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 (9/1/15)

Direct Quotes (U.S. Perspective)

• Swiss Franc 1.0423CHF 1 = $ 1.0423

• Euro 1.1305€ 1 = $ 1.1305

• British Pound 1.5306£ 1 = $ 1.5306

• Japanese Yen 0.008370¥ 1 = $ 0.008370

http://finance.yahoo.com/currency?u

Indirect Quotes

• Swiss Franc0.9594$1 = CHF 0.9594

• Euro 0.8847

• $1 = € 0.8847

• British Pound 0.6533$1 = £ 0.6533

• Japanese Yen 119.4775• $1 = ¥ 119.4775

Examples of Exchange Rates (1/29/13)

Direct Quotes (U.S. Perspective)

• Swiss Franc 1.0852CHF 1 = $ 1.0852

• Euro 1.3491€ 1 = $ 1.3491

• British Pound 1.5759£ 1 = $ 1.5759

• Japanese Yen 0.01103¥ 1 = $ 0.0110

http://finance.yahoo.com/currency-converter/?u

Indirect Quotes

• Swiss Franc0.9215$1 = CHF 0.9215

• Euro 0.7412

• $1 = € 0.7412

• British Pound 0.6346$1 = £ 0.6346

• Japanese Yen 90.6545$1 = ¥ 90.6545

Cross Rate Example:

NewYork

London Brussels

$1 =

£ 0.6

0$1 = Euro 0.75

£ 1 = Euro 1.50

$1,200,000 - $1,000,000 = $200,000

£ 600,000 Euro 900,000

DollarWeakens

Pound Weakens

DollarStrengthens

$1,000,000

Second Example:

NewYork

London Tokyo

$1 =

£ 0.6

0 $1 = ¥ 90

£ 1 = ¥ 135

$1,111,111 - $1,000,000 = $111,111

£666,667 ¥ 90,000,000

DollarStrengthens

Yen Weakens

DollarWeakens

$1,000,000

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

The Basic Relationship (FA is a financial asset; RA is a real asset)

MU money

P moneyMU FA1

P FA1

MU FA2

P FA2

L MU FAnP FAn

MU RA1

P RA1

MU RA2

P RA2

L MU RAnP RAn

A Helpful Concept: Arrow-Debreu Securities

• 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)

MU money

P moneyMU FA1

P FA1

MU FA2

P FA2

LMU FAnP FAn

MU RA1

P RA1

MU RA2

P RA2

LMU RAnP RAn

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?