollar rate of return is ($1.10 - $1.00)/$1.00 = 10%
Euro Deposit:
Today’s exchange rate ($1.100/) shows that a deposit of 1 will be $1.10 (= 1 x $1.100/€)
If you deposit €1 today, you will earn 5%/year. Thus, after a year, the deposit will be worth €1.05
You expect that this will be worth (€1.05 x $1.165/€ =) $1.223
The expected dollar rate of return is thus ($1.223 - $1.10)/$1.10 = 0.11 = 11%
Therefore, you expect to do better by holding your wealth in the form of euro deposits
The Rate of Depreciation is the percentage increase in the domestic-foreign (i.e. dollar/euro) exchange rate
over a year (in the above example, the dollar’s expected depreciation rate is *1.165-1.10]/1.10 = 5.9% 6%)
The dollar rate of return on foreign deposits is approximately the foreign interest rate plus the rate of
depreciation of the dollar against the foreign currency (i.e. To translate the euro return on euro deposits into
dollar terms, add the rate at which the euro’s dollar price rises over a year to the euro interest rate; in the
above example: 5% + 6% = 11%)
Expected ROR = 


Where
R
is today’s interest rate on one-year euro deposits,
E$/
is today’s dollar/euro exchange rate, and

is the expected dollar/euro exchange rate one year from now.
The expected rate of return difference between dollar and euro deposits is
R$
, today’s interest rate on one-
year dollar deposits less the above expression:  


When the difference is positive, dollar deposits yield the higher expected rate of return
When the difference is negative, euro deposits yield the higher expected rate of return
The Rate of Appreciation is the inverse of the rate of depreciation: 


Equilibrium in the Foreign Exchange Market
When market participants willingly hold the existing supplies of deposits of all currencies, the foreign
exchange market is in equilibrium
The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of
return
The Interest Parity Condition is when the expected returns on deposits of any two currencies are equal when
measured in the same currency: 


Example: Suppose that today’s $/€ exchange rate is $1.00/€ and the expected rate for next year is $1.05/€.
Expected rate of dollar depreciation = (1.05 1.00)/1.00 = 0.05 = 5%/year
When you buy a euro deposit, you earn the interest R as well 5% in dollars
Suppose that today’s exchange rate jumps suddenly to $1.03/€, but the expected rate remains at $1.05/€.
Expected rate of dollar depreciation = (1.05 1.03)/1.03 = 0.019 = 1.9%/year
The expected rate of dollar depreciation has fallen by 3.1%
Exchange rates always adjust to maintain interest parity
Holders of deposits will always want to hold the deposit in the currency that has the highest return, driving the
exchange rate back to equilibrium
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