5 The Financial System: Banks and Foreign Exchange

Question 1

What are the type and categories of banks?

Answer 1

Banks => central and commercial banks => Retail banks & Wholesale banks & investment banks

Question 2

What is the central bank?

Answer 2

This is the entity responsible for the monetary policy of its country. Primary responsibility is to maintain stability of the national currency & money supply. Active duties involve:

1. Controlling subsidised-loan interest rates, and
2. Acting as a “bailout” lender of last resort to the banking sector during times of financial crisis
3. Supervisory powers, ensure banks and other financial institutions do not behave recklessly
4. Managing foreign currency reserves

Most countries = state-owned and minimal degree of autonomy.

Question 3

What are commercial banks?

Answer 3

Involved with making commercial transactions with customers. E.g. -

1. Clearing banks
2. Retail banks
3. Wholesale banks
4. Investment banks/merchant banks

Due to merger & acquisition activity => some banks offer range of services

Question 4

What is the influence of commercial banks?

Answer 4

1. Provide safe place to keep wealth
2. Act as a financial intermediary
3. Facilitate payments made via cheque (clearing system)
4. Lending via overdrafts/loans
5. Foreign exchange dealing
6. Other services

Question 5

What is credit creation?

Answer 5

• Banks can create credit in an economy. They do not keep cash reserves that match the value of all customer deposits.

Question 6

What are the 4 main functions of money?

Answer 6

1. Store of value (save it for later)
2. Unit of account (used in pricing goods and services)
3. Medium of exchange (facilitates the trading process)
4. Standard of deferred payment (determines value of future payments e.g. on loans)

Question 7

What is the formula to calculate the value of the increase in deposits?

Answer 7

intial deposit/ cash ratio = increase in deposits

• Sometimes govt determines to the banks what cash ratio they need to hold.

{1/cash ratio} is sometimes referred to as the CREDIT MULTIPLIER

=> increase in deposits = initial deposit x credit multiplier

Question 8

What is the capital adequacy ratio?

Answer 8

• Banks have to have a minimum amount of capital held to cover risks
• Laid down by Bank of International Settlements (BIS) via capital adequacy ratio

Question 9

What is the foreign exchange market?

Answer 9

Where converting of currencies from one to another takes place. Includes:
1. When individuals travel/ do business abroad or when companies’ trade with other companies => convert currency
2. if £ strengthens relative to the $ => relatively cheaper for consumers in the UK to buy goods from US
3. XR has direct effect on competitiveness of firms
4. Free market XR set by interaction between demand
& supply of currency

LOOK AT GRAPH ON PG 56

Question 10

What is a spot exchange rate?

Answer 10

This is an XR quoted for immediate delivery of relevant currency

Question 11

What is a forward exchange rate?

Answer 11

An XR that can be agreed on now for delivery of currency in particular date in the future

Question 12

What are the two different types of exchange rate quotations?

Answer 12

1. Indirect quote - showing how many units from UK perspective can be bought with the US dollar - what can be obtained for a single unit of the £
2. Direct quote - From UK perspective, how many units of the £ (home currency) can be obtained from a single unit of the $

DIRECT QUOTE = 1 / INDIRECT QUOTE

Question 13

What is the exchange rate spread?

Answer 13

Normally quoted as a bid-offer spread, reflects different rates that currency markets are offering for either buying or selling a currency.

• Margin rates are where financial institutions make their money
• $/£ 1.9825 - 2.0015
• Above, the dollar is the variable currency.
• Bank will buy at high rate and sell at low rate (BUY HIGH, SELL LOW)

Question 14

How do interest rates influence the exchange rates?

Answer 14

• If UK interest rates increase relative to others => increase in demand for £s as investors switch funds to £ to take advantage of the more attractive investment opportunity
  => strengthening of the spot rate of £ to $
  => $ to £ forward rates adjusted by banks to avoid investors making risk free profits from converting currencies now and making risk free profit at a later date on the forward rate.

LOOK AT EXAMPLE ON PAGE 58

Question 15

What is the formula for estimating forward spot rate and interest rates in two countries (interest parity formula)?

Answer 15

Forward rate ($/£) = spot rate ($/£) x 1 + $ interest rate/ 1 + £ interest rate

Question 16

How does inflation influence the XR?

Answer 16

• erodes the buying power of money
• if one country has higher inflation than another => buying power within country with higher inflation being eroded away faster than that of lower inflation country
• WEAKENING of currency in the high inflation country

Question 17

What is the purchasing power parity formula?

Answer 17

Future spot rate (yen/£) = current spot rate (yen/£) x 1+Yen inflation rate/ 1 +£ inflation rate

Question 18

What influence does the balance of payments have on the XR?

Answer 18

= balance between exporting and importing of goods and services. If importing more than exporting -> more money flowing out of country than is coming in
=> weakening of the currency as greater demand to switch funds to out of home currencies

Question 19

What influence does speculation of on the XR?

Answer 19

Speculators = ppl who seek to make gains by trading in currencies in expectation of certain XR movements.
- If buying and selling currencies in large enough quantities, actions can influence a whole market
- If currency is going to strengthen, can buy it and then sell it at a gain when it has strengthened.
E.g. George Soros

Question 20

What is XR management?

Answer 20

The approach a govt takes in relation to exchange rates and how they are influenced and used as economic tools

Question 21

What is a free floating XR?

