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Chapter 11
Real Exchange Rate = Nominal Exch. Rate Foreign Countrys Price Level
Home Countrys Price Level
o better indication
of purchasing
power of dollar
o increase in real
exchange rate
will make it
more difficult for
U.S. firms to
compete
Arbitrage
o exchange arbitrage simultaneous purchase
and sale of currency in different foreign
exchange markets in order to profit from
exchange rate differential in two locations
o two or three point arbitrage possible
assume: 1 = $1.50; 1 = 4 francs; 1 franc = $0.50
sell $1.5 million for 1 million
sell 1 million for 4 million francs $500,000 profit
sell 4 million francs for $2 million
o such transactions shift supply & demand for
currencies eliminating opportunities for profits
and establishing consistent exchange rates
Forward Market