365 Topic2 - Exchange Rate and Foreign Exchange Market...

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Unformatted text preview: Exchange Rate and Foreign Exchange Market ECO365 Topic 2 Overview ECO365 2 1. Exchange Rate Essentials Defining the Exchange Rate Appreciations and Depreciations Multilateral Exchange Rates 2. Exchange Rates in Practice Exchange Rate Regimes: Fixed Versus Floating Recent Exchange Rate Experiences Overview ECO365 3 3. The Market for Foreign Exchange The Spot Contract Transaction Costs Derivatives Private Actors Government Actions 4. Arbitrage and spot exchange rates Arbitrage with Currencies Cross Rates and Vehicle Currencies 5. Arbitrage and interest rates Riskless Arbitrage: Covered Interest Parity (CIP) Risky Arbitrage: Uncovered Interest Parity (UIP) Exchange Rate : Definition ECO365 4 Definition : Exchange rate is the price of one (Foreign) currency expressed in terms of another (Home) currency. E 1/2 will denote the exchange rate in units of country 1 currency per units of country 2 currency. Example : If the U.S. dollar price of one U.K. pound sterling (1) is $1.85, then E $/ = 1.85. Exchange Rate : Depreciation ECO365 5 Definition : When the Home currency depreciates, the price of the Foreign currency in terms of the Home currency goes up. A more valuable Foreign currency. Exports are cheaper , imports are dearer . Example : Exchange rate changes from 1.5 CAD per EUR to 2 CAD per EUR => CAD depreciates against EUR. Exchange Rate : Appreciation ECO365 6 Definition : When the Home currency appreciates, the price of the Foreign currency in terms of the Home currency goes down. A more valuable Home currency. Exports are dearer , imports are cheaper . Example : Exchange rate changes from 1.5 CAD per EUR to 1 CAD per EUR => CAD appreciates against EUR. Exchange Rate : Example ECO365 7 Exchange Rate : Multilateral rates ECO365 8 The bilateral exchange rate, as seen above, shows the price at which one currency is exchanged for another. In practice, it is possible for a currency to appreciate relative to one currency, while depreciating relative to another. In order to understand the average change in the value of a currency, we need to use a multilateral exchange rate. Exchange Rate : Multilateral rates ECO365 9 Changes in the Effective Exchange Rate (EER) tell us how the value of a currency has changed on average against a basket of currencies. If the home country trades with countries 1,,N then the fractional (%) change in EER relative to the base year is given by the trade-weighted average change in each bilateral exchange rate: Exchange Rate : Multilateral rates ECO365 10 Exchange Rate : Regimes ECO365 11 Definition : An exchange rate regime refers to a governments policy regarding the exchange rate....
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This note was uploaded on 02/24/2012 for the course ECO 365 taught by Professor Jordimondria during the Spring '08 term at University of Toronto- Toronto.

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365 Topic2 - Exchange Rate and Foreign Exchange Market...

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