Ch 14 Flashcards
When a country’s currency depreciates
Foreigners find that exports are cheaper and domestic residents find that imports from abroad are more expensive
Foreign Exchange Market
Market in which households, firms, and institutions buy and sell foreign currencies to make international payments
Why is the dollar regarded as a vehicle currency?
The dollar is sometimes called a vehicle currency because of its pivotal role in many foreign
exchange deals.
How is the exchange rate denoted?
E $/€
Depreciation/appreciation 
The decrease or increase in value of currency relative to another currency
What does it mean when a currency has depreciated? 
Imports become more expensive for that country and exports become cheaper 
Foreign exchange markets 
Set of markets where foreign currencies and other assets are exchanged for domestic ones (NO ROOM FOR ARBITRAGE)
What is a vehicle currency?
A currency used widely for international transactions by parties, who don’t reside in the currency’s country
Who are the participants of foreign exchange market? 
Commercial banks, corporations, non-bank, non-bank financial institutions, and the central bank
What are spot rates and forward rates?
Spot = Exchange Rates for currency in the present
Forward = “…” that will occur at a future forward date
Foreign exchange swap 
Combo of a spot sale with a forward purchase
Futures contract + how does it differ from forward?
Designed by a third-party for a standard amount of foreign currency, delivered or received on the standard date (CAN be bought + sold at any time before exp date, unlike forward)
What affects demand of currency deposits?
Rate of return, risk, and liquidity
Real rate of return
Inflation adjusted ROR representing additional goods and services that can be bought with earnings from the asset.
Currency deposit interest rate
Amount earned by lending unit of currency for a year (ROR for deposit in domestic currency is interest earned)
Dollar rate of return on euro assets 
R$ = R€ + (Ee$/€ - E$/€)/E$/€
Last term is exp depreciation of dollar
(Uncovered) Interest parity 
When deposits of all currencies offer the same expected rate of return (no guarantee you’ll get the rate)
aka when both sides of the dollar rate of return on euro assets are equal
If the dollar depreciates today, why do euro assets look less attractive to me?
If € appreciates and we bank on the $ depreciating, then the depreciation term becomes smaller since expectations for the exchange rate go down and are self-fulfilled
If the dollar depreciates, why can’t you hold as many euro assets 
A cheaper dollar cannot buy as many euro assets so we keep it in the US
How can one protect the value of currency 
Raise interest rates
True or false increasing interest rates for a certain currency leads to appreciation of that currency.
TRUE
What can cause the exchange rate to increase in a graph of the formula for exp depreciation of the dollar?
Higher expectations and a higher interest rate of the euro
What is Carry trade? 
Borrowing low interest currency, and earning profit by buying high interest currency
Why doesn’t the Carey trade hold in practice? 
Risk and liquidity plus the no arbitrage principle 
Covered interest parity
Relates interest rates across countries + the rate of change btwn forward rate and the spot rate
R$ = R€ + (F$/€ - E$/€)/E$/€
How does covered interest parity protect you? 
It uses the forward rate as opposed to the expected exchange rate, so it involves little risk
When are the UIP and the CIP both simultaneously true 
When the one-year forward rate quoted today is equal to the spot exchange rate expected the year from now
F = Ee
What is the main difference between the CIP and the UIP 
The CIP has no rate risk, while UIP has a rate risk
