exchange rates

Question 1

what determines an exchange rate?

Answer 1

the exchange rate between two countries is determined by the relative demand for each currency

Question 2

what does the demand for US$ determine in the UK£ market?

Answer 2

the demand for US dollars in the UK simultaneously determine the supply of UK pounds for this currency in the foreign exchange market and vice versa for UK pound in US

Question 3

what is an appreciation?

Answer 3

a rise in the price of a currency

Question 4

what is a depreciation?

Answer 4

a fall in the price of a currency

Question 5

what is the effect of a depreciation on the net trade?

Answer 5

all other things being equal, a depreciating currency will lead to a fall in price of that countries export and a rise in the price of the imports therefore leading to a rise in demand for exports and decrease in demand for imports so net trade increases

Question 6

what are the two types of exchange rates?

Answer 6

floating and fixed

Question 7

what is a fixed exchange rate?

Answer 7

a fixed exchange rate is where one currency is tied to the value of another

Question 8

what is a floating exchange rate?

Answer 8

a floating exchange rate is one where the currency is allowed to float and is determined by the market supply and demand

Question 9

what occurs in a floating exchange rate when the market traders wish to sell more pounds then there is demand from dollar holders?

Answer 9

the pound will depreciate as the excess supply of pounds will only be cleared by a fall in its dollar price

Question 10

what occurs in a floating exchange rate when the market trader wish to sell more pounds then there is demand from dollar holders?

Answer 10

if there is excess supply of pounds then the bank of engalnd must buy a sufficient amount of its own currency with the foreign currency reserves in order to equal the excess quantity of pounds the market is selling. this is the only way to keep the exchange rate fixed

Question 11

what is the condition for a fixed exchange rate to be sustainable in the long run?

Answer 11

the number of times the bank sells dollars and buys pounds is equal to the number of times it buys dollars and sells pounds

Question 12

what is the problem of fixing rates?

Answer 12

the central banks foreign reserves need to be able to cover any short term imbalances
it must have an idea on the long term intermediate value
the growths paths might diverge (eg the gold standard before and after the first world war)
can lead to deflated income if the pound is overvalued

Question 13

what was the bretton woods system?

Answer 13

it was a system that created the fixed dollar standard. japan and germanies who has there economies wrecked in WW2 were set at low levels compared to US and UK. this led to a rapid recovery by Japan and germnay with their ecomies and exports increasing causing their currencies to be undervalued
after 20 years the dollar and pound became relatively overvalued and the 1944 exchange rates could not hold leading to the Pound to devalue in 1967 and the US abandoned the dollar fixed rate system in 1973. after this floating rates have remained.

Question 14

what determines the flow of pounds and dollars onto the foreign exchange market?

Answer 14

the international trade in goods and services
the international flows of financial assets
the expectations of future changes in the pound/dollar exchange rate

Question 15

what are the factors of the international trade in goods and services?

Answer 15

the demand for US imports in the UK and the demand for Uk exports in the USA

Question 16

what are the factors of the international flows of financial assets?

Answer 16

the desire to place UK funds in the USa and the desire to place US funds in the UK

Question 17

what is the effect of future changes in the pound/dollar exchange rate?

Answer 17

it will affect both current account and financial account trading

Question 18

what is the nominal exchange rate?

Answer 18

The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another i.e. $ per £

Question 19

what is the real exchange rate?

Answer 19

The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another

Question 20

what is the international standard by which the purchasing power of all currencies is measured?

Answer 20

the us dollar

Question 21

why does the nominal exchange rate deviate from the real exchange rate?

Answer 21

it depends on the speculative flows of funds in the foreign exchange market. the nominal market price of any asset will depart from its real intrinsic value depending on how much people want to pay for it in current trades

Question 22

how can you estimatre the real exchange rate of any currency?

Answer 22

we can estimate the real exchange rate of any currency by measuring how much it can purchase of a sample basket of goods compared to other currencies
if the US dollar can purchase far more of a sample goods in china then the USA then we can adjust exchange rates to estimate their real PPP values. (real value fo US$ is greater then its nominal value in china)

Question 23

what is the advantage of PPP valued exchange rates?

Answer 23

Using PPP-valued exchange rates helps to reduce misleading internationalcomparisons (for example in comparing countries’ GDP per head)

Question 24

what are the disadvantages of using PPP valued exchange rates?

Answer 24

the PPP measurement is subject to critism. how can you select and value a sample basket of international goods ( certain cultures may value certain goods more then other countries)

Question 25

what is the relationship between price levels and the real per capita income?

Answer 25

price levels are positvely related to levels of real income per capita. so a single dollar measured in PPP rates generally buy more in a poor country then in a rich one. this is because the prices of tradeable goods between countries experience a narrowing of differences when measured by a common PPP exchange rate however for local domestic goods which are not traded internationally this does not occur. this is because the MPL is lower in poor, labour intensive countries and therefore wages are lower so overall price levels are lower

Question 26

what is dualism?

Answer 26

there is a two fold economy where there is a wealthy minority living in a high wage sector which consumes may imported goods and where price levels are more in line with rich countries and a poorer low wage sector operating in an informal economy based on local production where price levels are much lower. it is typical of less developed countries

Question 27

who operates on the foreign exchange markets?

