Currency Exchange Rates - Systems & Calculations

Question 1

When does demand for a country’s currency rises?

Answer 1

When someone buys merchandise, a capital asset or a financial instrument from another country, the seller wishes to be paid in their domestic currency

Thus, in general, when the demand for a country’s merchandise, capital assets and financial instruments rises, demand for its currency rises

Question 2

What is an exchange rate?

Answer 2

The exchange rate is the price of one country’s currency in terms of another country’s currency

For international exchanges to occur, the two currencies involved must be easily convertible in terms of another country’s currency

Question 3

What are the 4 systems for setting exchange rates are in use?

Answer 3

4 systems for setting exchange rates are in use are as follows:

1. Fixed rates
2. Freely floating rates
3. Managed floating rates
4. Pegged rates

Question 4

What is a Fixed exchange rate system?

Answer 4

In a fixed exchange rate system, the value of a country’s currency in relation to another country’s currency is either fixed or allowed to fluctuate only within a very narrow range

If the forces of supply and demand appear to be causing the values of the currency to fluctuate, the country’s government intervenes to maintain it within the specified range (or prints money, generating inflationary pressure)

Question 5

What is an advantage to a fixed exchange rate?

Answer 5

One very significant advantage to a fixed exchange rate is that it makes for a high degree of predictability in international trade because the element of uncertainty about gains and losses on exchange rate fluctuations is eliminated

Example: Since July 1986, the Saudi government has allowed its currency to trade within an extremely narrow band surrounding the ratio of 3.75 riyals to 1 U.S. dollar. Since the U.S. buys a tremendous amount of petroleum from Saudi Arabia, this system has the advantage of adding a degree of stability to the U.S. oil market

Question 6

What is a disadvantage to a fixed exchange rate?

Answer 6

A disadvantage is that a government can manipulate the value of its currency

Example: One of the complaints of authorities in the U.S. with respect to its enormous trade deficit with China is the belief that the Chinese government has held value of the yuan in an artificially low range in order to make its exports more affordable

After years of urging by the U.S. government, China allowed its currency to rise almost 18% between 2005 and 2008. After further negotiations, China agreed in June 2010 to allow the yuan to rise even more

Question 7

What is a Freely floating exchange rate system?

Answer 7

In a freely floating exchange rate system, the government steps aside and allows exchange rates to be determined entirely by market forces of supply and demand

Question 8

What is an advantage of a freely floating exchange rate system?

Answer 8

The advantage of such a system is that it tends to automatically correct any disequilibrium in the balance of payment

Question 9

What is a disadvantage of a freely floating exchange rate system?

Answer 9

The disadvantage is that a freely floating system makes a country vulnerable to economic conditions in other countries

Question 10

What is a Managed float exchange rate system?

Answer 10

In a managed float exchange rate system, the government allows market forces to determine exchange rates until they move too far in one direction or another. The government will then intervene to maintain the currency within the broad range considered appropriate

The system is the one currency in use by major trading nations

Example: In 2000, the so-called G8 nations (Canada, France, Germany, Italy, Japan, the Russian Federation, United Kingdom and the U.S.) agreed on collective action to stop the slide of the euro against the U.S. dollar by selling dollars and buying euros

Question 11

What is an advantage of a managed float exchange rate system?

Answer 11

The advantage of managed float is that it has the market-response nature of a freely floating system while still allowing for government intervention when necessary

This system has allowed the network of international trade to be robust in normal times while responding effectively to such crises as the OPEC oil embargo of 1973-1974 and the large U.S. budget deficits of the 1980s and ’90s

Question 12

What is a disadvantage of a managed float exchange rate system?

Answer 12

The criticism of managed float is that it makes exporting countries vulnerable to sudden changes in exchange rates and lacks the self-correcting mechanism of a freely floating system

Question 13

What is a Pegged exchange rate system?

Answer 13

In a pegged exchange rate system, a government fixes the rate of exchange for its currency with respect to another country’s currency (or to a “basket” of several currencies)

The pegging country then calculates its currency’s movement with respect to the currencies of third countries based on the movements of the currency to which it has been pegged

Example: The currencies of Saudi Arabia and China, being essentially fixed with respect to the U.S. dollar, are pegged to the dollar with respect to the currencies of other countries. If the dollar appreciates to the euro, the riyal and yuan also appreciate against the euro

Question 14

What is a Spot rate?

Answer 14

The spot rate is the number of units of a foreign currency that can be received today in exchange for a single unit of the domestic currency

Question 15

What is a Forward rate?

