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Reference | Title | Link |
Bauer College (2010c) | Lecture Notes: Exchange Rates, Interest Rates, Prices and Expectations | here |
Summary
"This chapter presents simple models of exchange rate determination. These models apply arbitrage arguments in different contexts to obtain equilibrium relations that determine exchange rates. In this chapter, we define arbitrage as the act of simultaneously buying and selling (or borrowing and lending) the same or equivalent assets or commodities for the purpose of locking in a sure, known profit. This known profit is independent of expectations, uncertain events or states of nature. Financial markets are said to be inequilibrium if no arbitrage opportunities exist.
The equilibrium relations derived in this chapter are called parity relations. Because of the underlying arbitrage argument, parity relations establish situations where economic agents are indifferent between two financial alternatives. Thus, parity relations provide an “equilibrium” value or a “benchmark.” These benchmarks are very useful. For example, based on a parity benchmark, investors or policy makers can analyze if a foreign currency is “overvalued” or “undervalued.”" |
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