S owners of foreign assets hedging exchange rate risk

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Hurts u.s owners of foreign assets Hedging exchange rate risk o Currency futures o Limits Future contracts are only for six months Longer term hedge not possible Exchange rate changes often last for long periods of time Real exchange vs nominal exchange rates o Real exchange rate (E) measures the relative price of domestic and foreign goods o Real exchange rate measures relative prices in different countries and accounts for changes in the nominal exchange rate and local prices o The real exchange rate depends on the us price level , P, and the foreign price leve l, P* Cost of American goods in euros is the nominal exchange rate times the us price level Cost of American goods in euros = e P Cost of European goods in euros = P* Real exchange rate is the ratio of the two costs: E = cost of u.s goods/cost of European goods E = eP/P* Trade-weighted real exchange rate – a weighted average of a country’s real exchange rates with the weights proportional to the levels of trade Purchasing power parity (PPP) is the theory of exchange rate based on the idea that a currency purchases the same quantities of goods and services in different countries and implies that real exchange rates are constant over time Law of one price- the theory that an identical good or service has the same price in all locations Arbitrage eliminates price difference between different locations PPP applies the law of one price across borders o The law of one price equates the cost in either location eP=P* PPP implies that the real exchange rate equals 1 eP/P*=1 nominal exchange rate equals the ratio of price levels e=P*/P o how reasonable is PPP arbitrage is not perfect due to factors such as transport costs transport costs limit or prohibit trade in many goods, especially services trade barriers also cause deviation of actual real exchange rate from the PPP over time trade will cause price levels to adjust, moving the real exchange rate toward the PPP level o evidence for PPP ppp implies that percentage changes in nominal exchange rates are due to percentage changes of price levels:
% change in e = % change in (P*/P) Approximated by: % change in e = % change in (P*) - % change in (P) Percentage change in a price level is the rate of inflation o % change in e = pi*-pi Percentage change in a country’s nominal exchange rate is the difference between the foreign and domestic rates of inflation Real exchange rates in the short run o Exchange rates fluctuate considerably from year to year, contrary to PPP o Short run exchange rate behavior is explained by supply and demand not PPP o The exchange rate examined Is the U.S. trade-weighted real exchange rate Net Exports and Capital Flows o Americans sell dollars to buy foreign goods and services and foreign assets Supply of dollars=imports + capital outflows o People in foreign countries buy dollars to buy American goods and services and American assets

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