Forex Flashcards
What is the real exchange rate?
- The rest at which goods and services in one country can be exchanges for goods and services in another
- e = E x (Pdomestic/Pforeign)
- real exchange rate = nominal exchange rate x (domestic price level/foreign price level)
What is the law of one price?
The idea that identical products should sell for the same price everywher
What is the theory of purchasing power parity?
- States that exchange rates move to equalise the purchasing power of different currencies
- In the long run, an exchange rate should be at a le level that the equivalent amount of any country’s currency can buy the same amount of good and services
- In the long run, arbitrage activity causes PPP to hold
- Potential arbitrage profits increases demand for currency and subsequent appreciation continues until e = 1
What is the important implication of PPP?
- PPP makes an important prediction: if one country has a higher inflation rate than another country, its currency will depreciate relative to the currency of the other country
- If e = E x (Pdomestic/Pforeign),
- %∆e = %∆E + (πdomestic - πforeign)
- If PPP holds, e = 1, so that %∆ in E = foreign inflation - domestic inflation
Why is PPP not a complete explanation/
- Not all products can be traded internationally
- Product differentiation
- Barrier to trade
What is the exchange rate market int he short run?
- Exchange rate E (_/$) vs quantity of $ assets
- The demand for dollars represents the demand by foreign households and firms for domestic goods and financial assets
- The supply of dollars in exhafnge for a foreign currency is determined by the willingness of households and firms that own dollars to exchange them for the foreign currency
What are the determinants of the demand for dollars?
- Domestic interest rate iD
- Foreign interest rate IF
- Expected future exchange rate Eet+1
- Expected domestic price level
- Expected trade barriers
- Expected import demand
- Expected export demand
- Expected productivity
What determinants of demand have a positive relationship with the quantity of dollars demanded?
- Domestic interest rate iD
- Expected future exchange rate Eet+1
- Expected trade barriers
- Increase increases demand
- Expected export demand
- Increase increases demand
- Expected productivity
- Increase increases demand
Why are domestic interest rates and dollars demand related?
- When domestic real interest rates rise, the domestic currency appreciates
- When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates
What determinants of demand have a negative relationship with the quantity of dollars demanded?
- Foreign interest rate IF
- Increase decreases demand
- Expected domestic price level
- Increase decreases demand
- Expected import demand
- Increase decreases demand
What are the determinants of the supply for dollars?
- Fed
- A higher domestic money supply causes the domestic currency to depreciate
What is the interest rate parity condition?
- To eliminate any arbitrage profits, the difference between the interest rates on a foreign bond and domestic bond must equal the expected change in the exchange rate between the two currencies
- Expected return: RF = iF + ((Eet+1 - Et)/Et)
- The interest rate parity condition holds that difference in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates
- This condition also means
- Interest rates on domestic bond = interest rate on foreign bond - expected appreciaton of the domestic currency
- If the expected returns (including expected changes in the exchange rate) from the domestic and foreign bonds are not the same, then investors can make arbitrage profits
Why might the interest rate parity condition not hold/
- Differences in interest rates in different countries do not always reflect expectations of future changes in exchange rates for several reasons:
- Differences in default risk and liquidity
- Transaction costs
- Exchange-rate risk
How doe we account for forex risk in the interest rate parity condition?
- Interest rates on domestic bond = interest rate on foreign bond - expected appreciation of the domestic currency - currency premium
- iD = iF + ((Eet+1 - Et)/Et)
- Et = Eet+1/(iF - iD + 1)
- Eet+1 & Et + related
- iD & Et + related
- iF & Et - related
