Review Session. Functions of Money Medium of Exchange Store of Value Unit of Accounting.

Review Session

Functions of Money

• Medium of Exchange

• Store of Value

• Unit of Accounting

Examples of Exchange Rates (1/29/13)

Direct Quotes (U.S. Perspective)

• Swiss Franc 1.0852CHF 1 = $ 1.0852

• Euro 1.3491€ 1 = $ 1.3491

• British Pound 1.5759£ 1 = $ 1.5759

• Japanese Yen 0.01103¥ 1 = $ 0.01103

http://finance.yahoo.com/currency?u

Indirect Quotes

• Swiss Franc0.9215$1 = CHF 0.9215

• Euro 0.7412

• $1 = € 0.7412

• British Pound 0.6346$1 = £ 0.6346

• Japanese Yen 90.6545$1 = ¥ 90.6545



• Swiss Franc 1.0754CHF 1 = $ 1.0754

• Euro 1.3168€ 1 = $ 1.3168

• British Pound 1.5534£ 1 = $ 1.5534

• Japanese Yen 0.010256¥ 1 = $ 0.010256


Indirect Quotes

• Swiss Franc0.9299$1 = CHF 0.9299

• Euro 0.7594$1 = € 0.7594

• British Pound 0.6437$1 = £ 0.6437

• Japanese Yen 97.505$1 = ¥ 97.505

The Basic Relationship (FA is a financial asset; RA is a real asset)

MU money

P moneyMU FA1

P FA1

MU FA2

P FA2

L MU FAnP FAn

MU RA1

P RA1

MU RA2

P RA2

L MU RAnP RAn

And $1 buys 5 bags of good stuff

Then $1 = DKK 5

And DKK 1 = $ 0.20

Now, suppose $1 buys 2 bags of better stuff

And €1 buys 3 bags of the better stuff

Then €1 = $1.50

And $1 = € 0.67

Cross Rate Example:

NewYork

London Brussels

$1 =

£ 0.6

0€1 = $1.50

£ 1 = € 1.15

$1,035,000 - $1,000,000 = $35,000

£ 600,000 € 690,000

DollarWeakens

Pound Weakens

DollarStrengthens

$1,000,000

Would be equilibrium if €1 = £0.90

Generic Currency Arbitrage: Same Time

NewYork

London Brussels

Requires three locations and means of exchange

Excha

nge r

ateExchange rate

Exchange rate

Generic Currency Arbitrage: Across Time

FRAtoday

2 locations, 2 dates

NYtoday

FRAlater

%i or prices

NYlater

%i or prices

Means for transition

Exchange rate

Exchange rate

Lessons Learned from Currency Arbitrage:

• Interest Rate Parity– Real rate same for every currency

• Purchasing Power Parity– A Dollar (or Euro, or Pound, or Franc, etc.) buys same stuff in

every country (except for cost of transport)

Yield Curve

• Upward sloping yield curve

• Flat yield curve

• Downward sloping yield curve

R

Convexity

R

Convexity

R

Convexity

Generic Rate Arbitrage: No Coupon

Day 90

Initial Time Day 120

Requires three dates and means of transfer across time

Inter

est r

ateInterest rate

or derivative

Interest rate

Generic Interest Rate Arbitrage: Different Coupons

C(Example: 8%)

C–x(Example: 6%)

C+x(Example: 10%)

Requires three equally-spaced coupons, with prices out of balance

Price too high Sell two bonds

Buy one of each

Generic Interest Rate Arbitrage: Different Coupons

C(Example: 8%)

C–x(Example: 6%)

C+x(Example: 10%)

Requires three equally-spaced coupons, with prices out of balance

Price too low Buy two bonds

Sell one of each

Generic Interest Rate Arbitrage: Same Coupon, Different Maturities

M(Example: 7 yrs)

M–x(Example: 6 yrs)

M+x(Example: 8 yrs)

