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CHAPTER 2.

EXCHANGE RATE DETERMINATION:

 Exchange Rate Quotations, Balance of Payments, Prices, Parities and Interest Rates

1. Foreign Exchange Rate an! "#otation

A foreign exchange rate is the price of one currency expressed in terms of another currency. Aforeign exchange quotation (or quote), on the other hand, is a statement of willingness to buyor sell at an announced rate: Quotation of banks rates.

!n the retail market (newspapers, airports, etc..) quotes are most often gi"en as the homecurrency price of foreign currency.

A #ross $xchange %ate is an exchange rate between two currencies, A and &, neither of which is #. !t can be calculated as the ratio of the exchange rate of A to the dollar, di"ided bythe exchange rate of & to the dollar. 'he following sample of formulations can be used tocalculate cross exchange rates:

 EURO

TL

US 

 EURO

US 

TL×=

((  or

TL

 EURO

US 

TL

US 

 EURO×=

(( or

TL

US 

 EURO

TL

 EURO

US  ((×=

Inter$an% "#otation

* dollar is ma+or worldwide currency in"ol"ed in the most of the foreign exchangetransactions. 'his caused professionals dealers and brokers to state foreign exchangequotations in different ways. 'here ha"e been two ways of representing foreign exchangerates worldwide for * . #ountries use any one of these two methods to announce foreignexchange rates in the markets.

irst, ma+ority of the countries express foreign exchange prices for one * dollar which isknown as Euroean terms. 'he following quote is an example to $uropean terms:

Ψ-/. 0 * or - * : -/. Ψ

'his quote shows the amount of 1apanese 2en that can be purchased for one * which can be also named as 1apanese terms. Additionally, when for example, '3 is expressed in terms of * , the quote is said to be in 'urkish terms. $uropean terms were adopted in -456 tofacilitate worldwide trading through telecommunications.

*econd, se"eral countries express * dollar price for one unit of other currencies which isknown as !merican terms. 'he following quote is an example to American terms:

* .4/ 0 Ψ or - Ψ : .4/ *

'he abo"e quote shows the amount of * that can be purchased for one 1apanese 2en whichcan be calculated by taking the reciprocal of the rate presented in $uropean terms. 'herefore,

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2en0.4/)*( 0 )*(.-/

-=

"en

American terms of presenting quotes are used for the .7. pound sterling, the euro, Australiandollar, 8ew 9ealand dollar and !rish punt.

Direct an! In!irect "#ota

oreign exchange rates can be expressed in terms of currencies other than *. 'here are twocommon methods other than $uropean and American terms: irect quote and !ndirect quote.

A direct quote is a quotation expressing home currency price in terms of a foreign currencywhere an indirect quota is a quotations expressing foreign currency price in terms of a home

currency. #onsider the following rates:

$%; -. or - =&>: -. .?6 0 $%; or - $%;: .?6 =&>

'his quotation shows the amount of =&> that can be purchased for one $%;. !t is this timea direct quote in .7. showing the internal "alue of =&> for one unit of $%; and is anindirect quote in the $%; area showing the external "alue of $%; against =&>.

&i! an! A% 'o((er) "#otation

!nterbank quotations are gi"en as a bid and ask. A bid is the price in one currency at which adealer will buy another currency. ;n the other hand, an offer (ask) is the price at which adealer will sell the other currency. 'o make profit, bid price is greater than ask price. 'hedifference between the two will gi"e the spread (profit). &id of one currency is the offer of opposite currency at the same time. A trader seeking to buy with $%; is simultaneouslyoffering to sell $%; for .

;utright quotations, that full price to all of its decimal points is gi"en, can be gi"en in a fewmethods in worldwide "ideo screens:

Exhi$it 2.1 O#tright "#otation in the Inter$an% Mar%et

&i! * A% '+en,- /)

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Metho! 1. --6.@5 --6.B5Metho! 2. --6.@5 B5Metho! 0. @5 C B5

Quotes can be gi"en in the first term (bid) as --6.@5. !n the second term (offer), they may begi"en as --6.@5 B5 on a "ideo screen. ;r @5 to B5 assuming that leading digits (--6.) arealready known. 'he last @ digits are small figure frequently changing, while leading digits are

 big figures seldom changing.

Dhen quotations are con"erted from $uropean terms into American terms, bid and offer re"erse. %eciprocal of bid becomes offer and reciprocal of offer becomes bid. 'o make a

 profit, offer price should be greater than the bid price. #onsider the following quotes in 'ableEE:

Exhi$it 2.2 &i! an! A% "#otation in E#roean an! Aerican Ter

&i! A% rea!

