Modern Financial Systems: Theory and Applications

CHAPTER 13

Exchange Rates and Markets

This chapter examines exchange rates, the markets in which exchange rates are established, and the institutions that affect those markets. Theoretical benchmarks for international price and interest rate relations are established mainly under assumptions of no arbitrage opportunities, that is, under the neoclassical paradigm. Hence the chapter begins by examining benchmarks for effective exchange rates, the Fisher relation, interest rate parity, purchasing power parity, and forward parity. The chapter next examines foreign exchange trading, including spot and forward transactions, the role of the dealing banks, covered interest arbitrage, and the carry trade. It also discusses management issues in managing foreign currency risk, including the use of currency and interest swaps, both short- and long-term, and the evolution of international risk trading. Finally, the chapter considers exchange rate management at the macroeconomic level, examining exchange rate systems, central bank intervention, the European Monetary System, the Euro, and the European Central Bank.

INTRODUCTION

Chapter 11 described securities markets, and Chapter 12 described markets for trading risks, noting that many of the transactions described are international in scope. This chapter considers additional international influences on asset pricing, both short- and long-term. It first considers the theory of exchange rate relationships, then the workings of the foreign ...