When other factors are the same, people will buy assets in New York and stop buying them in Hong Kong, so that their price in New York rises and their price in Hong Kong falls, until they are equal in the two markets. 16
Spot Rates and Forward Rates Spot rates are exchange rates for currency exchanges on the spot, or when trading is executed in the present. Typically a spot transaction must be executed within two days. Forward rates are exchange rates for currency exchanges that will occur at a future (for- ward) date. ° forward dates are typically 30, 90, 180 or 360 days in the future. ° rates are negotiated between individual institutions in the present, but the exchange occurs in the future. ° the forward rate is set by contract today. 17
Exchange rate instruments Foreign exchange swaps: a combination of a spot sale with a forward repurchase, both negotiated between individual institutions. ° swaps often result in lower fees or transactions costs because they combine two transactions. And they allow parties to meet each others needs for a temporary amount of time. Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date. ° contracts can be bought and sold in markets, and only the current owner is obliged to ful°ll the contract. ° futures contract are standardized and can be resold before settlement. ° similar to a forward contract, with the key di/erence being that a futures contract is traded on an exchange while a forward contract is a private contract between the two parties. ° advantage of futures contract is its liquidity and lack of default risk. Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date. 19
° contracts can be bought and sold in markets. ° a contract gives the owner the option, but not obligation, of buying or selling currency if the need arises. 20
Demand for foreign currency assets What in²uences the demand (willingness to buy) for deposits denominated in domestic or foreign currency? 1. Returns: (a) Rate of return: the percentage change in value that an asset o/ers during a time period. The annual return for $100 savings account with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/$100 = 2% (b) Real rate of return: in±ation-adjusted rate of return. It is stated in terms of real purchasing power: the amount of real goods & services that can be purchased with the asset. The real rate of return for the above savings deposit when in±ation is 1.5% is: 2% ²1.5% = 0.5%. After accounting for the rise in the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year. (c) If prices are °xed, the in±ation rate is 0% and (nominal) rates of return = real rates of return. Because trading of deposits in di/erent currencies occurs on a daily basis, we often assume that prices do not change from day to day. This is a good assumption to make for the short run.
- Exchange Rate, Foreign exchange market, foreign exchange markets, United States dollar