Section 4 - Exchange rates Flashcards
how does the foreign exchange rate market behave?
Like other markets with downward-sloping demand curves and upward-sloping supply curves
what is the balance of payments in terms of exchange rates?
a formal and systematic record of transactions between the residents of one country and the rest of the world
what are the different versions of the balance of payments? and explain these
- current account refers to the cross-border flow of goods, services and other net income from abroad
- capital account involves the flows of transactions in financial assets
- visible trade is trade in goods
- invisible trade refers to flows of services
what must the overall balance of payments sum to and when?
sum to zero once government intervention is included
if domestic residents are exporting more than they are importing then….
they must be increasing their holdings of foreign assets
what is a floating exchange rate?
the value of a county’s currency fluctuates with market forces
the market sets the exchange rate
what is a fixed exchange rate
the government manipulates the value of the countries currency
try to keep exchange rate fixed or in some form of range
what is an optimal currency area OCA
a geographic region created to maximise a region’s economic efficiency through use of a single currency.
what is the intention of an OCA
intended to allow for closer integration of capital markets and facilitate trade between countries within it.
what may countries with close economic ties benefit from?
- a common currency area
- reduced transaction costs for inter-country trade within the OCA
- enhanced sale of production leading to scale economies with larger ‘domestic market’
what does a common currency result in in terms of loss
loss of each country’s ability to direct fiscal and monetary policy interventions to stabilise its own economy
what are the conditions generally considered to be essential for a successful currency union
- labour should be fully mobile between countries, with few meaningful barriers. Different languages and pension schemes for example would be considered barriers
- capital should be able to move between countries with no restrictions
- if labour and capital are not fully mobile; then a risk-sharing mechanism (such as an automatic fiscal transfer scheme) should be available to redistribute income to less well off regions
- countries should have similar business cycles so that the central bank can set a single interest rate appropriate to all countries. This could happen if some countries were experiencing a boom whilst others were in a slump
what is exchange rate risk?
uncertainty in the return on a foreign investment due to the uncertainty in the rate that domestic currency can be exchanged for foreign currency.
does the FOREX market have a physical presence?
no
what is the FOREX market
market for foreign exchange
who are final customers of the FOREX market?
- corporations requiring foreign currency, for example, to purchase foreign inputs to their production process, or which wish to exchange foreign currency earned through the export of their goods for domestic currency
- financial institutions wishing to buy foreign financial assets
- private individuals who may wish to purchase foreign currency, such as for a holiday abroad
how are participants of forex linked and who are the 300 participants
linked via computers
The market makers are the major international banks who also trade on their own behalf. Some participants act only as brokers dealing on behalf of their clients
what type of market is FOREX?
continuous dealers marker
where do foreign exchange transactions on the FOREX market that are for immediate delivery of foreign currency take place?
on the spot market
when are transactions on the spot market usually settled?
T+2 days - but this may be extended for example when one of the foreign currency markets has a bank holiday
in the spot market what will currency market makers quote?
two spot prices
- the lower rate is the bid price - price they are willing to buy sterling
- the higher rate is the rate at which they are willing to sell sterling - ask price
the difference between these two rates is the market makers spread, which is how they generate their profit.
when is the forward rate said to be trading at a premium?
if the forward price of the currency is higher than the spot price
what is a forward market transaction?
an agreement to buy currency at a future date and at. fixed price agreed now
when is the forward rate said to be trading at a discount?
when the currency’s spot price is higher than its forward rate
an increase in domestic interest rates will tend to cause that country’s currency to…………
appreciate
a decrease in domestic interest rates will tend to cause that country’s currency to…………
depreciate
if the UK raises interest rates how will this affect demand for sterling?
and what would this cause?
will increase demand for sterling
meaning investors can take advantage
what is Covered interest rate parity
Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.
what is uncovered interest rate parity
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.
