Exchange Rates

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Exchange Rates the Foreign Exchange Market
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An exchange rate is the price of one currency in
terms of another

• If were thinking of (say) dollars per yen, this
  is a direct exchange rate.
• The opposite (indirect exchange rate) is the
  inverse yen per dollars, for example.

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Simple Arithmetic
The arithmetic of exchange rates is simple. If
we know the direct dollar to pound rate is 1.50,
a sweater costing 50 must equal 1.5 (/ ) x
50 75 In plain English Fifty pounds at 1.5
dollars per pound equals seventy five dollars.
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Depreciation

• When the direct exchange rate goes down, the
  currency has depreciated.
• Among other things, this makes imports more
  expensive and exports more competitive.
• Depreciation of a currency can be equated with
  weakness of the country itself. This is
  particularly true for smaller countries.

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Prices and Exchange Rates

• Prices convey per unit information
• Exchange rates convey per information
• An exchange-rate-weighted ratio of a domestic to
  foreign price, then, conveys units per unit
  information a pure relative price.

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Example

• (5/ )x(50/sweater)/(25/jeans)
• (250/sweater)/(25/jeans)
• (250/sweater)x(jeans/25)
• (jeans/sweater)x(250/25)
• 10 jeans/sweater
• In words at an exchange rate of 5 per , if a
  sweater costs 50 and jeans cost 25, 10 pairs of
  jeans are worth one sweater.

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Foreign Exchange Markets Major Participants

• Commercial Banks holding deposits denominated in
  various currencies
• Corporations
• Nonbank Financial Institutions such as pension
  funds and trading houses
• Central banks

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Foreign Exchange Markets Characteristics

• International
• Operates 24/7
• Subject to Arbitrage (i.e. the law of one
  price)
• Largely uses US as a vehicle or key currency
  (i.e. not subject to barter)

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Foreign Exchange Markets
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