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comm 220: market analysis > chapter 15: Exchange Rates and Exchange Rate Systems > Flashcards

chapter 15: Exchange Rates and Exchange Rate Systems Flashcards

1
Q

Every country must choose an which types of exchange rate system?

A

fixed level

flexible

in between

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2
Q

fixed exchange rate system

A

no variation

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3
Q

flexible exchange rate system

A

variation determined by supply and demand for the country’s currency on a minute-by-minute basis

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4
Q

semi-fixed or semi- flexible exchange rates

A

between fixed and flexible

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5
Q

The exchange rate

A

the price of one currency stated in terms of a second currency

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6
Q

in which two ways can an exchange rate be given?

A

units of domestic currency per unit of foreign currency

vice versa

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7
Q

identify three reasons for holding foreign currency

A

trade and investment purposes

to take advantage of interest rate differentials, or interest rate arbitrage

to speculate

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8
Q

interest rate arbitrage

A

the practice of using favorable interest rate differentials to invest in a higher-yielding currency

arbitrageurs borrow money where interest rates are relatively low and lend it where rates are relatively high

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9
Q

arbitrage

A

the idea of buying something where it is relatively cheap and selling it where it is relatively expensive

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10
Q

Speculators

A

businesses that buy or sell a currency because they expect its price to rise or fall

They have no need for foreign exchange to buy goods or services or financial assets

they hope to realize profits or avoid losses through correctly anticipating changes in a currency’s market value

forex shit

they help to bring currencies into equilibrium after they have become over- or undervalued

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11
Q

four main participants in foreign currency markets

A

retail customers

commercial banks

foreign exchange brokers

central banks

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12
Q

the most participant in foreign currency markets

A

commercial banks

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13
Q

retail customers in currency markets include whom?

A

firms and individuals

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14
Q

why would retail customers hold foreign exchange?

A

to engage in purchases

to adjust their portfolios

to profit from expected future currency movements

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15
Q

forex broker

A

keeps track of buyers and sellers of currencies

acts as a deal maker by bringing together a seller and a buyer (most often banks buying for their customer)

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16
Q

Firms that do business in more than one country are subject to what?

A

exchange rate risks

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17
Q

how do exchange rate risks come to exist?

A

currencies are constantly changing in value and, as a result, expected future payments that will be made or received in a foreign currency will be a different domestic currency amount from when the contract was signed

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18
Q

who faces the exchange rate risks in a transaction? purchaser or the seller?

A

the purchaser is uncertain of the price in the currency of the seller

the seller knows the exact dollar amount it will receive

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19
Q

mechanisms to deal with exchange rate risks

A

the forward exchange rate

the forward market

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20
Q

the forward exchange rate

A

the price of a currency that will be delivered in the future

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21
Q

the forward market

A

the market in which the buying and selling of currencies for future delivery takes place

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22
Q

why are forward markets an everyday tool for international traders, investors, and speculators

A

because they are a way to eliminate the exchange rate risk associated with future payments and receipts

allow an exporter or importer to sign a currency contract on the day they sign an agreement to ship or receive goods

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23
Q

spot market

A

the market for buying and selling in the present

the transactions are denoted in spot prices

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24
Q

hedging

A

bondholders and other interest rate arbitrageurs using forward markets to protect themselves against the foreign exchange risk incurred while holding foreign bonds and other financial assets

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25
Q

how is hedging accomplished?

A

by buying a forward contract to sell foreign currency at the same time that the bond or other interest-earning asset matures

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26
Q

covered interest arbitrage

A

When interest rate arbitrageurs use the forward market to insure against exchange rate risk

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27
Q

what will an increase in demand of a currency do to its value?

A

it will cause an appreciation in value

raise in price

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28
Q

what will an increase in supply of a currency do to its value?

A

it will cause an depreciation in value

decrease in price

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29
Q

if the overall demand of a certain currency increases, what happens to the exchange rate?

why?

