Lecture 3 Exchange Rates Flashcards
Foreign exchange market (FX) is two tiered consisting of:
1) Decentralized wholesale or interbank market consisting of market makers
2) Retail market in which indy and corps transact with local banks
FX transaction types
Spot market - Currencies can be bought or sold for immediate delivery
Forward market - currencies can be bought or sold for delivery in the future at a price agreed upon today
Derivatives on foreign exchange include futures, options, and currency swaps.
Quoting exchange rates: American quotation
EUR/USD, GBP/USD, NZD/USD, and AUS/USD, though in fact they are quoted numerically the opposite way.
GBP/USD (also known as “cable”) is actually quoted as dollars per pound, so that 1.61 means $1.61 per pound.
How is GBP/USD (also known as “cable”) quoted
dollars per pound, so that 1.61 means $1.61 per pound.
Quoting exchange rates: European quotation
The currencies of most emerging markets, the Japanese yen, and the Swiss franc are quoted as units of domestic currency per dollar.
These exchange rates are written, for example, as USD/MXP for the Mexican peso and USD/TWD for the New Taiwan dollar (新臺幣 or 新台幣), and USD/JPY (“dollar-yen”) and, for example, though in fact they too are quoted numerically the opposite way.
How is USD/MXP for the Mexican peso quoted
The Mexican peso is actually quoted as pesos per dollar, so that 17.05 means 17.05 pesos per dollar.
Why currencies quoted relative to the U.S. dollar?
The main reason is that the U.S. dollar is still the world’s main reserve currency
80% of currency trades are against the dollar. Cross-trades (such as the Czech Krona and Swedish krone) involve first going out of one currency into the dollar, then out of the dollar into the other currency.
What is appreciation? Give an example. What does appreciation do to country?
Strengthening of a currency
If the peso appreciates relative to the U.S. dollar a peso buys more dollars. (20 pesos / 1 dollar to 10 pesos / 1 dollar)
Appreciation makes imports cheaper/exports more expensive
appreciation can make imports cheaper, reduce inflationary pressures, and increase the purchasing power of consumers in the international market. However, it can also make exports more expensive and potentially hurt a country’s trade balance.
What is depreciation? Give an example. What does depreciation do to country?
Weakening of a currency.
If the peso depreciates relative to the dollar a peso buys fewer dollars. (10 pesos / 1 dollar to 20 pesos / 1 dollar)
Depreciation makes imports more expensive/exports cheaper.
Depreciation can lead to higher import costs, which might increase domestic prices and contribute to inflation.
What is the difference between depreciation and devaluation?
Both involve a decline in an exchange rate
Depreciation occurs when a currency weakens as a result of normal market movements.
Devaluation occurs when a central bank ceases to support a fixed exchange rate. Sudden sharp declines in value of currency.
