Chapter 13: Exchange Rate and the Foreign Exchange Market: An Asset Approach

Definitions

•Exchange rate: the price of one currency in terms of another.

•Depreciation: a decrease in the value of a currency.

•Appreciation: an increase in the value of a currency.

⇒If EDC/FC ↑, then DC depreciates and FC appreciates.

•Foreign exchange market: the market in which international currency trades take

place.

•Spot exchange rates (EDC/FC): today’s exchange rate.

•Forward exchange rates: the exchange rate that is contracted today for the exchange

of currencies at a specified date in the future.

⇒Forward discount and forward premium

•Expected exchange rates (

e

DC/FC

E

): the exchange rate that agents are expected to

prevail in the future.

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Equilibrium in the Foreign Exchange Market: Interest Rate Parity (Asset Approach

to the Exchange Rate)

•Suppose I have two investment options: one is to invest in DC denominated deposit

and the other one is to invest in FC denominated deposit. Which deposit should I

choose?

•Invest in DC denominated deposit:

⇒For each DC I invest in the DC denominated deposit, I get (1 + R) units of

DC in the future.

Example: If R = 6%, the amount of DC received a year later is:

•Invest in FC denominated deposit:

1) Convert DC into FC: each DC, I get

DC/FC

E

1

units of FC.

⇒If EDC/FC = 1.25, the number of FC purchased per DC sold:

2) Invest in FC deposit: for each unit of DC invests in FC denominated deposit, I receive

+

*

R 1

E

DC/FC

1

units of FC in the future.

⇒If R* = 4%, the amount of FC received a year from now (per unit of DC invested

in FC denominated deposit):

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