Foreign Exchange Markets

Question 1

What is an exchange rate?

Answer 1

The price of one currency in terms of another

Question 2

What are bid and offer rates?

Answer 2

Bid rate= the rate at which the bank will buy pounds (i.e sell dollars)
Offer rate= the rate at which the bank will sell pounds (i.e buy dollars)

Question 3

What is the foreign exchange market?

Answer 3

Global market place that facilitates the trading of different national currencies. The rate at which one currency is exchanged for another is determined by supply and demand

Question 4

What is meant by appreciation and depreciation?

Answer 4

Appreciation= a currency rises in value relative to another currency
Depreciation= a currency falls in value relative to another currency

Question 5

What is a nominal exchange rate?

Answer 5

tracks the movement of a currency against another currency.
Rise= appreciation of indexed currency
Fall= depreciation of indexed currency

Question 6

What is a real exchange rate?

Answer 6

tracks the changes in economic competitiveness of one currency against another
Rise= loss of competitiveness of indexed currency
Fall= rise in competitiveness of indexed currency

Question 7

How do you calculate the real exchange rate?

Answer 7

Nominal exchange rate x price index UK / price index UK

Question 8

What is the effective exchange rate?

Answer 8

the measure of whether a currency is appreciating or depreciating against a weighted basket of foreign currencies.
Real effective exchange rate gives a better idea of changes in competitive position than the nominal effective exchange rate

Question 9

What is the difference between spot and forward exchange rates?

Answer 9

Spot= immediate delivery
Forward= quoted for a given date in the future

Question 10

What is transaction risk?

Answer 10

Adverse effect of a transaction due to exchange rate changes

Question 11

How is transaction risk managed?

Answer 11

• Netting= engage in a similar deal with an alternative currency so losses of one currency are offset by the gains of another
• Matching= keep cash flow in the foreign currency and use it to fund activities abroad
• Hedging= buy forward instruments that allow you to ‘fix’ exchange rate to the forward rate to offset losses

Question 12

What is translation risk?

Answer 12

Fluctuations in the balance sheet or income statement when denoted in different currencies

Question 13

How is translation risk managed?

Answer 13

Matching the currency of assets and liabilities

Question 14

What is economic risk?

Answer 14

Supply and demand risk due to exchange rate changes

Question 15

How is economic risk managed?

Answer 15

Avoiding cost increases by being flexible and able to quickly change suppliers. Strong marketing to create brand loyalty means there will be little changes in demand despite exchange rate changes

Question 16

Who are the buyers and sellers of currency?

Answer 16

• Commercial companies
• International and commercial banks
• Dealers acting as marker makers of currency (big banks)
• Brokers
• Governments
• Speculators and arbitrageurs (take advantage of FX pricing anomalies)
• Fund managers
• Central banks
• Tourists

Question 17

How does the demand for domestic currency change?

Answer 17

• Appreciation of domestic currency= demand decreases
• Depreciation of domestic currency= demand increases

The lower the exchange rate the cheaper domestic goods are for foreigners. This implies the country exports more so foreign currency is changed to domestic.

Question 18

What factors cause shifts in the demand curve?

Answer 18

• Foreign income= increase causes increased demand for domestic goods abroad
• Foreign tastes= foreigners develop liking for domestic good means demand for the good and therefore domestic currency increases
• Foreign price= foreign price changes impact demand for domestic goods
• Quality of domestic goods= high quality means higher demand

Question 19

How does the supply of domestic currency change?

Answer 19

• Appreciation of domestic currency= supply increases
• Depreciation of domestic currency= supply decreases

The higher the exchange rate the cheaper foreign goods are for consumers. This implies the country imports more so domestic currency is exchanged for foreign currency.

Question 20

What factors cause shifts in the supply curve of domestic currency?

Answer 20

• Domestic income= if increases it causes demand for foreign goods to increases so people exchange domestic currency for foreign currency
• Domestic taste= if foreign goods become popular their demand increases
• Domestic price= pricing strategy of domestic firms affects consumer choices
• Quality of foreign goods= if foreign goods become desirable their demand increases

Question 21

What is a floating exchange rate regime?

Answer 21

Authorities don’t intervene to but/sell currencies in the Forex. They allow the value of their currency to fluctuate due to supply and demand.

Question 22

What are the advantages and disadvantages of a floating exchange rate regime?

Answer 22

Advantages
- monetary policy is free
- economic fluctuations are reduced
Disadvantages
- currency fluctuations are increases
- lower planning security
- lower trade benefits

Question 23

What is a fixed exchange rate regime?

Answer 23

Exchange rate is fixed against another currency at a given target exchange rate. The central bank of that currency commits to buying and selling currency to maintain the fixed rate.

Question 24

How does the central bank maintain a fixed exchange rate?

Answer 24

If domestic currency needs to depreciate the central bank prints new currency and buys domestic currency.
If domestic currency needs to appreciate the central bank sells foreign currency its accumulated from past purchases

Question 25

What are the advantages and disadvantages of a fixed exchange rate regime?

Answer 25

Advantages
- currency fluctuations are reduced
- More planning security
- more trade benefits
Disadvantages
- monetary policy cannot be used for other goals
- economic fluctuations are emphasised (e.g. in a recession, a fixed FX doesn’t allow exports to pick up and prolongs a recession)

Question 26

What is purchasing power parity?

Answer 26

A basket of traded goods should cost that same regardless of the currency in which it was sold.

Question 27

What are the assumptions of PPP?

Answer 27

• all goods are identical in both countries
• trade barriers and transportation costs are low
• many goods aren’t traded across borders