FX Markets

Question 1

What do FX Markets allow and facilitate?

Answer 1

FX Markets allow the exchange of one currency for another.

This facilitates;

• International Trade
• Investment in Overseas Assets

This is because Goods or Investments must be paid for with the currency of the host country.

Question 2

How is the Exchange rate defined?

Answer 2

An Exchange rate is the price of one currency in terms of another. Although Foreign (FX, Forex) can be confusing, since they are ‘relative’ prices.

Question 3

What 2 systems were present before the Washington Consensus?

Answer 3

1st: Golden Standard
Exchange rates were fixed to a certain amount of Gold
$35 per ounce of gold
The depletion of Gold reserves coupled with lack of confidence led to its downfall.

2nd: Bretton Woods System (1944-1971)

The Smithsonian Agreement I (1971) increased the flexibility of the BW system.

The Smithsonian Agreement II (1973) abandoned fixed rates entirely, allowing rates to float freely.

Question 4

According to the course, why was Golden Standard abandoned?

Answer 4

• High US inflation (led to doubts that exchange rate can be maintained)
• Depletion of Gold reserves (meaning that central banks were unable to maintain the value of the currency)

Question 5

What are the 2 Smithsonian Agreements?

Answer 5

• The Smithsonian Agreement I (1971) increased flexibility of the BW system.
• The Smithsonian Agreement II (1973) abandoned any link to any asset with currency. This served as the inception of the free-floating rate.

Question 6

Why is the credibility of a fixed exchange rate system so vital?

Answer 6

Once the credibility of a fixed exchange rate system is damaged, speculative selling can make it unsustainable.

A reason for this is that Private sector currency trading now dwarfs the size of governments’ currency reserves.

Question 7

How do Exchange rates affect International Trade?

Answer 7

International trade is sensitive to exchange rate shifts.

As an example:
Export competitiveness is equally affected by:-
- A 1% shift in producer prices (in own currency)
- A 1% shift in the exchange rate (as it makes goods more expensive abroad)

Question 8

What impact does the strength of the currency have on the Economy?

Answer 8

• A strengthening currency (Appreciation) reduces export competitiveness, but lowers the prices of imports; most notably oil imports.
• A weakening currency (Depreciation) increases the price of imports, and can increase inflation. But also makes exports more competitive.

Question 9

What methods have governments used in the past to control exchange rates?

Answer 9

• Formal targets (Such as ERM, HKD/$ peg)
• Informal targeting
• Shifts in interest rates (Using the power of ‘Hot cash flows’)
• Direct intervention in the FX markets

Question 10

What was the main reason for the UK joining the ERM?

Answer 10

ERM = Exchange Rate Mechanism

In order to control UK inflation, by limiting movement of the Exchange rate (Thus preventing rate from dropping and causing inflation as a result)

Question 11

When and Why did the UK fall out of the ERM?

Answer 11

16th September 1992 (Black Wednesday)

With UK inflation higher than that of Germany, coupled with a slowing UK economy, speculators doubted that the exchange rate was sustainable.

Speculators began to sell £s against the Mark. This put a downward pressure on the Rate.

To support the Rate, the UK BofE bought pounds on a large scale and also raised interest rates. However, on Black Wednesday, the Bank could buy no more and had to let go of the ERM. This was also arguably a result of lack of communication. Pound fell sharply against other currencies.

Question 12

Who lost and who gained on Black Friday?

Answer 12

The UK government was by far the ultimate loser in this ordeal, as it lost its credibility for the rest of its term.
Bank of England lost more than £3bn in its failed attempt, whereas speculators made corresponding gains. George Soros alone is said to have made £1bn.

Question 13

When was the Euro introduced and when were others phased out?

Answer 13

The Euro was introduced on January 1st 1999 to represent the (then) 11 currencies of 15 EU Members (DUKS opted out).

Other rates (German Mark, French Franc, Italian Lira etc.) were phased out on January 1st 2002, as they were permanently fixed together.

Question 14

What are the basic features of the Euro?

Answer 14

• Removed the need for FX transactions between EMU members.
• Second most widely traded currency (after the Dollar)
• Euro-denominated instruments are popular
• The hosts of the Euro are subject to a single Monetary Policy, which is the ECB

Question 15

What are the 4 trading activities that drive the FX Markets?

Answer 15

• Trade transactions
• International Investment Flows
• Hedging (reducing FX risk)
• Speculating (deliberately taking FX risk)

Question 16

What are the 2 types of Currency risk?

Answer 16

Transaction risk

Translation risk

Can be hedged by using derivatives; dealing in related forwards or using swaps

Question 17

What is Transaction risk?

Answer 17

Transaction risk:

Exchange rate movements alter the price of goods they need to buy or sell abroad.

