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1、,Chapter 19,The Foreign Exchange Market, 2005 Pearson Education Canada Inc.,Foreign Exchange I,Exchange rate: price of one currency in terms of another Foreign exchange market: the financial market where exchange rates are determined Spot transaction: immediate (two-day) exchange of bank deposits Sp
2、ot exchange rate Forward transaction: the exchange of bank deposits at some specified future date Forward exchange rate,Foreign Exchange II,Appreciation: a currency rises in value relative to another currency Depreciation: a currency falls in value relative to another currency When a countrys curren
3、cy appreciates, the countrys goods abroad become more expensive and foreign goods in that country become less expensive and vice versa Over-the-counter market mainly banks, 2005 Pearson Education Canada Inc.,19-4,Foreign Exchange Rates, 2005 Pearson Education Canada Inc.,19-5,The Foreign Exchange Ma
4、rket,Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation Currency appreciates, countrys goods prices abroad and foreign goods prices in that country 1. Makes domestic businesses less competitive 2. Benefits domestic consumers FX traded in over-the-counter mark
5、et 1. Trade is in bank deposits denominated in different currencies,19-6,Law of One Price,Example: Canadian steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are:Canadian Steel Japanese Steel In Canada $100 $200 In Japan 5000 yen 10,000 yen If E = 100 yen/$ then price
6、s are:Canadian Steel Japanese Steel In Canada $100 $100 In Japan 10,000 yen 10,000 yen Law of one price E = 100 yen/$, 2005 Pearson Education Canada Inc., 2005 Pearson Education Canada Inc.,19-7,Purchasing Power Parity (PPP),PPP Domestic price level 10%, domestic currency 10% 1. Application of law o
7、f one price to price levels 2. Works in long run, not short run Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy 2. Many goods and services are not traded: e.g. haircuts, 2005 Pearson Education Canada Inc.,19-8,PPP: Canada and U.S.,19-9,Factors Affecting E in Long Run,
8、Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E , 2005 Pearson Education Canada Inc., 2005 Pearson Education Canada Inc.,19-10,Expected Returns and Interest Parity,Re forFrancois Al $ Deposits iD + (Eet+1 Et)/Et iD Euro Deposits iF iF (Eet+1 Et)/Et Relativ
9、e Re iD iF + (Eet+1 Et)/Et iD iF + (Eet+1 Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes iD = iF (Eet+1 Et)/Et Example: if iD = 10% and expected appreciation of $, (Eet+1 Et)/Et, = 5% iF = 15%, 2005 Pearson Education Canada Inc.,19-11,Deriving RF Curve,Assume iF = 10%, Eet
10、+1 = 1 euro/$ Point A: Et = 0.95, RF = .10 (1 0.95)/0.95 = .048 = 4.8% B: Et = 1.00, RF = .10 (1 1.0)/1.0 = .100 =10.0% C: Et = 1.05, RF = .10 (1 1.05)/1.05 = .148 = 14.8% RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF Deriving R
11、D CurvePoints B, D, E, RD = 10%: so curve is vertical EquilibriumRD = RF at E*If Et E*, RF RD, sell $, Et If Et E*, RF E*, RETF RETD, sell $, Et If Et E*, RETF iD , real rate , Eet+1 more than iD RF out RD out and Et , 2005 Pearson Education Canada Inc.,19-18,Response to Ms ,1. Ms , P , Eet+1 expect
12、ed appreciationof F , RF shiftsright 2. Ms , iD , RD shiftsleft Go to point 2 and Et 3. In the long run, iDreturns to old level, RD shifts back, goto point 3 and getExchange Rate Overshooting, 2005 Pearson Education Canada Inc., 2005 Pearson Education Canada Inc.,19-19,Why Exchange Rate Volatility?,