Answer 15

The forward rate is the number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at some definite date in the future

Question 16

When would a domestic currency be trading at a forward premium with respect to a foreign currency?

Answer 16

If the domestic currency fetches more units of a foreign currency in the forward market than in the spot market, the domestic currency is said to be trading at a forward premium with respect to the foreign currency

Example: If the pound is fetching more francs in the forward market than in the sport market, the pound is currently trading at a forward premium with respect to the franc. This reflects the market’s belief that the pound is going to increase in value in relation to the franc

Question 17

When would a domestic currency be trading at a forward discount with respect to a foreign currency?

Answer 17

If the domestic currency fetches fewer units of a foreign currency in the forward market than in the spot market, the domestic currency is said to be trading at a forward discount with respect to the foreign currency

Example: If the franc is fetching fewer pounds in the forward market than in the spot market, the franc is currently trading at a forward discount with respect to the pound. This reflects the market’s belief that the franc is going to lose value in relation to the pound

Question 18

What is the calculation for a Forward premium or discount?

Answer 18

The forward premium or discount on one currency with respect to another currency can be calculated by multiplying the percentage spread by the number of forward periods in a year:

(Forward rate - Sport rate) / Spot rate
x Days in year / Days in forward period

Question 19

If the domestic currency is trading at a Forward Premium, what is expected to happen?

Answer 19

If the domestic currency is trading at a forward premium = gain in purchasing power

Question 20

If the domestic currency is trading at a Forward Discount, what is expected to happen?

Answer 20

If the domestic currency is trading at a forward discount = loss in purchasing power

Question 21

What is a Cross rate?

Answer 21

A cross rate is used when the two currencies involved are not stated in terms of each other. The exchange must be valued in terms of a third currency (very often the U.S. dollar)

= Domestic currency per U.S. dollar / Foreign currency per U.S. dollar

Example: A firm in Sweden needs to make a payment of 100,000 yen today. However, the krona is not stated in terms of yen, so a cross rate must be calculated

Question 22

What is the relationship between the supply of and demand for a foreign currency by consumers and investors?

Answer 22

This relationship is depicted in the exchange rate equilibrium graph

The demand curve for the foreign currency is downward sloping because, when that currency becomes cheaper, goods and services denominated in that currency become more affordable and domestic consumers need more of that currency

The supply curve for the foreign currency is upward sloping because, when that currency becomes more expensive, goods and services become more affordable to users of the foreign currency. leading them to inject more of their currency into the domestic market

Question 23

What is a country’s balance of payments?

Answer 23

The balance of payments consists of two major categories:

The current account is the net of all cross-border transactions associated with the exchange of goods, services, interest and dividends and non-reciprocal transfers (foreign aid, remittances to relatives, etc.)

The net of cross-border transactions associated with goods alone is called the balance of trade

The capital account is the net of all cross-border transactions associated with capital assets and financial instruments

Question 24

Why does a nation with an unfavorable balance of payment need to keep reserves of their currency as well as other foreign currency?

Answer 24

When a nation has an unfavorable balance of payments, it must keep reserves of its own or other countries’ currency sufficient to net the deficit to zero

The necessity of holding such reserves depletes the country’s reserves of foreign currencies and ties up domestic funds that could be used for other purposes

Question 25

How can the impact of currency exchange rates on the balance of trade be summarized?

Answer 25

The impact of currency exchange rates on the balance of trade can be summarized as follows:

If a country’s currency is weak, its goods and services are more affordable to foreign consumers. These countries tend to have a positive balance of trade

By the same token, if a country’s currency is strong, its goods and services are more expensive to foreign consumers. These countries tend to have a negative balance of trade

Question 26

What is one reason why the U.S. has a negative balance of trade?

Answer 26

One of the reasons that the United States has run a deficit balance of trade every year since 1975 is that the strong dollar has encourage U.S. consumers to purchase large quantities of imported goods while simultaneously making U.S.-made goods less desirable to foreign consumers

Question 27

What is a short-term approach that the government can do to correct a deficit balance of payments?

Answer 27

As a short-term measure, a government can attempt to correct a deficit balance of payments by deliberately devaluing its currency. This makes the country’s goods more affordable, causing export to rise

Disadvantages of this approach:

1. By making imports more expensive, consumers can complain because they have fewer choices
2. Over the long run, domestic producers can raise their own prices to match those of the more expensive imported goods