Part 7. Currency Exchange Rates Flashcards
what does 1.25 USD/EUR mean?
USD = price currency (direct quote from point of views of investor in price currency country).
EUR = base currency (indirect quote from point of view of investor in base currency country).
i. e. the price of 1 euro is 1.25 USD, so 1.25 is the price of one unit of the base currency in terms of the other.
i. e. the quote of 1/1.25 = 0.8 EUR/USD would be a direct ER quote for EUR-based investor, and indirect quote for USD-based investor.
Nominal exchange rate
$1.416/euro suggests in order to purchase one euro’s worth of g/s in Euroland, the cost in US dollars will be $1.416.
Real exchange rate
The dollar cost of purchasing the same unit of g/s based on new (current) dollar/euro exchange rate and relative changes in price levels of both countries.
Spot exchange rate
The currency exchange rate for immediate delivery, for most currencies means the exchange of currencies takes place 2 days after the trade.
Forward exchange rate
The currency exchange rate for an exchange to be done in the future.
A forward is an agreement for an agreement to exchange a specific amount of one currency for a specific amount of another on a future date specified in forward agreement.
Speculative transation/position
When a transaction in foreign exchange markets increases currency risk.
Sell side vs Buy side
Sell-side - the primary dealers in currencies and originators of forward FX contracts are larger multinational banks.
Buy-side - this consists of many buyers of foreign currencies and forward FX contracts.
Buy side buyers
- Corporations
- Investment accounts
- Retail money accounts - mutual funds, pensions funds, insurance companies not using derivatives
4, Leveraged accounts - firms who use derivatives including hedge funds, firms trading own accounts, other trading firms
- Government/Gov entities - sovereign wealth funds, pension funds, etc.
- Retail market - by households and small institutions
Cross rate
The exchange rate between 2 currencies is implied by exchange rates with a common third currency.
i.e. these are necessary when there is no active FX market in the currency pair.
No arbitrage condition
The free trade of currencies and forward currency contracts mean the percentage difference between forward and spot exchange rates is approx. equal to the difference between 2 countries’ interest rates.
This is due to an arbitrage trade with riskless profit to be made when the relation does not hold.
Forward discount/premium
A currency is calculated relative to spot exchange rate, for the base currency is the percentage difference between forward price and spot price.
Countries that do not have their own currency
- Formal dollarisation = use currency of another country, but cannot have their own monetary policy as they do not create money/currency.
- Monetary union = join a common currency, and them giving up the ability to set up a monetary policy of the European Central Bank.
Countries have their own currency
- Currency board arrangement
- An explicit commitment to exchange domestic currency for specified foreign currency at a fixed exchange rate, e.g. HK monetary authority can earn interest on its US dollar balances, whose currency is only issued when fully backed by holdings of an equivalent amount of US dollars. - Conventional fixed peg arrangement
- A country pegs its currency within margins of +-1% vs another currency or basket that includes the currencies of its major trading or financial partners.
- Direct intervention = monetary authority maintain ER within band by purchasing or selling foreign currencies in foreign exchange market.
- Indirect intervention = includes changes in IR policy, regulation of foreign exchange transactions, convincing people to constrain foreign exchange activity.
- Target zone
- The permitted fluctuations in currency value relative to another currency or basket of currencies are wider (+-2%); the monetary authority has more policy discretion as band is wider. - Crawling peg
- The ER adjusted periodically for higher inflation vs currency used in peg (passive crawling peg).
- A series of ER adjustments overtime announced and implemented; influencing inflation expectations (active crawling peg).
- Management of exchange rates within crawling bands
- The width of bands identify permissible ER is increased over time; used to transition from fixed peg to floating rate when monetary authority lack of credibility makes immediate change to floating rates impractical.
- MP flexibility increases with band width.
- Managed floating exchange rate
- The monetary authority attempts to influence ER in response to specific indicators such as BOP, inflation rates, or employment without target ER or predetermined ER path.
- Intervention will be direct or indirect; management of ER induce trading partners to respond in ways to reduce stability.
- Independent floating
- The ER is market-determined and foreign exchange market intervention is used to slow rate of change and ST fluctuation, not keep ER at target level.
Elasticities approach
The focus on the impact of exchange rate changes on the total value of imports and on the total value of exports.
The trade deficit (surplus) must be offset by a surplus (deficit) in the capital account, by viewing the effects of change in exchange rate on capital flows that good flows.
A depreciation of currency will increase X and decrease M, ambiguously reducing trade deficit; its not the quantity of X & M, but total expenditure on M & X must change in order to affect trade deficit.
Absorption approach
To analyse the effect of change in exchange rate focus on capital flows.
