Midterm Notes - Dollarization The use of the U.S dollar as the official currency of the country International Fisher Effect If capital by way of CIA

Midterm Notes - Dollarization The use of the U.S dollar as...

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Dollarization: The use of the U.S. dollar as the official currency of the countryInternational Fisher Effect: If capital, by way of CIA, attempts to find higher rates of return internationally resulting from current interest rate differentials, the real rates of return between currencies are equalized.SWAP: purchase and sale of a given amount of foreign exchange for 2 given value datesForward Rate as Unbiased Predictor:The forward rate is assumed to be an unbiased predictor if the future spot rateArbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium invest in the lower yielding currency.Chapter 6: The Foreign Exchange MarketFunctions of the Forex MarketThe Forex market is the mechanism by which participants transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.Change in Spot Rate:Direct Terms: (end-begin)/beginIndirect Terms: (begin-end)/endSwap Rate: simultaneous purchase for one date and sale (reversing the transaction) for another (hedging purposes). The party with the higher interest currency pays the net interest differential to the other. Expressed as a point basis. Point Quotation: Difference between forward rate and spot rate for both bid and askChapter 7: Foreign Currency DerivativesBenefits of Derivatives:1.Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at a greater cost2.Hedge risks that otherwise would not be possible to hedge3.Make underlying markets more efficient4.Reduce volatility of stock returns5.Minimize earnings volatility6.Reduce tax liabilities7.Motivate management (agency theory affect)Foreign Currency FuturesFutures Contract: an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place, and price.
Most important futures market in U.S. is International Monetary Market (IMM) in ChicagoContract SpecificationsSize of Contract: Called Notional Principal ; trading must be done in an even multiple of currency unitsMethod of Stating Exchange Rates: “American Terms” direct quote aka in $Maturity Date: contracts mature of 3rdWednesday of Jan, March, April, June, July, Sept, Oct, DecLast Trading Day: contracts may be traded through the 2ndbusiness day prior to the Wed. that they mature on aka Monday before maturity, unless there’s a holiday.Collateral & Maintenance Margins:Purchaser must deposit a sum as an initial margin or collateral, can be letter from bank, T-bill, or cash. Maintenance margin also required. Value of contract is market to market daily, and all changes in value are paid in cash daily, amount to be paid is called variation margin.

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