CGMA BA1 Fundamentals of Business Economics - The financial system: banks and foreign exchange

Question 1

What is the primary responsibility of a central bank?

Answer 1

To maintain the stability of the national currency and money supply.

Question 2

What is a commercial bank?

Answer 2

A bank that engages in financial transactions with customers, including loans, deposits, and investments.

Question 3

How do commercial banks create credit?

Answer 3

Banks lend out a portion of deposited funds, keeping only a fraction as reserves, allowing more money to circulate in the economy.

Question 4

What is a reserve ratio?

Answer 4

The percentage of customer deposits that a bank keeps in reserves rather than lending out.

Question 5

What are the four main functions of money?

Answer 5

Store of value – Money can be saved and used later.
Unit of account – Used to measure and compare the value of goods/services.
Medium of exchange – Facilitates trade and transactions.
Standard of deferred payment – Used to settle future debts and obligations.

Question 6

How do you calculate total increase in deposits?

Answer 6

Initial deposit / Cash ratio

Question 7

What is the capital adequacy ratio?

Answer 7

A measure ensuring banks hold sufficient capital to cover their risk-bearing assets.

Question 8

Which organization sets capital adequacy requirements for banks?

Answer 8

The Bank of International Settlements (BIS)

Question 9

What is the impact of a stronger £ relative to the $?

Answer 9

UK consumers can buy US goods more cheaply.
US consumers find UK goods more expensive.

Question 10

How does the exchange rate affect business competitiveness?

Answer 10

A strong currency makes exports more expensive and imports cheaper, affecting trade.

Question 11

What is a SPOT exchange rate?

Answer 11

A SPOT exchange rate is an exchange rate that is quoted for immediate delivery of the relevant currency

Question 12

What is a Forward exchange rate?

Answer 12

A FORWARD exchange rate is a rate that can be agreed on now for delivery of a currency at a particular date in the future.

Question 13

What is an indirect quote from the UK perspective?

Answer 13

A quote showing how many units of a foreign currency ($) can be obtained for one unit of the home currency (£).

Question 14

What is a direct quote from the UK perspective?

Answer 14

A quote showing how many units of the home currency (£) can be obtained for one unit of a foreign currency ($).

Question 15

What is the relationship between direct and indirect exchange rates?

Answer 15

Direct quote = 1 ÷ Indirect quote.

Question 16

What is an exchange rate spread?

Answer 16

The difference between the buying (bid) and selling (offer) price of a currency.

Question 17

What happens if UK interest rates increase relative to US interest rates?

Answer 17

Demand for £ increases as investors switch funds to take advantage of higher returns in the UK.

Question 18

How does an increase in demand for £ affect the exchange rate?

Answer 18

The £ strengthens (appreciates) relative to the $.

Question 19

Why do banks adjust forward exchange rates?

Answer 19

To prevent investors from making risk-free (arbitrage) profits by converting currencies at a favorable rate now and reversing the transaction later.

Question 20

How does arbitrage work in foreign exchange markets?

Answer 20

Investors exploit differences in interest rates and exchange rates to make risk-free profits.

Question 21

What is the Interest rate parity formula?

Answer 21

Forward Rate = spot rate * (1 + Interest rate ($) / 1+ Interest Rate (£))

Question 22

What is the Purchasing power parity formula?

Answer 22

Future Spot Rate = Current Spot Rate * (1+ Inflation rate / 1 + inflation rate)

Question 23

What is the balance of payments in simple terms?

Answer 23

The balance between a country’s exports and imports of goods and services.

Question 24

What happens if a country imports more than it exports?

Answer 24

More money flows out than in, leading to a weakening of the currency due to higher demand for foreign currency.

Question 25

What are the two main ways a government can influence the exchange rate?

Answer 25

Directly by buying and selling currency using foreign reserves. Indirectly by changing domestic interest rates.

Question 26

What is a free-floating exchange rate?

Answer 26

A system where market forces alone determine the exchange rate, with no government intervention.

Question 27

What is a managed (dirty) floating rate system?

Answer 27

A system where the government intervenes to keep the exchange rate within an acceptable range using currency reserves.