E#roean "#ote F --6.@5 0 F --6.B5 0 F .- 0 Aerican "#ote .6< 0 F .6/ 0 F .- 0 F

%eciprocal of bid quotes in $uropean terms becomes ask in American terms. *pread (profit) in$uropean terms is F .- 0 in $uropean terms where it is .- 0 F American terms.

Exreing For3ar! "#otation on a Point &ai

'raders usually quote forward rates in terms of points (swap rates). A point is the last digit of a quotation. #urrency prices for are usually expressed to < decimal points. A point G .-of most currencies. 1apanese 2en and !talian 3ira are quoted to @ points. A forward quotationexpressed in points is not a foreign exchange rate as such. !t is the difference between theforward rate and the spot rate.

'raders follow an operational rule that indicates whether forward quote is at a premium or adiscount. Hore specifically, if bid in points is greater than offer in points, forward rate is saidto be at a discount and points should be subtracted from spot rate. ;n the other hand, if bid in

 points is less than offer in points, forward rate is said to be at a premium and points should beadded to spot rate. A forward bid and offer quotation expressed in points is also called a swaprate (&orrowing a short term loan of one currency at another currencys rate).

#onsider 'able EE below:

Exhi$it 2.0 ot an! For3ar! "#otation (or the E-RO an! 4aanee +en

$uro: *pot and orward (0I) 2en: *pot and orward (F0)

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'erm HidC%ate &id Ask HidC%ate &id Ask  

*pot -.644 -.645 -.4- --6.B@ --6.@5 --6.B5

#ash - Deek -.4B B < --6.@B C- C4%ates - month -.4-5 -5 -4 --5.6@ C/- C/

@ month -.4B< B/ B? --5.B6 C4/ C4BB month -.4/B /B /< --?.4- C-

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where n represents the number of days in this case. &ut when for example numerator is -@, nmight be also the number of months.

'he percentage change here will be:

f Ψ G L-.>>, no currency unit can loose its "alue -L or higher. ;therwise, '3should be withdrawn from the market, meaning NOeroP >>.

*o

egree of de"aluation0depreciation G

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L/./@-,4/,@

,4/,@, data. !t is a statistical statement thatsystematically summariOes, for a specified time period, the economic transactions of aneconomy with the rest of the world. $conomic transactions include exports, imports, incomeflows, capital flows, gifts and similar oneCsided transfer payments. 'he net of all of thesetransactions is matched by a change in the countryMs international monetary reser"es. &;> areimportant to business managers, in"estors, consumers, and go"ernment officials because thedata influence and are influenced by other key macroeconomic "ariables such as =>,employment, price le"els, etc.. Honetary and fiscal policy must take &;> into account at thenational le"el. &;> helps to forecast a countryMs market potential, especially in the short run.A country experiencing a serious &;> deficit is not likely to expand imports. &;> is an

indicator of pressure for a countryMs foreign exchange and for a firm for foreign exchangegains or losses.

1.1 Mea#ring a Nation; Per(orance: De(icit an! #r#e in &OP

&;> measures, summariOes and states all the financial and economic transactions betweenresidents of one country and residents of the rest of the world. !f a nation recei"es less thanwhat it spends, then it incurs a NdeficitP. !f a nation recei"es from abroad more than it spends,then it incurs a NsurplusP.

.redits# /oreign Exchange Earned 

'ransactions that earn foreign exchange are recorded in &;> as a NcreditP with a (J) sign.

#redits are obtained by selling to nonCresidents either real or financial assets or ser"ices. Ex) Borro-ing, Exorts and foreign students uni+ersity fees, etc))

 0e$its# /oreign Exchange Exended 

'ransactions that expend foreign exchange are recorded as NdebitsP and are marked as (C)sign. Ex) Imorts, urchasing foreign ser+ices 1insurance2, lending, host country student fees

 for foreign schools, etc3

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&;> is systematically defined and summariOed by !nternational Honetary und (!H)institution by setting up its own standard in representing &;> for the countries. According to!H classification of &;>, there are

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.aital !ccount * 5rou B

!t measures capital transfers and the acquisition or disposal of nonCproduced and nonCfinancialassets.

#apital transfers → transfer of ownership of fixed assets, transfer of funds, the cancellation of liabilities by creditors. !t also includes both go"ernmental and pri"ate debts.

