Chapter 4

Question 1

Factors determine Exchange Rate

Answer 1

Inflation
Interest Rates
Income Levels
Government controls
Expectations

Question 2

1. a) higher US Inflation

Answer 2

increase in US demand for UK goods &pounds
decrease in supply for UK pounds (weak UK demand for US goods & $)
higher US prices
appreciation in UK pound (bc strong demand &weak supply of pounds)

Question 3

1.b) lower US Inflation

Answer 3

decrease in US demand for UK goods &pounds
Increase in supply for UK pounds
strong UK demand for US goods
(lower prices inUS)
Depreciation in UK pound (bc of weak demand &strong supply of pounds)

Question 4

2. a) Higher US Interest Rates

Answer 4

decrease in US demand for UK pound
Increase supply of UK pounds (uk investors want to take advantage of the higher IR in US)
Depreciation of Uk pound (weak demand &strong supply of pounds)

Question 5

2. b) lower US Interest Rates

Answer 5

Decrease in supply of Uk pound
Increase in Us demand for Uk pound (take adv. of higher IR)
Appreciation in Uk pound (strong demand &weak supply)

Question 6

3. a) Higher Income Level

Answer 6

Increase in US demand for UK goods
no change in supply of UK pounds
appreciation in UK pounds (only strong demand for pound)

Question 7

3. b) lower Income Level

Answer 7

Decrease in US demand for UK goods
No change in Supply of UK pounds
Depreciation of UK pound( weak demand for pound)

Question 8

4. Government Control

Answer 8

impose FX barriers
impose Foreign trade barriers
intervene FX markets (buying/selling currencies)
affect macro-variables (inflation, IR levels, income)

Question 9

5. Expectations

Answer 9

investors expect Ir in one country to rise the might invest in that country
this leads to rise demand for foreign currency & increase in theFX for foreign currency

Question 10

Institutional speculation based on expected depreciation

Answer 10

If financial institutions believe that a currency is valued higher than it should be in the foreign exchange market they may borrow funds in that currency and convert it to their local currency now before the currency’s value declines to its proper level

Question 11

The “Carry” Trade

Answer 11

Where Investors attempt to capitalise on the differential in interest rates between two countries

Question 12

What is the equilibrium exchange rate based on?

Answer 12

Demand

Supply

Question 13

What are the factors that can influence a currency’s spot rate?

Answer 13

e = percentage change in the spot rate
ΔINF= change in the differential between U.S. inflation and the foreign country's inflation
ΔINT = change in the differential between the U.S. interest rate and the foreign country's interest rate
ΔINC = change in the differential between the U.S. income level and the foreign country's income level
ΔGC= change in government controls
ΔEXP = change in expectations of future exchange rates

Question 14

Real Interest Rate Formula

Answer 14

= nominal rate - inflation rate

Question 15

international banks

Answer 15

core of FX market
serve retail clients (eg bank customers) in conducting foreign commerce or making international investment in financial assets that require FX

Question 16

non bank dealers

Answer 16

large non bank financial institutions
ex: investment banks, mutual funds, pension funds, hedge funds
size and frequency of trades make it cost effective to establish their own dealing rooms to trade directly in the interbank market

Question 17

FX brokers

Answer 17

match dealer orders to buy and sell currencies for a fee

don’t take a position themselves

Question 18

Central bank

Answer 18

national monetary authority
intervention-process of using foreign currency reserves to buy one’s own currency in order to decrease its supply and increase its value in the FX market
ex: success at high value may reduce exports and increase imports, alleviating persistent trade deficits
often lose bank reserves in the process
joint interventions have more success

Question 19

triangular arbitrage

Answer 19

process of trading out the US$ into a second currency then trading it for a third currency, which is in turn traded for US$ where purpose it to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate is not in alignment with the cross-exchange rate