Chapter 7- Exchange rates

Question 1

Why is there a need for foreign exchange?

Answer 1

Foreign currency cannot be used for domestic transactions.Hence if we are buying (importing) goods from other countries, we need to pay in their currency; the opposite is true when other countries are buying from us

Question 2

Define the foreign exchange market.

Answer 2

the system through which a nation’s currency is exchanged for the currency of another.

Question 3

Why is the foreign exchange market defined as a system?

Answer 3

It’s defined as a system because it does not have a specific location but rather consists of communications of networks that operate 24 hours a day.

Question 4

Why is the foreign exchange market defined as a system?

Answer 4

It’s defined as a system because it does not have a specific location but rather consists of communications of networks that operate 24 hours a day.

Question 5

What is an exchange rate?

Answer 5

It is a relative price that indicates the price of one currency in terms of another currency.

Question 6

What is an increase in the value of a currency in terms of another?

Answer 6

Appreciation, also known as revaluation of currency.

Question 7

What is an decrease in the value of a currency in terms of another?

Answer 7

Depreciation, also known as devaluation of currency.

Question 8

What does the bilateral nature of exchange rates imply?

Answer 8

It implies that exchange rates can be quoted in two ways; as direct or indirect quotations.

Question 9

How are direct quotations used to quote exchange rates?

Answer 9

It expresses the value of the foreign currency in terms of the domestic currency. For example US$1= R9.81

Question 10

How are indirect quotations used to quote exchange rates?

Answer 10

The indirect quotation would show the value rand in terms of the US dollar. For example, R1= US$0.1013

Question 11

What is the difference between the fixed and floating exchange rate system?

Answer 11

In a fixed exchange rate system, the exchange rate can be kept unchanged. In a floating exchange rate system, it can be allowed to change in accordance with the demand for and supply of a currency.

Question 12

How does the fixed rate exchange system work?

Answer 12

The central bank of a country is required to undertake transactions in the foreign exchange market to keep the exchange rate a specific level, or within prescribed limits. In this system, a country can devalue its currency if it raises it’s rate if the rates are quoted directly.

Question 13

What are the 2 foreign exchange sub-markets?

Answer 13

• Spot Market
• Forward Market

Question 14

How does the spot market work?

Answer 14

-Transactions are concluded for immediate delivery, usually in 2 days.
-Spot exchange rates differs with the size of transaction
*Individuals & business =less favorable rates
*Big businesses & banks=more favorable rates =larger transactions

Question 15

How does the forward market work?

Answer 15

– transactions are concluded for delivery on a stipulated future date which is further away than two days
- Purpose is to fix the price of a foreign currency at current levels to avoid exchange risk

Question 16

What are nominal exchange rates?

Answer 16

They are the actual rates charged in foreign exchange dealings. They do not indicate whether it is cheaper or more expensive to purchase goods abroad or domestically.

Question 17

What are real exchange rates used for?

Answer 17

To show the price difference between two commodities, however it indicates nothing about the quality of the products

Question 18

What are effective exchange rates?

Answer 18

-An index that describes the strength of a currency relative to a basket of other currencies.
- Tells us whether the relative value of a currency is stronger or weaker

Question 19

Analyze the demand for foreign exchange.

Answer 19

The demand for a particular currency is largely a derived demand. In other words, the currency is needed for purchase of goods, services or assets, and to make current or capital transfers.

Question 20

Distinguish between direct and Indirect demand.

Answer 20

If for example, the demand for imports from the USA increases, there will be an indirect increase in demand for dollars because the dollars are demanded for the purchase of goods. Direct demand is for those involved in currency trading.

Question 21

Explain the relationship between the exchange rate of two currencies and the quantity demanded for a particular currency.

Answer 21

This relationship is illustrated in figure 7.2. In this figure, the demand for US dollars declines when the rand appreciates. In other words, fewer rands are needed to purchase the same quantity of US dollars. Conversely, a depreciation of the rand against the US dollar results in a greater demand for the US dollar. The demand curve slopes downwards, only if the direct method of quoting the currency is used.

Question 22

Explain the relationship between the exchange rate of two currencies and the quantity supplied for a particular currency.

Answer 22

Again using figure 7.2, The supply of US dollars will rise as the rand appreciates against the US dollar. The supply of foreign exchange depends on the value of goods and services and assets sold to the rest of the world.

Question 23

Define the market clearing rate.

Answer 23

Where the total quantity of the demand for the currency is equal to the total quantity of currency supplied= equilibrium exchange rate.

Question 24

List the Factors that could cause an increase in the SA demand for foreign currency.

Answer 24

-Increase in GDP
-Increase in demand
-Improved quality of foreign goods
-Perceived domestic political threat
-Increased interest rate differential between foreign & domestic assets
-Expected depreciation of the rand
-Expected economic downturn in economic activity

THESE ARE THE SAME FACTORS THAT COULD INFLUENCE THE SUPPLY OF FOREIGN CURRENCY!!!!

Question 25

What exchange rate system does South Africa use and how does it work?

Answer 25

Unitary exchange rate system. In this system, spot-exchange rate and forward-exchange rate are essentially determined by market forces with limited exchange rulings still applicable to residents.

Question 26

What role does the SARB play with exchange rates?

Answer 26

-The SARB does not intervene to manage the level of the exchange rate.
-It adheres to a policy of a flexible/ floating exchange rate.
-However, the bank is not impassive to challenges posed by volatility of the exchange rate.
-It therefore stands ready to become involved in the foreign exchange market to smooth out abrupt adjustments

Question 27

List the factors that affect exchange rates. (FYI)

Answer 27

-Changes in inflation (inflation differentials)
-Changes in interest rates (interest rate differentials)
-Changes in expected exchange rates
-Public debt
-Business cycles
-Terms of trade
-Strong economic performance
-Non-economic developments like political threats

Question 28

Intervention and history in the SA foreign exchange market.

Answer 28

-The SA foreign exchange market has developed in a relatively sophisticated market in which the exchange rates of the rand are determined under relatively free conditions.

Heavy intervention in 1990s
-Stabilizing the exchange rate of the rand.
-Intervention in the forex market largely took place in the forward market due to low
levels of foreign reserves.
-Intervention in the spot market need large foreign reserves.
-The intervention did not prevent the depreciation of the rand – in fact brought
substantial costs to the government.
-SARBS intervention policy was asymmetrical – caused sharp rand depreciation from
time to time without an meaningful appreciation
-Despite announcing the adoption of free floating of the rand in 1998, a crisis in
emerging market economies forced SARB to continue intervening in the forex market
But once the crisis subsided, intended adoption of floating rand continued.