TAILIEUCHUNG - Lecture International economics: Chapter 12 - Hendrik Van den Berg

Chapter 12 - The foreign exchange market. After studying this chapter you will be able to: Review the historical development of foreign exchange markets; explain how the foreign exchange rate reflects the demand and supply of goods, services, and assets, and the other flows that make up the balance of payments; explain geographic arbitrage, triangular arbitrage, and intertemporal arbitrage. | The Foreign Exchange Market The foreign exchange market is a market in national moneys; the exchange rate is the price. (Robert Aliber) The Goals of This Chapter Review the historical development of foreign exchange markets. Explain how the foreign exchange rate reflects the demand and supply of goods, services, and assets, and the other flows that make up the balance of payments. Explain geographic arbitrage, triangular arbitrage, and intertemporal arbitrage. Introduce the spot and forward foreign exchange markets and derive the interest parity condition. Explain foreign exchange risk and how to hedge risk. Describe effective exchange rates. The Foreign Exchange Market Most international transactions require the exchange of national currencies. Foreign Exchange Markets are the markets where the many different national currencies are exchanged. Changing foreign exchange rates add to the risk of many foreign transactions. In markets where the forces of supply and demand are free to drive the prices of currencies, the exchange rates are said to float. Some countries try to fix the value of their currencies at some target rate, often by by selling or buying currencies in the foreign exchange markets to neutralize shifts in supply and demand. The Evolution of the Foreign Exchange Market Markets for foreign exchange have operated for over two thousand years, ever since there have been distinct national moneys. Early money changers carefully weighed and examined coins in order to determine their true gold or silver content. The development of modern banking brought the exchange of bills rather than actual coins made of precious metals. With the exchange of paper, money changers had to consider the reputation of the banks that issued the paper. The Evolution of the Foreign Exchange Market The advent of paper or fiat money made the job of the money changer much more difficult and increased the risk of holding different national moneys. The relative value of each fiat money

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