Lecture6_fnechio -...

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Lecture 6: Exchange Rates, Arbitrage and Parity onditions Conditions Fernanda Nechio Fernanda.nechio@sf.frb.org
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d Roadmap The Demand for Foreign Currency Assets Equilibrium in the Foreign Exchange Market Interest Rates, Expectations, and Equilibrium
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e Demand for The Demand for Foreign Currency Assets The demand for a foreign currency bank deposit is influenced by the same considerations that influence dd f th t the demand for any other asset: Returns – percentage increase in value of an asset Risk–the variability of the asset return Liquidity–how easily the asset can be sold or exchanged for goods.
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e Demand for The Demand for Foreign Currency Assets Interest Rates A currency’s nominal interest rate ( i ) is the amount of that currency an individual can earn by lending a unit of the currency for a year. xample At a dollar interest rate of 10% per year the lender of Example : At a dollar interest rate of 10% per year, the lender of $1 receives $1.10 at the end of the year. Important : the nominal interest rate i is different from the real t t t interest rate r .
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e Demand for The Demand for Foreign Currency Assets Interest Rates on 3 month Dollar and Yen Deposits, 1980 2011
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e Demand for The Demand for Foreign Currency Assets Exchange Rates and Asset Returns The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. order to decide whether to buy a foreign currency or a In order to decide whether to buy a foreign currency or a Dollar deposit, one must calculate the Dollar return on a foreign currency deposit.
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e Demand for The Demand for Foreign Currency Assets HC t Buy FC FC t Lend/deposit HC T FC T Sell FC Calculating the Dollar return on a Euro deposit
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e Demand for The Demand for Foreign Currency Assets HC t Buy €1000 for E t =$1.1 FC t eposit: 5% Deposit: 5% rate C C Sell €1000*(1.05) for E T =1.2 Rate of return in dollars? 000*1.05*1.2 - 000*1.1)/1000*1.1=17.6% HC T FC T (1000 1.05 1.2 1000 1.1)/1000 1.1 17.6% In euros? (1050-1000)/1000=5%
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e Demand for The Demand for Foreign Currency Assets Final return: t T T t T E E E E E i * * * ] ) 1 [( A Simple Rule t t t E i E i E 1 ) 1 ( p The Dollar rate of return on foreign deposits is approximately equal to the foreign interest rate plus the rate of depreciation of the dollar against the foreign currency. p g g y This return is uncertain since E T is unknown as of time t .
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e Demand for The Demand for Foreign Currency Assets Covered Interest Parity: It is possible to obtain a certain return by using a forward transaction ; Denote F t,T the forward rate at time t for delivery of dollars ainst ros time against euros at time T .
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This note was uploaded on 10/17/2011 for the course ECON 182 taught by Professor Kasa during the Spring '08 term at University of California, Berkeley.

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Lecture6_fnechio -...

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