Exchange rates and the Foreign Exchange Market: An Asset Approach

8 important questions on Exchange rates and the Foreign Exchange Market: An Asset Approach

Central role exchange rates

They allow us to compare the prices of goods and services produced in different countries.

The major actor in the foreign exchange market:

1) Commercial banks.
2) Corporations.
3) Nonbank financial institutions.
4) Central banks.

Spot exchange rates

Two parties agree to an exchange of bank deposits and execute the deal immediately. A deal is called a spot transaction.
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Foreign exchange option

Gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.

Foreign currency deposits future value depends on two factors:

The interest rate it offers (R) and the expected change in the currency's exchange rate against other currencies (E^e)

Assets expected rate of return

The percentage difference between that expected future value and the price you pay for the asset today.

Savers care about two main characteristics of an asset other than its return:

1) Risk
An asset with a high expected rate of return may thus appear undesirable to savers if its realized rate of return fluctuates widely.



2) Liquidity.
Assets differ according to the cost and speed at which savers can dispose of them.

Participants in the foreign exchange market base their demands on:

Exclusively on a comparison of those assets' expected rates of return.
The risk and liquidity motives appear to be os secondary importance.

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