9.1: The Functions of the Foreign Exchange Market

Question 1

What is an exchange rate?

Answer 1

An exchange rate is the rate at which one currency is converted into another. For example, how many Japanese yen can be obtained for one US dollar.

Question 2

How do changes in the value of currencies impact global businesses?

Answer 2

Changes in currency values can significantly affect the sales and profits of global businesses.

For instance, if a currency depreciates, it can lead to foreign exchange losses for importers in that country, while an appreciation can hurt exporters.

Question 3

Why is it important for managers to understand the foreign exchange market?

Answer 3

Understanding the foreign exchange market is crucial for managers because changes in exchange rates can fundamentally impact an enterprise’s sales and profits, influencing business strategy and operations.

Question 4

Can future exchange rates be perfectly predicted?

Answer 4

No, future exchange rates cannot be perfectly predicted, which introduces risks in international trade and investment.

Question 5

How did the change in the value of the U.S. dollar against the euro between 2001 and 2017 affect international business?

Answer 5

The U.S. dollar’s value fell against the euro from 2001 to early 2014, making American goods cheaper in Europe and boosting U.S. exports, but making European goods more expensive in the U.S. However, from 2015 to 2017, the dollar’s value rose, making American exports to the euro zone more expensive.

Question 6

: What is the relationship between the international monetary system and the foreign exchange market?

Answer 6

The international monetary system provides the institutional structure within which the foreign exchange market functions.

Changes in this system can profoundly influence the development of foreign exchange markets.

Question 7

What is foreign exchange risk?

Answer 7

Foreign exchange risk refers to the uncertainties and potential financial losses that arise from volatile changes in exchange rates.

Question 8

Can the foreign exchange market provide complete insurance against foreign exchange risk?

Answer 8

No, the foreign exchange market cannot provide complete insurance against foreign exchange risk. International businesses can still suffer losses (or gains) due to unanticipated changes in exchange rates.

Question 9

How do currency fluctuations impact international trade and investment?

Answer 9

Currency fluctuations can significantly alter the profitability of international trade and investment deals, making profitable deals unprofitable and vice versa.

Question 10

What are the main types of foreign exchange transactions?

Answer 10

The main types of foreign exchange transactions are

spot exchanges,
forward exchanges,
and currency swaps.

Question 11

What is a spot exchange?

Answer 11

A spot exchange involves the immediate exchange of currencies at current market rates.

Question 12

What is a forward exchange?

Answer 12

A forward exchange involves the exchange of currencies at a specified rate at a future date, providing a hedge against foreign exchange risk.

Question 13

What is a currency swap?

Answer 13

A currency swap is an agreement to exchange currency in the future, which involves swapping principal and interest in one currency for the same in another currency.

Question 14

What happens when a country’s currency is not convertible?

Answer 14

When a country’s currency is not convertible, it means it cannot be exchanged for other currencies, which complicates foreign trade and can limit a country’s participation in the global market.

Question 15

What are the two main functions of the foreign exchange market?

Answer 15

The two main functions of the foreign exchange market are

2) 1) to convert the currency of one country into the currency of another, and

2) to provide some insurance against foreign exchange risk, which arises from unpredictable changes in exchange rates.

Question 16

What is foreign exchange risk?

Answer 16

Foreign exchange risk refers to the adverse consequences that can result from unpredictable changes in exchange rates.

Question 17

Why are exchange rates critically important in the global economy?

Answer 17

Exchange rates are critically important because they affect the price of every country’s imports and exports, influence foreign direct investment decisions, and indirectly impact people’s spending behaviors.

Question 18

What is meant by the term “currency war”?

Answer 18

A “currency war” refers to a situation where countries compete against each other to achieve a relatively lower exchange rate for their own currency, often through government policies, to gain a trade advantage.

Question 19

What are the implications of a country intentionally devaluing its currency?

Answer 19

Intentional devaluation of a country’s currency can make its exports cheaper to foreigners, potentially leading to higher exports and job creation in the export sector.

However, it can also lead to international trade tensions and accusations of unfair trade practices.

Question 20

What are the main uses of foreign exchange markets for international businesses?

Answer 20

International businesses use foreign exchange markets for:

2) 1) converting foreign earnings to their home currency,
2) paying for foreign products or services in the local currency,
3) investing spare cash in foreign money markets,
4) engaging in currency speculation.

Question 21

What is currency speculation in the context of foreign exchange markets?

Answer 21

Currency speculation involves the short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.

Question 22

What is the carry trade?

Answer 22

The carry trade involves borrowing in one currency with low interest rates and investing in another currency where interest rates are higher.

The profit is the difference in interest rates, minus transaction costs, but it’s subject to the risk of exchange rate fluctuations.

Question 23

How does currency conversion work in a practical scenario, like tourism?

