Foreign Exchange and the International Monetary System

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Foreign Exchange and the International Monetary
System

• Chapters 19, 20

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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

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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.

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Volatility in forex market not explained by PPT

• Purchasing power changes slowly.
• Most forex trading is not to finance
  import/export traded.

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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.

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19th Century Gold Standard

• 1 oz of gold 20 4
• 1 5
• Suppose 1 5.25.
• Whats the arbitrage opporunity?

• Liberty Gold Dollar (1849-1854)

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Bretton Woods Agreement 1944

• Established a system of fixed exchange rates.
• Major architect of agreement J.M. Keynes called
  gold a barbarous relic.

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Nixon Closes the Gold Window (1971)

• 1960s 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.

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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.

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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
  couldnt get the exchange rate at BW levels.

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Debt Instruments

• Chapter 4

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Present Value

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

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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.

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Four Types of Credit Market Instruments

• 1. Simple loan

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2. Fixed Payment, or Amortized, Loan

• Examples car loans, mortgages

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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)

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Special Type of Coupon Bond Consol or Perpetuity

• Fixed coupon received forever.

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4. Discount, or Zero Coupon, Bond

• Identical in cash flow structure to a simple
  loan. The difference is that theres an active
  secondary market for zero coupon bonds.