0321316762_IM_13 - Chapter 13 Exchange Rates and the...

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Chapter 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach T Chapter Organization Exchange Rates and International Transactions Domestic and Foreign Prices Exchange Rates and Relative Prices The Foreign Exchange Market Box: A Tale of Two Dollars T h e A c t o r s Characteristics of the Market Spot Rates and Forward Rates Foreign Exchange Swaps Futures and Options The Demand for Foreign Currency Assets Assets and Asset Returns Risk and Liquidity Interest Rates Exchange Rates and Asset Returns A Simple Rule Return, Risk, and Liquidity in the Foreign Exchange Market Equilibrium in the Foreign Exchange Market Interest Parity: The Basic Equilibrium Condition How Changes in the Current Exchange Rate Affect Expected Returns The Equilibrium Exchange Rate Interest Rates, Expectations, and Equilibrium The Effect of Changing Interest Rates on the Current Exchange Rate The Effect of Changing Expectations on the Current Exchange Rate Summary Appendix: Forward Exchange Rates and Covered Interest Parity
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64 Krugman/Obstfeld • International Economics: Theory and Policy, Seventh Edition T Chapter Overview The purpose of this chapter is to show the importance of the exchange rate in translating foreign prices into domestic values as well as to begin the presentation of exchange-rate determination. Central to the treatment of exchange-rate determination is the insight that exchange rates are determined in the same way as other asset prices. The chapter begins by describing how the relative prices of different countries’ goods are affected by exchange rate changes. This discussion illustrates the central importance of exchange rates for cross-border economic linkages. The determination of the level of the exchange rate is modeled in the context of the exchange rate’s role as the relative price of foreign and domestic currencies, using the uncovered interest parity relationship. The euro is used often in examples. Some students may not be familiar with the currency or aware of which countries use it; a brief discussion may be warranted. A full treatment of EMU and the theories surrounding currency unification appears in Chapter 20. The description of the foreign-exchange market stresses the involvement of large organizations (commercial banks, corporations, nonbank financial institutions, and central banks) and the highly integrated nature of the market. The nature of the foreign-exchange market ensures that arbitrage occurs quickly, so that common rates are offered worldwide. Forward foreign-exchange trading, foreign- exchange futures contracts and foreign-exchange options play an important part in currency market activity. The use of these financial instruments to eliminate short-run exchange-rate risk is described.
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0321316762_IM_13 - Chapter 13 Exchange Rates and the...

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