Chapter_10_Exchange_Rates_and_Foreign_Ex

Many have adopted variants of fixed exchange rate

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Many have adopted variants of fixed exchange rate regimes Managed float , designed to prevent dramatic changes in the exchange rate without committing to a strict peg. Crawl , where the exchange rate follows a trend, rather than a strict peg.
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Recent Exchange Rate Experiences
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Objectives 3. The Market for Foreign Exchange •. Understand some of the basic characteristics of the foreign exchange (FX) market •. Identify the types of contracts and the purposes of each in the economy. Spot, forward, and other derivatives •. Identify the private actors and how they use foreign exchange Commercial banks, large corporations, and nonbank financial institutions. •. Understand the role of government intervention
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The Market for Foreign Exchange Overview The foreign exchange market has no central organized market or exchange Over-the-counter trading (OTC) - bilaterally between two parties. Large market $3.2 trillion traded per day (April 2007) Main centers account for more than 50% of transactions: London, New York, and Tokyo Trades spread over most time zones
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The Market for Foreign Exchange Transaction Costs Costs associated with conducting trades in a market. Spread Difference between the “buy at” and “sell for” prices. Example of a market friction or transaction cost that create a wedge between the price paid by the buyer and the price received by the seller. Reflects intermediaries standing between the individual seeking to exchange currency and the foreign exchange market. Spreads are larger for individuals than they are for banks and corporations involved in large-volume transactions. Spreads tend to be higher for thinly or low-volume traded currencies or for high-risk currencies.
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The Market for Foreign Exchange The Spot Contract How the spot contract works: A and B agree to trade one currency for another for delivery on the spot at set price. The price they agree upon is known as the spot exchange rate. Characteristics of the spot market Default risk very low; settlement is now nearly instantaneous. Most common type of trade, accounting for nearly 90% of all foreign exchange market transactions. Personal transactions account for a very small share of total transactions .
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The Market for Foreign Exchange Derivatives Derivatives are contracts with pricing derived from the spot rate. Derivatives allow investors to trade foreign exchange for delivery at different times and at different contingencies. In general, derivatives allow investors to alter payoffs, affecting the risk associated with his/her collection of investments (e.g., portfolio). Hedging: risk reduction Speculation: risk taking. Types: forwards , swaps , futures , and options .
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Foreign Exchange Derivatives Forwards A and B agree to trade currencies at set price on the settlement date. Contract cannot be traded to third parties. The settlement date can be in one month, 3 months, 6 months, or 1 year.
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