Requires three equally-spaced maturities, with prices out of balance

Price too high (YTM too low)

Sell two bonds

Buy one of each

Generic Interest Rate Arbitrage: Same Coupon, Different Maturities

M(Example: 7 yrs)

M–x(Example: 6 yrs)

M+x(Example: 8 yrs)

Requires three equally-spaced maturities, with prices out of balance

Price too low(YTM too high)

Buy two bonds

Sell one of each

Lessons Learned from Bond Arbitrage:

• Yield curve behavior must be monotonous in any currency– If upward sloping anywhere, must be upward sloping overall

– If downward sloping anywhere, must be downward sloping overall

– Slope must gradually move toward zero at ever diminishing rate until curve becomes flat

– Once curve becomes flat, it must remain flat

– There can be no kinks in the curve

• Yield curves for different risk classes (say, AAA versus junk) – may rest at different risk levels,

– but quality gap must be same overall

Lessons Learned from Bond Arbitrage:

• Yield curves may have different shapes for bonds in different currencies, but– Once bond prices are adjusted for forward currency exchange

rates, yield curves must have same shape

– Once bond prices are adjusted for forward currency exchange rates, quality gap must be same overall

• Derivatives can be very useful in managing interest rate risk

• Interest rate derivatives must conform to the shape of the yield curve

http://www.smartmoney.com/investing/bonds/the-living-yield-curve-7923

Questions for discussion:

• What is the marginal utility of money?

• What is the price of money?

• What is the marginal utility of a financial asset?

• What is the marginal utility of a real asset?

• Consider the ratio of marginal utility to price. What does it mean for this ratio to be the same for all financial assets and real assets in the world?



• Swiss Franc 0.9416CHF 1 = $ 0.9416

• Euro 1.4257€ 1 = $ 1.4257

• British Pound 1.6321£ 1 = $ 1.6321

• Japanese Yen 0.0108¥ 1 = $ 0.0108


Indirect Quotes

• Swiss Franc1.062$1 = CHF 1.062

• Euro 0.7014$1 = € 0.7014

• British Pound 0.6127$1 = £ 0.6127

• Japanese Yen 92.6950$1 = ¥ 92.695



• Swiss Franc 0.9824CHF 1 = $ 0.9824

• Euro 1.4865€ 1 = $ 1.4865

• British Pound 1.6508£ 1 = $ 1.6508

• Japanese Yen 0.0112¥ 1 = $ 0.0112


Indirect Quotes

• Swiss Franc1.0179$1 = CHF 1.062

• Euro 0.6727$1 = € 0.6727

• British Pound 0.6059$1 = £ 0.6059

• Japanese Yen 88.905$1 = ¥ 88.905



• Swiss Franc 1.2692CHF 1 = $ 1.2692

• Euro 1.4209€ 1 = $ 1.4209

• British Pound 1.622£ 1 = $ 1.622

• Japanese Yen 0.01297¥ 1 = $ 0.01297


Indirect Quotes

• Swiss Franc0.7879$1 = CHF 0.7879

• Euro 0.7038$1 = € 0.7038

• British Pound 0.6165$1 = £ 0.6165

• Japanese Yen 77.085$1 = ¥ 77.085



• Swiss Franc 1.0837CHF 1 = $ 1.0837

• Euro 1.3313€ 1 = $ 1.3313

• British Pound 1.5502£ 1 = $ 1.5502

• Japanese Yen 0.01281¥ 1 = $ 0.01281


Indirect Quotes

• Swiss Franc0.9228$1 = CHF 0.9228

• Euro 0.7511$1 = € 0.7511

• British Pound 0.6451$1 = £ 0.6451

• Japanese Yen 78.075$1 = ¥ 78.075

Review Session. Functions of Money Medium of Exchange Store of Value Unit of Accounting.

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Transcript of Review Session. Functions of Money Medium of Exchange Store of Value Unit of Accounting.