A person holding a net asset position (a long position)or a net liability position(a short position)in a foreign currency is exposed to exchange rate risk. The value of the person’s income or net worth will change if the exchange rate changes in a way that the person does not expect. Hedging is the act of balancing your assets and liabilities in a foreign currency to become immune to risk resulting from future changes in the value foreign currency to become immune to risk resulting from future changes in the value foreign currency to become immune to risk resulting from future changes in the value of foreign currency. Speculating means taking a long or a short position in a foreign currency, thereby gambling on its future exchange value. There are a number of ways to hedge or speculate in foreign currency.A forward exchange contract is an agreement to buy or sell a foreign currencyFor future delivery at a price (the forward exchange rate) set now. Forward foreign exchange contracts are useful because they provide a straightforward way to hedge anexposure to exchange rate risk or to speculate in an attempt to profit from future spotexchange rate values. An interesting hypothesis that emerges from the use of the for-ward market for speculation is that the forward exchange rate should equal the average expected value of the future spot rate.International financial investment has grown rapidly in recent years. Investment inforeign-currency assets is more complicated than domestic investment because of theneed for currency exchanges, both to acquire foreign currency now and to translatethe foreign currency back in the future. If the rate at which the future sale of foreigncurrency will occur is locked in now through a forward exchange contract, we havea hedged or covered international investment. If the future sale of foreigncurrency will occur at the future spot rate, we have an uncovered internationNinvestment, one that is exposed to exchange rate risk and therefore speculative.As a result of covered interest arbitrage to exploit any covered interestdifferentiaf between the returns on domestic and covered foreign investments, weexpect that covered interest parity will exist (as long as there are no actual orthreatened government restrictions on international money flows). Covered interestparity states that the percentage by which the forward exchange value of a currencyexceeds its spot value equals the percentage point amount by which its interest rate islower than the other country's interest rate. For countries with no capital controtsand for comparable short-term financial assets, covered interest parity holds almostperfectly when actual rates are examined empirically.At the time of the investment, the expected overall return on an uncovered interna-tional investment can be calculated using the investor's expected future spot exchangerate. The overall expected return on the uncovered international investment can becompared to the return available at home. The expected uncovered interestdifferential is one factor in deciding whether to make the uncovered international invest-ment. Exposure to exchange rate risk must also be considered in the decision. If this riskis of little or no importance, then we hypothesize that uncovered interest pariW willexist. The expected rate of appreciation of a currency should equal the percentage pointamount by which its interest rate is lower than the other country's interest rate. Uncovered interest parity is not easy to test or examine empirically using actual rates, because wedo not directly know the expected future spot rate or the expected rate of appreciation. Itappears that uncovered interest parity is useful as a rough approximation, but it does notapply almost perfectly. Rather, exchange rate risk appears to be of some importance, and investors' expectations or forecasts of future spot exchange rates appear to be somewhat biased. (A similar conclusion is that, empirically, the forward exchange rate is a rough but somewhat biased predictor of the furore spot exchange rate.)This chapter has surveyed what we know (and don’t know ) about determinants of exchange rate .the asset market approach explains exchange rates as being part of equilibrium for the markets for financial assets denominated in different currencies . we gain insights into short-run movements in exchange rate by using a variant of the asset market approach that focuses on portfolio repositioning by international investors, especially decisions regarding investments in bonds denominated in different currencies .If uncovered interest parity tends to hold (at least approximately), then any changes in domestic or foreign interest rates (i and it) or the expected future spot exchange rate (ee~) create an uncovered interest differential and also create pressures for a return toward uncovered interest parity. Focusing on the pressures on the current spot exchange rate e, the price of foreign currency, it tends to be raised by:An increase in the interest rate differential (is-i).An increase in the expected future spot exchange rate (ee~)Changes in the expected future spot exchange rate tend to be self-confirmingexpectations in that the current spot rate tends to change quickly in the directionexpected. Furthermore, there appear to be several types of influences on the expectedfuture spot exchange rate, including recent trends in the actual spot rate, beliefs thatthe exchange rate eventually moves toward its PPP value, and unexpected new infor-mation ("news") about economic performance or about political situations. The rapidlarge reaction of the current exchange rate to such news as a change in monetarypolicy is called overshooting~ The current exchange rate changes by much morethan would be consistent with long-run equilibrium.Our understanding of the long-run trends in exchange rates begins withpurchasing power parity (PPP), Absok~te PPP posits that international competi-tion tends to equalize the home and foreign prices of traded goods and services so thatP = e ~ Pj. overall, where the Ps are price levels in the countries and e is the exchangerate price of foreign currency. Relative PPP focuses on the product-price inflationrates in two countries and the change in the exchange rate that offsets the inflation-rate difference. Relative PPP works tolerably well for longer periods of time, say, a decadeor more. Over the long run, a country with a relatively high inflation rate tends to havea depreciating currency, and a country with a relatively low inflation rate tends to havean appreciating currency.The monetary approach seeks to explain exchange rates by focusing ondemands and supplies for national moneys, since the foreign exchange market is where one money is traded for another. The transactions demand for a national money can be expressed as k ~ P ~ Y, a behavioral coefficient (k) times the price level (P) times the level of real domestic product (Y). The equilibrium M' = k ~ P ~ Y matches this demand against the national money supply (M'), which is controlled by the central bank's monetary policy. A similar equilibrium holds in any foreign country: Mz!' = kz ~ Ps. Y,.Combining the basic monetary equilibriums with PPP yields an equation for pre- dicting the exchange rate value of the currency of a foreign country; e = (M'/Mj~:) ~ (Yj/Y) ~ (k/k) Ignoring any changes in the ks, we can use this equation to predict that ' f "the price of foreign currency (e) is raised by:o An increase in the relative size of the money supply (3a'/MT).An increase in the relative size of foreign production (Yj./Y).Furthermore, the elasticities of the impact of (M'/Mf) and (Yz/Y) on e should approxi- mately equal 1.We would like to be able to use economic models to predict exchange rates inthe future, but our ability to do so is limited. Economic models provide almost no ability to predict exchange rates for short periods into the future, say, about a yearor less. This inability is based largely on the importance of unpredictable news asan influence on short-term exchange rate movements, but it may also reflect therole of expectations that extrapolate recent trends in the exchange rate, leading to bandwagon effects and (speculative) bubbles. We have some success in predict-ing exchange rate movements in the long run. Over long periods, exchange ratestend to move toward values consistent with such economic fundamentals as relative money supplies and real incomes (the monetary approach) or, similarly, relativeprice levels (PPP).We also presented four ways of measuring the exchange-rate value of a currency. The nominal bilateral e~change rate is the regular market rate between two currencies. The r~omi_~aJ effective exchange rate is a weighted average of the market rates across a number of foreign currencies. The real bilatera~ e~changerate incorporates both the market exchange rate and the product price levels for two countries. The rea~ effective excharNe rate is a weighted average of real bilateral exchange rates across a number of foreign countries. A real exchange rate can be used as an indicator of deviations from PPP or as an indicator of a country's international price competitiveness.。