Reading 20: Currency Exchange Rates

Question 1

Define an exchange rate & distinguish between nominal and real exchange rates and spot and forward exchange rates.

Answer 1

Exchange Rate- simply the price or cost of units of one currency in terms of another.

Real Exchange Rate- tells us the exchange rates for the purchasing of goods and services using the new current exchange rates

Real Exchange Rates= Nominal Exchange Rates/ (CPI Price/CPI Base)

Question 2

Describe functions of and participants in the foreign exchange market.

Answer 2

The participants can be Investors, Investment Banks, Banks, Govt Entities, Corporations, etc.

Question 3

Calculate and interpret the percentage change in a currency relative to another currency.

Answer 3

% change in currency =(new currency- old currency)/ (old currency)

Question 4

Calculate and interpret currency cross rates.

Answer 4

Currency cross rates are used when 2 countries are dealing with each other, but they do NOT trust each others currency and so they decide to hedge their risk with US Dollars.

They us dimensional analysis to convert a Mexican dollar into a base US dollar and an Australian dollar to base US dollar.

Then, they multiply to get get the ratio of Australian dollars/ mexican dollars. So then they can just pay that amount straight up and the other party can convert it for them.

Question 5

Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation.

Answer 5

A Forward Quotation/ Forward Exchange rate= “the current spot rate” + amount of points (each point is .0001)

Spot Rate = is the current conversion rate for exchange of a currency.

Points= points are added for an advanced rate for the amount of months or days in advance so its adjusted/ compensated.

Question 6

Calculate and interpret a forward discount or premium.

Answer 6

The Forward Premium is the premium % that is given from the forward quotation and the spot rate.

Forward Premium=
[(Forward Quotation- Spot Rate)/ Spot Rate]

Question 7

Describe exchange rate regimes.

Answer 7

Floating Exchange Rates- exchange rates that are determined by demand of foreign consumers and supply of foreign currency being exchanged for domestic goods/investments.

Managed Exchange Rates- these exchange rates are monitored and managed by the “central bank.” They have the corrected policy for what is a predetermined exchange rate.
**CENTRAL BANK never lets the exchange rate go below/above a certain level

Fixed Exchange Rates- “pegged” system; the value of a currency is FIXED AGAINST ANOTHER CURRENCY.

Question 8

Explain the effects of exchange rates on countries’ international trade and capital flows.

Answer 8

We look at 2 approaches to see the effect of exchange rates on countries’ international trades(accounts balance) and capital flows (capital balance):

1. ) Elasticity Approach (Marshall-Lerner Approach)
   a. ) If the PED for goods is greater than 1, than a DECREASE in the exchange rate for a foreign countries currency will actually cause an increase in exports and a decrease in imports (IMPROVEMENT OF ACCOUNT BALANCE).

b. ) if PED <1 then it will lead to a worsening of the account balance (X-M).
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2. ) Absorption Approach- absorption approach is based on GDPexp=GDPinc equation.

X-M= (S-I) +(T-G)
Current Account Balance = Capital Account Balance

*****If left hand goes down, then right hand goes down!!!