 8onCproduced and nonCfinancial assets →  intangibles like patented entities, leases,

transferable contracts, and goodwill.

 /inancial !ccount * 5rou . 

!t pro"ides data on long term financial flows such as foreign direct in"estments, portfolioin"estments, and other long term capital mo"ements.

irect in"estments abroad → (C)

oreign irect !n"estment → (J)

>ortfolio and other in"estments → purchases and sales of equity and debt securities, changes

in trade credit, loans, currency, and deposits.

=roup A J =roup & J =roup # G &asic &alance

 8et Errors and Omissions * 5rou 0

!t reflects the transactions that are known to ha"e occurred but for which no specific measurewas made. 'hey are recorded to pre"ent imbalances in &;>. $x. rugs, narcotics in imports,etcR

Total, 5rous ! through 0

Also called the o"erall balance, or the official settlements balance. !t is the net result of trading, capital and financial acti"ities. !t is the sum of all autonomous transactions that must

 be financed by the use of official reser"es or other nonCreser"e official transactions.

 Reser+es and Related Items * 5rou E 

'he net result of the o"erall balance must be financed by the changes in official monetaryreser"es.

'he sum of changes in reser"es on line B4 is identical to the total change in foreign exchangereser"e position reported on line B6.

1.2 Aroache in &aancing &OP

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'he basic aim of countries is to arri"e at a Oero balance in their &;>. &ut ha"ing a Oero balance in &;> is almost impossible for countries. !t is not so easy to balance foreignCbasedexpenditures with foreignCbased receipts. !mbalances in &;> will affect the whole economyof countries and their relationships with the world.

'here are "arious policies that countries may follow in case of imbalances (surpluses or deficits) in &;>. !f there are temporary deficits in &;>, these deficits could be financed byreser"es or to apply a repairing policy. &ut if deficits are chronic or continuous, then financingthrough reser"es might not be possible because the international reser"es of countries are notunlimited. ;ne of the ways to put a pressure on &;> deficits is to limit foreign trade andexchange rate transactions through custom tariffs, quotas, and limiting foreign exchangetransactions. 'he aim in this case is to narrow import "olume and to pre"ent capital outflows.Kowe"er, this strategy e"en does not stop deficits but put a pressure on these deficits. And thistype of strategies is against liberaliOation trends and policies in a globaliOed world. And it isagainst the policies of Dorld 'rade ;rganiOation (D';) and !H.

*o there are some other alternati"es repairing policies to be applied during &;> !mbalances:

1.2.1 Exchange Rate A!

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$x J $m ≥ -

Dhere $x represents the foreign demand elasticity for exported goods0ser"ices and $mrepresents domestic demand elasticity for imported goods0ser"ices. According to this

approach, in the case of lower elasticities for exported and imported goods0ser"icesde"aluation will not be effecti"e. !t may e"en affect &;> negati"ely. Kowe"er, the newstudies ha"e shown that these elasticity coefficients are enough high to ha"e the positi"eeffects of de"aluation.

0.2 Nationa Incoe Aroach

 8ational income balance can be represented by the following 7eynesian equation:

2 G # J ! J = J (E H)

*o when there is an increase in consumption (#), in"estment (!), go"ernment expenditures (=)and net exports (exports imports), national income will increase. =o"ernments usuallyconsider ! and = at national le"el and as a national policy to affect national income. Another important assumption of the 7eynesian theory is that H depends on 2. Dhen 2 increases, Hwill also increase. 'his positi"e relationship between 2 and H is named as import function: HG m (2) where m is marginal propensity to import.

'he first policy to be adopted is related with fiscal policy. or example, when there is a deficitin &;>, by fiscal policy, go"ernment will tend to reduce the expenditure side of the equation,taxes will tend to increase, and 2 will decrease so that H will also decrease. #onsequently, netexports will also be decreasing.

'he second type of policy to be adopted is related with monetary policy. !n case of a deficit in&;>, go"ernment will apply a restricti"e monetary policy to reduce money supply andincrease interest rates so to reduce !, 2 and H. Kowe"er, monetary policy is commonlyrelated with not trade balance of &;> but with capital account balance of &;>. An importantdisad"antage of restricti"e fiscal and monetary policies is unemployment problem. Dhen 2decreases, this will speed up unemployment.

