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Foreign Exchange and the International Monetary System - PowerPoint PPT Presentation

Foreign Exchange and the International Monetary System. Chapters 19, 20. Foreign exchange market. OTC (several hundred dealers, mostly banks) Wholesale vs. retail Transactions size: \$1 million or larger Daily volume in excess of \$1 trillion/day. Purchasing Power Parity Theory.

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Foreign Exchange and the International Monetary System

Chapters 19, 20

Maclachlan, Money & Banking Spring 2006

• OTC (several hundred dealers, mostly banks)

• Wholesale vs. retail

• Transactions size: \$1 million or larger

• Daily volume in excess of \$1 trillion/day

Maclachlan, Money & Banking Spring 2006

A method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods.

Creates a balance in trade. When a country has an inflation, its currency depreciates.

Maclachlan, Money & Banking Spring 2006

Maclachlan, Money & Banking Spring 2006

Exchange rates adjust so that expected returns across assets of equal risk are equalized.

So if the expected return on European assets is higher than ones in the U.S. assets, the value of the Euro will appreciate.

In equilibrium all expected returns are equal.

Maclachlan, Money & Banking Spring 2006

£1 = \$5

Suppose £1 = \$5.25.

What’s the arbitrage opporunity?

Liberty Gold Dollar (1849-1854)

19th Century Gold Standard

Maclachlan, Money & Banking Spring 2006

Established a system of fixed exchange rates.

Major architect of agreement J.M. Keynes called gold a “barbarous relic.”

Maclachlan, Money & Banking Spring 2006

1960’s inflation in US

Accumulation of \$’s in ROW

German CB requests gold for \$’s.

Nixon refuses to honor agreement signaling the beginning of the end of fixed exchange rates.

Maclachlan, Money & Banking Spring 2006

CB enters into forex market to influence value of currency.

E.g. Fed buys \$ to keep value high.

Sterilized

CB enters into forex market and then conducts OMO to keep money supply constant.

E.g. Fed buys \$ in forex market and then conducts expansionary OMO.

Exchange Rate Interventions

Maclachlan, Money & Banking Spring 2006

Evidence shows sterilized interventions have little effect.

Consider, Germany during final years of BW.

No matter how many dollars they bought they couldn’t get the exchange rate at BW levels.

Maclachlan, Money & Banking Spring 2006

Debt Instruments

Chapter 4

Maclachlan, Money & Banking Spring 2006

What is a future cash flow (FV ) worth now?

Maclachlan, Money & Banking Spring 2006

Cash flows at the same date can be added together, but cash flows at different dates cannot be added together.

Maclachlan, Money & Banking Spring 2006

1. Simple loan

Maclachlan, Money & Banking Spring 2006

Examples: car loans, mortgages

Maclachlan, Money & Banking Spring 2006

Most bonds with maturities greater than a year are of this form.

Coupons bonds issued by

• Federal government (Treasurys)

• State and local governments (munis)

• Corporations (corporates)

Maclachlan, Money & Banking Spring 2006