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FOREIGN EXCHANGE RATES

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... EXCHANGE RATES. Cross (Inferred) Rate. If we know the rate of exchange ... activities exert pressures on the exchange rates that drive them to equilibrium ... – PowerPoint PPT presentation

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Title: FOREIGN EXCHANGE RATES


1
FOREIGN EXCHANGE RATES
  • Domestic Currency Units
  • Direct Rate
  • Foreign Currency Unit
  • for example, USD 0.7948/C

2
FOREIGN EXCHANGE RATES
  • Foreign Currency Units
  • Indirect Rate
  • Domestic Currency Unit
  • for example, Mex 10.966/USD

3
FOREIGN EXCHANGE RATES
  • Cross (Inferred) Rate
  • If we know the rate of exchange between U.S.
    dollars and Canadian dollars, as well as the
    exchange rate between US dollars and Mexican
    pesos, we can infer the exchange rate between
    Canadian dollars and Mexican pesos
  • USD 0.7948/C Mex10.966/USD
  • Mex8.7158/C

4
LATERAL ARBITRAGE

Canada
USD 0.7948/C
Mex8.869/C
United States
Mexico
Mex10.966/USD
5
LATERAL ARBITRAGE
  • Since the quoted rate between the Mexican peso
    and the Canadian dollar is higher than it should
    be, we want to sell at that quoted rate.
  • USD 0.7948/CMex10.966/USD

6
LATERAL ARBITRAGE
  • USD 1,000,000
  • divided by USD 0.7948/C
  • C 1,258,178
  • times Mex 8.869/C
  • Mex11,158,782
  • divided by Mex10.966/USD
  • USD 1,017,580

7
LATERAL ARBITRAGE
  • The market forces created by arbitrage activities
    exert pressures on the exchange rates that drive
    them to equilibrium (within transactions costs)
  • USD 0.7948/C Mex10.966

8
LAW OF ONE PRICE
  • With free trade, identical goods will tend toward
    a single, worldwide price (adjusted for
    transportation costs, duties, etc.)
  • t t t
  • P P X
  • d f

9
PURCHASING POWER PARITY
  • If the Law of One Price Holds in all periods
  • t1 t1 t1
  • P P X
  • d f
  • t t t
  • P P X
  • d f

10
PURCHASING POWER PARITY
  • t1
  • X
  • 1infl (1infl )
  • d f t
  • X
  • or
  • t1 t (1infl )
  • X X d
  • (1infl )
  • f

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