Question 28

What is a fixed exchange rate (XR) system?

Answer 28

A system where the government maintains the exchange rate at a set value using currency reserves.

Question 29

What is a "moveable peg" system?

Answer 29

A fixed exchange rate system that allows periodic revaluation or devaluation of the currency.

Question 30

What is a currency board?

Answer 30

A system where a country fixes its currency’s value to a stronger currency and holds 100% reserves in that currency.

Question 31

What is a currency bloc?

Answer 31

A group of countries that fix their exchange rates against a major currency to promote stability and trade.

Question 32

Why do countries form currency blocs?

Answer 32

To facilitate trade and create stability within the group by linking to a major trading partner’s currency.

Question 33

What are the advantages of a floating exchange rate system?

Answer 33

No government intervention, saving time and effort on policies. Natural equilibrium is achieved through supply and demand.

Question 34

What are the disadvantages of a floating exchange rate system?

Answer 34

High potential volatility, leading to increased foreign exchange (FX) risk. Large swings in exchange rates can cause instability in the balance of payments.

Question 35

What is the main advantage of a fixed exchange rate system?

Answer 35

It creates certainty for international trade by maintaining stable exchange rates.

Question 36

What is the main disadvantage of a fixed exchange rate system?

Answer 36

The government must implement policies (e.g., adjusting interest rates, taxes, and spending) to maintain the exchange rate.

Question 37

What is a single currency zone?

Answer 37

A single currency zone involves multiple countries adopting a single currency, such as the euro in the EU, to simplify trade and economic integration.

Question 38

What is an advantage of a single currency zone?

Answer 38

One advantage is reduced currency conversion costs and easier, more transparent trading between member countries.

Question 39

What is a disadvantage of a single currency zone?

Answer 39

A disadvantage is that it is hard to ensure monetary policy (e.g., interest rates) is suitable for all countries, especially if they are at different stages in their economic cycles.

Question 40

What is a benefit of a single currency zone in terms of exchange rates?

Answer 40

A single currency zone removes exchange rate risk, eliminating fluctuations in currency value between member countries.

Question 41

What is a major drawback of a single currency zone in terms of individual policies?

Answer 41

A major drawback is the reduced ability of member countries to adopt individual policies that suit their specific economic needs.

Question 42

What is transaction risk?

Answer 42

Exchange rate movements between the time of the transaction and its settlement can change the transaction's value.

Question 43

What is economic risk?

Answer 43

Economic risk is the risk a business faces when trading in a specific country, where the performance of that economy can affect future cash flows and exchange rates, influencing the present value of expected future income.

Question 44

What is translation risk?

Answer 44

Translation risk is the risk a business faces when it holds assets and/or liabilities in a non-native currency.

Question 45

What does "hedging" mean in the context of risk management?

Answer 45

Hedging refers to the process of protecting against potential risks

Question 46

What are the two main types of hedging techniques?

Answer 46

The two main types of hedging techniques are internal and external techniques.

Question 47

What is the internal hedging technique of invoicing customers in your home currency?

Answer 47

Invoicing customers in your home currency shifts the exchange risk to the customer.

Question 48

What does "leading and lagging" refer to in hedging?

Answer 48

Leading and lagging involves either getting customers to pay earlier (offering discounts) or delaying payments to suppliers to take advantage of favorable exchange rates.

Question 49

How does the "matching receipts and payments" internal hedging technique work?

Answer 49

This technique involves matching incoming payments from customers in one currency (e.g., USD) with payments to suppliers in the same currency.

Question 50

What is a forward contract in external hedging?

Answer 50

A forward contract is an agreement with a bank that fixes the exchange rate for a future transaction.

Question 51

What is money market hedging?

Answer 51

Money market hedging involves borrowing or lending money in the money markets to match an overseas transaction, thus eliminating transaction risk.

Question 52

What is a futures contract in external hedging?

Answer 52

A futures contract is a standardized agreement to convert a fixed amount of one currency into another at a set future date. It’s similar to a forward contract, but futures are tradable and can be bought or sold before maturity.

Question 53

How does an option work in flexible hedging?

Answer 53

An option allows protection against adverse exchange rate movements by paying a premium upfront.