0.0 Foreign Tra!e &aance an! Tota Con#tion 'A$ortion) Aroach

Absorption approach is adopted "ersion of national income model into foreign economicrelationships. 'he most important contribution of this approach is that of explaining foreigntrade according to the general working of the economy. Dhen there is a deficit in &;>, thentotal expenditures of the country exceeds its production capacity according to this approach,meaning it produces less than it consumes.

2 G # J ! J = J (ECH)

De can reCwrite the abo"e equation as below:

2 G A J (ECH) where A means total domestic expenditures and

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2 A G E H

*o, if 2 S A, then total domestic production will be greater than total domestic expendituresand this excess production will be exported to outside and will be a surplus in foreign trade

 balance. !f 2 T A, then there will be a deficit in foreign trade balance. As a result, if 2increases, the difference between 2 and A will be decreased and foreign trade balance will beobtained.

;n the other hand, when economy is underemployed and 2 rises, A will also be rising but if 

∆2 S ∆A (and H>* is positi"e), then de"aluation will be beneficial. Dhen economy is fully

employed, then de"aluation will not be beneficial, there is no idle capacity in the economyand excess demand will be partially met by import and prices will tend to increase. !f de"aluation is applied in a full employed economy, inflation will further rise.

0.5 Monetar8 Aroach For Foreign &aance

$lasticity and absorption approaches consider only foreign trade in foreign balancingdisregarding capital mo"ements. 'here ha"e been important de"elopments in financialmarkets and international capital mo"ements in our new world. !n order to consider the effectsof capital mo"ements on foreign balancing, monetary approach has been de"eloped in -45s.Honetary approach relates deficits0surpluses in &;> into monetary imbalances. Honetaryimbalances occur because of the differences in the money to be kept by public and moneysupplied by central bank. !f money supply is greater than demand for money, public will usethis excess in domestic and foreign expenditures. &ut if money supply is less than the demandfor money, then this deficit will be compensated by foreign monetary flows.

Among the critical assumptions of the theory is that demand for money in e"ery economy isthe real demand deri"ed by some factors. ;ne of these factors is the income le"el of people.'here is a direct relationship between real income and real demand for money. 'he secondtype of factor is that demand for money depends on interest rates among which there is anindirect relationship. &ecause when interest rates increase, sa"ings will increase and this willreduce the demand for money.

%eal emand for money: Hd 0 >

*o the relationship between the demand for money and income and interest rates is:Hd 0 > G f (y, i)

Although demand for money is due to the public, money supply is determined by the central bank.

Honey supply is: H* G A ( J %)

Dhere A is the money multiplier, is the emission made by the central bank for internaleconomic and financial purposes, and % is the domestic currency dri"en to the market by theuse of foreign reser"es. (J%) is the monetary base of the country.

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Dhen international reser"es increase, then (to pre"ent appreciation of domestic currency) themore domestic currency will be dri"en to the market. !f international reser"es decrease, then(to pre"ent depreciation), the domestic currency will be drawn from the market. !n fixedexchange rate systems, this mechanism gains more importance since the central bank inter"enes into the market to stabiliOe the economy. Kowe"er, in floating rate systems, there is

no need for inter"ention and % loses its importance.

3etMs assume that is dri"en to the market by the central bank at the beginning so thatdemand for money is still constant. Dhat will happenU

-. Honey supply increases@. #onsumption and in"estmentCsa"ings increaseB. >art of the in"estment goes to the foreign portfolios (the sum of current, capital and financial accounts)near Oero. ;therwise it will inter"ene in the foreign exchange market by buying or sellingofficial foreign exchange reser"es.

!f &;> S , then a surplus demand for domestic currency will occur, and exchange rate ↑

(domestic currency depreciates) and to preser"e fixed rate system go"ernment will inter"ene

and sell domestic currency (so that domestic currency will appreciate, and exports ↓, and

imports ↑) to bring &;> back to Oero.

>'3

Q'3

>$

Q$

$

*'3

'3

Q*-

Q-

$xcessemand

>-

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! &;> T , excess supply of the currency will occur, the go"ernment will inter"ene and buy

domestic currency with its reser"es of foreign currencies or gold.

!f foreign exchange reser"es ↓, then go"ernment cannot inter"ene and will ha"e to make

de"aluation.

5.1.2 Foating Exchange Rate Co#ntrie

'he go"ernment has no responsibility to peg the foreign exchange rate. 'he fact that thecurrent and capital account balance do not sum to Oero will automatically alter the exchangerate in the direction necessary to obtain a &;> near Oero.

