5014 - Finance of International Trade - Determinants of Exchange Rates p81 - 98

Question 1

If there is a lot of demand and limited supply then…

Answer 1

Prices are High

Question 2

If there is a lack of demand and a lot of supply then…

Answer 2

Prices are Low

Question 3

Exchange Rates are primarily influenced by…

Answer 3

Supply and Demand for a currency

Question 4

Governments role in exchange rates

Answer 4

Governments are active in buying and selling making it more and less scarce depending on the countries goals

Question 5

Factors that impact the desire to invest in a currency (demand)

Answer 5

• Economic and Political stability of the country
• Interest rate of the country
• Expectation and speculation

Question 6

Purchasing Power Parity Theory in Context

Answer 6

If I can buy an item for £100 in the UK and $140 in the US, the rate should be £1 = $1.40

But, if the actual exchange rate is £1 = $1.50 you would have $0.10 left

In time either the price of the item will rise or the rate of exchange will fall to meet this discrepancy

Question 7

Interest Rate Parity Definition

Answer 7

Theory according to which the interest rate differential between 2 countries is equal to the differential between the forward and spot exchange rate

Question 8

Interest Rate Parity in Context

Answer 8

UK interest = 5%
German Interest Rate = 6%

At face value - you could take out a loan in the UK at 5% and invest it at 6% and make a risk free return. But if it was that easy everyone would do it but exchange rates change

Question 9

Interest Parity Condition

Answer 9

When the
FX market is in equilibrium and deposits of currencies offer the exact same expected rate of return. Can be expressed with a formula mentioned later

Question 10

Covered Interest Rate Parity

Answer 10

Refers to a theoretical condition in which the relation between interest rates and spot + forward currency

Question 11

Covered Interest Parity - Forward Rates

Answer 11

You won’t know the exchange rate in 1 years time but you could ask for a forward rate. This condition is referred to as ‘‘covered’’ as we have covered ourselves by selling the currency forward

Question 12

Uncovered Interest Parity

Answer 12

Waiting to exchange rather than taking out ‘cover’ by using a forward rate so you are not covered by a pre-booked rate rather the future spot rate which could be anything.

Question 13

Inflation and Exchange Rates: The Fisher Effect

Answer 13

• If a country’s inflation rate increases relative to its trading partners, then the country’s current account balance is likely to decrease

Higher Inflation = Higher Prices = Cheaper Imports and more expensive exports - Think SPICED but any currency

Imports increase and exports decline

The increased supply of the currency to pay for imports will drive down its value

Question 14

SPICED Anagram

Answer 14

Strong
Pound
Imports
Cheap
Exports
Dear

Question 15

Fisher Effect Definition

Answer 15

An economic theory describing the relationship between inflation and both real and nominal interest rates.

States:
The REAL interest rate equals the NOMINAL interest rate minus EXPECTED inflation rate

Question 16

Scenario: Strong Dollar

Answer 16

• Attracts capital to the US and increases demand as investors seek a strong currency
• Makes imports cheaper, forces domestic producers of goods with import substitutes to lower prices
• Lowers domestic cost of living and inflation

Question 17

Scenario: Weak Dollar

Answer 17

• US products would be more-competitive globally and exports would increase
• To meet increased demand for US products both at home and abroad, production will go up, increasing employment and stimulating growth
• However, you need to watch out for inflation as domestic firms increase prices on good facing weak foreign competition