Forex equilibrium
International Finance Theory and Policy b y Steven M. An alternative graphical approach is sometimes used to depict the equilibrium exchange rate in the foreign exchange market FOREX. The graph is called the rate of return diagram since it depicts rates of return for assets in two separate countries as functions of the exchange rate. The equilibrium condition depicted in the diagram equilibrium the interest rate parity condition. In effect, the diagram identifies the equilibrium exchange rate that must equilibrium to satisfy the interest rate parity condition. Recall the rate of return formulae for deposits in two separate countries. Consider an investor, holding US dollars, comparing the purchase of a one-year certificate of forex at a US bank with a one-year CD issued by a British or UK bank. The rate of return on the US deposit works out simply to be the US interest rate, shown below. In its simplest form it is written as follows. Recall from that the exchange rate ratio represents the expected percentage change in the value of the pound. Suppose, as an example, that this term were positive. That would mean the investor believes the pound will appreciate during the term of the investment. Furthermore, since it is an expected appreciation of the pound, it will add to the total rate of return on the British investment. Assuming forex paribus, as we always do in these exercises, the expected exchange rate remains fixed. That will mean the numerator of the exchange rate expression will fall in value, forex will the value of the entire expression. The interpretation of this change is that the equilibrium expected appreciation of the pound falls, which, in turn, lowers the overall rate of return. This exchange rate is an equilibrium because any deviations away from interest rate parity IRP will motivate changes in investor behavior and force the exchange back to the level necessary to achieve IRP. The equilibrium adjustment story is next. International Finance Theory and Policy - Chapter FOREX Equilibrium with the Rate of Return Diagram An alternative graphical approach is sometimes used to depict the equilibrium exchange rate in the foreign exchange market FOREX. Finance Finance Chapter 5 Chapter 6 Chapter 10 Chapter 20 Chapter 30 Chapter 40 Chapter 50 Chapter 60 Chapter 70 Chapter 80 Chapter 90 Chapter Chapter
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