foreign exchange Flashcards
what is an exchange rate?
the value of 1 currency in the terms of another
when the value of an exchange rate is set by the govt or central bank it is called?
Fixed exchange rate
in relation to fixed exchange rates, what happens if demand & supply are not balanced?
the government has to use reserves if demand for foreign currency is greater than supply
what are floating exchange rates?
• when Exchange rates set by market forces= supply & demand
spot market
– for currency deals for immediate delivery/instruments
with maturity date within 2 business days after transaction
forwards & forward swaps
involves future delivery of currency at
specified future date (forward- any future date, more than two days)
What is Herstatt risk?
Is the risk that one party will fail to deliver terms of the contract at time of settlement, due to timing issues e.g different time zones, so banks are open at different times
what is SF/NZD asking?
the price of SF1, in terms of NZD
what is NZD/USD asking?
the price of NZD1 in terms of USD
the buying price is called?
the bid price
the selling price is called?
offer price
what is the commodity currency usually expressed as?
the one that is expressed as 1 e.g. 1 NZD, 1USD, 1 ringgit
what is the term currency
Is the currency that doesn’t have the 1 in it & varies in price
What is a direct quote?
- local currency price of 1 unit of USD
- USD is base currency and for example NZD is term currency
- e.g. in NZ, direct quote is USD/ $NZ = 1.2821 for NZD/USD 0.78
what is a indirect quote?
- Where the USD is the terms currency & the other currency (say NZD) =base currency
- e.g. NZ$1 = USD$ 0.8207 (direct quote is 1USD = 1.2185 NZD)
what is a cross rate?
A FX rate between two currencies
derived via a third
What direction does the demand and supply curve slope?
Demand- Down
Supply- Up
If NZ & US had low inflation rates and then US had a substantial and long increase in inflation what occurs
- price of US goods increases
- NZ demand for US goods decreases
- reduction in NZ demand for USD
(same as reduction in supply of NZD - S1)
What is the purchasing power parity?
• Asserts that if the product is the same across all countries e.g.
Big Mac, then so should be its price (once currency changed
into foreign at the prevailing rate)
If PPP hols what happens to the currency of a country if it has high or low inflation?
a country with high inflation will tend to depreciate relative to
countries with low inflation.
So high inflation depreciating currency
Relationship between interest rates between countries known
as?
interest rate parity
What happens if NZ interest rates rise compered to AUS that stay the same?
– Australians would put some money in
accounts in NZ to earn higher interest
– Increase in demand for NZD by Australians & at same time
New Zealanders keep investments in NZ
– So reduction of supply of NZD in FX market
– Overall, increase in interest rate causes
appreciation of NZD
The currency of the nation with _____ interest rates normally
sells at a forward _____ in terms of currency of nation with
lower interest rates.
& currency of nation with relatively _____ interest rates
normally sells at _____ forward relative to high rate country.
- Higher
- Discount
- Lower
- Premium
The different effect an increase in interest rates due to inflation has on currency compered to an increase due to real rate of interest
– If increase in interest rates due to inflation expectations increase, then, all
else being constant, currency will depreciate
– If increase in interest rates due to increase in real rate of interest,
then, all else being constant, currency will appreciate
Exchange rate expectations
• If market participants expect a depreciation of NZD, then all
else being constant, depreciation will occur (funds moved
offshore
• increase in supply of NZD on FX market as holders seek
to buy foreign currencies before value falls)
What is a Current-account (CA) balance?
- records the money from
selling goods & services to rest of world + income earned on
overseas investments versus payments
What happens in CA payments are greater than CA receipts
CA in deficit, need to finance
by borrowing FX so foreign debt increase & interest payments increase
Countries with accumulated CA deficit have ____ currency & countries with accumulated CA
surplus tend to have ____ currency
- Weak
- Strong
What efffect can political conditions have on currency?
Change in power can have a negative effect on country’s currency
What are the 4 main types of FX risk?
- Transaction exposure
- Translation exposure
- Operational exposure
- Economic exposure
What is transaction exposure?
- when the value of a company’s cash inflows
received in various currencies is affected
What is translation exposure?
- when value of assets & liabilities (usually of
foreign subsidiary) is affected
What is operational exposure?
- extent to which exchange rate volatility may affect a firm’s future operating cash flows- revenue & costs
What is economic exposure?
- broad measure that tries to capture impact of
unexpected exchange rate volatility on NPV of firm- combines
transaction & operating FX exposures
e.g. two firms (Aus & German)
selling similar product into Europe & AUD
What are a firms 4 possible responses to FX risk?
• to hedge nothing (argument company not in FX business)
• to hedge everything (too expensive)
• to forecast
• to partially hedge
- when conditions are appropriate & select most suitable
method).
what are the two categories of hedging?
(a) External or market measures
– futures/forwards
(b) Internal measures – structural techniques – match exposures – leading and lagging – diversification
