International Economics ECON 390
Lotta Moberg
Lecture notes – November 7 - 10: The Asset Approach to Foreign Exchange and
Exchange Rates
1. Exchange Rates allow us to denominate the cost or price of a good or
service in a common currency.
Exchange rate regimes
2. Freely floating currency
 Market determined
3. Managed/”dirty” float
 Monetary intervention to stabilize it
4. Pegged currency
 Can be ”crawling”, within a band, or both
5. Fixed currency
 Against another currency, basket of currencies or commodities
6. Currency board
 A tool do discipline a fixed currency regime
7. Currency Union
 Transnational common monetary policy
8. Dollarization
 Relying on another country’s monetary policy
9. Currency depreciation makes imports are more expensive and domestically
produced goods and exports less expensive.
10. Currency appreciation lowers the price of exports relative to the price of
imports.
Foreign Exchange Markets
11. Markets where currencies and other assets are exchanged
 Institutions buy and sell for investment purposes.
 The daily volume of foreign exchange transactions was $5.3 trillion in 2013
 85% of transactions were foreign currencies exchanged for U.S. dollars.
 Commercial and investment banks dominate
No arbitrage on Foreign Exchange Markets
International Economics ECON 390
Lotta Moberg
 Arbitrage = buy at a low price and sell at a higher price
 Computer and telecommunications technology transmit information rapidly
 The integration of financial markets makes significant differences in
exchange rates across locations impossible
Exchange Rates and Contracts
12. Spot rates
 For currency exchanges executed in the present
13. Forward rates
 For currency exchanges that will occur at a future date
14. Futures contract
 Designed for a standard amount and delivery date of foreign currency
15. Foreign exchange swap
 A combination of a spot sale with a forward repurchase
16. Options contracts
 An option, not an obligation, to buy or selling currency
Factors that influence the return on assets determine the demand of those assets
17. Rate of return
 The percentage change in value that an asset offers during a time period
18. Real rate of return
 The inflation-adjusted rate of return
 If inflation is 0%, then nominal rate of return = real rate of return.
 Because trading of deposits in different currencies occurs on a daily basis,
we can assume no inflation
What matter s for a currency’s value?
19. Risk
 If higher, you do not want to hold it
20. Liquidity
 Higher means easier to use the asset to buy goods and services
International Economics ECON 390
Lotta Moberg
21. We can assume that risk and liquidity of currency deposits in foreign
exchange markets are the same, regardless of their currency denomination.
22. Therefore, what matter s for investors are the rates of return on currency
deposits, determined by:
 Interest rate on an asset
 Expectations about currency appreciation or depreciation
Interest rates
23. The amount of a currency one can earn by lending or depositing a unit of
the currency for a year.
24. The approximate dollar rate of return on euro deposits:
R€ + (Ee$/€ – E$/€)/E$/€
 The interest rate on euro deposits plus the expected rate of appreciation of
euro deposits
A Model of Foreign Exchange Markets
25. Equilibrium is at interest parity
 When deposits of all currencies offer the same expected rate of return.
 Interest parity implies no arbitrage in the foreign exchange market
The effect of current exchange rate on the expected rate of return of a foreign
currency
26. Depreciation of the domestic currency today lowers the expected rate of
return on foreign currency deposits.
 The initial cost of investing in foreign currency deposits increases, thereby
lowering the expected rate of return of foreign currency deposits.
27. Appreciation of the domestic currency today raises the expected return of
deposits on foreign currency deposits.
 The initial cost of investing in foreign currency deposits decreases, thereby
raising the expected rate of return of foreign currency deposits.
International Economics ECON 390
Lotta Moberg
28. Learn to illustrate: 1. The determination of the equilibrium Dollar/Euro
exchange rate. 2 The effect of a rise in the dollar interest rate. 3. The effect
of a rise in the Euro interest rate.
29. If people expect the euro to appreciate in the future, Euro-denominated
assets will buy more dollars and dollar-denominated goods.
 This leads to an actual appreciation, i.e. a self-fulfilling prophecy.
 An expected depreciation of a currency also leads to an actual depreciation.
How do we explain the existence of carry trade in the absence of arbitrage?
30. Selling and buying currencies should not be profitable
31. Risk and liquidity factors may explain the arbitrage
32. As exchange rates tend to fluctuate, perhaps it is a matter of timing during
an adjustment to a new equilibrium
Covered Interest Parity
33. Relates interest rates to forward and spot exchange rates:
R$ = R€ + (F$/€ – E$/€)/E$/€
34. Rates of return on dollar deposits = “covered” foreign currency deposits
35. If covered interest parity did not hold, you could you earn a risk-free return