Economics Flashcards
(currency exchange rates)
foreign exchange (FX) market
Measured by daily turnover, the foreign exchange (FX) market—the market in which currencies are traded against each other—is by far the world’s largest market.
This is about 10 to 15 times larger than daily turnover in global fixed-income markets and about 50 times larger than global turnover in equities.
The FX market is also a truly global market that operates 24 hours a day, each business day. It involves market participants from every time zone connected through electronic communications networks that link players as large as multibillion-dollar investment funds and as small as individuals trading for their own account—all brought together in real time. International trade would be impossible without the trade in currencies that facilitates it, and so too would cross-border capital flows that connect all financial markets globally through the FX market.
FX market
foreign exchange is a key market for investors and market participants to understand. The world economy is increasingly transnational in nature, with both production processes and trade flows often determined more by global factors than by domestic considerations. Likewise, investment portfolio performance increasingly reflects global determinants because pricing in financial markets responds to the array of investment opportunities available worldwide, not just locally. All of these factors funnel through, and are reflected in, the foreign exchange market.
Exchange Rate
An exchange rate is simply the price or cost of units of one currency in terms of another
the exchange rate—the price at which foreign-currency-denominated investments are valued in terms of the domestic currency—becomes an increasingly important determinant of portfolio performance
how does global market affect
Even investors adhering to a purely “domestic” portfolio mandate are increasingly affected by what happens in the foreign exchange market. Given the globalization of the world economy, most large companies depend heavily on their foreign operations
Almost all companies are exposed to some degree of foreign competition, and the pricing for domestic assets—equities, bonds, real estate, and others—will also depend on demand from foreign investors. All of these various influences on investment performance reflect developments in the foreign exchange market.
Individual Currencies
Individual currencies are often referred to by standardized three-letter codes that the market has agreed upon through the International Organization for Standardization (ISO)
e.g. USD- US Dollar, EUR- Euro, INR-Indian Rupee
difference between referring to an individual currency and an exchange rate
- One can hold an individual currency (for example, in a EUR100 million deposit), but an exchange rate refers to the price of one currency in terms of another (for example, the exchange rate between the EUR and USD)
- An individual currency can be singular, but there are always two currencies involved in an exchange rate: the price of one currency relative to another. The exchange rate is the number of units of one currency (called the price currency) that one unit of another currency (called the base currency) will buy. An equivalent way of describing the exchange rate is as the cost of one unit of the base currency in terms of the price currency.
identify exchange rates
will identify exchange rates using the convention of “A/B,” referring to the number of units of currency A that one unit of currency B will buy. For example, a USD/EUR exchange rate of 1.1700 means that 1 euro will buy 1.1700 US dollars (i.e., 1 euro costs 1.1700 US dollars).1 In this case, the euro is the base currency and the US dollar is the price currency.
a decline in this exchange rate indicates that the USD is appreciating against the EUR or, equivalently, the EUR is depreciating against the USD
Nominal Exchange Rates
The nominal exchange rate E is defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency. A decrease in this variable is termed nominal appreciation of the currency.
Real Exchange Rates
The real exchange rate (RER) between two currencies is the nominal exchange rate (e) multiplied by the ratio of prices between the two countries, P/P*.
which are indexes often constructed by economists and other market analysts to assess changes in the relative purchasing power of one currency compared with another
purchasing power parity (PPP)
Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries’ currencies through a “basket of goods” approach. Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries
PPP asserts that nominal exchange rates adjust so that identical goods (or baskets of goods) will have the same price in different markets. Or, put differently, the purchasing power of different currencies is equalized for a standardized basket.
In practice, the conditions required to enforce PPP are not satisfied: Goods and services are not identical across countries; countries typically have different baskets of goods and services produced and consumed; many goods and services are not traded internationally; there are trade barriers and transaction costs (e.g., shipping costs and import taxes); and capital flows are at least as important as trade flows in determining nominal exchange rates. As a result, nominal exchange rates exhibit persistent deviations from PPP. Moreover, relative purchasing power among countries displays a weak, if any, tendency toward long-term equalization.
Foreign price level in domestic currency
Foreign price level in domestic currency = Sd/f × Pf
Sd/f is the spot exchange rate
Pf is foreign price level quoted in terms of the foreign currency
Real exchange rate
Real exchange rate(d/f) = (Sd/f × Pf)/Pd = Sd/f × (Pf/Pd)
real exchange rate
real exchange rateGBPEUR=SGBPEUR×(CPIeurCPIUK