Question 18

What is Translation risk?

Answer 18

The £ value of foreign assets/liabilities is affected as they are “marked to market” in the accounts at the latest exchange rates.

Balance sheet effect, not a Cash flow effect

Question 19

What is Currency Arbitrage?

Answer 19

A no-risk trade in currencies, due to its instantaneous nature.
This method takes advantage of the difference in bid/ask prices between different financial centres.

Question 20

Why is Currency arbitrage difficult?

Answer 20

FX markets are generally efficient, thus the scope for simple arbitrages is minimal.

This is partly due to the fact that Traders have set up automatic systems to take advantage of such mis-pricings in different markets.

Question 21

What is Purchasing Power Parity?

Answer 21

PPP is an attempt at a valuation model for exchange rates, to determine whether current market rates are over or under valued.

Question 22

What is the Law of One Price?

Answer 22

A Law that serves as the underlying concept for PPP. It states that similar traded goods and services that provide similar benefits should have the same price in different countries.

However, there are substantial and persistent deviations from this version of PPP, which undermines its usefulness as a valuation measure.

Question 23

What is relative PPP?

Answer 23

A concept that suggests that the nominal exchange rate adjusts to maintain a constant real exchange rate in response to differences in inflation rates.

Question 24

What is the accepted ‘Half-Life’ of Exchange Rate Deviations?

Answer 24

Exchange rate ‘deviations’ from PPP levels tend to have a half-life of 3 to 5 years.

Question 25

Why is PPP not a very powerful tool to explain real exchange rate movements?

Answer 25

Imports and Exports only account for a very small proportion of FX turnover. Most FX trade is purely capital transactions. (potential reference to Hot Cash flows)

Question 26

What factors may affect exchange rates?

Answer 26

• Relative inflation rates
• Relative real interest rates
• Relative economic growth rates
• Demand for a country’s goods and services and financial assets
• Government Policy
• Rapid productivity growth
• Current Account

Question 27

How do relative inflation rates affect exchange rates?

Answer 27

State with higher inflation rate will tend to see its currency devalue relative to other countries with lower inflation rates (PPP?)

Question 28

How do relative real interest rates affect Exchange Rates?

Answer 28

States with higher real rates might attract more capital and have stronger currencies.

Question 29

How do relative economic growth rates affect Exchange Rates?

Answer 29

States with higher real growth may tend to attract more capital.

Question 30

How does demand for a state’s goods, services and financial assets affect Exchange Rates?

Answer 30

The higher demand, the greater a state’s currency is likely to be (Ceteris Paribus). This is because all goods and services have to be paid for in the host state’s currency.

Question 31

How does Government Policy affect Exchange Rates?

Answer 31

Restrictions on foreign exchange, trade and investment can depress a currency’s value, as the currency is bought less.

Question 32

How does rapid productivity growth affect Exchange Rates?

Answer 32

States experiencing particularly high productivity growth tend to see their currencies appreciate against slower-growing competitors, as more people invest in their currency.

Question 33

How does the Current Account affect Exchange Rates?

Answer 33

Large current account deficits can foreshadow currency problems since these imply a large amount of foreign capital is needed to finance current spending levels.

A trade deficit might also be an indication that the currency is currently overvalued and needs to fall to restore export competitiveness.

Question 34

What Risk factors can help determine the Exchange Rate?

Answer 34

• A short history (Political changes could lead to currency trading at low values)
• Reputation (Stable State’s tend to have higher currency values)
• Foreign Currency reserves (Larger reserves can help resist crises and maintain value, such as China’s reserves)
• High Debt and Borrowing levels in foreign currencies may reflect high risk, leading to currency trading at low values

Question 35

Why is it difficult to forecast Exchange Rates?

Answer 35

Forecasting is difficult due to the vast numbers of factors, and their unpredictable nature.
Although analysts always find convincing explanations for movements that occur.

Economist models are only useful in explaining long-term movements, over periods of up to 2 years.

Question 36

What is a Spot FX Transaction?

Answer 36

The immediate exchange of currencies at the current (spot) exchange rate.

Question 37

What is a Forward FX Transaction?

Answer 37

The exchange of currencies at a specified date in the future at an exchange rate which is specified now (the forward exchange rate)

Question 38

What are Carry Trades?

Answer 38

The practice of borrowing in countries with low interest rates and lending into those with higher interest rates. These tend to make money, but are risky due to the large potential losses if it is done the wrong way.

Question 39

Describe the FX markets.

Answer 39

• FX markets are huge and liquid
• Currency risk is a major concern for corporations, investors and financial institutions. All of which hedge/speculate as appropriate.
• FX markets are more unpredictable than other markets, but there are a number of factors that can be identified as affecting exchange rates in the long-term.