Foreign Exchange Flashcards
Foreign exchange market
a market for converting the currency of one country into that of another country
Exchange Rate
the rate at which one currency is converted into another
Spot Exchange Rate
the rate at which a foreign exchange dealer converts currency on any particular day
Forward Exchange Rate
the exchange rate governing forward exchange transactions, calculated at the time of the exchange but based on future expectations. (Forward Exchange– when two parties agree to exchange currency and execute a deal at some specific date in the future )
Nominal exchange rate
the rate at which a person can trade the currency of one country for the currency of another country
– AU$1 buys US$.78 or 94 Japanese Yen
Real exchange rate
the rate at which a person can trade the goods and services of one country for the goods and services of another ( the exchange rate in real-time when you trade goods and services)
– Real exchange rate = Nominal exchange rate * domestic price/Foreign price, or
– Nominal exchange rate * a price index of the domestic basket of goods and services/a price index of a foreign basket of goods and services
Why real exchange rate? – A depreciation or fall in the Australian real exchange rate means that the Australian goods and services have become cheaper relative to foreign goods and services, resulting in the rise of Australian exports, and Australian imports fall.
Currency Speculation
moving funds from one currency to another over the short-term in hopes of profiting from shifts in the exchange rate (put your money at risk and expecting to have profit in return in a short amount of time, e.g. stock trading– to gamble your money)
Hedging
the process of insuring one’s business against foreign exchange risk by using forward exchange or currency swaps
Currency hedging: hedging through use of instruments in forward exchange market (e.g. forward contracts, options, futures)
Strategic hedging: Diversifying markets (natural hedging); with different exchange rates, spreading risk by earning in multiple currencies ,adjusting operational decisions, e.g. Move production offshore, make productivity gains, sign longer-term contractual commitments, switch to domestic suppliers.
Arbitrage
The purchase of securities in one market for immediate resale in another market to profit from a price discrepancy.
Law of One Price
The principle that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell of the same price when their price is expressed in the same currency.
Purchasing Power Parity (PPP) Theory :
The real or PPP exchange rate when comparing the price of identical products at two markets.
Absolute PPP: The purchasing power is always the same at home and abroad, then the real exchange rate cannot change and the nominal exchange rate between the currencies of two countries should reflect the price levels of those two countries.
Relative PPP: PPP theory predicts that exchange rates are determined by relative prices, price levels will increase if there is inflation and that changes in relative prices will result in a change in exchange rates.
What are the approaches to forecasting exchange rates ?
Based on the assumption of inefficient market– a market in which prices do not reflect all available information
- Fundamental Analysis : draws on economic theory to consturct economic models for predictiing exchange rate movements Technical Analysis : uses price and volume data to determine past trends, which are expected to continue into the future
What are the examples of foreign exchange risks??
Transaction Exposure:
Individual transactions is affected by fluctuations in foreign exchange values. (short-term effect on individual transactions)
Translation Exposure:
The extent to which the reported consolidated results and balace sheets of a corporation are affected by fluctuations in foreign exchange values. ( the impact of currency exchange rate changes on the reported financial statements of a company.
Economic Exposure:
The extent to which a firm’s future international earning power is affected by changes in exchange rates. (long-term effect of the changes in exchange rates on the economy)
How to determine the exchange rate?
• Demand and supply
• It is determined by the market, government intervention
• The price should be the same across countries
Nominal exchange rate differs from real exchange rate