Answer 21

An XR system that involves no intervention at all by govt

• market forces dictate XR and govt doesn’t use any currency reserves to influence
• Retain some degree of certainty of XR - govt intervene by using currency reserves to keep XR at acceptable level. = MANAGED FLOATING RATE SYSTEM

Question 22

What are the two ways a govt can influence the XR?

Answer 22

1. Directly buy and sell currency using foreign currency reserves
2. Indirectly via ability to change the level of domestic interest rates

Question 23

What is a fixed XR system and what types can you get?

Answer 23

= Fixed and zero fluctuation allowed - fixed against a benchmark e.g. gold or major other currency e.g. US dollar

1. Moveable Peg system = periodic revaluation of currency - doesn’t cater for small movements
2. Currency board = fixes value of nation’s currency at specific fixed rate to that of a stronger currency
   - Member country has to hold currency reserves to cover 100% of local currency
3. Currency bloc = number of country’s fix their XR’s against a major currency. Facilitate trading between them and other countries in the bloc

Question 24

What are the advantages and disadvantages of floating XR system?

Answer 24

ADS:

1. No govt intervention => save time and effort on forming policies
2. Natural equilibrium arrived at through D & S

DISADS:

1. Greatest potential volatility in XR’s => higher FX risk
2. Large swings in XR => big movements in b of p and instability

Question 25

What are the advantages and disads of fixed XR system?

Answer 25

ADS:
1. Creates certainty for international trade

DISADS:
1. Govt will have to implement policies solely to keep the XR at its set level

Question 26

What is a single currency zone?

Answer 26

E.g. adopted by dozen of EU members => have a single currency. Members have similar economic outlooks and goals.
- Less flexible economic policies

Question 27

What are the advantages and disadvantages of a single currency zone?

Answer 27

ADS:

1. Reduced currency conversion costs and easier/more transparent trading between member countries
2. Wider availability of financing within zone
3. Removes XR risk

DISADS:

1. Hard to ensure monetary policy is right for everyone esp if countries facing diff stages of economic cycles
2. Reduced ability to adopt individual policies

Question 28

What are the two main international trade risks?

Answer 28

1. Credit risk (letters of credit, credit insurance, credit guarantees)
2. Foreign Exchange Risk:
   a) Transaction Risk (use of internal or external hedging techniques)
   b) Economic Risk (have customers in a wide range of countries)
   c) Translation Risk (accounting issue, try to match assets and liabilities in same currency)

Question 29

What is the credit risk?

Answer 29

• Risk that a debtor does not pay on time.
• A company engaging in international trade should ensure they have their internal credit control procedures in a suitable way (credit checks, terms of trade, credit control function, aged debtor reporting)

Question 30

What is the transaction risk in foreign exchange?

Answer 30

• Risk that business is exposed when entering into short term transaction involving credit in foreign currency.
• By the time the transaction has been completed - XR may have changed & value of transaction changed.

Question 31

What is the economic risk in foreign exchange?

Answer 31

• Business exposed to when trading in country - affected by economic performance of the economy.
• Present value of company’s expected future cash flows influenced by performance of an economy => consequential XR’s.
  E.g. if American company selling to UK vs UK supplier selling to UK => if the $ weakens => more attractive for UK client to buy from US dollar => UK supplier suffered reduction in future cash flows due to longer-term movement in XR.

Question 32

What is translation risk in foreign exchange?

Answer 32

• Risk a business is exposed to when it holds assets and/or liabilities in a non-native currency.
• End of financial yr these have to be translated into native currency to be included in the yr end a/c’s.
• These yr end values likely to => book losses or gains.
• Generally no impact here on cash flows of the firm.

Question 33

What is the hedging transaction risk?

Answer 33

• process of RISK MANAGEMENT. Techniques can be internal or external.

Question 34

What are examples of the hedging internal techniques?

Answer 34

1. Invoice customers in your home currency = not poplr with clients as passing all XR onto them. Could use stable 3rd currency => both parties take some of the risk
2. Leading and Lagging = Getting customers to pay earlier or delaying paying suppliers, to take advantage of expected favourable XR’s. Maybe interest rate to consider.
3. Matching receipts and payments = if you have receipts in $ - consider buying supplies from US - match timing of receipts with payments to suppliers in $ and no conversion of currency will have to take place. Have a $ bank a/c which money can flow through.

Question 35

What are examples of hedging external techniques which involve fixed contracts?

Answer 35

1. Forward contracts - Contract with bank which fixes the XR that will be used on the future transaction today => transaction risk is being taken by the bank, for a fee.
2. Money Market Hedging - borrowing or lending money in the money markets to match overseas transactions & eliminate transaction risk (‘home-made’ forward contract)
3. Futures Contracts - standardised contracts to convert a fixed amount of one currency into another at a fixed future date. Similar to the forward contract except futures are tradable.

Question 36

What are examples of hedging external techniques which involve flexible contracts?

Answer 36

1. Options - protect against adverse movements in the XR.
   - Pay upfront premium to set worse case scenario XR. If XR moves in your favour - you do not have to exercise your option.
   - If rates move against you the option will be exercised and you use the agreed XR
   - Similar to insurance contracts, paying a premium in case you have an accident. If accident happens => make a claim, otherwise you will not.