Table 13 4 todays dollareuro exchange rate and the

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Unformatted text preview: ency denominated deposits to construct a model of foreign exchange markets. This model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity. – Interest parity implies that deposits in all currencies are equally desirable assets. – Interest parity implies that arbitrage in the foreign exchange market is not possible. Model of Foreign Exchange Markets (cont.) Markets Interest parity says: R$ = R€ + (Ee$/€ ­ E$/€)/E$/€ Why should this condition hold? Suppose it didn’t. – Suppose R$ > R€ + (Ee$/€ ­ E$/€)/E$/€ – Then no investor would want to hold euro deposits, driving down the demand and price of euros. – Then all investors would want to hold dollar deposits, driving up the demand and price of dollars. – The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved: R$ > R€ + (Ee$/€ ­ E$/€)/E$/€ Model of Foreign Exchange Markets (cont.) Markets How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits? Model of Foreign Exchange Markets (cont.) Markets Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why? – When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits. Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. Why? – When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby lowering the expected rate of return of foreign currency deposits. Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/€ = $1.05 per Euro Fig. 13-3: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits Expected The Current Exchange Rate and the Expected Rate of Return on Dollar Deposits Dollar Current exchange rate, E$/€ 1.07 1.05 1.03 1.02 1.00 0.031 0.050 R$ 0.069 0.079 0.100 Expected dollar return on dollar deposits, R$ Fig. 13-4:...
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