ECO3024F - International Finance - Chapter 14

Exchange Rates

The price of one currency in terms of another currency

Exchange Rate: Direct

The price of national currency units expressed in terms of foreign currency units

Exchange Rate: Indirect

The price of foreign currency units in terms of national currency units

Depreciation

A decrease in the value of one (home) currency relative to another (foreign) currency

What Happens When a Currency Depreciates

Imports become more expensive while domestically produced goods and exports become less expensive

Appreciation

An increase in the value of a currency relative to another currency.

What Happens When a Currency Appreciates

Imports become less expensive, while domestically produced goods and exports become more expensive.

Foreign Exchange Market

A global marketplace for exchanging national currencies.

Vehicle Currency

The currency used to invoice an international trade transaction, especially when it is not the currency of either the importer or the exporter.

Most Dominant Vehicle Currency

The US Dollar ($)

Spot Rates

Exchange rates for currency exchanges that take place "on the spot" or in real time

Forward Rates

Exchange rates for currency that will take place in the future

How are Spot and Forward Rates Determined

Rates are negotiated in the present between two parties, but the exchange takes place in the future

Foreign Exchange Swaps

A combination of a spot sale and a forward repurchase

Futures Contract

A third-party contract for a standard amount of foreign currency delivered/ received on a standard date.

Futures Contract: Properties

Contracts can be bought and sold on the open market, and only the current owner is required to fulfil the contract.

Option Contract

A third-party contract for a standard amount of foreign currency delivered/received on or before a standard date.

Option Contract: Properties

Contracts can be bought and sold on the market, and they give the owner the option, but not the obligation, to buy or sell currency if the need arises.

Rate of Return

The percentage change in value that an asset provides over a given time period.

Real Rate of Return

The percentage of profit earned on an investment, adjusted for inflation.

Rates of Return Determinants

Interest rate that the assets will earn.

Expectations about appreciation or depreciation.

Currency Deposit's interest rate

The amount of a currency that an individual or institution can earn by lending a unit of the currency for a year.

Rate of Return for a deposit in Domestic Currency

Is the interest rate that the deposit earns.

Effect of an Expected Appreciation

An expected appreciation of a currency leads to an actual appreciation (self-fulfilling prophecy)

Effect of an Expected Depreciation

An expected depreciation of a currency leads to an actual depreciation (self-fulfilling prophecy)

Covered Interest Parity

Relates interesst rate across countrires and the rate of change between forward exchange rates and the spot exchange rate