Chapter 10 Flashcards by Rachana Dugar

What affects exchange rates?

Trade deficit/surplus
Trade policies

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What is the exchange rate?

Price of currency stated in terms of a second currency

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What is appreciation?

Currency becomes more valuable; foreign currency costs less

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What is depreciation?

Currency becomes less valuable’ foreign currency costs more

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What is the flexible exchange rate system?

Values change daily

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What is the fixed exchange rate system?

Value of their currency is fixed and does not move in value

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Why do people hold foreign currency?

Trade and investment purposes
Interest rate arbitrage
Speculation

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What is trade and investment in currencies?

Traders, investors and travellers routinely transact in foreign currencies

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What is interest rate arbitrage?

Financial arbitrageurs borrow money where interest rates are low and lend it where the rates are high
They kept Japanese yen strong

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What is speculation?

Speculators buy or sell currency because they expect prices to rise/fall; they sell overvalued currencies and buy undervalued ones

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Who are the 4 main participants in the foreign currency market?

Retail customers
Commercial banks
Forex brokers
CB

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Who are retail customers?

Firms and individuals who hold foreign currency to:
Engage in purchases
Adjust their portfolios
Profit from future currency movements

They buy/sell through commercial banks

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What are commercial banks?

Hold currencies
Largest participant in currency markets
Banks trade with each other to adjust holdings when there is a surplus/shortage

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Who are foreign exchange brokers?

Middlemen between banks and buyers and sellers of forex

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Who is the CB?

Hold forex as reserves and to supply domestic banks that need it

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What is exchange rate risk?

Loss or gain due to fluctuations in 2 currencies

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What is forward exchange rate?

Price of a currency that will be delivered in the future

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What is the forward market?

Market in which buying and selling of currencies for future delivery take place

What is spot market?

Market for buying and selling of currencies in the present

What are factors that determine exchange rates?

Short run - interest parity and speculation
Medium run - business cycle
Long run - purchasing power parity

How do you calculate real exchange rate?

Nominal exchange rate x (P*/P)

What is hedging?

Use forward market to protect themselves against the forex risk incurred while holding foreign bonds
Buy a forward contract to sell foreign currency at the same time that the bond matures

What is covered interest arbitrage?

Interest rate arbitrageurs use the forward market to insure against exchange rate risk

What is purchasing power parity?

The equilibrium exchange rate allows the same quantity of goods to be bought in either currency

How is the business cycle a determination of the exchange rate?

Faster growth at home means more imports, more demand for foreign currency Faster growth abroad means more home country exports, more supply of foreign currency

How is interest parity condition a determinant of exchange rates?

The difference between any pair of countries' interest rates is equal to expected change in the exchange rate i - i^* = ( F - R ) / R i = home interest rate i^* = foreign interest rate F = expected future exchange rate R = current exchange rate

When is the currency expected to depreciate?

When F > R Said to be selling at a discount since i > i^*

When is the currency expected to appreciate?

When F < R Said to be selling at a premium since i < i^*

How is speculation a determinant of exchange rate?

Buying and selling of assets in anticipation of a change in value

How does an interest rate arbitrageur work?

Let i = home interest rate i^* = foreign interest rate i>i^* If $1 is invested, $(1+i) at home - if they invest abroad they change dollars for pounds and get 100/R so it becomes £(1/R)(1+i^*) which is changed to $ Interest rate arbitrageur who knows how many pounds they will have can sign a forward contract to sell pounds for dollars F(1/R)(1+i^*)

What is a pegged/fixed exchange rate?

Setting the value of the country's currency Countries can give up their currency and adopt another More commonly, value of money is set to a fixed amount of another currency

What is a hard peg?

Exchange rate is not allowed to change values

What is a soft peg?

Exchange rate is allowed to change within some limit

What is a managed float exchange?

Implies some level of government intervention to control the currency, but less than with a pegged system

What is a gold standard?

Type of fixed exchange rate; value of currency is set to a quantity of gold

What is the Bretton Woods exchange rate system?

Modified gold standard after WW2 till 1970s Fixed exchange rates between currencies - USD pegged to gold and other currencies to USD

What are 3 rules that countries need to follow in order to maintain the gold exchange standard?

1. Must fix the value of their currency unit in terms of gold 2. Nations keep supply of money fixed in some constant proportion to their supply of gold 3. Nations must stand ready and willing to provide gold in exchange for their currency

What is a crawling peg?

Type of pegged exchange rate Peg to a single currency but they regularly adjust the exchange rate

What is market exchange (nominal) exchange rate?

Price of a unit of foreign currency

What is real exchange rate?

Market exchange (nominal) rate adjusted for price differences

How to calculate the real exchange rate?

Nominal exchange rate x (foreign price/domestic price)

What does RER show?

Whether a currency is depreciating/appreciating in its purchasing power over foreign g/s

What is the optimum currency area?

Region that adopts a single currency - euro Conditions need to be met: - business cycle must be synchronized - labor and capital must be mobile between countries - policies for addressing regional differences in growth when the business cycles do not match