2 Flashcards
what is the nominal exchange rate?
it is the relative price of 2 currencies
what is depreciation?
a currency depreciation is a decrease in the value of the currency relative to another currency
a depreciated currency means that it is more or less valuable?
a depreciated currency is less valuable: it can be exchanged for (can buy) a smaller amount of foreign currency
what happens to the nominal exchange rate when the currency depreciates?
it increases, because you are gonna need more dollars to get one of the other currency
the nominal exchange rate USD/euro increases. what does this mean for both currencies?
the dollar depreciates while the euro appreciates
what is appreciation?
a currency appreciation is an increase in the value of a currency relative to another
an appreciated currency is more or less valuable?
it is more valuable: it can be exchanged for (can buy) a larger amount of foreign currency
the nominal exchange rate USD/euro decreases. what does this mean for both currencies?
the dollar appreciates while the euro depreciates
an depreciated CAD dollar means that imports are more or less expensive for canadian consumers?
imports are more expensive
an depreciated CAD dollar means that CAD exports are more or less expensive for foreign consumers ?
CAD exports are less expensive for foreign consumers
an depreciated CAD dollar means that for CAD investors, purchasing foreign assets is more or less profitable ?
purchasing foreign assets is less profitable
an depreciated CAD dollar means that for CAD investors, selling foreign assets is more or less profitable ?
selling foreign assets is more profitable
an depreciated CAD dollar means that for foreign investors, selling CAD assets is more or less profitable ?
selling CAD assets is less profitable
an depreciated CAD dollar means that for foreign investors, purchasing CAD assets is more or less profitable ?
purchasing CAD assets is more profitable
an appreciated CAD dollar means that for CAD investors, purchasing foreign assets is more or less profitable ?
purchasing foreign assets is more profitable
an appreciated CAD dollar means that for CAD investors, selling foreign assets is more or less profitable ?
selling foreign assets is less profitable
an appreciated CAD dollar means that for foreign investors, selling CAD assets is more or less profitable ?
selling CAD assets is more profitable
an appreciated CAD dollar means that for foreign investors, purchasing CAD assets is more or less profitable ?
purchasing CAD assets is less profitable
what are the 2 main exchange rate regimes?
- flexible exchange rate (floating regimes)
- fixed exchange rates (pegs)
what defines a flexible exchange rate?
- exchange rate fluctuates in a wide range
- gvnmt (central bank) makes no attempt to fix the exchange rate against any base currency
- appreciations and depreciations can occur at any time
what defines a fixed exchange rate?
- exchange rate fluctuates in a narrow range (or not at all) against some base currency
- central bank intervenes in the foreign exchange market to implement and maintain the peg
what are the various types of fixed exchange rates?
- dollarization
- currency board
- peg with horizontal bands
- crawling bands (managed floating)
what is dollarization (fixed)?
one country unilaterally adopts the currency of another country (no separate legal tender)
what is currency board (fixed)?
legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. domestic currency is issued only against foreign exchange, eliminating bank functions like the control of money supply
what is peg with horizontal bands (fixed)?
the exchange rate is maintained within certain margins of fluctuation around a fixed central rate
what is crawling bands (managed floating - fixed)?
the exchange rate fluctuates within a band; the band is periodically adjusted (in relatively small steps - adjustments may not be automatic)
the monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target
what is a currency union?
union members share the same currency
a single central bank is accountable to the member nations (eurozone)
what is the Forex market?
it is a global decentralized market for currency trading
who are the main players of the forex market and their functions?
- commercial banks: buying/selling deposits in different currencies
- corporations
- nonbank financial institutions: buy/sell foreign assets for investment
- central banks: official international reserves transactions
who are the most important players in the forex market?
commercial and investment banks
what is arbitrage?
it is a trading strategy that exploits any profit opportunities arising from price differences, it means buying low and selling high
What implies no arbitrage on currencies across markets?
the integration of financial markets implies no arbitrage on currencies across markets
what are spot rates?
exchange rates for currency exchanges ‘‘on the spot’’: trading is executed in the present
what are forward rates?
exchange rates for currency exchanges that will occur at a future forward date, typically 30, 90, 180 or 360 days in the future. the rate is set in the present, but the exchange occurs in the future
T o F: spot and forward exchange rates move closely
True
why using forward exchange rates?
to hedge exchange rate risk
what is foreign exchange swaps?
a combination of a spot sale with a forward repurchase
ex: exchange USD for euros today with a promise to repurchase USD in 3 months
what are future contracts?
obligation to purchase or sell currency on a specific settlement date in the future; future contracts can be bought and sold in financial markets
what are options contracts, currency call option?
owner has the right to buy currency at a specified strike price within a specified period of time
what are options contracts, currency put option?
owner has the right to sell currency at a specified strike price within a specified period of time
what are the 3 factors that influence the demand for domestic or foreign assets?
