Part B: Foreign Exchange Market

Question 1

Functions of foreign exchange markets (3)

Answer 1

Transfer PP from one nation and currency to another.

Provide credit for foreign transactions

Provide facilities for hedging and speculation

Question 2

When does demand for currency arise (when we need foreign currency)

Answer 2

Tourists visit another country

Import

Invest abroad

Question 3

Where does supply of currency arise from (3)

Answer 3

Foreign tourist expenditures

Export earnings

Foreign investments coming here

(Since we supply currency for the foreigners)

Question 4

Who participates in the FEM (6)

Answer 4

Tourists

Exporters/importers

Investors

Commercial banks

Foreign exchange brokers

Central banks

Question 5

Commercial banks function

Answer 5

Serve as clearinghouses for currency exchange

Question 6

Foreign exchange brokers

Answer 6

Clearinghouse for surpluses and shortages between the commercial banks

Question 7

Central banks function

Answer 7

Buyer or seller of the last resort in the FEM

(Buy domestic currency to appreciate, sell domestic currency to depreciate)

Question 8

3 aggregative prices in open economy model

Answer 8

Domestic prices P
Foreign prices P*
Relative price of foreign exchange S (converting P into P*)

Question 9

Assume only two economies, the United States and
the European Monetary Union.
Domestic currency = dollar ($)
Foreign currency = euro (€)

What is S (exchange rate)

Answer 9

S = $/€

The number of dollars needed to purchase one euro

Question 10

What is S determined by in a flexible exchange system

Answer 10

Supply and demand for the currency.

Question 11

Pros/cons of fixed exchange rate system (1,2)

Answer 11

Pros: Future rates are known.

Cons:
Government can just revalue their currencies

Countries are also vulnerable to economic conditions in other countries

Question 12

Freely floating exchange rate pros cons (2, 2)

Answer 12

Insulation - from problems of other countries (unlike
Government not constrained by the need to maintain a fixed rate when considering new policies.

Less capital flow restrictions, improved market efficiency.

Cons:
May need substantial resources to manage exchange rate fluctuations.

The country that experiences problems may have its problems compounded.

Question 13

Managed float

Answer 13

Exchange rates can move freely daily, however government can intervene to prevent rates moving too much to stabilise.

Question 14

Con of managed float

Answer 14

Government may manipulate its exchange rates such that its own country benefits at the expense of other countries.

Question 15

Pegged exchange rate and example

Answer 15

Fixed to another currency. (Usually US as most stable)

Pesos to USD

Question 16

Currency board, and example

Answer 16

Pegging value of local currency to some other specified currency.

E.g HKD $7.80:$1 USD ALWAYS

Question 17

Difference between currency board and pegged (4)

Answer 17

Currency board - domestic currency is 100% backed by foreing currency. (Basically eliminating independent monetary policy.

A peg requires active management - currency board is automatic.

Currency board loses independent M.P so increased exposure to shocks from anchor.

Loss of money creation and lender of last resort

Question 18

Dollarization

Answer 18

Replacement of a country’s currency with US dollars

Question 19

Why may they do this?

Answer 19

If hyperinflation, so abandon local currency.

Question 20

Pros and cons of dollarization (1,3)

Answer 20

Avoids possibility of speculative attack on domestic currency

Loss of independent monetary policy

Increased exposure to shocks from anchor country

Inability to create money and act as a lender of last resort

Question 21

Direct vs indirect quotations

Answer 21

Direct quotations - value of a foreign currency in terms of the home currency (basically where the home currency
≉1)

Indirect quotations represent the number of units of a foreign currency per unit of home currency

Question 22

Example: With the £ as the home currency
£0.625:$1 is called a ‘direct quote’ i.e. like the price of
any other ‘product’.

This is the same as
$1.6 to the £1’ or $1.6:£1 which is called an ‘indirect quote’

Question 23

Banks provide foreign exchange services for a fee: how is this expressed

Answer 23

Bid ask spread = ask rate - bid rate / ask rate

Their ask (sell) price will be greater than bid (buy) price to make profit

Question 24

What is the cross exchange rate?

Formula? Assume dollar is the home currency

Answer 24

When exchange rate for 2 currencies against the dollars exist, we can then find the exchange rate between them.
(NOTE IT IS IMPLIED EXCHANGE RATE)

S = $ value of currency 1 / $ value of currency 2

Question 25

1. Suppose $/€ exchange rate is $1.25 and the $/£ exchange rate is $2. 2. Canadian dollar was worth £0.43. You still have C$200 from your trip and could exchange them for pounds at the airport, but the airport foreign exchange desk will only buy them for £0.40. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for £0.055 per peso. You met a tourist who is willing to buy your C$200 for 1,500 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.

Answer 25

S = euro/£ = 2 / 1.25 = 1.6

Question 26

Effective exchange rate

Answer 26

A weighted average of the exchange rates between the domestic currency and the nation’s most important trading partners.

Question 27

Arbitrage

Answer 27

Purchase one currency for immediate resell in another market. (Similar to derivatives where buy in low price to sell in high price market)

Question 28

Balance of payments

Answer 28

Records transactions between one country and the rest of the world

Question 29

Main purpose of balance of payments

Answer 29

Help government in their monetary, fiscal and trade policies

Question 30

Spot and forward exchange rate

Answer 30

Spot - current exchange rate that calls for payment and receipt within 2 business days from the transaction date Forward - exchange rate that calls for delivery of the foreign exchange in future, after contract is signed.

