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Week 1 notes - Econ 122

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by: Audrey Notetaker

Week 1 notes - Econ 122 Econ 122

Audrey Notetaker
GPA 3.5
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About this Document

these notes cover what was taught in lecture during week 1
International Finance
Class Notes




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"Yes please! Looking forward to the next set!"
Deborah Greenholt

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This 4 page Class Notes was uploaded by Audrey Notetaker on Friday January 15, 2016. The Class Notes belongs to Econ 122 at University of California - Los Angeles taught by Burstein in Fall 2016. Since its upload, it has received 28 views. For similar materials see International Finance in Economcs at University of California - Los Angeles.

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Date Created: 01/15/16
01/06/2016 ▯ Monday (1/4): ▯ ▯ No notes – just went over syllabus  ▯ ▯ Wednesday (1/6): ▯ ▯ ­Policy can intervene in the exchange rate markets which can have various implications  on interest rate etc. but may be used to boost an economy to make its goods cheaper abroad  ▯ ▯ ­If currency can buy more of another currency it has appreciated and if it buys less it has  depreciated  ▯ Appreciations and Depreciations: ▯ ­To determine the size of an appreciation or depreciation, we compute the proportional  change as follows:   In 2011 the dollar value of the Euro was $1.298  In 2012 the dollar value of the Euro is $1.318   Change is = 1.318 – 1.298 = $0.02   Percentage change is 0.02/1.298 (original dollar value) = 1.54%   Thus the Euro appreciated against the dollar by 1.54 percent  ▯ ▯ Multilateral Exchange Rate: ▯ ­Economists calculate multilateral exchange by aggregating bilateral exchange rates   Ex: Home country trades 40% with country 1 and 60% with country 2. It’s exchange  rate appreciates by 10% against country 1 and depreciates 30% against 2  Multiply each exchange rate by trade share and add:  o (­10% x 40%) + (30% x 60%) = (­0.1 X 0.4) + (0.3 x 0.6) = ­0.04 + 0.18 = .14 = 14%  ▯ ▯ ­Some countries fix their exchange rates while others let it float  ▯ ▯ Foreign Exchange Market: ▯ ­Spot and forward foreign exchange markets are over the counter markets – no central  marketplace where buyers and sellers congregate   Interbank market (about 100­200 banks worldwide willing to buy or sell foreign  currency)   Nonbank dealers (investment banks, mutual funds) about 40% of the market  Central banks of countries  ▯ Corresponding Bank Relationships:   Large commercial banks maintain demand deposit accounts with one another, which  facilitates the efficient functioning  ▯ The Bid Ask Spread:  The bid price is the price a dealer is willing to pay you for something   The ask price is the amount a dealer wants   Percent Spread = 100 x  Ask Price – Bid Price                                    Ask Price  ▯ ▯ Derivatives in the Market for Foreign Exchange:  ▯ Forwards:   A forward contract differs from a spot contract in that the two parties make the  contract today but the settlement date for the delivery of the currencies is in the future or “forward” – the time to delivery or maturity varies however the price is fixed as of  today to the contract carries no risk  ▯ Swaps:   A swap contract combines a spot sale of foreign currency with a forward repurchase  of the same currency  ▯ Monday (1/11): ▯ ▯ Covered interest parity (CIP)  must be indifferent between two currencies  ▯ Uncovered interest parity (UIP)  ▯ ▯ ­Investor owns 10,000 Euros  ▯ ­5% interest in Euro area  ▯ ­15.5% interest in UK ▯ ­Spot exchange rates $/ pound = 1.5 and $/Euro = 1.2  ▯ ­Find forward exchange rate for Euros to pounds (this is covered interest parity)   Alternative 1: Invest in euro area, end of year 10,000 = 10,000 x 1.05 (from interest  rate) = 10,500 Euros   Alternative 2: Euros to pounds spot exchange rate = 1.2/1.5 = 0.8 pounds per euro   So 10,000 Euros = 8.,000 pounds x 1.155 = 9,240 pounds by the end of the year   10,500 Euros = (forward exchange rate) x 9,240  the forward exchange rate must be  so that these two equal each other   SO Forward Exchange Rate = 1.136 or 1/1.136 = 0.88  ▯ ▯ ­Suppose instead that the foreign exchange rate did not equal .88 but instead equaled  0.8799 you can make a lot of money doing this by following the below steps:  1) Borrow 1 million Euros at interest rate of 5%   2) Trade 1 million Euros for 800,000 pounds at spot exchange rate which equals 0.8   3) Invest 800,000 pounds at interest rate 0.155   4) Sell 924,000 pounds these at the forward exchange rate to get 1,050,119 euros   5) Repay loan at 1,000,000 x 0.05 interest = 1,050,000 and earn a profit of 119 euros  ▯ ▯ CIP: (1 + interest rate currency 1) = (1 + interest rate currency 2) x Forward exchange /  Spot exchange between currencies ▯ ▯ UIP: (1 + interest rate currency 1) = (1 + interest rate currency 2) x Expected spot  exchange/ actual spot exchange  ▯ ▯ Wednesday (1/13): ▯ ▯ ­If CIP and UIP both hold than it can be said that Forward spot exchange rate will equal  expected spot exchange  ▯ ▯ Testing UIP: ▯ 1) CIP + UIP  Forward Spot Exchange = Expected Spot Exchange  ▯ ▯ The Carry Trade:  Borrow cheap in an area in which interest rates are very low (say Japanese Yen)   Convert yen to a new currency for a country in which interest rates are very high  Invest or lend in this country make a high return and convert back to yen to pay back  loan  This strategy however carries risk because you are hoping that the currency of  country 2 does not depreciate against country 1 (say Yen)   Actual Profit = i (interest on foreign currency) + {Actual rate of depreciation of home currency} – I (interest rate on home currency) Eq. 11.4  ▯ ▯ The Sharpe Ratio: ▯ ▯ ▯


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