Chapter02

# Chapter02 - Chapter 2 The International Monetary System I...

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Chapter 2 The International Monetary System Outline I. Basic Currency Terminology A) Exchange rate = price of one currency in terms of another currency. For example, 1.050 SFr/C\$ would mean that it takes 1.05 Swiss Francs to buy one Canadian dollar. Spot exchange rate is the price that is quoted for “on the spot” or immediate delivery (market convention in the interbank market is that spot delivery takes place in two days). Forward exchange rate is the price quoted for a future transaction between two currencies. With a forward contract, one can “lock in” the rate at which currencies are exchanged on a future date. The forward rate may deviate from the spot rate, indicating that one currency is selling at forward premium or discount with respect to the other currency. Example: If the current spot rate is \$1.75/£ and the 180-day forward rate is \$1.70/£, then the pound is said to be selling at a forward discount (if you are getting confused, replace the units in the denominator by apples. Apples in the future are cheaper in this case, or “they are selling at a forward discount”). The annualized percentage discount can be calculated by 360 1.75 1.70 360 100 100 5.88% 1.70 180 S F F n - - × × = × × = B) Fixed exchange rate regime = The “home country” of a currency has chosen to fix the exchange rate to some other currency or commodity. For example, the Chinese renminbi has its value fixed in terms of the U.S. dollar. Even though called “fixed exchange rate,” the officials in charge of the currency may occasionally choose to devaluate (reduce) or revaluate (increase) the fixed value of the currency with respect to the reference currency in order to re-align the exchange rate with economic fundamentals. C) Floating or flexible exchange rate regime = The government allows free market forces to determine the value of its currency. Under a floating rate regime, no administered devaluations or revaluations are needed since the market forces continuously alter the exchange rate in response to

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## This note was uploaded on 07/11/2008 for the course BUSN 101 taught by Professor Holcomb during the Fall '08 term at Gonzaga.

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Chapter02 - Chapter 2 The International Monetary System I...

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