Risk Management (1) Flashcards
If a company is exporting from, say, the UK to the US, and the US $ weakens from, say, $/£ 1.3 to $/£ 1.4?
Any exports from the UK will be more expensive when priced in $
Goods imported from the US will be cheaper in £
What is the spot exchange rate?
The market exchange rate for buying/selling the currency for immediate delivery
What is the forward exchange rate?
The exchange rate for buying or selling the currency at a specific date in the future
Differences in interest rates => Expected differences in inflation rates
Fisher effect
Differences in interest rates => Difference between spot and forward exchange rate
Expectations theory
Expected difference in inflation rates => Expected change in spot exchange rate
Purchasing power parity
Differences in interest rates => Expected change in spot exchange rate
International fisher effect
What is absolute PPP?
States that the exchange rate simply reflects the different cost of living in two countries
Disadvantage of absolute PPP?
They are of limited practical use in financial management
What is relative PPP?
The future spot exchange rate is based on the current spot rate and the inflation rate differential between the two currencies
What does interest rate parity state?
The forward exchange rate is based on the spot rate and the interest rate differential between the two currencies
What does PPP predict?
The future spot rate
What does IRP predict?
The forward rate
What happens according to the fisher effect?
Countries with a higher rate of inflation have higher nominal interest rates in order to offer the same real return as countries with low inflation
What is the concept of arbitage?
The forces of supply and demand would lead to a change in the forward exchange rate so that risk-free profit making was not possible
What is the forward rate?
The forward rate is an unbiased estimate of the future spot rate
What are the two principal parts of monetary transactions between a country and the rest of the world?
Current account
Capital account
What is current account?
Shows the net amount a country is earning if it is in surplus, or spending if it is in defic
What is capital account?
Records the net change in ownership of foreign assets and includes the foreign exchange market operations of a nation’s central bank
What is the main component of a current account?
The balance of trade, which is net earnings on exports minus payments for imports
How must any current account surplus (deficit) be balanced by?
A capital account deficit (surplus) of equal size
What does a rise in the value of a nation’s currency make its exports?
Less competitive and imports cheaper, with these effects tending to correct a current account surplus.
What does a fall in value of a nation’s currency cause?
Imports more expensive and increases the competitiveness of exports, and so helps to correct a deficit
What if a country exports more than it imports?
The demand for its currency will tend to increase. Extra demand tends to cause a rise of the currency’s price relative to others.
What if a country imports more than it exports?
The supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports
