Chapter 2: Introduction to Exchange Rates and the Foreign Exchange Market Flashcards
Exchange Rate
The price of some foreign currency expressed in terms of a home (domestic) currency
Appreciation
When one currency buys more of another currency
Happens when the exchange rate falls
Depreciation
When one currency buys less of another currency
Happens when the exchange rate rises
Effective Exchange Rate
The calculated multilateral exchange rate changes for baskets of currencies using trade weights to construct an average of all the bilateral exchanges for each currency in the basket
Exchange Rate Regime
A pattern of exchange rate behavior
Fixed (Pegged) Exchange Rate Regime
An exchange rate regime in which a country’s exchange rate either does not fluctuate or fluctuates in a narrow range against some base currency over a sustained period, usually a year or longer. A country’s exchange rate can remain rigidly fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries
Floating (Flexible) Exchange Rate Regime
An exchange rate regime in which a country’s exchange rate is allowed to do whatever it wants. Appreciations and depreciations may occur whenever.
Band
A very small area for fluctuation about an exchange rate peg
Dirty Float (aka Managed Float)
A middle-ground, in which an exchange rate is allowed to float until the government doesn’t want it to, and then fixes it.
Exchange Rate Crisis
Dramatic depreciations
Crawl
A fixed arrangement in which one currency is allowed to slowly depreciate against another one. If the exchange rate follows a simple trend, it is a crawling peg. If the exchange rate allows for some variation about the trend, it is a crawling band
Dollarization
When one country unilaterally adopts the currency of another country
Currency (Monetary) Union
An agreement under which there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member nations, who all use the same currency
Foreign Exchange (FX or forex) Market
A collection of private individuals, corporations, and some public institutions, that buy and sell currencies.
Spot Contract
The simplest FX Market transaction, in which an immediate exchange of one currency for another occurs
Essentially riskless
These account for the majority of the activity in the forex market
Spot Exchange Rate
Exchange rate for a spot contract
Forward Contract
Two parties make the contract today, but the settlement date for the delivery of the currencies is in the future. The maturity (time to deliver) varies, and the contract carries no risk
Swap Contract
Combines a spot sale of foreign currency with a forward repurchase of the same currency. This is common for parties who trade often, because it lowers transaction costs
Futures Contract
A promise that the two parties holding the contract will deliver currencies to each other at some future date at a prespecified exchange rate, just like a forward contract. Unlike a forward contract, however, futures contracts are standardized, mature at certain regular dates, and can be traded on an organized futures exchange
Options
An option provides the buyer with the right to buy or sell a currency in exchange for another at a prespecified exchange rate at a future date. The other party, the seller, must perform the trade if asked to do so, but the buyer is under not obligation to trade, and will generally not exercise the option of the spot price on the expiration date turns out to be more favorable.
Commercial Banks
The majority of forex traders work for these. They trade for themselves and also serve clients who want to import or export goods, services, or assets.
Interbank Trading
Approximately 3/4 of all fx market transactions are handled by 10 banks.
The vast majority of forex transactions are profit-driven interbank trades and it is the exchange rates for these trades that underlie quoted market exchange rates
Corporations in the FX Market
Some corporations may trade in the fx market if they are engaged in extensive transactions either to buy inputs or sell products in the foreign markets. This is expensive, but they can bypass having to pay the bank to do it for them, and it might be worth it, depending on various factors
Capital Controls
Restrictions on cross=border financial transactions
Black (Parallel) Markets
Illegal market where individuals may trade at exchange rates determined by market forces and not set by the government
Arbitrage
A trading strategy that exploits any profit opportunities arising from price differences
Vehicle Currency
The vast majority of currency pairs are exchanged for one another through a third currency, called the vehicle currency
Forward Exchange Rate
Exchange rate used in forward contracts
Covered interest Parity (CIP)
Dolalr return on dollar deposits equals the dollar return on euro deposits
(1+i(h)) = (1 + i(f))(F/E)
Expected Exchange Rate (Ee)
Forecasted exchange rate
Uncovered Interest Parity
Dollar return on dollar deposits equals the expected dollar return on euro deposits
(1+i(h)) = (1 + i(f))(Ee/E)
