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Exchange Rates. Chapter 8. Figure 8.1 Exchange rates, trade and multinational activity. Firm in Home serve foreign markets / source from abroad?. no. yes, source from abroad. yes, serve foreign market. Stay domestic. Export or local production?. Import or local production?.

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Figure 8.1 Exchange rates, trade and multinational activity

Firm in Home

serve foreign markets / source from abroad?


yes, source from abroad

yes, serve foreign market



Export or

local production?

Import or

local production?



local production

local production


Multinational activity:


Multinational activity:



nature of exchange rate risk

nature of exchange rate risk

Selling in foreign currency

Producing and selling in foreign currency

Producing in foreign currency

Buying in foreign currency

exposure to exchange rate risks
Economic exposure

Transaction risk

Translation risk

Spot versus forward exchange rates

Exposure to exchange rate risks

Figure 8.3 Australia – USA; spot and forward exchange rates of US dollar, 1976-2011

Data source: IFS.

Arbitrage (Table 8.3)

Players and markets

Forward exchange rates and hedging

Trading volume (Fig. 8.4)


Figure 8.4 Global foreign exchange market turnover, 1998 – 2010

Data source: BIS (2010), triennial central bank survey


Figure 8.5 Most used currencies on the foreign exchange market, 1998 – 2010

Data source: BIS (2010); * Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200 percent instead of 100 percent.

Exchange rates and prices

Effective exchange rates


Figure 8.6 Exchange rates and prices, 1960-2009

Calculations based on World Development Indicators online; 64 observations; the line has a 45 slope.


Figure 8.8 De facto exchange rate arrangements, April 30, 2010

Data source: IMF (2010, Appendix II); selected countries listed for each regime, see also Table 23.1


Figure 8.10 Out-of-sample exchange rate forecasting

Data source: Meese and Rogoff (1983)


Figure 8.11 Canada; interest rates and inflation rate (CPI), 1970 – 2011

Data source: IFS; bank rate (end of period) and cpi (% change), monthly data


Figure 8.12 UK; interest rates and term structure, 1980-2011

Data source: IFS; 3 and 6 month Paris Interbank Offer rate

arbitrage and interest parity
Fisher equation:

r = i - π

Covered interest parity (Fig. 8.13)

Equilibrium condition:

[F(1+iUS)/E]L = [(1+iEU)]L

 F/E = (1+iEU)/(1+iUS)

Arbitrage and interest parity

(BOX 8.4) Figure 8.14 Australia – USA: 12-month covered interest parity

Data source: IFS; shown interest rates are interbank offered rates, 1986-2005

interest parity transaction costs exchange rates and capital mobility
rhome = rforeign + risk + TC

A simple version of uncovered interest parity (UIP) condition:

rhome = rforeign + dE ; TC = 0, risk = dE

Given rforeign ,UIP indicates that in a world of

high degree of capital mobility, the domestic

interest rate can differ from the foreign interest

rate only if the exchange rate is not fixed.

Interest parity, transaction costs, exchange rates, and capital mobility