IMF - Block 1 Flashcards
What happens when the euro appreciates, and how does it relate to exchange rates?
When the euro appreciates, it means that the euro increases in value, and this is reflected in a decrease in the exchange rate relative to a foreign currency.
What is the preferred exchange rate definition used in this course?
In this course, the preferred exchange rate definition is “home per foreign,” where the exchange rate represents the price of a foreign currency in domestic currency.
What is the correct answer regarding the relationship between the euro’s appreciation and the exchange rate, given the exchange rate definition used in the course?
When the euro appreciates, the exchange rate decreases.
What is the risk premium in the context of forward market transactions, and why does it exist?
The risk premium is the additional amount paid in a forward market transaction to avoid risk and uncertainty. It exists because the forward exchange rate may differ from the expected future spot rate.
What is the purpose of a forward market, and how does it benefit traders in foreign exchange transactions?
The forward market allows traders to fix the price and quantity of a future foreign exchange transaction in advance, eliminating the uncertainty and risk associated with future spot exchange rates. This benefit provides a hedge against potential adverse price movements.
What is the key difference between a forward market transaction and a spot market transaction?
In a forward market transaction, a contract is signed for a future exchange rate, while a spot market transaction occurs at the current market rate.
Can you provide an example of how forward contracts are used by traders and investors?
For instance, an exporter expecting payment in a foreign currency months from now can sell that currency forward. Similarly, an investor buying foreign currency to invest in foreign bonds can sell the proceeds of the investment forward, reducing exchange rate risk.
What problem do forward contracts solve for traders and investors in international transactions?
Forward contracts help traders and investors avoid the exchange risk associated with uncovered contracts when they have future payments or transfers involving foreign currencies.
Why is it stated that the phrase “Depreciation of the exchange rate” is strictly incorrect?
The phrase is considered incorrect because an exchange rate can only increase or decrease; it cannot “lose value.”
What are intermediate exchange rate regimes, and how do central banks act in them?
Intermediate exchange rate regimes involve central banks taking actions to influence exchange rates. In reality, very few rates are perfectly fixed or floating, but for theoretical and educational purposes, extreme fixed and floating regimes are convenient.
What are the characteristics of fixed exchange rate regimes, and what instruments do central banks use in these regimes?
Fixed exchange rate regimes involve central banks acting to keep the exchange rate at an official level. Instruments used in these regimes include forex interventions, interest rates, and capital controls.
How do different exchange rate regimes vary in terms of central bank (CB) interference?
Exchange rate regimes differ in their central bank (CB) interference. Fixed regimes involve CB actions to maintain the rate at an official level, while floating regimes do not involve CB interference.
List the type of fixed exchange rate systems (in the order of decreasing fixity)
-No separate legal tender (e.g., countries with euro, Ecuador has US $)
– Currency board (e.g., Hong Kong $ vs. US $)
– Other fixed pegs
– Pegs within horizontal bands
– Crawling pegs.
What is the crawling peg system?
A crawling peg is a system in which the exchange rate is adjusted periodically or continuously but within a predetermined range, it provides more flexiblity but still offers a degree of stability compared to a floating exchange rate system
Give a real world example of a crawling peg?
The State of Kuwait employed a crawling peg to manage its currency’s exchange rate, the Kuwaiti Dinar is periodically adjusted within a specificed range in relation to a basket of various currencies, including the U.S. Dollar
What is the spot exchange rate, and how is it defined?
The spot exchange rate represents the price for an immediate transaction, although it is typically effective two days after the deal. For example, if you pay €0.86 to get one dollar now, the exchange rate is €0.86/$. It is denoted as St for the rate at time t.
Why is the future spot rate (St+1) considered risky, and how does it affect financial transactions?
The future spot rate is risky because it can change, impacting the cost of transactions. For example, if you expect St+1 to be the same as St (€0.86/$), but it increases to €0.88/$, your actual cost will be higher. This uncertainty makes St+1 risky at time t.
How can one avoid the risk associated with the future exchange rate St+1?
To avoid the risk in future exchange rates (St+1), one can enter into a forward contract. A forward exchange rate, such as €0.87/$ to get one dollar next month, provides certainty and eliminates risk.
What are the two types of multilateral spot rates, and what do they measure?
The two types of multilateral spot rates are (nominal) effective rates and real effective rates. Effective rates are trade-weighted averages of indices of nominal and real rates, respectively. They measure overall competitiveness in international trade.
What is a nominal effective exchange rate, and how is it calculated?
A nominal effective exchange rate is a trade-weighted average of nominal exchange rates, considering a country’s trade relationships with its partners. It reflects the overall value of a country’s currency in international trade. To calculate it, you take a weighted average of bilateral exchange rates.
What does a nominal effective exchange rate help assess?
A nominal effective exchange rate helps assess a country’s currency strength or weakness in international trade by considering its trade relationships and the average value of its currency concerning its trading partners.
What is a real effective exchange rate, and why is it important?
A real effective exchange rate adjusts nominal effective rates for differences in price levels (inflation) between countries. It is essential because it provides a more accurate measure of a country’s trade competitiveness.
What is the core equation used to calculate the Real Exchange Rate (RER)?
he core equation for calculating the Real Exchange Rate (RER) is RER = eP/P, where “e” represents the nominal exchange rate (e.g., dollar-euro exchange rate), “P” is the average price of a good in one currency area (e.g., the euro area), and “P” is the average price of the same good in another currency area (e.g., the United States).
How is the Real Exchange Rate (RER) calculated in the Big Mac example with specific price values?
To calculate the RER in the Big Mac example, you multiply the nominal exchange rate (e=1.36) by the price in Germany (e.g., 2.5 euros) and divide it by the price in the other currency (e.g., $3.40). This gives us a real exchange rate of 1.2.