- expected real return
- riskiness of the asset
- liquidity of the asset
what is the nominal rate of return (R) ?
it is the percentage change in the value of an asst during a given time period
what is the real rate of return (r) ?
it is the inflation-adjusted rate of return - the amount of G&S that can be purchased with earnings from the asset
how do you calculate the real rate of return (r)?
r = R - inflation rate
how does risk affect assets?
2 assets can have the same expected return but very different risk (preference depends if you are risk averse)
how does liquidity affect assets?
it is the ease of using the asset to buy G&S (how quickly you can transform your asset into cash)
how do we call the future date on which the currencies are actually exchanges?
the value date
T o F: forward and spot rates are not equal on the value date
F: forward and spot exchange rates move closely and are equal on the value date
how do we call the spot sale of a currency combined with a forward repurchase of the currency?
a foreign exchange swap
according to the interest rate parity, the dollar rate of return on euro deposits is
approximately the euro interest rate plus the rate of depreciation of the dollar against the euro
if the dollar interest rate is 10% and 6% pour the euro, then an investor should be indifferent between dollars and euros if…
if the expected dollar depreciation against the euro is 4%
what effect does a depreciation of the domestic currency today has on the expected rate of return on foreign deposits?
a depreciation of domestic currency today lowers the expected rate of return on foreign currency deposits
what effect does a depreciation of the domestic currency today has on the initial cost of investing and the expected rate of return of the foreign currency deposit?
depreciation of domestic currency = initial cost of investing in foreign currency deposits increases = lowers the expected rate of return of foreign currency deposits
what effect does a appreciation of the domestic currency today has on the initial cost of investing and the expected rate of return of the foreign currency deposit?
appreciation of domestic currency = initial cost of investing in foreign currency deposits decreases = increases the expected rate of return of foreign currency deposits
what happens when the dollar interest rate increases?
the demand for US$ deposits increases, therefore the dollar appreciates to restore interest rate parity condition (exchange rate decreases) and the expected return on euro deposits increases
what happens when the euro interest rate increases?
the demand for euro increases, therefore it appreciates while the dollar depreciates = exchange rate increases
what happens when there is an expected appreciation of the euro?
the euro appreciates to day because the expected rate of return on euro deposits increases since foreigners will get more dollars per euro invested, therefore the interest rate parity condition implies the euro appreciates today to restore
what is the most important factor determining the willingness to hold currency deposits?
expected rates of return
T o F: an expected appreciation of a currency leads to an actual appreciation today
true
what influences rates of return on currency deposits?
interest rates and expected exchange rates
what principle maintains equilibrium in the foreign exchange market?
interest rate parity; expected returns on deposits in domestic and foreign currency are equal
what does an increase in the interest rate of a currency leads to?
it leads to an increase in its expected rate of return and to a currency appreciation
what does an expected currency appreciation leads to ?
it leads to an increase in the expected return for that currency, leading to a currency appreciation
what is the principle of carry trade?
making profit from an interest rate differential by borrowing (go short) low interest rate currencies and buy (go long) high interest rate currencies)
what is the problem if carry trade yields a profit?
systematically-profitable carry trade is not compatible with the interest parity condition (carry trade is exploiting arbitrage opportunities)
why interest parity may not hold systematically in the data (reasons why interest rate parity might fail)?
- risk premium
- systematic forecast errors about the expected exchange rate
- transaction costs
- capital controls
what is the risk associated to carry trade?
you collect small profits but take large losses when high interest rate currencies suddenly depreciate
what does the covered interest rate parity implies?
it implies that the return on dollar deposits and ‘‘covered’’ foreign currency deposits (using forward exchange rate) are the same
what is the difference between the uncovered interest parity (UIP) and the covered interest parity (CIP)?
UIP is computed using the expected exchange rate while the CIP is computed using the forward exchange rate
when can both UIP and CIP hold?
UIP and CIP can both hold if the forward rate quoted today is equal to the spot rate people expect to materialize in the future
illustrate the interest rate parity
illustrate the effect of a rise in the dollar interest rate on the interest rate parity
illustrate the effect of a rise in the euro interest rate on the interest rate parity condition
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