Maclachlan, Money & Banking Spring 2006 1 Foreign Exchange and the International Monetary System...

Maclachlan, Money & Banking Spring 2006

1

Foreign Exchange and the International Monetary System

Chapters 19, 20


2

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


3

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.


4

Volatility in forex market not explained by PPT

Purchasing power changes slowly.

Most forex trading is not to finance import/export traded.


5

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.


6

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)


7

Bretton Woods Agreement 1944

Established a system of fixed exchange rates.

Major architect of agreement J.M. Keynes called gold a “barbarous relic.”


8

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.


9

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.


10

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.


11

Debt Instruments

Chapter 4


12

Present Value

What is a future cash flow (FV ) worth now?

ni

FVPV

)1(


13

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.


14

Four Types of Credit Market Instruments

1. Simple loan


15

2. Fixed Payment, or Amortized, Loan

Examples: car loans, mortgages


16

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)


17


18

Special Type of Coupon Bond: Consol or Perpetuity

Fixed coupon received forever.

i

couponPV


19

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.

Maclachlan, Money & Banking Spring 2006 1 Foreign Exchange and the International Monetary System...

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