Introduction To Exchange Rates

Question 1

What is an exchange rate?

Answer 1

• the price of one currency in terms of another

Question 2

Describe the two ways in which exchange rates can be quoted

Answer 2

Price quotation system - Normally as domestic currency per unit of foreign currency

Volume quotation system- Sometimes as foreign currency per unit of domestic currency

Question 3

What do exchange rates allow is to do?

Answer 3

• denominate the cost or price of a good or service in a common currency

Question 4

What is depreciation?

Answer 4

• a decrease in the value of a currency
• a weakening of the currency

Question 5

What is appreciation?

Answer 5

• increase in the value of a currency
• currency had strengthened

Question 6

What does an appreciated currency mean?

Answer 6

• currency is more valuable and can be exchanged for a larger amount of foreign currency
• imports become less expensive and exports become more expensive

Question 7

Using price quotation system what happened when the exchange rate rises?

Answer 7

• home currency depreciates
• foreign currency appreciates
• relative cheapening of domestic currency
• exports less expensive
• imports more expensive

Question 8

What does a depreciated currency mean?

Answer 8

• depreciated currency is less valuable
• imports are more expensive
• domestically produced goods and exports less expensive

Question 9

Using the price quotation system what happens when the exchange rate falls?

Answer 9

• home currency appreciates
• foreign currency depreciates
• relative rise in the value of domestic currency

Question 10

What are the two types of exchange rate regimes?

Answer 10

• floating
• fixed

Question 11

What is a fixed rate regime

Answer 11

• also known as a pegged exchange rate
• exchange rate fluctuates in a narrow range (1-2%) or not at all against some base currency over a sustained period
• government intervenes to maintain this

Question 12

What is a floating exchange rate regime?

Answer 12

• also known as a flexible regime
• exchange rate fluctuated in a wider range
• government does not intervene

Question 13

What are foreign exchange markets?

Answer 13

• set of markets where foreign currencies and other assets are exchanged for domestic ones

Question 14

Who are the participants in foreign exchange markets?

Answer 14

• commercial banks
• non-bank financial institutions ( mutual funds, hedge funds, etc.)
• non-financial businesses (firms)
• central banks

Question 15

What is a spot contract?

Answer 15

• simplest FOREX transaction regarding the immediate exchange of currency for another between two parties
• also the most common type of transaction

Question 16

What other FOREX contracts exist?

Answer 16

• forwards
• swaps
• futures
• options

Collectively called derivatives

Question 17

What is a forward contract?

Answer 17

• contract in which the two parties make the contact today but the settlement date is in the future

Question 18

What are forward rates?

Answer 18

• exchange rates for currency exchanges that will occur at a future date
• involve delivery of currency at some specified time in the future
• useful in hedging exchange rate risk

Question 19

What is the nominal exchange rate?

Answer 19

• relative price of two currencies

Question 20

What is the real exchange rate?

Answer 20

• compared the relative price of two countries goods baskets

Question 21

What are the 7 stylised facts regarding exchange rates?

Answer 21

1. Exchange rates are very volatile
2. Exchange rates are persistent
3. Exchange rates are unpredictable
4. Short- run exchange rate is many times more volatile than its determinants
5. Long-run countries with high inflation tend to have depreciating currencies
6. The faster a country’s money supply growth is the faster the exchange rate depreciates
7. Countries with large trade deficits tend to have depreciating currencies