FOREIGN EXCHANGE RATES Domestic Currency Units Direct Rate = Foreign Currency Unit for example, USD /C$

FOREIGN EXCHANGE RATES Foreign Currency Units Indirect Rate = Domestic Currency Unit for example, Mex$ /USD

FOREIGN EXCHANGE RATES Cross (Inferred) Rate If we know the rate of exchange between U.S. dollars and Canadian dollars, as well as the exchange rate between US dollars and Mexican pesos, we can infer the exchange rate between Canadian dollars and Mexican pesos: USD /C$ * Mex$10.966/USD = Mex$8.7158/C$

LATERAL ARBITRAGE Canada Mexico United States Mex$8.869/C$ Mex$10.966/USD USD /C$

LATERAL ARBITRAGE Since the quoted rate between the Mexican peso and the Canadian dollar is higher than it should be, we want to sell at that quoted rate. USD /C$*Mex$10.966/USD<Mex$8.869/C$

LATERAL ARBITRAGE USD 1,000,000 divided by USD /C$ C$ 1,258,178 times Mex$ 8.869/C$ Mex$11,158,782 divided by Mex$10.966/USD USD 1,017,580

LATERAL ARBITRAGE The market forces created by arbitrage activities exert pressures on the exchange rates that drive them to equilibrium (within transactions costs): USD /C$ * Mex$ < Mex$8.869/C$

LAW OF ONE PRICE With free trade, identical goods will tend toward a single, worldwide price (adjusted for transportation costs, duties, etc.) t t t P = P * X d f

PURCHASING POWER PARITY If the Law of One Price Holds in all periods t+1 t+1 t+1 P = P * X d f t t t P = P * X d f

PURCHASING POWER PARITY t+1 X 1+infl = (1+infl ) d f t X or t+1 t (1+infl ) X = X * d (1+infl ) f

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