International Finance. Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach. Chapter Outline. The basics of exchange rates Foreign exchange markets The demand of currency A model of foreign exchange markets. The Basics of Exchange Rates.
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Exchange Rates and the Foreign Exchange Market: An Asset Approach
Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month.
R$ - [R€ + (Ee$/€ - E$/€)/E$/€ ] = 2% - 1% = 1%
Expected dollar return
on dollar deposits, R$
R$Figure 3: The Current Exchange Rate and the Expected Rate of Return on Dollar Deposits
hold euro deposits
No one is willing to
hold dollar depositsFigure 4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Consider alternative one-year investments for $100,000:
Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward.
Future value = $100,000(1 + i£)×
(1 + i£) ×
= (1 + i$)
Assuming these investments have the same risk (they probably do if they are short-term bank deposits), they must have the same future value (otherwise an arbitrage would exist).
3. Commercial and investment banks that invest in deposits of different currencies dominate the foreign exchange market.
4. Rates of return on currency deposits in the foreign exchange market are influenced by interest rates and expected exchange rates.
5. Equilibrium in the foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity.
7. An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and leads to an actual appreciation.