2.8 Currency Exchange Rates

Question 1

Purchasing power parity (PPP)

Answer 1

asserts nominal exchange rates will adjust, so identical baskets of goods have the same real price in different countries

–> In practice, PPP rarely holds because baskets are not identical across countries and trade barriers exist.

Question 2

While FX markets facilitate international trade in goods and services, the dominant transactions in FX markets are from what?

Answer 2

capital transactions

Question 3

Spot transactions

Answer 3

used to exchange currencies immediately

Question 4

Forward transactions

Answer 4

agreements to exchange currencies further in the future

Question 5

Most FX transactions are done through what?

Answer 5

forward contracts, FX swaps, and FX options

Question 6

forward contract

Answer 6

the specific date, amount, and exchange rate are set on the trade date

Question 7

difference between futures contract and forward contract

Answer 7

futures contract has the following:

• Trade on exchanges rather than in the over-the-counter (OTC) market
• Have standardized terms, such as amounts and settlement dates
• Require collateral to be posted and are marked-to-market at the end of each trading day

Question 8

An FX swap

Answer 8

a simultaneous spot and forward transaction

The swap transactions can extend existing forward positions to later dates

Rolling the position forward leads to cash flow on the settlement date

FX swaps are also used to convert funding from one currency into another.

Question 9

FX options

Answer 9

give the right (not obligation) to make an FX transaction in the future

A fee must be paid upfront to purchase this option.

Question 10

The buy-side of FX Markets can be broken down into several categories:

Answer 10

• Corporate accounts – purchases and sales of goods and services; investment flows
• Real money accounts – investment funds managed by entities like insurance companies and mutual funds; restricted in the use of leverage
• Leveraged accounts – entities like hedge funds and commodity trading advisers that engage in active trading for profit
• Retail accounts – includes exchanging currency at the airport kiosk and small electronic trading accounts
• Governments – could be transactional or following policy goals

-= Central banks – sometimes intervene to protect the domestic exchange rate

• Sovereign wealth funds (SWFs) – used by countries with large current account surpluses to hold capital flows rather than reserves managed by central banks

Question 11

The sell-side of FX Markets can be broken down into several categories:

Answer 11

composed of major multinational banks (e.g., Deutsche Bank, Citigroup)

With their economies of scale, IT expertise, and global client bases, these tier-one banks are able to offer the most competitive FX quotes

Regional and local banks act as sell-side participants as well, but to a much lesser degree than larger banks.

Question 12

the world’s three largest FX trading market

Answer 12

London

New-York

Tokyo

Question 13

A Japanese company seeking to hedge the exchange rate risk attributable to a large USD-denominated payment expected from an American customer in six months would most likely:

A
sell USD in the spot market.

B
buy JPY in the forward market.

C
buy USD in the forward market.

Answer 13

B
buy JPY in the forward market.

Because the Japanese company is expecting a payment denominated in USD, it has long USD exposure. If the company does not hedge this exposure, it will suffer in the event that the USD depreciates relative to the JPY over the next six months. This exposure can be hedged by entering a forward contract to sell USD and buy JPY.

Question 14

A direct quote

Answer 14

uses the domestic country for the price currency and the foreign country for the base currency

Investor in the Eurozone:

Direct quote: EUR/GBP = 1.25 (1 GBP costs 1.25 Euro).

Question 15

An indirect quote

Answer 15

the reciprocal of the direct quote

Investor in the Eurozone:

Indirect quote: GBP/EUR = 1/1.25 = 0.80 (1 Euro costs 0.80 GBP).

Question 16

The bid

Answer 16

represents the price at which the bank will buy the base currency

Banks profit by buying at the bid price and selling at the offer price

Question 17

the offer

Answer 17

represents the price at which the bank will sell

Banks profit by buying at the bid price and selling at the offer price

Question 18

points (or “pips”)

Answer 18

present the difference between the forward rate quote and the spot rate quote

Question 19

forward premium for the base currency

Answer 19

when the forward rate is greater than the spot rate

the points are positive

Question 20

a forward discount for the base currency

Answer 20

If the points are negative

Question 21

A forward premium indicates:

A
an expected increase in demand for the base currency.

B
the interest rate is higher in the base currency than in the price currency.

C
the interest rate is higher in the price currency than in the base currency.

Question 22

A country’s exchange rate regime

Answer 22

s the policy framework adopted by its central bank.

Question 23

The ideal currency regime would have the following properties:

how are these unrealistic

Answer 23

1. Exchange rates between currency pairs are credibly fixed.
2. All currencies would be fully convertible (i.e., unrestricted capital flows).
3. Each country undertakes an independent monetary policy for domestic objectives.

these three properties are inconsistent with each other. If the first two were true, different currencies would be interchangeable like coins and bills of the same currency. Under such conditions, the impact of using lower interest rates as part of an independent monetary policy would be offset by capital outflows. Similarly, attempts to raise interest rates would be rendered ineffective by capital inflows. Therefore, it is not possible to achieve the ideal currency regime.

Question 24

the Smithsonian Agreements

Answer 24

In 1973, the Smithsonian Agreements put an end to the Bretton Woods system, and the world moved to a system of flexible exchange rates

Question 25

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.

Answer 25

1. Arrangements with No Separate Legal Tender
2. Currency Board System
3. Fixed Parity
4. Target Zone
5. Active and Passive Crawling Pegs
6. Fixed Parity with Crawling Bands
7. Managed Float
8. Independently Floating Rates

Question 26

A currency board system (CBS)

Answer 26

a legislative commitment to fix the exchange rate with a specified foreign currency.

The foreign currency is held as a reserve to back the entire monetary base.

Hong Kong is an example of a CBS backed by US dollar reserves.

Unlike dollarization, a currency board system allows the monetary authority to earn a profit (called seigniorage) on the spread between the interest earned on assets (reserves) and the minimal interest paid on its liabilities (the monetary base).

Question 27

Fixed parity differs from CBS in two ways

Answer 27

First, there is no legislative commitment to maintain a fixed exchange rate.

Second, the foreign exchange reserves’ target level is discretionary rather than linked to the domestic money supply.

Question 28

Target zone regimes

Answer 28

fixed-rate parity regimes with wider bands (up to ± 2%). This gives the monetary authority more latitude.

Question 29

Active and Passive Crawling Pegs

Answer 29

Under this regime, exchange rates are adjusted frequently to keep pace with inflation.

The approach is active if the adjustment is announced in advance.

This helps the monetary authority influence inflation rates.

Question 30

Fixed Parity with Crawling Bands

Answer 30

This regime allows a country to wean off a fixed parity system gradually (e.g., starts from ± 1%, then ± 2%, then ± 3%, and so on).

Question 31

Managed Float

Answer 31

In this approach, a country bases its exchange rate policy on internal or external policy targets.

Question 32

Independently Floating Rates

Answer 32

This regime allows the market to determine the exchange rate and the monetary authority to carry out an independent monetary policy.

Most major currencies use this approach, although some government intervention is still present.

Question 33

the J-curve effect

Answer 33

happens because there is a lag on ordered goods that already have a specified price

the impact of a currency devaluation is felt with a lag