Study guide - Chapter 2 Exchange Rates and Foreign Exchange Market: An Asset Approach

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16 May 2011
Chapter 2 Exchange Rates + Foreign Exchange Market: An Asset Approach
Exchange rate the price of one currency in terms of another
oIs also an asset price the principles governing the behaviour of other asset prices also
govern the behaviour of exchange rates
oA way of transferring purchasing power f/ present into future
oDollar/euro exchange rate closely tied to ppls expectations about the FUTURE level of that rate
Goal: understand role of exchange rates in international trade + how exchange rates are determined
Exchange Rates + International Transactions
Exchange rates allow us to compare the prices of diff countries’ goods + services (compare w/ relative
Exchange rate can be quoted in 2 ways
oDirect dollars per foreign currency (ex: $0.05 per yen)
oIndirect foreign currency units per dollar (ex: 121yen per $1)
Domestic + Foreign Prices
If we know exchange rate b/w 2 currencies, we can compute relative price of one country’s export in
terms of anothers money
Changes in E = depreciation or appreciation
Depreciation makes its goods cheaper for foreigners
Appreciation - makes goods more expensive for foreigners
When one currency depreciates against another, the second currency must simultaneously appreciate
against the first
*When a country’s currency depreciates, foreigners find its exports are cheaper, domestic residents find
imports more expensive! (vice versa)
Exchange Rates + Relative Prices
Imports + exports demands (like demands for all goods + services) are influenced by RELATIVE prices
Must translate to common currency when comparing
Ex: $75 sweater, $45 jeans in US; 50 pounds sweater, 30 pounds jeans in Britain
oPrice of sweaters in terms of jeans in US = 75/45 = 1.67 pairs of jeans per sweater
oPrice of sweaters in terms of jeans in Britain = 50/30 = 1.67 pairs of jeans per sweater
When E change, assume that price remains the same (ex: $45 jeans) relative price changes as
exchange rate changes!
*All else equal, an APPRECIATION of a country’s currency RAISES relative price of its exports +
LOWERS the relative price of its imports (vice versa)
The Foreign Exchange Market
E determined by the interaction of households, firms, financial institutions that buy + sell foreign
currencies to make international payments
Foreign exchange market - the market in which international currency trades take place
The Actors
1.Commercial banks
Exchange of bank deposits denominated in diff currencies
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Interbank trading - foreign currency among banks
Quote to other banks exchange rates at which it is willing to buy currencies f/ them + sell currencies to them
Bring buyers +sellers of currencies together economize on search costs
Operations in several countries frequently make/receive payments in foreign currencies
3.Nonbank financial institutions
Services involving foreign exchange transactions (ex: mutual fund)
4.Central banks
Sometimes intervene in FX markets
Volume usually not large, but participants in FX market watch central bank actions closely for clues about
future macro policies that may affect foreign exchange rates
Characteristics of the Market
Arbitrage - opportunity to buy low and sell high
oExcess demand/supply, drive the price to reach equilibrium
Vehicle currency widely used to denominate international contracts made by parties who do not live
in the country that issues the vehicle currency
oMost transactions are exchanges of foreign currencies for US dollars
Spot Rates + Forward Rates
Spot Exchange Rates - trade immediately
Forward exchange rate - agree to exchange deposit in a future transaction date
Spot rate usually does NOT equal forward rate (but do move closely together!)
Value date the future date on which the currencies are actually exchanged
Using the Forward rate can help HEDGE foreign currency risk (lock in profit/rate)
Foreign Exchange Swaps
Swap a spot sale of currency combined w/ a forward repurchase of the currency
Ex: Company A received $1M and knows it will have to pay those to another supplier in 3 months 
can invest the $1M in euro bonds may result in lower brokers’ feeds than 2 separate transactions of
selling dollars for spot euros + selling the euros for dollars on forward market
Futures + Options
Futures contract but a promise that a specified amt of foreign currency will be delivered on a
specified date in the future
oCan sell the futures contract on an organized exchange realizing profit/lose right the way
oUseful if your view on the future spot exchange rate were to change
Forward contract also receive same amt of foreign currencies, but must fulfill the deal
Foreign exchange option gives owner the right to buy/sell a specified amt of foreign currency at a
specified price at any time up to a specified expiration date (no obligation to exercise the right)
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