Macroeconomics plus MyEconLab plus eBook 1-semester Student Access Kit (6th Edition)

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Econ 304 Sonoma State University Fall 2007 Dr. Robert Eyler Suggested Answers to Homework #6 1. The difference between the spot and forward market for currency is large in explaining how exchange rates change. a. Define spot and forward exchange rates as discussed in class. The spot exchange rate is the number of foreign currency units per domestic currency unit for transactions that take place immediately or within two days per a spot contract. Most spot transactions do not involve contracts and are simple trades. The forward exchange rate is the number of foreign currency units per domestic currency unit for transactions that take place in a contract at a future date for a certain price and quantity. The price in these contracts is the forward exchange rate. Both of these markets are determined in the current time period; there are two stated exchange rates for currency, if a forward market exists, at all times. b. Explain why we would expect the spot exchange rate to fall if the forward rate today were less than the spot rate today. The forward exchange rate is the market’s best guess today as to the value of the spot exchange rate in the future. The future date depends on the specific forward market being investigated. Suppose the 60-day forward rate is 0.7 and the spot rate is 1. The forward market is telling the spot market that the expectations are for supply of the domestic currency to exceed its demand over the next 60 days, and the forward market is mocking that exact notion by speculating on the domestic currency falling in value, and e f falls. The forward market is a market that either exploits or insures expectations. If the forward market is less than today’s spot market, the spot market is expected to fall in value and to cover against that risk, traders engage in contracts to sell more currency in 60 days that buy it, thus lowering the forward rate. c. If the difference between foreign and domestic interest rates increased, what should happen to both forward and spot exchange rates? Explain. According to both interest rate parity theory (IRP) and the economic logic of the exchange rate, as the difference between the foreign and domestic interest rates gets larger, there will be two, parallel incentive mechanisms to change exchange rates. First, the relatively larger foreign interest rate will increase capital outflows from the domestic economy toward the higher rate economy while capital inflows toward the domestic economy will fall because of the relatively lower domestic interest rate. Second, these changes in the BOP will cause the supply of the domestic currency in the foreign money market to rise, and the demand for the domestic currency to fall. As a result, exchange rates will fall in the spot market; currency exchanges that act as a precursor to purchasing foreign financial investments that pay a relatively higher rate of return drive the international value of the domestic currency down. e s . The forward rate sees the opposite effect, as it is used for cover against the spot exchange rate rising and reducing profit.
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