Lecture 5 Flashcards
Hedging
Attempt to reduce exchange rate exposure—which means, you
are exposed to risk of a changing exchange rates. Companies hedge by trying to lock in forward rates which both parties can agree upon
Exchange rate
The price of a currency/ the value of a currency
Appreciated currency
When foreign capital flows in
Depreciated currency
When foreign capital flows out
(e) Nominal exchange rate
- e= Home Country Currency Price of one unit of foreign currency
- e= X units of Home Currency/1 Unit of Foreign Currency
- Ok, now think about it: when e goes up, this means, the value of your currency goes down
- Because if it takes 1 home units to buy 1 foreign unit, and this raises to 10 home units to buy 1 foreign unit (e increases), then the value of your currency has gone down from 1 foreign unit to .10 foreign units—it is worth only 1/10th of what it was before
- And when e goes down, the value of your currency goes up
- (For this reason, we sometimes use 1/e, because this coordinates with your logical faculties better: as 1/e goes up, then your currency increases in value)
Effective Exchange rate (re)
- This is the nominal exchange rate weighed against a basket of foreign currencies
- Where the weights are determined by the amount of foreign trade that the home currency has with foreign currencies
- So this is a way of saying what the average “real” (vs. the nominal) exchange rate is, given the value of this currency relative to the other currencies that it is normally exchanged in
Pus increases
US goods increase i price. Thefore, it takes more Mexican goods to buy a unit of US goods. The real value of the peso has fallen. -> Since it is in the numerator, the increase in Pus increases the value of re
Pm increases
Mexican goods increase in price. Therefore, it takes fewer Mexican goods to buy a unit of US goods. The real value of the peso has risen. -> Sice it is in the denominator, the increase in Pm decreased the value of re.
e increases
It takes more Mexican pesos to buy US dollars. The real value of the peso has fallen. -> The increase in e increases the value of re
PPP hypothesis
The nominal exchange rate will adjust so that the purchasing power of a currency will be the same in every country. 1/Pm= 1/e x 1/Pus
Interest rate parity condition
Rm = Rus + (eê-e)/e Mexico/US
Rh = Rf + (eê-e)/e Home/foreign
Floating Flexible (clean) float
The exchange rate is market-determined
Floating managed (dirty) float
The exchange rate is primarily market-determined, but the country´s monetary authority intervenes in the currency market to influence the movements of the exchange rate
Residual Other managed arrangements
Volatile currecy market conditions prevent the use of any clearly defined exchange rate arrangement
Soft peg Crawling bands
The country´s monetary authority intervenes to maintain the exchange rate in a band around a central rate, and these bands are periodically adjusted
Soft peg Crawling pegs
The exchange rate is fixed in value to another currency or to a basket of other currencies but is adjusted periodically by small amounts
Soft peg Stabilized arrangement
The exchange rate is fixed in value to another currency or to a basket of other currencies but actual practice might deviate from this
Hard peg Fixed or conventioal peg
The exchange rate is fixed in value to another currency or to a basket of other currencies
Hard peg Currency board
The exchange rate is fixed in value to another currency, and the domestic currency is fully backed by reserves of this foreign currency
Hard peg No seperate legal tender
The legal tender of the country is a currency of another currency
The impossible trinity
- Monetary independence
- Exchange rate stability
- Capital mobility (allow foreign savings/foreign investment)
