KEY POINTS

1. The exchange rate in a country is the price of a unit of foreign currency expressed in terms of the home currency. This price is determined in the spot market for foreign exchange.
2. When the home exchange rate rises, less foreign currency is bought/sold per unit of home currency; the home currency has depreciated. If home currency buys x% less foreign currency, the home currency is said to have depreciated by x%.
3. When the home exchange rate falls, more foreign currency is bought/sold per unit of home currency; the home currency has appreciated. If home currency buys x% more foreign currency, the home currency is said to have appreciated by x%.
4. The exchange rate is used to convert the prices of goods and assets into a common currency to allow meaningful price comparisons.
5. Exchange rates may be stable over time or they may fluctuate. History supplies examples of the former (fixed exchange rate regimes) and the latter (floating exchange rate regimes), as well as a number of intermediate regime types.
6. An exchange rate crisis occurs when the exchange rate experiences a sudden and large depreciation. These events are often associated with broader economic and political turmoil, especially in developing countries.
7. Some countries may forgo a national currency to form a currency union with other nations (e.g., the Eurozone), or they may unilaterally adopt the currency of another country (“dollarization”).
8. Looking across all countries today, numerous fixed and floating rate regimes are observed, so we must understand both types of regime.
9. The forex market is dominated by spot transactions, but many derivative contracts exist, such as forwards, swaps, futures, and options.
10. The main actors in the market are private investors and (frequently) the government authorities, represented usually by the central bank.
11. Arbitrage on currencies means that spot exchange rates are approximately equal in different forex markets. Cross rates (for indirect trades) and spot rates (for direct trades) are also approximately equal.
12. Riskless interest arbitrage leads to the covered interest parity (CIP) condition. CIP says that the dollar return on dollar deposits must equal the dollar return on euro deposits, where forward contracts are used to cover exchange rate risk.
13. Covered interest parity says that the forward rate is determined by home and foreign interest rates and the spot exchange rate.
14. Risky interest arbitrage leads to the uncovered interest parity (UIP) condition. UIP says that when spot contracts are used and exchange rate risk is not covered, the dollar return on dollar deposits must equal the expected dollar returns on euro deposits.
15. Uncovered interest parity explains how the spot rate is determined by the home and foreign interest rates and the expected future spot exchange rate.