econ423lec18

econ423lec18 - 7/15/2009 1 FOREIGN EXCHANGE MARKETS FOREIGN...

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Unformatted text preview: 7/15/2009 1 FOREIGN EXCHANGE MARKETS FOREIGN EXCHANGE MARKETS JULY 15 TH , 2009 Lauren Heller Econ 423, Financial Markets The Plan for Today b Exchange Rates in the Short Run b Calculating expected returns across countries b Deriving currency demand and supply curves. b Foreign Exchange Interventions b Homework #6 Questions Recall from last time b Thanks to PPP, in the long run, changes in exchange rates are determined by the relative demand for domestic vs. foreign goods. b Four major factors affecting this demand: 1. Relative price levels 2. Tariffs and quotas 3. Preferences for domestic vs. foreign goods 4. Productivity Recall from last time b The appreciation of a currency (%) from time t to t+1 can be calculated as: b Factors driving long-run exchange rate changes generally move slowly over time. b What about the short run? t t t E E E- + 1 Exchange Rates in the Short Run b Recall that an exchange rate is simply the price of domestic bank deposits in terms of foreign bank deposits. b One asset priced in terms of another b For this reason, we can use tools weve already learned to analyze this market. b Determinants of Asset Demand Exchange Rate Example b If he deposits them in a U.S. bank, he must convert the euros to dollars b The difference in Bonos expected return depends on two things: 1. Local interest rates ( i f and i d ) 2. Expected future exchange rates. b Suppose Bono is deciding whether or not to deposit some of his excess euros in Ireland (at i f ) or in a U.S. bank (at i d ). 7/15/2009 2 Exchange Rate Example b If she deposits them in a foreign bank, she must convert the dollars to euros. b The difference in Beyonces expected return also depends on: 1. Local interest rates 2. Expected future exchange rates. b Beyonc has a similar problem. She can deposit her excess dollars locally, or she can deposit them in a foreign bank. R e for Bono R e for Beyonc $ Deposits i D + E t + 1 e- E t ( 29 E t i D F Deposits i F ( 29 t t t F E E E i-- + e 1 Relative R e i D- i F + E t + 1 e- E t ( 29 E t i D- i F + E t + 1 e- E t ( 29 E t Exchange Rate Example b We can use the following table to compare the expected returns for each musician: R e for Bono R e for Beyonc $ Deposits i D + E t + 1 e- E t ( 29 E t i D F Deposits i F ( 29 t t t F E E E i-- + e 1 Relative R e i D- i F + E t + 1 e- E t ( 29 E t i D- i F + E t + 1 e- E t ( 29 E t Exchange Rate Example b We can use the following table to compare the expected returns for each musician: Expected appreciation of the dollar relative to the euro R e for Bono R e for Beyonc $ Deposits i D + E t + 1 e- E t ( 29 E t i D F Deposits i F ( 29 t t t F E E E i-- + e 1 Relative R e i D- i F + E t + 1 e- E t ( 29 E t i D- i F + E t + 1 e- E t ( 29 E t Exchange Rate Example b What happens if the dollar appreciates ?...
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This note was uploaded on 08/31/2009 for the course ECON 423 taught by Professor Vd during the Summer '08 term at UNC.

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econ423lec18 - 7/15/2009 1 FOREIGN EXCHANGE MARKETS FOREIGN...

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