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.
ECMC61 - Chapter 13 1
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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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