A

the exchange rate increases

the currency that is increasingly demanded will appreciate in value relative to the other currency that it is against

in the graph, the demand curve shifts to the right, making the equilibrium higher

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30
Q

if the overall demand of a certain currency decreases, what happens to the exchange rate?

why?

A

the exchange rate decreases

the currency that is less and less demanded will depreciate in value relative to the other currency that it is against

in the graph, the demand curve shifts to the left, making the equilibrium lower

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31
Q

if the overall supply of a certain currency decreases, what happens to the exchange rate?

why?

A

the exchange rate increases

the supply of the currency will be more scare making it gain value relative to the currency it is against

in the graph, the supply curve shifts to the left, making the equilibrium higher

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32
Q

purchasing power parity

A

a phenomenon in the long run

states that the equilibrium value of an exchange rate is the level that allows a given amount of money to buy the same quantity of goods abroad that it will buy at home

keeps the purchasing power over goods and services constant

so in the long run, the exchange price that should be that in which it allows to buy the same amount of goods

ex: $100 and 50Euros buy you one watch

the long term exchange rate should be $2 per Euro

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33
Q

what does it mean if in exchange rate is above that of the long term exchange rate?

A

the currency in the numerator position is under valued

the currency in the denominator position is over valued

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34
Q

what does it mean if in exchange rate is below that of the long term exchange rate?

A

the currency in the numerator position is over valued

the currency in the denominator position is under valued

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35
Q

what is key behind purchasing power parity (taking advantage of currencies being under value or over valued compared to another)?

is this realistic? why?

A

arbitrage

buying where the goods are cheaper and selling where they are more expensive

nahhh

ex: tariffs, bank costs, quotas, insurance etc

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36
Q

the forces tied to business cycles that have more immediate impacts on the position of the supply and demand curves for foreign exchange are considered long run, medium run, or short run?

why?

A

medium run

the time period from the peak of one expansion to the next is usually several years in duration

they are pressures on an exchange rate that may last for several years, but almost always less than a decade and usually less than five to seven years

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37
Q

The most important medium-run force that influences exchange rates

A

the strength of a country’s economic growth

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38
Q

what does rapid economic growth imply for exchange rates??

how?

A

the effect of rapid economic growth at home is a depreciating currency

Rapid growth implies rising incomes and increased consumption

consumer confidence increases so they spend more, some of which will be on imports and travel abroad

rapid economic growth at home is translated into increased imports and an outward shift in the demand for foreign currency, which increase the equilibrium exchange rate

the foreign currency will be increasingly stronger than the currency at home

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39
Q

what does slow economic growth such as a recession imply for exchange rates??

how?

A

reduces the exchange rate and appreciates the currency

increase in consumer uncertainty about jobs and reduction many people’s incomes

consumption expenditures fall, expenditures on imports decline falls as well

the demand for foreign exchange falls causing leftward shift of the demand curve, which lower the equilibrium rate

the foreign currency will be increasingly weaker than the currency at home

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40
Q

does foreign economic growth influence our domestic demand for foreign currency?

what will it affect tho?

A

naaah

it will affect the supply curve

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41
Q

what does more rapid foreign growth lead to when it comes to foreign currency?
why?

A

reduces the strength of the foreign currency compared to our domestic currency

leads to more exports from the home country

More exports to foreigners increase the supply of foreign currency and shift the supply curve rightward

reduces equilibrium rate

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42
Q

what does slower foreign growth lead to when it comes to foreign currency?
why?

A

increases the strength of the foreign currency compared to our domestic currency

leads to less exports from the home country

less exports to foreigners decreases the supply of foreign currency and shift the supply curve leftward

increases equilibrium rate

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43
Q

true or false

The effect of growth is symmetrical

A

true

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44
Q

how long are long run factors that affect the exchange rates?

A

over 10 years

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45
Q

how long are medium run factors that affect the exchange rates?

