Topic 2
Interest Rates and Foreign Exchange: Spot Markets
Staying Competitive in a Floating Rate
Environment
FX Markets
•
•
•
•
•
Spot Market (Today’s Topic)
Forward Market (Next Topic)
Futures and Options
Swaps
Other Derivatives
Alternative Exchange Rate Systems
•  Pegged Rates
•  Floating Rates
–  Free Float
–  Managed Float
Functions of Money
•  Medium of Exchange
•  Store of Value
•  Unit of Accounting
Better Money, Worse Money
•  What makes some money better?
–
–
–
–
Swiss Franc
Euro
Yen
U.S. Dollar
•  What makes some money worse?
–
–
–
–
Ruble
Cruziero
Peso
Rupia
Examples of Exchange Rates (9/10/13)
Direct Quotes (U.S. Perspective)
•  Swiss Franc
1.07
Indirect Quotes
•  Swiss Franc
CHF 1 = $ 1.07
•  Euro
1.3260
€ 1 = $ 1.3260
•  British Pound
•  Euro
•
1.5735
£ 1 = $ 1.5735
•  Japanese Yen
0.9346
$1 = CHF 0.9346
0.7542
$1 = € 0.7542
•  British Pound
0.6355
$1 = £ 0.6355
0.010031
¥ 1 = $ 0.010031
http://finance.yahoo.com/currency?u
•  Japanese Yen
$1 = ¥ 100.305
100.305
Examples of Exchange Rates (1/29/13)
Direct Quotes (U.S. Perspective)
•  Swiss Franc
1.0852
Indirect Quotes
•  Swiss Franc
CHF 1 = $ 1.0852
•  Euro
1.3491
€ 1 = $ 1.3491
•  British Pound
•  Euro
•
0.7412
$1 = € 0.7412
1.5759
•  British Pound
0.01103
•  Japanese Yen
£ 1 = $ 1.5759
•  Japanese Yen
0.9215
$1 = CHF 0.9215
0.6346
$1 = £ 0.6346
¥ 1 = $ 0.01103
90.6545
$1 = ¥ 90.6545
http://finance.yahoo.com/currency?u
Cross Rate Example:
$1,200,000 - $1,000,000
$1,000,000
= $200,000
New
York
Dollar
Weakens
Dollar
Strengthens
Brussels
London
£ 1 = Euro 1.50
£ 600,000
Pound Weakens
Euro 900,000
Second Example:
$1,111,111 - $1,000,000
$1,000,000
= $111,111
New
York
Dollar
Strengthens
Dollar
Weakens
Tokyo
London
£ 1 = ¥ 135
£666,667
Yen Weakens
The Determination of Exchange Rates
•  Equilibrium Spot Exchange Rate
–  Supply and Demand for Exchange
•  Asset Market Model of Exchange Rates
–  Supply and Demand for Financial Assets
•  Central Bank Intervention
–  Unsterilized
no domestic offset
–  Sterilized
domestic money supply adjusted to compensate
¥ 90,000,000
The Basic Relationship (FA is a financial asset; RA is a real asset)
MU
money
MU
FA
1
MU
FA
2
MU
FA
n
=
=
=
! =
P
money
P
FA
1
P
FA
2
P
FA
n
MU
RA
1
MU
RA
2
MU
RA
n
=
=
=
! =
P
RA
1
P
RA
2
P
RA
n
!
A Helpful Concept: Arrow-Debreu Securities
MU
money
MU
FA
1
MU
FA
2
MU
FA
n
=
=
=
! =
P
money
P
FA
1
P
FA
2
P
FA
n
MU
RA
1
MU
RA
2
MU
RA
n
=
=
=
! =
P
RA
1
P
RA
2
P
RA
n
!
•  Arrow-Debreau securities:
–  One of these pays a dollar if a specific state of the world occurs at a
specific time,
–  but pays nothing otherwise
–  (a lottery ticket also works this way, but covers a very limited span of
events)
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?
What does the price of an Arrow-Debreau security reflect?
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?