Foreign Exchange Markets

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The Law of One Price ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],P € = s €/$  P $

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Absolute PPP ,[object Object],[object Object],[object Object],[object Object],[object Object],S €/$ = P € / P US

Absolute PPP ,[object Object],[object Object],[object Object],[object Object]

Relative PPP ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],P € = s €/$  P $ 1 + i € = E( s €/$ ) 1 + i $ s €/$

What is the evidence ? ,[object Object],[object Object],[object Object],[object Object]

Interest rate parity ,[object Object],[object Object],FORWARD MARKET

Example of a forward market transaction ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Interest rate parity ,[object Object],In the above figure, Point G indicates a situation of disequilibrium. Here, the interest differential is -3% while forward premium on home currency is only 2 %. The transfer of funds abroad with exchange risks covered will yield an additional 1% annually. At point H, the interest differential remains at -3% but forward premium increases to 4%. Now it becomes profitable to reverse the flow of funds. The 3% reduction in interest rates is more than made up for by the 4% gain on forward exchange transaction, leading to a 1% increase in the interest yield. This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates

Evidence on interest rate parity ,[object Object],[object Object]

The Fisher condition ,[object Object],[object Object],[object Object],[object Object],[object Object]

Example of capital market equilibriu m ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

International Fisher Effect Expected change in home currency value of foreign currency(%) In the figure below, point E is a point of equilibrium because it lies on the parity line with 3% interest differential in favour of home country just offset by the anticipated 3% HC depreciation relative to foreign currency. Point F, however illustrates a situation of disequilibrium. If a 3% HC depreciation is anticipated but the interest differential is only 2% then funds would flow from home country to foreign country to take the advantage of the higher exchange adjusted return there. This capital out flow will continue until exchange adjusted returns are equal in both nations.

LIMITATIONS OF CURRENCY TRADING AS AN EXAMPLE OF A NEAR-PERFECTLY COMPETITIVE MARKET

SHORT RUN EQUILIBRIUM FOR PERFECT COMPETITION

EFFECTS OF A CHANGE IN MARKET DEMAND

Foreign Exchange Markets

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