maclachlan, money & banking spring 2006 1 foreign exchange and the international monetary system...
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Maclachlan, Money & Banking Spring 2006
1
Foreign Exchange and the International Monetary System
Chapters 19, 20
Maclachlan, Money & Banking Spring 2006
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Foreign exchange market
• OTC (several hundred dealers, mostly banks)
• Wholesale vs. retail
• Transactions size: $1 million or larger
• Daily volume in excess of $1 trillion/day
Maclachlan, Money & Banking Spring 2006
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Purchasing Power Parity Theory
A method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods.
Creates a balance in trade. When a country has an inflation, its currency depreciates.
Maclachlan, Money & Banking Spring 2006
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Volatility in forex market not explained by PPT
Purchasing power changes slowly.
Most forex trading is not to finance import/export traded.
Maclachlan, Money & Banking Spring 2006
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Asset Demand Theory
Exchange rates adjust so that expected returns across assets of equal risk are equalized.
So if the expected return on European assets is higher than ones in the U.S. assets, the value of the Euro will appreciate.
In equilibrium all expected returns are equal.
Maclachlan, Money & Banking Spring 2006
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19th Century Gold Standard
1 oz of gold = $20 = £4
£1 = $5
Suppose £1 = $5.25.
What’s the arbitrage opporunity?
Liberty Gold Dollar (1849-1854)
Maclachlan, Money & Banking Spring 2006
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Bretton Woods Agreement 1944
Established a system of fixed exchange rates.
Major architect of agreement J.M. Keynes called gold a “barbarous relic.”
Maclachlan, Money & Banking Spring 2006
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Nixon Closes the Gold Window (1971)
1960’s inflation in USAccumulation of $’s
in ROWGerman CB requests
gold for $’s.Nixon refuses to
honor agreement signaling the beginning of the end of fixed exchange rates.
Maclachlan, Money & Banking Spring 2006
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Exchange Rate Interventions
UnsterilizedCB enters into forex
market to influence value of currency.
E.g. Fed buys $ to keep value high.
SterilizedCB enters into forex
market and then conducts OMO to keep money supply constant.
E.g. Fed buys $ in forex market and then conducts expansionary OMO.
Maclachlan, Money & Banking Spring 2006
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Effect of Interventions
Evidence shows sterilized interventions have little effect.
Consider, Germany during final years of BW.
Buying dollars, selling DM and then buying DM to prevent inflation.
No matter how many dollars they bought they couldn’t get the exchange rate at BW levels.
Maclachlan, Money & Banking Spring 2006
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Debt Instruments
Chapter 4
Maclachlan, Money & Banking Spring 2006
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Present Value
What is a future cash flow (FV ) worth now?
ni
FVPV
)1(
Maclachlan, Money & Banking Spring 2006
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Rule of the Cash Flow Timeline
Cash flows at the same date can be added together, but cash flows at different dates cannot be added together.
Maclachlan, Money & Banking Spring 2006
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Four Types of Credit Market Instruments
1. Simple loan
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2. Fixed Payment, or Amortized, Loan
Examples: car loans, mortgages
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3. Coupon Bond
Most bonds with maturities greater than a year are of this form.
Coupons bonds issued byFederal government (Treasurys)State and local governments (munis)Corporations (corporates)
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Special Type of Coupon Bond: Consol or Perpetuity
Fixed coupon received forever.
i
couponPV
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4. Discount, or Zero Coupon, Bond
Identical in cash flow structure to a simple loan. The difference is that there’s an active secondary market for zero coupon bonds.