(A) Draw a Demand Curve for Foreign Exchange (Spot Foreign

question 18

Essay

(a) Draw a demand curve for foreign exchange (spot foreign exchange) by a home country and briefly indicate why the curve has a downward slope. Then draw an upward-sloping supply curve of foreign exchange to that country. (You do not need to explain why it is upward-sloping.) Then indicate the equilibrium exchange rate in this spot market and briefly explain why the market moves to this equilibrium position.
(b) Define the "forward market" for foreign exchange, draw a demand curve and supply curve for the forward market, and indicate the equilibrium forward exchange rate.Assume that the equilibrium forward exchange rate is identical to the equilibrium spot exchange rate in part (a) of this question.
(c) Into this situation where the spot and exchange rates are equal, now suppose that, for whatever reason, short-term interest rates suddenly rise in the home country while they do not change in foreign countries. In the context of covered interest arbitrage, what forces are set in motion and what will happen to the spot and forward exchange rates because of this change in domestic interest rates? Carefully explain.

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