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Pine Street Capital Essay

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Foreign Exchange and Carry Trade Market

“A Model to Estimate Foreign Exchange”

Student: CARLOS ESCOBAR

Professor: Garen Markarian

1. Introduction

The foreign exchange market is the largest financial market and also one of the deepest and most volatile, given that it is through this market that a large part of international business and capital flow takes place and also because it is used by central Banks and governments to execute their monetary policies.

Additionally, different types of exchange rates are extremely sensitive to market information and expectations, which explains this market’s volatility and the difficulty in making predictions for it. Factors such as fiscal balances, interest rates, stock markets, commodity markets, and the volatility of the global markets, as well as various other factors, affect exchange rates and the way that they are assumed by the participants in the capital market.

The development of derivative instruments has contributed to the growth of this market and has allowed new participants, who do not have access to physical currency, to take part on it. They take part on it through the derivatives market, either for hedging or speculation purposes, benefitting also from the leverage that characterizes derivatives.

The main objective of this paper is to identify the variables that determine the Chilean Peso/Dollar (CLP/USD) spot parity and Brazilian Real/Dollar (BRL/USD) spot parity, within the context of strategies known as “Carry Trade”, which attempt to take advantage of the differences between interest rates of various countries. The paper is based on the Chilean and Brazilian markets, using the exchange rates parity of Chilean Peso/Dollar and the Brazilian Real/Dollar, and the intersection between both of them. For this, an econometric model will be used in order to determine the relevance of a group of selected explaining the variations in the currencies mentioned. This objective is sustained...

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