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Review Session. Functions of Money Medium of Exchange Store of Value Unit of Accounting.

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Presentation on theme: "Review Session. Functions of Money Medium of Exchange Store of Value Unit of Accounting."— Presentation transcript:

1 Review Session

2 Functions of Money Medium of Exchange Store of Value Unit of Accounting

3 Examples of Exchange Rates (1/29/13) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

4 Examples of Exchange Rates (4/30/13) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

5 The Basic Relationship (FA is a financial asset; RA is a real asset)  MUmoney P  MUFA 1 P 1  MUFA 2 P 2    MUFA n P n  MURA 1 P 1  MURA 2 P 2    MURA n P n

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7 And $1 buys 5 bags of good stuff Then $1 = DKK 5 And DKK 1 = $ 0.20

8 Now, suppose $1 buys 2 bags of better stuff

9 And €1 buys 3 bags of the better stuff Then €1 = $1.50 And $1 = € 0.67

10 Cross Rate Example: New York London Brussels $1 = £ 0.60 €1 = $1.50 £ 1 = € 1.15 $1,035,000 - $1,000,000 = $35,000 £ 600,000 € 690,000 Dollar Weakens Pound Weakens Dollar Strengthens $1,000,000 Would be equilibrium if €1 = £0.90

11 Generic Currency Arbitrage: Same Time New York London Brussels Requires three locations and means of exchange Exchange rate

12 Generic Currency Arbitrage: Across Time FRA today 2 locations, 2 dates NY today FRA later %i or prices NY later %i or prices Means for transition Exchange rate

13 Lessons Learned from Currency Arbitrage: Interest Rate Parity –Real rate same for every currency Purchasing Power Parity –A Dollar (or Euro, or Pound, or Franc, etc.) buys same stuff in every country (except for cost of transport)

14 Yield Curve Upward sloping yield curve Flat yield curve Downward sloping yield curve R Convexity R R

15 Generic Rate Arbitrage: No Coupon Day 90 Initial TimeDay 120 Requires three dates and means of transfer across time Interest rate or derivative Interest rate

16 Generic Interest Rate Arbitrage: Different Coupons C (Example: 8%) C–x (Example: 6%) C+x (Example: 10%) Requires three equally-spaced coupons, with prices out of balance Price too high Sell two bonds Buy one of each

17 Generic Interest Rate Arbitrage: Different Coupons C (Example: 8%) C–x (Example: 6%) C+x (Example: 10%) Requires three equally-spaced coupons, with prices out of balance Price too low Buy two bonds Sell one of each

18 Generic Interest Rate Arbitrage: Same Coupon, Different Maturities M (Example: 7 yrs) M–x (Example: 6 yrs) M+x (Example: 8 yrs) Requires three equally-spaced maturities, with prices out of balance Price too high (YTM too low) Sell two bonds Buy one of each

19 Generic Interest Rate Arbitrage: Same Coupon, Different Maturities M (Example: 7 yrs) M–x (Example: 6 yrs) M+x (Example: 8 yrs) Requires three equally-spaced maturities, with prices out of balance Price too low (YTM too high) Buy two bonds Sell one of each

20 Lessons Learned from Bond Arbitrage: Yield curve behavior must be monotonous in any currency –If upward sloping anywhere, must be upward sloping overall –If downward sloping anywhere, must be downward sloping overall –Slope must gradually move toward zero at ever diminishing rate until curve becomes flat –Once curve becomes flat, it must remain flat –There can be no kinks in the curve Yield curves for different risk classes (say, AAA versus junk) –may rest at different risk levels, –but quality gap must be same overall

21 Lessons Learned from Bond Arbitrage: Yield curves may have different shapes for bonds in different currencies, but –Once bond prices are adjusted for forward currency exchange rates, yield curves must have same shape –Once bond prices are adjusted for forward currency exchange rates, quality gap must be same overall Derivatives can be very useful in managing interest rate risk Interest rate derivatives must conform to the shape of the yield curve

22 Questions for discussion: What is the marginal utility of money? What is the price of money? What is the marginal utility of a financial asset? What is the marginal utility of a real asset? Consider the ratio of marginal utility to price. What does it mean for this ratio to be the same for all financial assets and real assets in the world?

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24 Examples of Exchange Rates (9/3/09) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc1.062 $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

25 Examples of Exchange Rates (11/20/09) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

26 Examples of Exchange Rates (9/2/11) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥

27 A Helpful Concept: Arrow-Debreu Securities Arrow-Debreau securities: –One of these pays a dollar if a specific state of the world occurs at a specific time, –but pays nothing otherwise –(a lottery ticket also works this way, but covers a very limited span of events)  MUmoney P  MUFA 1 P 1  MUFA 2 P 2    MUFA n P n  MURA 1 P 1  MURA 2 P 2    MURA n P n

28 Examples of Exchange Rates (11/28/11) Direct Quotes (U.S. Perspective) Swiss Franc CHF 1 = $ Euro € 1 = $ British Pound £ 1 = $ Japanese Yen ¥ 1 = $ Indirect Quotes Swiss Franc $1 = CHF Euro $1 = € British Pound $1 = £ Japanese Yen $1 = ¥


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