Chapter 14 (3)
Exchange Rates and the Foreign Exchange Market:
An Asset Approach
◼ Chapter Organization
Exchange Rates and International Transactions
Domestic and Foreign Prices
Exchange Rates and Relative Prices
The Foreign Exchange Market
The Actors
Box: Exchange Rates, Auto Prices, and Currency Wars
Characteristics of the Market
Spot Rates and Forward Rates
Foreign Exchange Swaps
Futures and Options
The Demand for Foreign Currency Assets
Assets and Asset Returns
Box: Nondeliverable Forward Exchange Trading in Asia
Risk and Liquidity
Interest Rates
Exchange Rates and Asset Returns
A Simple Rule
Return, Risk, and Liquidity in the Foreign Exchange Market
Equilibrium in the Foreign Exchange Market
Interest Parity: The Basic Equilibrium Condition
How Changes in the Current Exchange Rate Affect Expected Returns
The Equilibrium Exchange Rate
Interest Rates, Expectations, and Equilibrium
The Effect of Changing Interest Rates on the Current Exchange Rate
The Effect of Changing Expectations on the Current Exchange Rate
Case Study: What Explains the Carry Trade?
Summary
APPENDIX TO CHAPTER 14 (3): Forward Exchange Rates and Covered Interest Parity
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11. The euro is less risky for you. When the rest of your wealth falls, the euro tends to appreciate, cushioning
12. The chapter states that most foreign exchange transactions between banks (which accounts for the vast
majority of foreign exchange transactions) involve exchanges of foreign currencies for U.S. dollars, even
when the ultimate transaction involves the sale of one nondollar currency for another nondollar
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13. The interest rate parity condition tells us that interest rates and exchange rates are directly linked.
14. A tax on interest earnings and capital gains leaves the interest parity condition the same because all
its components are multiplied by one less the tax rate to obtain after-tax returns. If capital gains are
17. If the dollar depreciated, all else being equal, we would expect outsourcing to diminish. If, as the
problem states, much of the outsourcing is an attempt to move production to locations that are relatively
