PT2 SU 8.3 Exchange Rates Systems and Calculations Flashcards
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What is the exchange rate?
The exchange rate is the price of one country’s currency in terms of another country’s currency.
What are the four systems for setting exchange rates?
Fixed rates, Freely floating rates, Managed floating rates, Pegged rates.
What is a fixed exchange rate system?
In a fixed exchange rate system, the value of a country’s currency is either fixed or allowed to fluctuate only within a very narrow range.
What is the advantage of a fixed exchange rate system?
The advantage is high predictability in international trade, eliminating uncertainty about exchange rate fluctuations.
What is a disadvantage of a fixed exchange rate system?
A disadvantage is that a government can manipulate the value of its currency.
What is a freely floating exchange rate system?
In a freely floating exchange rate system, exchange rates are determined entirely by the market forces of supply and demand.
What is the disadvantage of a freely floating exchange rate system?
A freely floating system makes a country vulnerable to economic conditions in other countries.
What is a managed float exchange rate system?
In a managed float exchange rate system, the government allows market forces to determine exchange rates but intervenes when necessary to maintain a broad range.
What is the advantage of a managed float exchange rate system?
The advantage is that it combines the market-response nature of a freely floating system with government intervention when necessary.
What is a disadvantage of a managed float exchange rate system?
The criticism is that it makes exporting countries vulnerable to sudden changes in exchange rates and lacks a self-correcting mechanism.
What is a pegged exchange rate system?
In a pegged exchange rate system, a government fixes the rate of exchange for its currency with respect to another country’s currency or a basket of currencies.
What is the spot rate?
The spot rate is the number of units of a foreign currency that can be received today in exchange for a single unit of the domestic currency.
What is the forward rate?
The forward rate is the number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at a future date.
What is a forward premium?
A forward premium occurs when the domestic currency exchanges for more units of a foreign currency in the forward market than in the spot market.
What is a forward discount?
A forward discount occurs when the domestic currency exchanges for fewer units of a foreign currency in the forward market than in the spot market.
How do you calculate the forward premium or discount?
Forward premium or discount = [(Forward rate - Spot rate) / Spot rate] x [(Days in year / Days in forward period)]
What is a cross rate?
A cross rate is used when two currencies are not stated in terms of each other, and the exchange is valued in terms of a third currency, often the U.S. dollar.
What does the demand curve for foreign currency represent?
The demand curve for foreign currency is downward sloping, as when the currency becomes cheaper, goods and services in that currency become more affordable, leading to higher demand.
What does the supply curve for foreign currency represent?
The supply curve for foreign currency is upward sloping, as when the currency becomes more expensive, it leads to more of the foreign currency being injected into the domestic market.
What does currency appreciation mean?
When one currency gains purchasing power with respect to another currency, it is said to have appreciated against that currency.
What does currency depreciation mean?
When one currency loses purchasing power with respect to another currency, it is said to have depreciated against that currency.
What happens when a currency depreciates?
When a currency depreciates, it leads to an increase in the cost of foreign goods and services, making imports more expensive.
What is the effective interest rate on a foreign currency loan?
The effective interest rate on a foreign currency loan is impacted by changes in the exchange rate, which affects the value of the interest and principal paid.