A country running a current account deficit, with a financial account balance of Oero, willha"e a net &;> deficit. An excess supply of domestic currency will appear in world markets.

'hen domestic currency will fall in "alue (depreciation), &;> will mo"e back to Oero.

>'3

Q'3

>$

Q$

$

*'3

'3

Q-

Q*-

$xcess

*upply

>-

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5.1.0 Manage! Foat

#ountries operating with managed floats take actions to maintain their desired exchange rate"alues. 'hey alter the markets "aluation of a specific exchange rate rather than through

inter"ention in the foreign exchange markets.

'hey primarily change relati"e interest rates to influence the economic fundamentals of exchange rate determination.

'he aim is to attempt to alter the financial account balance, especially shortCterm portfolios, torestore an imbalance caused by deficit in current account.

A country may wish to increase domestic interest rates to attract additional capital or in"estments from abroad.

&usiness managers use &;> trends to make forecasting in go"ernment policies on domesticinterest rates.

$x. !n those countries ha"ing a deficit in current account, in"estors may expect interest ratesto increase.

5.2 Econoic De6eoent Iact

&;> is also used for economic de"elopment analysis. A deficit or surplus is not good or badfor a country.

rom a national income "iewpoint,

Dhen a deficit occurs in current account →  then bad effect on => and employment if 

underemployment exists, whereas a surplus ha"e a positi"e effect.

Dhen deficit → => ↓, emp ↓, unemp.↑

Dhen surplus → =>↑, emp. ↑, unemp. ↓

nder full employment, a current account deficit that can be financed by abroad would also

allow imports of in"estment goods to ↑.

rom a program "iewpoint,

$conomic de"elopment → requires net imports of goods and ser"ices which means a deficit

in current account (↑) financed by foreign sa"ings.

rom a liquidity "iewpoint,

eficit → a country is being a net longCterm creditor of the rest of the world through directforeign in"estments and long term loans.

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$x. 8eeding foreign loans to close deficits.

>. INTERNATIONA= PARIT+ CONDITION

De ha"e to describe firstly Vparity conditionsV in order to answer the following questions:

Are changes in exchange rates predictableU Kow are exchange rates related to interest ratesU Kow does inflation affect exchange ratesU Dhat is the proper exchange rateU And etc...

>.1 Parit8 Con!ition

!nternational Honetary *ystem (!H*) is currently characteriOed by a mix of freely floating,

managed floating and fixed floating exchanges. 8o single theory is a"ailable to forecastexchange rates under all conditions.

>arity conditions are certain basic economic relationships, which help to explain exchangerate mo"ements.

>arity conditions are "ery important out of the consideration of the reasons behindexchange rate mo"ements.

>arity conditions well explain the relations among exchange rate mo"ements, inflation,and interest rates.

*o in order to make a forecast about future rates, we ha"e to understand parity conditions better.

>.2 Price an! Exchange Rate

!f the identical product or ser"ice can be sold in two different markets, and no restrictions(tariffs) exist on the sale or transportation costs, the products price should be the same in

 both markets. 'his concept is called the a3 o( one rice. A primary principle of competiti"e markets GGS to equaliOe prices across markets if no

restrictions on the sales and costs

!f two markets are two different countries, the products price may be stated in differentcurrency terms, but the price of the product should remain the same.

$x. >F G > W *

Dhere

>F G price of the product in 1apan (1apanese 2en)> G price of the product in *A (* )* G spot exchange rate

And( P 

 P S " 

if no higher price (or inflation) in one of the countries

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>.0 P#rchaing Po3er Parit8 an! the =a3 o( One Price

>>> is an applied "ersion of the law of one price theory, saying that any good would

 be priced the same in different markets or in different countries in all o"er the world, if there were no tariffs, restrictions on sales and costs.

'his theory was firstly stated by a *wedish, =usta" #assel in -4-6. Ke explained this theory after Dorld Dar ! to create the framework of new official

exchange rates while returning back to =old *tandard again. Dhen rates were imbalanced in later periods in the fixed rate system, it was used also

 by the central banks to create the balanced rates. De can use the same formulation of >F G > W * to find >>> between two currency. 'he >>> exchange rate between two currencies could be stated by:

( PI 

 PI 

S 

" 

=

where >!2 is the price index in 1apan>! is the price index in *A in their local currencies

$x. !dentical basket of goods: !n 1apan G 2- !n *A G -* G 2- 0 - G 2-0

'his is the absolute "ersion of the theory of >>>, stating that the spot exchange rate isdetermined by the relati"e prices of similar basket of goods.

