Chapter 10 - Forex market

Question 1

foreign exchange market

Answer 1

a market for converting the currency of one country into that of another country
-without it, international trade/investment would be impossible

Question 2

exchange rate

Answer 2

the rate at which one currency is converted into another.

It can change over time.

Question 3

fiscal policies

Answer 3

what governments can influence by making decisions on how to spend money, tariffs, subsidies

Question 4

monetary policy

Answer 4

people who control money make policies on interest rates and inflation

Question 5

functions of forex market

Answer 5

1. converts currency of one into another
2. for businesses to: convert money from operations, make payments, invest short term cash, currency speculation (carry-trade)

Question 6

Currency speculation

Answer 6

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

Question 7

Carry-trade

Answer 7

Involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. Based on belief that there will be no adverse movements that would lead to losing money

Question 8

Spot exchange rate

Answer 8

The rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
Ex: When a tourist goes to a bank to convert her money, the exchange rate is the spot rate for that day.

Question 9

Forward exchange rates

Answer 9

Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Like a speculation on what you think will be the future rate (30,90,180 days)

Question 10

Currency swaps

Answer 10

The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
i.e. transactions between international businesses and banks, banks and banks, and governments

Question 11

Example of forward exchange rate

Answer 11

Embraer’s jets sold in US dollars to be exchanged back into reals when sold to determine profit margin. As the real was worth more, the company made less money so Embraer bet that it would increase and locked in the current price. However, it decreased so they had to pay the higher price.

Question 12

Nature of forex market

Answer 12

Global network of banks and brokers connected by electronic communication system
rapidly growing
the market never sleeps
most transactions have dollars
arbitrage: buy low, sell high

Question 13

Theory of exchange rate determination

Answer 13

demand and supply of one currency compared to another

• -> the law of one price
• -> Purchasing power parity
• -> money supply and price inflation
• -> Empirical tests and PPP theory

Question 14

The law of one price

Answer 14

if no transportation cost/tariffs, products that are identical, should sell for the same price regardless of the country

Question 15

Purchasing power parity

Answer 15

Comparison of prices of identical products determine the real or PPP exchange rate
The price of a basket of goods should be roughly equivalent in each country accounting for difference in exchange
a change in relative price = a change in exchange rate

Question 16

Money supply

Answer 16

The growth rate of a country’s money supply determines its likely future inflation rate

Question 17

Inflation

Answer 17

money supply increases faster than outputs

too little inflation is good but does not stimulate economy

Question 18

high inflation leads to

Answer 18

depreciation in foreign exchange value of currency

Question 19

Government influence on money supply

Answer 19

could just tell the bank to supply more money usually for infrastructures, but they could also use tax revenues

Question 20

empirical tests and PPP theory

Answer 20

Exchange rates are determined by relative prices and changes in relative prices will result in a change in exchange rates
works best with countries with high inflation and underdeveloped capital markets

Question 21

Failure of PPP

Answer 21

ignores tariffs, transportation costs, barriers to trade to maintain the law of one price
many multinational companies that have influence over the prices in that industry

Question 22

Interest rates and exchange rates

Answer 22

strong relationship explained by The fisher effect: i=r+I
States that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I)
therefore if same real interest rate worldwide: the difference reflects different expectations about inflation

Question 23

International fisher effect

Answer 23

States that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries
Exchange rate between the U.S and Japan can be modeled as follows:
(S1 - S2)/S2 x 100 = i$ - iyen
S = Spot exchange rate, i = nominal interest rates

Question 24

Investor psychology

Answer 24

explain short term movement
Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates

Question 25

Bandwagon effect

Answer 25

explain short term movement
With traders moving as a herd in the same direction at the same time, one decides to do something others will follow which will make the market go even lower/higher

Question 26

Exchange rate forecasting (efficient market school)

Answer 26

1. Prices reflect all available public information
2. Forward exchange rates should be unbiased predictors of future spot rates
   BUT in reality: Inefficient Market School NOT TRUE

Question 27

Approaches to forecasting

Answer 27

Fundamental analysis and technical analysis

Question 28

Fundamental analysis

Answer 28

Draws on economic theory to construct sophisticated economic models for predicting exchange rate movements
Includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance of payment positions

Question 29

Technical analysis

Answer 29

Uses price and volume data to determine past trends, which are expected to continue into the future
There are analyzable market trends and waves that can be used to predict future trends and waves

Question 30

Currency convertibility

Answer 30

freely convertible (not universal)
externally convertible
nonconvertible

Question 31

Freely convertible

Answer 31

When the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it

Question 32

externally convertible

Answer 32

When only nonresidents may convert it into a foreign currency without any limitations (Venezuela)
–>can limit domestic companies’ ability to invest abroad, but not foreign companies wishing to do business in that country

Question 33

Nonconvertible

Answer 33

When neither residents nor nonresidents are allowed to convert it into a foreign currency (often temporary)

Question 34

capital flight

Answer 34

Capital flies out: Most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects

Question 35

Counter trade

Answer 35

goods and services can be traded for other goods and services
Makes sense when a country’s currency is nonconvertible

Question 36

foreign exchange rate risk

Answer 36

transaction exposure
translation exposure
economic exposure

Question 37

Transaction exposure

Answer 37

The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. For example you agree on a transaction now at a certain exchange rate and the rate changes = one will lose from this the other will win

Question 38

Translation exposure

Answer 38

concerned with present measurement of past performance

mostly when subsidiary performance outside of the country in another currency which depreciates or appreciates

Question 39

economic exposure

Answer 39

The extent to which a firm’s future international earning power is affected by changes in exchange rates
Concerned with long run effects of changes in exchange rates on future prices sales and costs.

Question 40

Reducing transaction/translation exposure

Answer 40

1. Forward exchange rate contracts
2. Buying swaps: locking in a price for a good or currency
3. Lead strategy: predict the future
4. Lag strategy: follow the events, wait to see what happens and capitalize on it

Question 41

Reducing economic exposure

Answer 41

Distribute the firm’s productive assets to various locations so the firm’s long term financial well-being is not severely affected by adverse changes in exchange rate

Question 42

other steps to manage forex risk

Answer 42

• central control of exposure
• should distinguish between translation/transaction and economic
• high need to forecast future exchange rate movement
• good reporting systems
• monthly foreign exchange exposure reports