A

less than 10 years

sometimes less than 7 and 5 years

46
Q

how long are short run factors that affect the exchange rates?

A

less than 1 year

47
Q

the most important short run force affecting exchange rates

A

the flow of financial capital

48
Q

how do the effects of financial capital flows range?

A

minor and subtle to dramatic and, at times, catastrophic.

49
Q

Two variables particularly responsible for a large share of short-run capital flows

A

interest rates

expectations about future exchange rates

50
Q

the interest parity condition

A

sums up the interest rate–exchange rate relationship in the short run

states that the difference between any pair of countries’ interest rates is approximately equal to the expected change in the exchange rate

51
Q

how can investors investing abroad protect against unanticipated losses due to currency fluctuations?

A

known as covered interest arbitrage

signing a forward contract to sell the foreign exchange from their future earnings

52
Q

when is a certain currency selling at a discount?

A

when the forward exchange rate (F) between the domestic currency and a foreign currency is higher than the spot rate (R)

F > R

the domestic currency is expected to depreciate

53
Q

when is a certain currency selling at a premium?

A

when the forward exchange rate (F) between the domestic currency and a foreign currency is lower than the spot rate (R)

F < R

the domestic currency is expected to appreciate

54
Q

The difference between the forward exchange rate (F) and the spot rate (R)

A

the expected appreciation or depreciation of a currency compared to another

55
Q

the interest parity condition

formula and meaning

A

i - i*

est environ égal à

(F - R) / R

F = forward exchange rate

R = Spot Rate

i = domestic interest rates

i* = foreign interest rates

it says that interest rate differences are approximately equal to the expected change in the exchange rate

56
Q

what will investors do if domestic interest rates are less than foreign interest rates (i < i) all the while forward rates are less than spot rates (F < R), but home policymakers decide for some reason to raise their inter- est rates to the same level as foreign rates: i = i?

why?

A

investors in both home and foreign markets will invest more at home because they earn the same rate of interest

they also expect domestic currency to appreciate in value (since F < R)

supply curve of foreign currency shifts right and demand shifts of foreign currency shifts left making the equilibrium spot rate decrease

57
Q

what happens if investors suddenly come to believe that a currency must depreciate more than they had anticipated?

A

it lowers the expected value of assets denominated in that currency

This can create a sudden exodus of financial capital and put enormous pressure on the country’s supply of foreign exchange reserves

people will want more foreign currency

they will try to convert their assets in foreign currency

58
Q

the largest center for forex exchange

A

London

59
Q

long run factor influencing exchange rates

A

Purchasing Power Parity

60
Q

if home goods are less expensive than foreign goods, what is the effect on R?

A

R Falls: An Appreciation in the Domestic Currency

61
Q

if home goods are more expensive than foreign goods, what is the effect on R?

A

R Rises: A Depreciation in the Domestic Currency

62
Q

medium run factor influencing exchange rates

A

The Business Cycle

63
Q

if the domestic economy grows more slowly than foreign economy, how does it affect R?

A

R Falls: An Appreciation in the Domestic Currency

64
Q

if the domestic economy grows faster than foreign economy, how does it affect R?

A

R Rises: A Depreciation in the Domestic Currency

65
Q

short run factors influencing exchange rates

A

Interest Parity

Speculation

66
Q

if home interest rates rise, or foreign rates fall, how does it affect R?

A

R Falls: An Appreciation in the Domestic Currency

67
Q

if home interest rates fall, or foreign rates rise, how does it affect R?

A

R Rises: A Depreciation in the Domestic Currency

68
Q

if there are expectations of a future appreciation, how does it affect R?

A

R Falls: An Appreciation in the Domestic Currency

69
Q

if there are expectations of a future depreciation, how does it affect R?

A

R Rises: A Depreciation in the Domestic Currency

70
Q

what is more important, what your currency is worth in another currency, or the purchasing power you would have with that second currency?

