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Exchange Rates and The Foreign Exchange Market: An Asset Approach
Exchange Rates and The Foreign Exchange Market: An Asset Approach
Exchange Rates
and the Foreign
Exchange
Market: An Asset
Approach
Preview
The basics of exchange rates
Exchange rates and the prices of goods
The foreign exchange markets
The demand for currency and other assets
A model of foreign exchange markets
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the real rate of return for the above savings account when
inflation is 1.5%: 2% 1.5% = 0.5%. The asset can
purchase 0.5% more goods and services after 1 year.
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R + (Ee$/ - E$/)/E$/
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
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- R
interest rate
on euro
deposits
- (Ee$/ - E$/)/E$/
expected
exchange rate
current
exchange rate
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(1.05 - E$/)/E$/
1.07
0.05
-0.019
0.031
1.05
0.05
0.000
0.050
1.03
0.05
0.019
0.069
1.02
0.05
0.029
0.079
1.00
0.05
0.050
0.100
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The Current
Exchange
Rate and
the Expected
Return on
Dollar
Deposits
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0.050
R$
0.069
0.079 0.100
Expected dollar return
on dollar deposits, R$
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A depreciation
of the euro is
an appreciation
of the dollar.
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People now
expect the
euro to
appreciate
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Summary
1. Exchange rates are prices of foreign
currencies in terms of domestic currencies,
or vice versa.
2. Depreciation of a countrys currency means
that it is less expensive (valuable) and
goods denominated in it are less expensive:
exports are cheaper and imports more
expensive.
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Summary (cont.)
3. Appreciation of a countrys currency means that it is
more expensive (valuable) and goods denominated
in it are more expensive: exports are more
expensive and imports cheaper.
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Summary (cont.)
5. Returns on bank deposits in the foreign
exchange market are influenced by interest
rates and expected exchange rates.
6. Equilibrium in the foreign exchange market
occurs when returns on deposits in domestic
currency and in foreign currency are equal:
interest rate parity.
7. An increase in the interest rate on a
currencys deposit leads to an increase in the
rate of return and to an appreciation of the
currency.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
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Summary (cont.)
8. An expected appreciation of a currency
leads to an increase in the expected rate of
return for that currency, and leads to an
actual appreciation.
9. Covered interest parity says that rates of
return on domestic currency deposits and
covered foreign currency deposits using
the forward exchange rate are the same.
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