1. Topic 2 Interest Rates and Foreign Exchange: Spot Markets Staying Competitive in a Floating Rate Environment

2. FX Markets Spot Market (Today’s Topic) Forward Market (Next Topic) Futures and Options Swaps Other Derivatives

3. Alternative Exchange Rate Systems Pegged Rates Floating Rates –Free Float –Managed Float

4. Functions of Money Medium of Exchange Store of Value Unit of Accounting

5. 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

6. Examples of Exchange Rates (9/1/15) Direct Quotes (U.S. Perspective) Swiss Franc1.0423 CHF 1 = $ 1.0423 Euro 1.1305 € 1 = $ 1.1305 British Pound 1.5306 £ 1 = $ 1.5306 Japanese Yen0.008370 ¥ 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

7. Examples of Exchange Rates (1/29/13) Direct Quotes (U.S. Perspective) Swiss Franc1.0852 CHF 1 = $ 1.0852 Euro 1.3491 € 1 = $ 1.3491 British Pound 1.5759 £ 1 = $ 1.5759 Japanese Yen0.01103 ¥ 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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?