Question 31

Forward discount

Answer 31

The percentage by which the forward rate is below the spot rate (per year)

Question 32

Forward premium

Answer 32

The percentage per year by which the forward rate is above the spot rate

Question 33

Forward discount or Forward premium formula

Answer 33

FR - SR / SR x 100

Question 34

If the spot rate is $2 = £1 , 3-month forward is $1.98 = £1 Is the pound at a 3-month premium or discount? And by how much?

Answer 34

1.98 - 2 / 2 x 100 = -1% so forward discount. If want to annualise x 4 to (since forward is 3 month)

Question 35

Currency swap

Answer 35

A spot sale of a currency combined with a forward repurchase of the same currency – as part of a single transaction. (LOOK PG41) (Opposite of covered interest arbitrage where we buy spot and sell forward to remove FER)

Question 36

Why engage in currency swaps

Answer 36

Combined transactions treated as one saves transaction costs. Good if don’t need to hold money for that period so sell and then buy as a future

Question 37

Currency futures: how the futures market differ from the forward market (3)

Answer 37

Futures - only few currencies traded (FORWARD ANY) Futures are in standardised contracts Futures are for smaller amounts

Question 38

Currency options

Answer 38

Contracts giving the purchaser the right, but not the obligation, to buy (call option) or to sell (put option) a standard amount of a traded currency on a stated date (European option) or any time before the date (American option) at a stated price

Question 39

Foreign exchange risks - how do they arise (3)

Answer 39

Because spot rates vary overtime Transactions exposure Translation exposure

Question 40

Business’s risk attitude and what do they do in response to foreign exchange risk?

Answer 40

Risk adverse - so they insure against foreign exchange risk

Question 41

Transaction exposure vs translation exposure

Answer 41

Transaction exposure is from transactions involving future payments and receipts in a foreign currency. Translation exposure is inventory/assets held abroad in terms of domestic currencies.

Question 42

When do contracted future foreign currency payments may become more expensive? (pay money to overseas)

Answer 42

If domestic currency depreciates Since costs more domestic currency to pay for the payment which is to be paid in foreign currency. A contract requires £100,000 payment in 3 months. Assume US to be home currency, so as dollar depreciates (needs more dollar for pound), cost would now be E.g used to be $1:£1 so dollar cost is $100,000 for £100,000, now $1.20:£1 so costs $120,000 for £100,000

Question 43

When do contracted future foreign currency receipts fall? (receive money from overseas)

Answer 43

If domestic currency appreciates. If US producer expects to receive £10000 payment if currently $1:£1, expected receipt is $10000 If changes to $0.90:£1, expected receipt is $90000. Sounds obvious - we dont want our domestic currency to appreciate since we will receive less since the foreign currency we get is now worth less. We want foreign currency to appreciate since whatever amount that is made (in foreign currency) will buy more home currency than before

Question 44

Hedging aim

Answer 44

Avoid exchange rate risk

Question 45

3 ways to hedge, and evaluations for 2nd and 3rd

Answer 45

1. Buy at current spot , let funds earn interest until needed. 2. Buy a forward contract Eval: May pay forward premium, increasing cost of transaction. 3. Buy a call option Eval: If not exercised, the premium is lost.

Question 46

Speculation

Answer 46

Acceptance of foreign exchange risk in the hope of making a profit (Sell while strong expecting it to fall and repurchase)

Question 47

2 types of speculation

Answer 47

Stabilising speculation - purchase foreign currency, when price falls, expecting to rise. Or sale of currency when price is high, expecting it to fall. (Like last example) Destabilising speculation - sale when low, expecting it will fall even lower. Or purchase currency when high, expecting it to rise even higher.

Question 48

Where are currency futures sold on?

Answer 48

International monetary market (IMM)

Question 49

Stabilising vs destabilising speculation

Answer 49

Stabilising moderates fluctuations in E.R Destabilising magnifies fluctuations in E.R, which can disrupt international trade & investment

Question 50

Assume that SR = $2/£1 and the three-month FR = $1.96/£1. a. how can importer who will have to pay £10,000 in three months hedge the foreign exchange risk? b. Indicate how an exporter who expects to receive a payment of £1 million in three months hedges the foreign exchange risk.

Answer 50

American importer would purchase forward of £10000 (costs 19600 in dollars using the forward rate), so after 3 months he will pay the $19600 and receive £10000 to make the payment Exporter would sell forward, so receives £10000 as $19600 after 3 months

Question 51

Assume that SR = $2/£1 and the three-month FR = $1.96/£1. a. how can importer who will have to pay £10,000 in three months hedge the foreign exchange risk? b. Indicate how an exporter who expects to receive a payment of £1 million in three months hedges the foreign exchange risk.

Answer 51

A) buy forward at $1.96:£1 - they have to pay £10,000 , so at SR costs £20,000, but FR costs 19600 so cheaper so buy. B) sell forward

Question 52

FR = $2.00/£1 and speculator believes in 3 months SR = $2.05/£1. a. How can a person speculate in the forward market? Speculator believes in 3 monthsSR = $1.95/£1 b. How can he speculate in the forward market? c. What will the result be if in three months SR = $2.05/£1 instead?

Answer 52

A) buy forward at $2:1 , and if belief is true, makes $0.05 per dollar. B) sell forward as believes spot rate falls. Makes $0.05 per dollar C) They sold forward at $2, but it has gone up to $2.05 so lose $0.05 per dollar