Learning Outcomes Flashcards
Describe Nominal and Real Interest Rates
The nominal rate reflects the raw return or cost, whereas the real rate gives a clearer view of economic value by considering inflation
Nominal Rate of Interest = Real Rate of Interest + Expected Rate of Inflation
What does the Monetary Policy Committee do
Is a body responsible for setting monetary policy, primarily by determining interest rates to achieve economic stability and specific macroeconomic objectives.
MPC Rate Increases - Borrowing Decreases - Spending Decreases - Demand Decreases - Prices Decrease - Inflation Decreases
Determinants of Interest Rates
Central Bank Policy
Inflation Expectations - high expectations cause high interest rates
Economic Growth - economic growth increases demand for investment putting upward pressure on IR
Interest Rate Theories
Liquidity Preference - Suggests that interest rates are determined by the demand and supply of money, people prefer holding cash when interest rates are lower because it’s more liquid but when rates are high they prefer to lend or invest to earn a return which reduces demand for money and raises interest rates.
Loanable Funds Theory - Focuses on the supply and demand for loanable funds, suggests that the interest rates are determined by the availability of savings (supply) and demand for loans (borrowers needing funds). When savings increase or borrowing demand decreases, interest rates fall
Interest Rate Risks
Default Risks - This is the risk that the borrower will not be able to repay the loan or bond, if there’s a higher chance of default the investor will demand for higher interest rates to compensate for the risk.
Liquidity - If an investment is harder to sell quickly, investors will want a higher return to compensate for the added difficulty
Taxation - Some bonds like municipal bonds, may be exempt from taxes which means they can offer lower interest rates because they are more attractive to investors who want to avoid taxes
The History of the Foreign Exchange
For centuries, the currencies of the world were backed by gold. In the 1920s the U.S. set the value of the dollar at 1 ounce : $20
After WW2 other countries valued their currencies on the US$ since everyone knew how much it was worth
In 1971 the US took away the gold standard altogether, this meant market forces alone determined the value of gold
Foreign Exchange Rate Terminologies
Foreign Exchange Markets - Global markets where currency is traded over the counter
Spot Exchange Rates - Is the rate existing in the market at any moment, it can be considered as the rate of exchange for immediate delivery of currency
Forward Exchange Rates - Is a rate for a given time in the future. A price js agreed now for an exchange at some time in the future.
Factors that cause Demand and Supply of a Currency to Shift
Taste/Preferences
Relative Income
Relative Price Level
Speculation
Interest Rate
Direct and Indirect Quotation
Direct - The number of units of the home currency necessary to buy one unit of foreign currency
£0.7254 - £0.7209 = $1
Indirect - The number of units of foreign currency bought with one unit of home currency
£1 = €1.3882 - 1.3866
Pegged Exchange Rates
A fixed exchange rate is a system where the other exchange rate has a set value against another currency
Pros:
Reduces risk in international trade
Introduces discipline in economic management
Cons:
Large holdings of foreign exchange reserves required
Fixed rates are inherently unstable
Floating Exchange Rate
The currency is worth whatever the buyers are willing to pay for it this is determined by supply and demand which are driven by foreign investment, inflation, import export ratios etc. Countries with more mature stable economies use a floating system.
They allow countries to retain control over their monetary policies.
Pros:
Freeing internal policy
Lower foreign exchange reserves required Fixed
Cons:
Lack of investment
Speculation
What is Purchasing Power Parity (PPP)
The exchange rate between countries which would enable exactly the same basket of goods to be purchased.
A basket that costs $100 in the US costs £50 in the UK the PPP between the uk and us would equal £1 = $2
Foreign Exchange Markets (UK)
The UK foreign exchange reserves are managed by the Bank of England.
London is the premier international centre for foreign exchange trading with a net daily volume over $6.59 trillion
The forex markets are simply the markets where you buy and sell currencies
London Interbank Offer Rate (LIBOR)
LIBOR was a benchmark rate international banks offered to each other (panel of between 11 and 18 banks)
At least 7 different maturities from overnight to 12 months
Replacements:
USD - SOFR
GBP - SONIA
CHF - SARON
JPY - TONAR
EURIBOR - ESTER
CAD - Enhanced CORRA
The Features of Money Markets
Money markets are markets in which short term instruments are traded (less than a year)
They are wholesale markets used by institutions rather than the personal sector
Trades are often >£1 million
The minimum deposit is £50,000
They’re generally really low risk and are issued by governments and institutions because of the low returns they’re expressed as basis points 1bp = 1/100 of 1%
