FX Markets Flashcards
What do FX Markets allow and facilitate?
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.
How is the Exchange rate defined?
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.
What 2 systems were present before the Washington Consensus?
1st: Golden Standard
Exchange rates were fixed to a certain amount of Gold
$35 per ounce of gold
The depletion of Gold reserves coupled with lack of confidence led to its downfall.
2nd: Bretton Woods System (1944-1971)
The Smithsonian Agreement I (1971) increased the flexibility of the BW system.
The Smithsonian Agreement II (1973) abandoned fixed rates entirely, allowing rates to float freely.
According to the course, why was Golden Standard abandoned?
- High US inflation (led to doubts that exchange rate can be maintained)
- Depletion of Gold reserves (meaning that central banks were unable to maintain the value of the currency)
What are the 2 Smithsonian Agreements?
- The Smithsonian Agreement I (1971) increased flexibility of the BW system.
- The Smithsonian Agreement II (1973) abandoned any link to any asset with currency. This served as the inception of the free-floating rate.
Why is the credibility of a fixed exchange rate system so vital?
Once the credibility of a fixed exchange rate system is damaged, speculative selling can make it unsustainable.
A reason for this is that Private sector currency trading now dwarfs the size of governments’ currency reserves.
How do Exchange rates affect International Trade?
International trade is sensitive to exchange rate shifts.
As an example:
Export competitiveness is equally affected by:-
- A 1% shift in producer prices (in own currency)
- A 1% shift in the exchange rate (as it makes goods more expensive abroad)
What impact does the strength of the currency have on the Economy?
- A strengthening currency (Appreciation) reduces export competitiveness, but lowers the prices of imports; most notably oil imports.
- A weakening currency (Depreciation) increases the price of imports, and can increase inflation. But also makes exports more competitive.
What methods have governments used in the past to control exchange rates?
- Formal targets (Such as ERM, HKD/$ peg)
- Informal targeting
- Shifts in interest rates (Using the power of ‘Hot cash flows’)
- Direct intervention in the FX markets
What was the main reason for the UK joining the ERM?
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)
When and Why did the UK fall out of the ERM?
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.
Who lost and who gained on Black Friday?
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.
When was the Euro introduced and when were others phased out?
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.
What are the basic features of the Euro?
- 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
What are the 4 trading activities that drive the FX Markets?
- Trade transactions
- International Investment Flows
- Hedging (reducing FX risk)
- Speculating (deliberately taking FX risk)
What are the 2 types of Currency risk?
Transaction risk
Translation risk
Can be hedged by using derivatives; dealing in related forwards or using swaps
What is Transaction risk?
Transaction risk:
Exchange rate movements alter the price of goods they need to buy or sell abroad.
What is Translation risk?
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
What is Currency Arbitrage?
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.
Why is Currency arbitrage difficult?
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.
What is Purchasing Power Parity?
PPP is an attempt at a valuation model for exchange rates, to determine whether current market rates are over or under valued.
What is the Law of One Price?
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.
What is relative PPP?
A concept that suggests that the nominal exchange rate adjusts to maintain a constant real exchange rate in response to differences in inflation rates.
What is the accepted ‘Half-Life’ of Exchange Rate Deviations?
Exchange rate ‘deviations’ from PPP levels tend to have a half-life of 3 to 5 years.