Foreign Exchange FNCE 4070 – Financial Markets and Institutions.
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Transcript of Foreign Exchange FNCE 4070 – Financial Markets and Institutions.
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Foreign Exchange
FNCE 4070 – Financial Markets and Institutions
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Forward FX Contract
Where the units of Spot and Forward are ccy1/ccy2
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Exchange Rates in the Long Run: Law of One Price
• The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.
• Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.
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Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)
• The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels.
• PPP Domestic price level 10%, domestic currency 10%─Application of law of one price to price levels─Works in long run, not short run
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Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)
• Problems with PPP– The transaction costs associated with cross-
border trade are not small. – Many goods and services are not traded
across borders– All goods and services are not identical
between countries
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Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run
• Anything that increases the demand for domestic goods relative to foreign goods will cause the domestic currency to appreciate relative to the foreign currency.
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Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run
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Exchange Rates in the Short Run
• In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic assets in terms of foreign currency.
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Exchange Rates in the Short Run: Supply and Demand Curves
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Explaining Changes in Exchange Rates: Increase in iD
• Demand curve shifts right when iD : because people want to hold more dollars
• This causes domestic currency to appreciate.
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Explaining Changes in Exchange Rates: Increase in iF
• Demand curve shifts left when iF : because people want to hold fewer dollars
• This causes domestic currency to depreciate.
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Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates
• Demand curve shifts left when : because people want to hold more dollars
• This causes domestic currency to appreciate.
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Explaining Changes in Exchanges Rates (a)
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Explaining Changes in Exchanges Rates (b)