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
- Exchange Rate, Foreign exchange market, United States dollar