22 I prices are fixed in the SR D emand for foreign currency assets What

# 22 i prices are fixed in the sr d emand for foreign

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22 I prices are fixed in the SR
D emand for foreign currency assets What influences the demand (willingness to buy) for deposits denominated in domestic or foreign currency? 2. Risk: variability in household’s wealth due to holding the asset 3. Liquidity: cost and speed at which households can get rid of an asset. But we assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination. Risk and liquidity are only of secondary importance when deciding to buy or sell cur- rency deposits. Importers and exporters may be concerned about risk and liquidity, but they make up a small fraction of the market. What’s important therefore is the rate of return on currency deposits. It is influenced by: 4. Interest rate: the amount of a currency an individual can earn by lending a unit of that currency for a year. The rate of return for a deposit in domestic currency (CAD) is the interest rate that the bank deposit earns in that country (Canada). 5. Expectations of exchange rates: in particular, the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency. 23 H I Heute l I I I II Immune
D emand for foreign currency assets A currency deposit’s interest rate is the amount of a currency that an individual or insti- tution can earn by lending a unit of the currency for a year. The rate of return for a deposit in domestic currency is the interest rate that the deposit earns. To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider the interest rate for the foreign currency deposit the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency. 24 Eg E YE utr Eller It r 44,41 litre ELIE ET Itr Ee 1 E Itr re I 1k
E xample \$100 DOLLAR market EURO market Buy DOLLAR bonds or deposits R(\$) = 10% Buy EURO bonds or deposits R(EUR) = 5% Exchange \$ for EUR E (\$/1EUR) = 1 TODAY Exchange EUR for \$ E (\$/1EUR) = 1.1 TOMORROW EQUAL? 25
E xample ( cont .) Suppose the interest rate on a dollar deposit is 10%, on euro deposit is 5%. Does a dollar deposit yield a higher expected rate of return? Suppose today the exchange rate is \$1.0/EUR1, and the expected rate 1 year in the future is \$1.1/EUR1. Then: \$100 can be exchanged today for EUR100. These \$100 will yield \$110 or EUR105 after 1 year. The EUR105 are expected to be worth \$1.1/EUR1 x 105 = \$115.5, giving 15.5% expected dollar rate of return on Euro deposits. Since the dollar rate of return is 10% per year, household will do better by holding his wealth in _______ deposits. 26 yearly 11 El 1 141 Euro Deposits E Deposits E It 114k C q I 1 re I I C 1.05 1.55
A simple rule Define the rate of depreciation of the dollar against the euro as the percentage increase in the dollar/euro exchange rate over a year.

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• Fall '12
• Bombardini
• Exchange Rate, Foreign exchange market, United States dollar