CH05 - CHAPTER 5 THE FOREIGN EXCHANGE MARKET AND PARITY...

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CHAPTER 5 THE FOREIGN EXCHANGE MARKET AND PARITY CONDITIONS CHAPTER OUTLINE I. Major Participants in the Exchange Market a) Commercial banks (1) Operating the payment mechanism (2) Extending credit (3) Reducing risk (4) Exchange trading by commercial banks (5) Global market and national markets b) Central banks II. Spot Exchange Quotation: Spot Exchange Rate a) Direct and indirect quotes for foreign exchange b) Cross rates c) Measuring a percentage change in spot rates (1) Direct quotations (2) Indirect quotations d) The bid-ask spread III. Forward Exchange Quotation: Forward Exchange Rate a) Key reasons for forward exchange transactions b) Speculation in the foreign exchange market (1) Speculating in the spot market (2) Speculating in the forward market IV. International Parity Conditions a) Efficient exchange markets b) The theory of purchasing power parity (1) Appraisal of the PPP theory c) The Fisher Effect (1) Appraisal of the Fisher Effect e) The International Fisher Effect (1) Short-run behavior f) The theory of interest-rate parity g) The forward rate and the future spot rate h) Synthesis of international parity conditions V. Arbitrages a) Geographic arbitrage (1) Two-point arbitrage (2) A three-point arbitrage b) Covered-interest arbitrage IV. Summary 32
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CHAPTER OBJECTIVE This chapter describes the organization and dynamics of the foreign exchange market so that students can understand the complex functions of international finance. More specifically, it is designed to illustrate: the roles of the major participants in the exchange market, the spot and forward markets, the theories of exchange rate determination (international parity conditions), and the roles of arbitragers. KEY TERMS AND CONCEPTS Spot rate is the rate paid for delivery of a currency within two business days after the day of the trade. Direct quote is a home currency price per unit of a foreign currency. Indirect quote is a foreign currency price per unit of a home currency. Cross rate is an exchange rate between two currencies when it is obtained from the rates of these two currencies in terms of a third currency. Bid price is the price at which a bank is ready to buy a foreign currency. Ask price is the price at which a bank is ready to sell a foreign currency. Bid-ask spread is the spread between bid and ask rates for a currency; this spread is the bank's fee for executing the foreign exchange transaction. Forward rate is the rate to be paid for delivery of a currency at some future date. Efficient exchange markets exist when exchange rates reflect all available information and adjust quickly to new information. Theory of Purchasing Power Parity (PPP) holds that the exchange rate must change in terms of a single currency so as to equate the prices of goods in both countries. Fisher Effect,
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This note was uploaded on 03/22/2009 for the course MANAGEMENT 5689-9856 taught by Professor Nialamnu during the Fall '08 term at Indiana State University .

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CH05 - CHAPTER 5 THE FOREIGN EXCHANGE MARKET AND PARITY...

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