Exchange Rates and International Transactions. Exchange rates translate different countries’ prices into comparable terms: $ Price of French Cognac = ($/ €) x (€/Bottle) Exchange rates are determined in the same way as other asset prices: Supply and Demand - PowerPoint PPT Presentation
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The Foreign Exchange Market• Major Players in the Foreign Exchange Market
– Commercial banks– International corporations– Nonbank financial institutions
• Interbank trading accounts for most activity in the foreign exchange market
• New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).
• The integration of financial centers implies that there can be no significant arbitrage opportunities (Buy Low – Sell High)
• The $ -- the world’s vehicle currency– In 2001, around 90% of transactions between banks
involved exchanges of foreign currencies for U.S. dollars.
Demand for a foreign currency bank deposit depends on Asset Return: the percent increase in the deposit’s value over
some time period.• Returns on deposits traded in the foreign exchange market depend
on interest rates and expected exchange rate changes.
Real Rate of Return: the rate of return measured in terms of some broad representative basket of products that savers regularly purchase adjust for price inflation
Risk: the variability the deposit contributes to savers’ wealth
Liquidity: the ease with which it can be sold or exchanged for goods
= the interest rate difference – expected appreciation of the euro
where:
R$ = interest rate on one-year dollar deposits
R€= today’s interest rate on one-year euro deposits
E$/€ = today’s dollar/euro exchange rate (number of dollars per euro)
Ee$/€ = dollar/euro exchange rate (number of dollars per euro)
expected to prevail a year from today
The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro (the euro’s rate of appreciation).
Interest Parity: The Basic Equilibrium ConditionThe foreign exchange market is in equilibrium when all currencies offer the same expected rate of return.
R$ = R€ + (Ee$/€ - E$/€)/E$/€
• If the $ is expected to depreciate, (Ee$/€ - E$/€)/E$/€ > 0, US
interest rates must exceed foreign rates by a like amount to keep funds from fleeing abroad.
• Depreciation of the $ today (with the expected future exchange rate unchanged) lowers the expected dollar return on euro deposits.
– If the $ becomes cheaper today, US deposits become more attractive euro deposits become less attractive euro interest rates must rise relative to the US rate to maintain interest rate parity
• Appreciation of the $ today raises the dollar return expected of euro deposits euro deposits become more attractive