Answer 23

In tourism, currency conversion allows a tourist to exchange their home currency for the local currency of the country they are visiting, as local prices are quoted in the local currency.

For example, a U.S. tourist in Scotland must convert dollars to British pounds to make purchases.

Question 24

What factors influence the profitability of investing in foreign money markets?

Answer 24

The profitability of investing in foreign money markets depends on the interest rates offered and the changes in the value of the invested currency against the investor’s home currency during the investment period.

Question 25

How did the dollar/yen carry trade change in importance from the mid-2000s to 2016?

Answer 25

The dollar/yen carry trade, significant in the mid-2000s, declined in importance during 2008-09 due to falling interest rate differentials as U.S. rates decreased.

However, by late 2016, it became important again due to negative interest rates in Japan and rising rates in the U.S.

Question 26

What is hedging in the context of gold production?

Answer 26

Hedging in gold production involves strategies to lock in prices for gold to protect against potential future price fluctuations.

It’s a way for gold producers to manage financial risk related to gold price movements.

Question 27

Why can the language used to describe exchange rates be confusing?

Answer 27

The language can be confusing because it describes a changing relationship between two currencies, each with its own exchange rate. This dual aspect of exchange rates can make the terminology seem complex.

Question 28

What does it mean when it is said that a currency is “strengthening”?

Answer 28

When a currency is said to be “strengthening,” it means that its value is increasing relative to another currency.

For example, if the euro is strengthening against the dollar, it means that one euro can buy more dollars than before.

Question 29

What does it mean when a currency is “weakening” or becoming “cheaper”?

Answer 29

A currency is “weakening” or becoming “cheaper” when its value is decreasing relative to another currency.

For instance, if the dollar is weakening against the euro, it means that one dollar can buy fewer euros than before.

Question 30

How should one interpret the statement “the euro gains against the dollar”?

Answer 30

The statement “the euro gains against the dollar” means that the value of the euro is increasing in comparison to the dollar. From a dollar perspective, the euro is becoming more expensive or dearer.

Question 31

What is the mirror image of a currency gaining strength?

Answer 31

The mirror image of a currency gaining strength is the other currency in the pair weakening. For example, if the euro is gaining against the dollar, the mirror image is that the dollar is weakening against the euro.

Question 32

What is a “petrocurrency” and how does it apply to the Canadian dollar?

Answer 32

A “petrocurrency” is a currency of a country whose value is heavily influenced by the price of raw materials, such as oil and natural gas, that it exports.

The Canadian dollar is increasingly recognized as a petrocurrency, with its value correlated to the price of oil.

Question 33

Why do Canadian businesses often use currencies other than the Canadian dollar for international transactions?

Answer 33

Canadian businesses often use currencies like the U.S. dollar, yen, euros, or Swiss francs for international transactions because these are more universally accepted and help avoid concerns related to fluctuations in the value of the Canadian dollar.

Question 34

How do exchange rate fluctuations affect small Canadian businesses exporting to the United States?

Answer 34

Small Canadian businesses exporting to the United States can be highly susceptible to exchange rate fluctuations.

A rise in the Canadian dollar can increase the cost for U.S. consumers, potentially damaging export-related profits.

Question 35

How do large Canadian companies manage the issue of currency fluctuations in international business?

Answer 35

Large Canadian companies typically operate internationally through established accounts in major currencies like U.S. dollars, making them less concerned about fluctuations in the Canadian dollar.

They may make an initial currency conversion, but afterwards, the state of the Canadian dollar has little impact on their foreign transactions.

Question 36

What is the purpose of hedging in the context of foreign exchange?

Answer 36

Hedging in foreign exchange is a strategy used by firms to protect against the risk of unpredictable changes in exchange rates that could have adverse financial consequences.

Question 37

What is a spot exchange rate?

Answer 37

A spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day, for immediate transactions.

Question 38

How do spot exchange rates change?

Answer 38

How do spot exchange rates change?
A: Spot exchange rates change continually based on the demand and supply of currencies. If the demand for a currency increases or its supply decreases, its value will likely appreciate relative to other currencies.

Question 39

What is a forward exchange rate?

Answer 39

A forward exchange rate is the rate agreed upon for a currency exchange that will occur at a future date.

It is used in forward exchange transactions, where two parties agree to exchange currencies on a specific future date.

Question 40

How do forward exchange rates provide insurance against foreign exchange risk?

Answer 40

Forward exchange rates provide insurance against foreign exchange risk by locking in a specific rate for a future transaction, thus protecting the firm from potential adverse changes in the exchange rate.

Question 41

What does it mean when a currency is selling at a discount or a premium in the forward market?

Answer 41

A currency is selling at a discount in the forward market if its forward exchange rate is lower than the spot exchange rate, indicating expectations of depreciation.

It is selling at a premium if its forward exchange rate is higher than the spot rate, indicating expectations of appreciation.