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 CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

Examples of Exchange Rates (1/29/13) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

Cross Rate Example: New York London Brussels $1 = £ 0.60 $1 = Euro 0.75 £ 1 = Euro 1.50 $1,200,000 - $1,000,000 = $200,000 £ 600,000 Euro 900,000 Dollar Weakens Pound Weakens Dollar Strengthens $1,000,000

Second Example: New York London Tokyo $1 = £ 0.60 $1 = ¥ 90 £ 1 = ¥ 135 $1,111,111 - $1,000,000 = $111,111 £666,667 ¥ 90,000,000 Dollar Strengthens Yen Weakens Dollar Weakens $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)  MUmoney P  MUFA 1 P 1  MUFA 2 P 2    MUFA n P n  MURA 1 P 1  MURA 2 P 2    MURA n P n

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)  MUmoney P  MUFA 1 P 1  MUFA 2 P 2    MUFA n P n  MURA 1 P 1  MURA 2 P 2    MURA n P n

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?