PPP can $e coni!ere! in t3o (or:

1. A$o#te PPP

*tates that spot exchange rate is determined by the relati"e prices of similar baskets ofgoods. 3ike in the example abo"e. >y G * . >

2. Reati6e PPP

Hore general idea than absolute >>> $xchange rates between two currencies will change so that it will reflect

inflationary effects. *o >>> regards inflationary effects.

De can formulate this theory as:

  f  d    P  P  E 

 E  E −=

−

-

where$ G exchange rate in the base year $- G exchange rate after the base year >d G inflation rate in domestic country>f  G inflation rate in foreign country

or example, if inflation in 'urkey is /L, and in *A -L, then we expect '3 to depreciateagainst by

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%elating exchange rate mo"ements to rates of inflation, we do not deal with the real "alues of $, >d, and >f , but deals with their percentage change.

$xhibit /.@  r in 1apan is >>. Host of them did not pro"e >>>.

• >>> was not accurate in predicting future exchange rates

• =oods0ser"ices do not in reality mo"e at Oero cost between countries

• !n fact, many goods are not tradable. ie. Kaircuts

• Hany goods are not the same quality across countries.

T3o Genera conc#ion ha6e $een a!e (ro thee tet:

-. >>> may hold up o"er the "ery long run but poorly for shorter time periods@. 'heory holds better for countries relati"ely with high rates of inflation and

underde"eloped capital markets.

t e6era ro$e exit 3ith thee tet:

-. Host of the tests  used price indexes of traded goods, howe"er there are many nonC

traded goods like housing and medical costs which affect traded goods and economic life.@. !t is difficult to find identical markets among countries because of taste differences, le"el

of de"elopments, le"el of incomes, etc.. >>> should be considered in identical markets.B. >>> requires knowledge of what the market is forecasting for inflation differentials but

the data that are a"ailable are either historical inflation rates or existing differentialinterest rates.

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Rea exchange rate  are rates calculated according to a base period, which are

excluded from inflationary effects.

;n the other hands, noina e((ecti6e exchange rate in!ex calculates, on a weighted

a"erage basis, the "alue of the sub+ect currency at different points in time, according to

trade with the countryMs ma+or trading partners. !t does not indicate true "alue of thecurrency.

Rea e((ecti6e exchange rate in!ex indicates how the weighted a"erage >> of the

currency has change relati"e to selected base period.

Exhi$it >.0: IMF in!ex #$ihe! (re?#ent8.

• !ndex is calculated for a base year of -44G-

• !f changes in exchange rates +ust offset differential inflation, real effecti"e excgange

rate G -• !f exchange rates strengthen more than differential inflation, then index S- and

sub+ect currency would be considered N;"er"aluedP.

• !ndex T -, then nder"alued.

A countryMs real effecti"e exchange rate index is an important tool for predicting upward or downward pressure on its &;> and exchange rate.

Exchange Rate Pa * Thro#gh

!ncomplete exchange rate passCthrough is one reason that a countryMs real effecti"e exchangerate index can de"iate for lengthy periods from its >>> equilibrium le"el of -.

'he degree to which the prices of imported and exported goods change as a result of exchangerate changes is termed  Pass – Through, which is the measure of response of imported andexported product prices to exchange rate changes.

$xample:Assume that &HD produces automobile in =ermany when exporting the auto to *A, the

 price of &HD in *A should be

S  P  P 

  0%  B%9  B%9 

-(×=

!f H appreciates -L against , >&HD proportionally is expected to increase -L. !f itincreases by the same L, then exchange rate passCthrough is said to be Coete (-L).

Kowe"er, if >&HD rises by less than ∆L in *, then the passCthrough is Partia.

Assume: >H&HD G H/4,/ *- G H-.50 >

&HD G B/,

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• !f H appreciate @L, *@ G H-.&HD theoretically should be &HD rose only -

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γ  ii

S 

S S −=×

−

(

@

@- -

isher open states that ∆L in spot rates should be equal to interest rate

differentials.

$xample:

• based in"estor buys a -Cyear 2en bond earning

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• DhenS 

S  / ii S/ 

−>−( , then funds will mo"e from *A to *witOerland, otherwise to *A.

Exae:

i G -L i'3 G 5L * G -: rofit on : -,rofit on 2en: -,

8/19/2019 Chp 2418

22/22

>oint E shows one possible equilibrium position where a