Currency Exchange Rates

Question 1

Real Exchange Rate

Answer 1

= nominal exchange rate * (CPIforeign/CPIdomestic)

Question 2

Scenario Analysis of USD /Brit Pound:

Answer 2

• Inflation in the UK, increases real exchange rate because a unit of a good in the UK is more expensive in USD than it did in the base period.
• Inflation in the US increase, decreases the real exchange rate, because a good is more expensive in Pound than it was in the base period.

Question 3

An increase(decrease) in nominal (USD/Euro) exchange rate when inflation in both countries equally increases (decreases) the real (USD/Euro) exchange rate, and the cost of a good in the UK increases (decreases) relative to the base period.

Answer 3

…

Question 4

When the real exchange rate increases, exports are cheaper for foreigners and imports from foreign country are more expensive.

Answer 4

…

Question 5

A spot exchange rate =

Answer 5

the currency exchange rate for immediate delivery, taking place two days after the trade.

Question 6

Forward exchange rate

Answer 6

a currency exchange rate for an exchange to be done in the future. (30-,60-,90-day agreements).

Question 7

Hedging risk

Answer 7

when a firm takes a position in the FX market to reduce an existing risk
i.e. currency forward contracts.

Question 8

Buyers in the FX markets

Answer 8

1. corporations - enter forward contracts because they regularly engage in cross border transactions
2. Investment Accounts - to hold or speculate
3. Governments - FX for transactions, investments, or Central Banks engage in FX transactions to affect ST exchange rates for government policy.

Question 9

Retail markets

Answer 9

FX transactions by households or small institutions.

i.e. tourism and speculation

Question 10

Real money accounts

Answer 10

institutional accounts that do not use derivatives.

Question 11

Leveraged Accounts

Answer 11

institutional accounts that do use derivatives

Question 12

Cross Rate

Answer 12

exchange rate between 2 currencies implied by their exchange rate with a common third currency

Question 13

For a spot currency rate

Answer 13

• each point is 0.0001

Question 14

When spot- and forward- exchange rates exist, the difference is approximately equal to the difference in the 2 countries interest rates

Answer 14

….

Question 15

No-Arbitrage Condition

Answer 15

If this doesn’t hold, there exists a profitable opportunity with no risk.

Question 16

Interest rate parity

Answer 16

= forward / spot

= (1-RATEdomestic) / (1 - RATEforeign)

Question 17

Forward discount / premium is calculated as…

Answer 17

the percent difference between the forward price and current spot rate of a unit of currency B to A.

Question 18

Exchange Regimes for Countries without Own Currency:

Answer 18

1. Formal dollarization - uses the currency of another country. Cannot create its own monetary policy.
2. Monetary Union – several countries use a common currency

Question 19

Exchange Regimes that have their own currency:

Answer 19

1. Currency Board Arrangements– A commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
   
   • Hong Kong
2. Conventional Fixed Peg – A country pegs its currency within +/- 1% versus another currency
3. Crawling peg – exchange rate is adjusted periodically, to adjust for inflation
4. Managed Floating Exchange Rate – Monetary authority attempts to influence the exchange rate in response to specific indicators
5. Independent Floating – exchange rate is market determined.

Question 20

Elasticities Approach

Answer 20

Focuses on impact of Exchange Rate on total value of imports and exports.

Question 21

Absorption Approach

Answer 21

Focuses on analyzing the effect of a change in exchange rates on capital flows.

Question 22

Elasticities Approach

Answer 22

• Marshall-Lerner condition: a depreciation in domestic currency will decrease a trade deficit.
  
  • Wx *x + Wm *(m-1) > 0
    Wx = proportion of trade that is exports
    Wm = proportion of trade that is imports
    x = price elasticity of demand of exports
    m = price elasticity of demand for imports
• If Wx = Wm, x + m > 1, which is the classic Marshall Lerner condition

Question 23

When a currency depreciates, the trade deficit decreases (improving itself)

Answer 23

…

Question 24

The J-curve

Answer 24

As currency depreciates may worsen trade deficit initially, importers adjust over time by reducing quantities.

Question 25

The Absorption Approach

Answer 25

• elasticities approach ignores capital flows
• Absorption approach is a macroeconomic technique that focuses on the capital account.

-BT = Y - E
BT = Balance of Trade
Y = National Income
E = Total Expenditure