PT2 SU 8.4 Exchange Rate Factors and Risk Mitigation Flashcards
What are the five factors that affect currency exchange rates?
Three trade-related factors (relative inflation rates, relative income levels, government intervention) and two financial factors (relative interest rates, ease of capital flow).
What happens to a country’s currency when its inflation rate rises relative to others?
Demand for the currency falls, supply increases, and its value depreciates.
How does an increase in a country’s income levels affect its currency?
Citizens buy more foreign goods, increasing demand for foreign currency and causing the local currency to depreciate.
How does government intervention affect exchange rates?
Government actions like trade barriers and currency controls can influence or distort exchange rate movements.
What happens to a currency when a country’s interest rates rise relative to others?
Demand for the currency increases, supply decreases, and its value appreciates.
Why is ease of capital flow a major factor in exchange rate determination today?
Fast electronic capital movements and large transaction volumes dominate trade-related factors.
What does Interest Rate Parity (IRP) theory state?
Forward premiums or discounts offset interest rate differences between countries.
What does Purchasing Power Parity (PPP) theory explain?
Exchange rates reflect inflation rate differences between countries.
What does International Fisher Effect (IFE) theory predict?
Changes in exchange rates result from differences in real and nominal interest rates.
Do exchange rate theories consider only one factor or multiple factors in practice?
In practice, multiple factors affect exchange rates.
What dictates long-term exchange rate movements?
Relative price levels based on purchasing power parity (PPP).
What dictates medium-term exchange rate movements?
Economic activity (e.g., recessions, booms) affecting imports and exports.
What dictates short-term exchange rate movements?
Interest rates and inflation expectations.
What is transaction exposure?
Risk arising from foreign-denominated payables or receivables.
What is the downside risk for a foreign-denominated receivable?
The foreign currency might depreciate.
What is the downside risk for a foreign-denominated payable?
The foreign currency might appreciate.
What happens if a foreign currency depreciates before a receivable is collected?
The firm receives fewer units of its domestic currency.
What happens if a foreign currency appreciates before a payable is settled?
The firm must pay more domestic currency to buy the foreign currency.
What is the main purpose of hedging in foreign exchange?
To reduce uncertainty, not to speculate.
What is a hedge for a foreign-denominated receivable?
Sell the foreign currency forward to lock in a definite price.
What is a hedge for a foreign-denominated payable?
Buy the foreign currency forward to lock in a definite price.
What happens in a hedge if exchange rates move favorably after locking in a forward rate?
The firm sacrifices potential extra profit to avoid possible loss.
How can a firm manage net receivables and payables?
By maintaining a near-zero net position in each foreign currency.
What is a money market hedge for a receivable?
Borrow foreign currency now, convert it to domestic currency, and repay when the receivable is collected.
