Currency Exchange Rates Flashcards
Real Exchange Rate
= nominal exchange rate * (CPIforeign/CPIdomestic)
Scenario Analysis of USD /Brit Pound:
- 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.
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.
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When the real exchange rate increases, exports are cheaper for foreigners and imports from foreign country are more expensive.
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A spot exchange rate =
the currency exchange rate for immediate delivery, taking place two days after the trade.
Forward exchange rate
a currency exchange rate for an exchange to be done in the future. (30-,60-,90-day agreements).
Hedging risk
when a firm takes a position in the FX market to reduce an existing risk
i.e. currency forward contracts.
Buyers in the FX markets
- corporations - enter forward contracts because they regularly engage in cross border transactions
- Investment Accounts - to hold or speculate
- Governments - FX for transactions, investments, or Central Banks engage in FX transactions to affect ST exchange rates for government policy.
Retail markets
FX transactions by households or small institutions.
i.e. tourism and speculation
Real money accounts
institutional accounts that do not use derivatives.
Leveraged Accounts
institutional accounts that do use derivatives
Cross Rate
exchange rate between 2 currencies implied by their exchange rate with a common third currency
For a spot currency rate
- each point is 0.0001
When spot- and forward- exchange rates exist, the difference is approximately equal to the difference in the 2 countries interest rates
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No-Arbitrage Condition
If this doesn’t hold, there exists a profitable opportunity with no risk.
Interest rate parity
= forward / spot
= (1-RATEdomestic) / (1 - RATEforeign)
Forward discount / premium is calculated as…
the percent difference between the forward price and current spot rate of a unit of currency B to A.
Exchange Regimes for Countries without Own Currency:
- Formal dollarization - uses the currency of another country. Cannot create its own monetary policy.
- Monetary Union – several countries use a common currency
Exchange Regimes that have their own currency:
- Currency Board Arrangements– A commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
- Hong Kong
- Conventional Fixed Peg – A country pegs its currency within +/- 1% versus another currency
- Crawling peg – exchange rate is adjusted periodically, to adjust for inflation
- Managed Floating Exchange Rate – Monetary authority attempts to influence the exchange rate in response to specific indicators
- Independent Floating – exchange rate is market determined.
Elasticities Approach
Focuses on impact of Exchange Rate on total value of imports and exports.
Absorption Approach
Focuses on analyzing the effect of a change in exchange rates on capital flows.
Elasticities Approach
- 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
- Wx *x + Wm *(m-1) > 0
- If Wx = Wm, x + m > 1, which is the classic Marshall Lerner condition
When a currency depreciates, the trade deficit decreases (improving itself)
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The J-curve
As currency depreciates may worsen trade deficit initially, importers adjust over time by reducing quantities.
The Absorption Approach
- 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
