The Foreign Exchange Market Forex An exchange rate

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The Foreign Exchange Market (Forex) • An exchange rate is the conversion factor between

The Foreign Exchange Market (Forex) • An exchange rate is the conversion factor between currencies of different countries. i. e. , how much one currency is worth in terms of another • Can be represented in two ways • Eg. $/£ or £/$ • Write as E$/£ or E£/$

The Foreign Exchange Market (Forex) • Review some ERs on x-rate website • Define

The Foreign Exchange Market (Forex) • Review some ERs on x-rate website • Define Appreciation and Depreciation rates • Define currency value • E$/£ is the value of the pound • E£/$ is the value of the pound • Review the Economist Exchange rate data (next page)

from May 7, 2020

from May 7, 2020

Floating vs Fixed Exchange Rates • With floating exchange rates a country allows the

Floating vs Fixed Exchange Rates • With floating exchange rates a country allows the private market (banks) determine the rate for each trade • With fixed exchange rates a government decrees the exchange rate that will prevail and takes steps to assure that rate is maintained • Show the IMP defacto exchange rate table to highlight countries with different exchange rate systems

The Foreign Exchange Market (Forex) Value of the pound in terms of $ •

The Foreign Exchange Market (Forex) Value of the pound in terms of $ • Quantity (value of pounds) • Price (exchange rate - $/£ ) • Market is at private banks • Demand is by holders of $ who wish to buy pounds • Supply is by holders of pounds who wish to buy $ Value of pounds traded

The Foreign Exchange Market (Forex) Value of the pound in terms of $ •

The Foreign Exchange Market (Forex) Value of the pound in terms of $ • Banks charge transaction fee • Show to Max profit they adjust their ER to maximize the quantity traded Value of pounds traded

The Foreign Exchange Market (Forex) Value of the pound in terms of $ •

The Foreign Exchange Market (Forex) Value of the pound in terms of $ • Market Participants • Traders • Exporters and importers of G&S • Recorded on current acct of Bo. P • Purchasing Power Parity (PPP) theory of exchange rate determination • Motivated by price differences Value of pounds traded

The Foreign Exchange Market (Forex) Value of the pound in terms of $ Value

The Foreign Exchange Market (Forex) Value of the pound in terms of $ Value of pounds traded • Market Participants • Investors/Savers • Buyers and sellers of assets • Eg. Financial institutions • Recorded on financial acct. of Bo. P • Interest rate parity (IRP) theory of exchange rate determination • Motivated by financial differentials

Interest Rate Parity Theory • Focuses on the participation of investors in the Forex

Interest Rate Parity Theory • Focuses on the participation of investors in the Forex • Investors are stewards of others’ money • Banks, pension funds, mutual funds, IRAs, etc. • Identify investor motivation to exchange currencies • Same goals as in domestic investment

Investor Objectives • High Rate of Return on investment • Ro. R = %

Investor Objectives • High Rate of Return on investment • Ro. R = % change in the value of an asset over time • Ro. R is sometimes the interest rate • Sometimes it’s a capital gain rate • Sometimes it’s more complicated (foreign investments) • Reduce risk / Ensure safety • Manage Liquidity

Interest Rate Parity Theory • Focuses exclusively on Ro. R • Assumes no risk

Interest Rate Parity Theory • Focuses exclusively on Ro. R • Assumes no risk and liquidity differences for domestic vs foreign assets • Derive theory by imagining a US $ holder comparing a simple investment in the US vs another in a foreign country. • Derive the Ro. R for the two investments

Interest Rate Parity Theory • Focuses exclusively on Ro. R • Assumes no risk

Interest Rate Parity Theory • Focuses exclusively on Ro. R • Assumes no risk and liquidity differences for domestic vs foreign assets • Derive theory by imagining a US $ holder comparing a simple investment in the US vs another in a foreign country. • Derive the Ro. R for the two investments

Rate of Return Calculations

Rate of Return Calculations

2020 Data for Ro. R Calculations 2019 Interest Rate 2020 ER 2019 ER Turkey

2020 Data for Ro. R Calculations 2019 Interest Rate 2020 ER 2019 ER Turkey 20% 7 TL/$ 6 TL/$ UK 1. 2% 1. 22 $/£ 1. 28 $/£ Switzerland - 0. 5% 0. 97 SF/$ 1. 01 SF/$ Mexico 8. 0% 24 p/$ 19 p/$

2020 Data for Ro. R Calculations 2019 Interest Rate % change in country currency

2020 Data for Ro. R Calculations 2019 Interest Rate % change in country currency wrt. US$ between 2019 -2020 Russia 8. 2% - 12. 4% Taiwan 0. 75% + 3. 5% Euro Area 0. 0% - 4. 3%

Rate of Return Calculations • On Whiteboard work out several ex post Ro. R

Rate of Return Calculations • On Whiteboard work out several ex post Ro. R calculations using the data on previous page • Ro. RTL = [[(1/7)/(1/6)](1 + 0. 20) – 1]x 100 = 2. 86% • Show same using expanded formula • Ro. R€ = 0 + (1 + 0)(- 0. 043) = -0. 043 or - 4. 3%