3.1 The Foreign Exchange Market

Question 1

What is the Foreign Exchange Market?

Answer 1

Market for converting currency of one country into that of another country

Question 2

What is the rate at which one currency is converted into another

Answer 2

Exchange Rate

Question 3

Foreign exchange market provides some _____ against _______, a risk that arise from such volatile changes in exchange rates.

Answer 3

insurance; foreign exchange risk

Question 4

Two (2) main functions of the Foreign Exchange Market

Answer 4

(1) Convert the currency of one country into the currency of another
(2) Provide some insurance against forex risk

Question 5

Enumerate the businesses uses of forex market

Answer 5

(1) convert payments received for its exports, income from foreign investments, or income received from licensing agreements with foreign firms
(2) make payment to a foreign company for its products or services in its country’s currency
(3) invest cash for short terms in foreign money markets
(4) engage in currency speculation

Question 6

____ typically involves the short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates

Answer 6

Currency speculation

Question 7

______ involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another country where interests are high

Answer 7

Carry trade (a kind of speculation)

Question 8

What is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day?

Answer 8

Spot exchange rates
- it changes continually
- value determined by supply and demand

Question 9

Transaction where two parties agree to exchange currency and execute the deal immediately

Answer 9

Spot exchange

Question 10

Transaction where two parties agree to exchange currency and execute the deal at some specific date in the future

Answer 10

Forward exchange
- exchange rates governing such future transactions are forward exchange rates
- usually quoted for 30, 90, and 180 days

Question 11

It is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Answer 11

Currency Swaps

Question 12

Who mostly engages in currency swaps when it is desirable to move out of one currency into another for a limited period without incurring forex risk?

Answer 12

(1) international businesses and their banks
(2) between banks
(3) between governments

Question 13

What is a common type of currency swap?

Answer 13

Spot against forward

Question 14

What is arbitrage?

Answer 14

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy

Question 15

Describe the nature of the Forex Market

Answer 15

(a) Global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

(b) Continues to grow rapidly

(c) Most important trading centers are London (largest), New York, Zurich, Tokyo, and Singapore

(d) A market is open 24 hours a day
High-speed computer linkages among trading centers around the globe have effectively created a single market
* can profit through arbitrage

(e) most transactions involve the dollar

Question 16

The three factors that have an important impact on future exchange rate movements in a country’s currency

Answer 16

(1) country’s price inflation
(2) interest rate
(3) market psychology

Question 17

What determines the exchange rates?

Answer 17

Demand and supply of one currency relative to the demand and supply of another

Question 18

What do the future exchange rate movements influence?

Answer 18

(1) export opportunities
(2) profitability of international trade and investment deals
(3) price competitiveness of foreign imports

Question 19

Describe The Law of One Price.

Answer 19

In competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

Question 20

Describe Purchasing Power Parity.

Answer 20

It is the comparison of prices of identical products determine the real or PPP exchange rate.

An efficient market has no impediments to the free flow of goods and services

The price of a “basket of goods” should be roughly equivalent in each country

Question 21

Describe Money Supply and Price Inflation

Answer 21

The growth rate of a country’s money supply determines its likely future inflation rate

• Inflation is when the money supply increases faster than output increases
• An increase in the money supply makes it easier to borrow, which increases demand for goods and services
• When the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled.

Question 22

Interest Rates and Exchange Rates.
In countries where inflation is expected to be high, interest rates will be __________. (high or low)

Answer 22

High because investors want more compensation for the decline in the value of their money

Question 23

Describe the Fisher Effect.

Answer 23

It states that nominal interest rates (i) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of the time for which the funds are to be lent (pi).

Interest rates reflect expectations about likely future inflation rates

i = r + pi

If the real interest rate is the same worldwide, any difference in interest rates between countries, reflects differing expectations about inflation rates

Question 24

Describe the Bandwagon Effect.

Answer 24

It is where traders move like a herd all in the same direction and at the same time, in response to each other’s perceived actions.

Can be both triggered and exacerbated by the idiosyncratic behavior of politicians

Question 25

Investor psychology and bandwagon effects play an important role in ____.

Answer 25

determining short-run exchange rate movements

Question 26

Two schools of thought addressing the forecasting of exchange rate

Answer 26

(1) Efficient Market School
(2) Inefficient Market School

Question 27

Describe the Efficient Market School.

Answer 27

(a) Efficient market is when prices reflect all available public information

(b) Forward exchange rates should then be unbiased predictors of future spot rates

*Inaccuracies will be random

Question 28

Describe the Inefficient Market School

Answer 28

(a) Inefficient market is when prices do not reflect all available information

(b) Forward exchange rates will not be the best possible predictors of future spot exchange rates

Question 29

Describe the Fundamental Analysis

Answer 29

(a) it is an approach to forecasting

(b) it draws on economic theory to construct sophisticated economic models for predicting exchange rate movements

(c) it includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance-of-payments positions

Question 30

Describe Technical Analysis

Answer 30

(a) An approach to forecasting

(b) Uses price and volume data to determine past trends, which are expected to continue

(c) There are analyzable market trends and waves that can be used to predict future trends and waves

(d) Has gained favor in recent years

Question 31

Enumerate and describe the three (3) forms of currency convertibility.

Answer 31

(1) Freely convertible
- Government allows both residents and nonresidents to purchase unlimited amounts of foreign currency

(2) Externally convertible
- Only residents can convert their holdings of domestic currency into foreign currency without any limitations

(3) Nonconvertible
-Neither residents nor nonresidents are allowed to convert it into a foreign currency

Question 32

Why do governments limit convertibility of their currency?

Answer 32

To preserve their foreign market reserves.

Question 33

What is capital flight?

Answer 33

It occurs when there is a rush to convert domestic currency to foreign currency

*most likely to occur when domestic currency value is depreciating rapidly

Question 34

How do companies deal with non convertibility?

Answer 34

They engage in countertrade

Countertrade refers to a range of barter-like arrangements by which goods and services can be traded for other goods and services.

Question 35

Enumerate and describe the three Forex Rate Risks.

Answer 35

(1) Transaction exposure - extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

(2) Translation exposure - impact of currency exchange rate changes on a company’s reported financial statements. It is concerned with the present measurement of the past events

(3) Economic exposure - extent to which a firm’s future international earning power is affected by changes in exchange rates. It is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs

Question 36

Enumerate the ways to reduce translation and transaction exposure.

Answer 36

(1) Forward exchange rate contracts
(2) Buying swaps
(3) Lead strategy
(4) Lag strategy

Question 37

Describe how a company could reduce its economic exposure.

Answer 37

Distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates

Question 38

Enumerate the other steps for managing foreign exchange risk

Answer 38

(1) Need central control of exposure to protect resources efficiently and ensure subunits to adopt correct mix of tactics and strategies

(2) Distinguish between transaction and translation exposure and economic exposure

(3) Need to forecast future exchange rate movements

(4) Establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions

(5) Produce monthly foreign exchange exposure reports.