1. Maclachlan, Money & Banking Spring 2006 1 Foreign Exchange and the International Monetary System Chapters 19, 20

2. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 4 Volatility in forex market not explained by PPT Purchasing power changes slowly. Most forex trading is not to finance import/export traded.

5. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 6 19 th 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. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 8 Nixon Closes the Gold Window (1971) 1960’s inflation in US Accumulation of $’s in ROW German CB requests gold for $’s. Nixon refuses to honor agreement signaling the beginning of the end of fixed exchange rates.

9. Maclachlan, Money & Banking Spring 2006 9 Exchange Rate Interventions Unsterilized CB enters into forex market to influence value of currency. E.g. Fed buys $ to keep value high. Sterilized CB 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. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 11 Debt Instruments Chapter 4

12. Maclachlan, Money & Banking Spring 2006 12 Present Value What is a future cash flow (FV ) worth now?

13. Maclachlan, Money & Banking Spring 2006 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. Maclachlan, Money & Banking Spring 2006 14 Four Types of Credit Market Instruments 1. Simple loan

15. Maclachlan, Money & Banking Spring 2006 15 2. Fixed Payment, or Amortized, Loan Examples: car loans, mortgages

16. Maclachlan, Money & Banking Spring 2006 16 3. Coupon Bond Most bonds with maturities greater than a year are of this form. Coupons bonds issued by  Federal government (Treasurys)  State and local governments (munis)  Corporations (corporates)

17. Maclachlan, Money & Banking Spring 2006 17

18. Maclachlan, Money & Banking Spring 2006 18 Special Type of Coupon Bond: Consol or Perpetuity Fixed coupon received forever.

19. Maclachlan, Money & Banking Spring 2006 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.