Answer 27

commercial banks - every large international transaction involves money transfers from one parties bank to another. therefore banks routinely buy and sell currencies on behalf of their clients and the greatest volume of these transactions are for corporate clients
multinational corporations - they will regularly be earning revenue in one country and paying bills occurring in others. such transactions internal to MNCs will mean they trade on the forex market independent of banks
nonbank financial institutions- move in and out of currencies so must use forex market
central banks - may enter forex market on behalf of their governments. they may also buy and sell their own currency in order to deliberately influence its exchange rate

Question 28

what is larger the flows of currency on the forex market of trade in goods and services?

Answer 28

the flows of currency dwarfs that of trade in goods and services. during April in 2010, the average daily movement of forex funds was valued at 3.98 trillion which is 200x the amount of worlds imports and exports

Question 29

what is the affect of financial innovation and telecommunications development on the financial market?

Answer 29

it has eliminated the forex transaction costs and thus enabled the transfer of huge sums across the globe at the touch of a button.

Question 30

what forces spot exchange rates between financial centers to be consistent with one another?

Answer 30

the process of arbitrage - buying in one place and selling in the other

Question 31

what is a spot price?

Answer 31

the price of one currency in terms of another as agreed on the spot

Question 32

what are forward exchange rates?

Answer 32

the price of one currency in terms of another agreed for some time in the future.

Question 33

why does the forward exchange rate differ from the spot exchange rate?

Answer 33

first you need a discount to be compensated for the loss of this sum for a month; and secondly there is the added risk that the spot rate may diverge in that time due to some unexpected shock

Question 34

what is a swap?

Answer 34

This is the spot sale of a currency today combined with a forward re-purchase of the same currency,say in 30 days time. One swap transaction is thus agreed instead of two: selling £ for $ today and then selling $ forward for £ in 30 days time

Question 35

what is a futures?

Answer 35

This is a promise or contract to buy, say, $ at an agreed date in the future at a given rate which youcan sell to a third party. (It is thus a sort of insurance)

Question 36

what is an options?

Answer 36

Similarly, you can agree to buy or sell the option to buy or sell a currency.

Question 37

what does the rate of return depend on?

Answer 37

the market rate of interest on a riskless asset that any particular country offers in its home market
risk- UK bonds are considered riskless. the rate of interest is certain to be paid. however even these may be risk of change in the nominated currencies exchange rate which can affect the ROI
liquidity - some assets are quicker and easier to sell. long term securities cannot be sold quickly unless at a much reduced price. secondary markets make assets more liquid

Question 38

what is the interest parity condition?

Answer 38

international flows of pounds and currencies and the consequent movement of the exchange rate will stabilise that is the £/$ forex market will reach equilibrium, when the expected rate of return on £ assets is equal to that of $ assets.

Question 39

what is the effect of inflation on interest and exchange rates?

Answer 39

if we assume that inflation in UK is zero and there is an inflation of 1% in USA then there is a 1% fall in the real value of the dollar compared to the pound. the real rate of interest would then have to rise in the US by 1 % go maintain the interest parity condition and keep the £/$ exchange rate stable. so the $ interest rate = £ interest rate + rate of depreciation of $

Question 40

what is the expected returns function?

Answer 40

it is a curve on the graph price of £ against rates of returns in US$. the slope indicates the varying expected returns. it shows what an investor will expect to earn if she deposits US$ in exchange fro some foreign asset

Question 41

what occurs if there is a change in expectations in the forex market so that expectations are higher?

Answer 41

then at any given exchange rate, this asset will be expected to earn more and so the expect returns curve will shift right

Question 42

what does the slope of the expected returns function show?

Answer 42

it indicates the varying expected returns

Question 43

what does a vertical line for the expected returns function mean?

Answer 43

A vertical line indicates a US dollar could be any price in pounds: total unpredictability

Question 44

what does a horizontal line for the expected returns function mean?

Answer 44

If expectations are unshakeable at £1 = US$1.20 then expected returns would be horizontalat that rate.

Question 45

how can you graphically determine the $/£ exchange rate on the expected returns function?

Answer 45

suppose that the market interest rate in the USA was r* and the expectations are unchanged. then if existing £ assets earn more $ returns than r* then traders will sell $ and buy £ and convert their $ deposits into £ assets. this will cause the price of the £ to increase and conversely the $ returns. the opposite will occur if $ returns on £ assets are lower then r*. the exchange rate will stabilise at the interest parity condition where they offer the same returns

Question 46

what will occur to the expected returns function of the US $ when there is an increase in the US interest rate?

Answer 46

an increase in US interest rate will lead to an increase in demand for and the relative price of the dollar and a fall in the price of the pound as people sell £ and denominated assets to buy $ denominated ones. this will cause a decrease in the price of pounds and an extension along the expected returns function

Question 47

what will occur to the expect returns function of US $ when there is an increase in the UK interest rate?

Answer 47

an expected rise in interest rates in the city of London will cause traders to sell $ and buy £. in this case the expected returns curve shifts forward and the I function/US rates are assumed unchanged and the £ appreciates

Question 48

why might a change in interest rates not influence exchange rates?

Answer 48

if the market rates in country X rise because of perceived risk perhaps political instability or economic downturn or markets think the economic policies are inflationary (real value of currency will fall) . if this is the case then the rise in the local intersert rate may attempt to counter pessimistic expectations. this will cause the expected returns function to shift forward at the same time as negative expectations reverse this trend. therefore keeping the exchange rate stable
however this policy might cause even more oanic and therefore expectations ay shift even more negatively and will not offset the falling exchange rate. an example being black Wednesday in the united kingdom