A

the purchasing power you would have with that second currency

basically, the real exchange rate

71
Q

The real exchange rate

A

the market exchange rate adjusted for price differences

nominal exchange rate

72
Q

real exchange rate formula

A

[(Nominal exchange rate) · (Foreign price)] / (Domestic price)

= real exchange rate

Rr = Rn · (P*/P)

Rr: Real exchange rate

Rn: Nominal exchange rate

P*: Foreign price

P: Domestic price

73
Q

purchasing power parity indicates long-run equilibrium or short-run equilibrium?

A

long-run equilibrium

74
Q

Fixed exchange rate systems (also called pegged exchange rate systems)

A

setting the value of a country’s currency in several ways

75
Q

ways in which we can set the value of a country’s currency in fixed exchange rate systems

A

giving up their currency altogether and adopt the currency of another country

setting the value of a nation’s money equal to a fixed amount of another country’s currency, or less commonly to a basket of several currencies

76
Q

the most common way to set the value of a country’s currency in fixed exchange rate systems

A

setting the value of a nation’s money equal to a fixed amount of another country’s currency

77
Q

do countries often give up their currency altogether and adopt the currency of another country?

A

nah

very few countries do so

78
Q

hard peg

A

when the exchange rate is not allowed to vary

79
Q

soft peg

A

Fixed exchange rates that fluctuate within a set band

can take several forms depending on the amount of variation allowed

80
Q

the most common exchange rates around the world by the end of the 20th century?

A

flexible exchange rate systems

81
Q

one type of fixed exchange rate that the world abandoned in the 1930s during the Great Depression

A

Gold standards

82
Q

the first countries to end the gold standard

A

the first ones to escape the depression

83
Q

Bretton Woods exchange rate system

A

1947–1971

a modified gold standard adopted by Western economies after World War II

abandoned in the early 1970s

84
Q

pure gold standards

A

highlight a pure form of fixed exchange rate with a hard peg

nations keep gold as their international reserve

Gold is used to settle most international obligations

nations must be prepared to trade it for their own currency whenever foreigners attempt to “redeem” the home currency they have earned by selling goods and services

In this sense, the nation’s money is backed by gold

85
Q

three rules that countries must follow in order to maintain a gold exchange standard

A
  1. they must fix the value of their currency unit in terms of gold to fix the exchange rate
  2. nations keep the supply of their domestic money fixed in some constant proportion to their supply of gold

–> to ensure that the domestic money supply does not grow beyond the capacity of the gold supply to support it

  1. nations must stand ready and willing to provide gold in exchange for their home country currency
86
Q

under the gold standards, what are ways to stop our currency from depreciating against another currency who’s demand increased (shifted right)?

A

sell gold reserves in exchange for our currency

– > supplying international money (gold) to the market through a sale of some of its gold stock

–> an increase in the supply of gold is equivalent to an increase in the supply of the foreign currency

basically, countries hold gold as a reserve instead of foreign currencies and sell their gold reserves in exchange for their own currency

increases the supply of gold (which is international money) and offsets the pressure on the home currency to depreciate

87
Q

two possibilities for the home country when selling its gold reserves

A

the demand for gold is satisfied and the pressure on its currency eases

or

it begins to run out of gold

88
Q

what happens when a country is running out of gold when trying to stop the depreciation of their currency against another currency?

A

the home country may be forced into a devaluation

basically, changing the gold price of its currency

each ounce of gold sold by the home country buys back a greater quantity of its currency than before

89
Q

difference between gold standards and pegged exchange rates

A

instead of gold, another currency is used to “anchor” the value of the home currency

90
Q

potential sources of problems with a pegged currency

why are they it a problem?

A

the home currency’s value is synchronized with its peg

–> changes between the peg and a third-party currency are identical for the home currency and the third party currency

significant difference in inflation rates between the home country and its peg

–> real exchange rates play a greater role in determining trade patterns than nominal rates

91
Q

how to avoid pegging our home currency’s value with another currency?

how is this a solution?

what currencies do countries usually pick?

A

peg our currency to a group of currencies

it reduces the importance of any single country’s currency in the determination of the home country’s currency value

the currencies of their most important trading partners

92
Q

The most common technique for dealing with the significant difference in inflation rates between the home country and its peg

A

the adoption of a crawling peg

93
Q

crawling pegs

A

soft pegs that are fixed but periodically adjusted

94
Q

the goal of crawling pegs?

A

offset any differences in inflation (changes in P) through regular adjustments in Rn

P: Domestic price

Rn: Nominal exchange rate

95
Q

are purely fixed or purely flexible exchange rate arrangements rare or common?

A

rare bruv

96
Q

Smithsonian Agreement

A

December 1971

the major industrialized countries agreed to devalue the gold content of the dollar

97
Q

according to economists, if the goal is to find the system that helps minimize negative shocks to an economy, what determines whether a more flexible or more fixed system should be adopted?

A

the source of the shock

98
Q

if the shock that shocks the economy comes from the monetary sector, according to economists, which rate is better to dealing with it?

ex: a central bank that goes overboard in printing new money

A

a fixed rate is better

in the example, the fixed rate imposes discipline on the central bank

99
Q

if the shock that shocks the economy comes from outside of the monetary sector, according to economists, which rate is better to dealing with it?

ex: a sudden change in the price of imported oil

A

more flexibility in the exchange rate enables the country to adapt to the changes more easily

100
Q

Dollarization

A

the term given to the adoption of another country’s currency

not the same as a monetary union such as the euro zone

101
Q

difference between dollarization and a monetary union

A

a union has a common central bank that issues the currency and carries out monetary policy

a country’s bank that adopts another currency has no ability to issue money

–> they have no control over monetary policy since they cannot expand or contract the money supply

102
Q

the four monetary unions in the world

A

the European Monetary Union (EMU)

the Eastern Caribbean Currency Union (ECCU)

the West African Economic and Monetary Union (WAEMU)

the Central African Economic and Monetary Community (CEMAC)

103
Q

the two oldest monetary unions

what currency do they use?

A

the West African Economic and Monetary Union (WAEMU)

the Central African Economic and Monetary Community (CEMAC)

they use the CFA franc

104
Q

the European Monetary Union (EMU) exchange rate system

A

Flexible

105
Q

the West African Economic and Monetary Union (WAEMU) exchange rate system

A

Fixed to euro

106
Q

the Central African Economic and Monetary Community (CEMAC)exchange rate system

A

Fixed to euro

107
Q

the Eastern Caribbean Currency Union (ECCU) exchange rate system

A

Fixed to dollar

108
Q

four potential reasons why a group of countries might want to share a common currency

A

a single currency eliminates the need to convert each other’s money and thereby reduces transaction costs in a number of ways

a single currency eliminates price fluctuations caused by changes in the exchange rate

the elimination of exchange rates through the adoption of a single currency can help increase political trust between countries seeking to increase their integration

the adoption of a common currency may give developing countries’ exchange rate system greater credibility

109
Q

costs of giving up a country’s national money?

A

getting rid of strong political symbolism

the country no longer has its own money supply as a tool for managing its economic growth

110
Q

the theory of optimal currency areas

A

started by Robert Mundell

four conditions for deciding whether the gains of area are greater than the costs:

  1. the business cycle must be synchronized and national economies must enter recessions and expansions at more or less the same time
  2. a high degree of labor and capital mobility between the member countries
  3. regional policies capable of addressing the imbalances that may develop
  4. The nations involved must be seeking a level of integration that goes beyond simple free trade
111
Q

The most important rule for a country’s exchange rate system

A

it it be credible

112
Q

Optimal currency areas

A

geographical regions within which it is optimal for countries to adopt the same currency

comm 220: market analysis (37 decks)

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